Factbox: Naked swaps, flash trading and other key terms

(BestGrowthStock) – The proposed overhaul of the country’s regulatory system and recent market volatility has introduced a slew of new words into the lexicon of the American public.

Here is a glossary of some of the jargon used by lawmakers, lobbyists, securities and futures regulators and others:

ALGORITHMIC OR AUTOMATED TRADING – using computers to enter trading orders, with the computer programs determining the time of submission, the price and the quantity. It is often executed without human intervention. Algorithmic trading is utilized by a variety of market participants, most notably by executing brokers to facilitate customer orders as well as by high frequency traders making markets in individual futures contracts or securities.

Commodity Futures Trading Commission Chairman Gary Gensler said last week the unexplained plunge May 6 and the rise of algorithmic trading necessitate a review to determine if further protections are needed in fast-paced, computer-driven markets.

CLEARINGHOUSES – the middle man between buyers and sellers of exchange-traded derivatives. They guarantee parties can meet their obligations by requiring them to post margin, or collateral.

Clearinghouses are sometimes part of an exchange such as the IntercontinentalExchange (ICE.N: ) and the CME Group Inc (CME.O: ), which handle credit default swaps. Exchanges have sprinted to launch clearinghouses for OTC products, since the crisis. Clearinghouses also can be freestanding entities.

The CFTC’s Gary Gensler has pushed for standard OTC derivatives to be traded on public platforms, such as exchanges, as well as cleared through clearinghouses to reduce risks of failure.

CREDIT DEFAULT SWAPS – a type of derivative used to protect against the risk of debt default. The buyer pays the seller an agreed sum each quarter, and in the event of default — such as bankruptcy — is paid the amount of debt insured by the seller.

One trade group estimated the CDS market was worth $36 trillion last year, an increase from $630 billion in 2001.

The swaps have been blamed for amplifying concerns about corporate and sovereign credit quality, and came under fire in the government bailout of U.S. insurer AIG (AIG.N: ), which took out-sized positions on risky assets such as subprime mortgages, without having enough capital to back up the contracts.

CO-LOCATION – allows traders to place their computer systems next to exchange servers, giving them the ability to execute strategies at lightning-fast speed through computer algorithms.

These market participants — sometimes called high-frequency traders — may include banks, hedge funds, and independent proprietary trading firms that are very sensitive to delays in sending orders to the electronic markets.

Critics charge that these traders who co-locate their servers receive an unfair advantage by getting an earlier look at market data, and a speed advantage in submitting orders. Its defenders say there is little evidence of unfair advantages.

Rapid trading, estimated to account for some 40 percent in U.S. futures volume and 60 percent of cash equities, was one of the most profitable lines of business throughout the financial crisis.

DERIVATIVES – contracts that derive their value from commodities, financial instruments, events or conditions. Bought and sold on regulated exchanges or bilaterally through over-the-counter dealers. Used for hedging and speculating — but not generally used to directly buy or sell the products on which they are based. In the United States, on-exchange derivatives are called futures.

END USERS – the final recipient of a product, such as utilities, processors and manufacturers. End users that count on using OTC contracts to hedge their risk have been lobbying Congress for exemptions from new clearing requirements because they say posting margin would hurt them. They commonly pledge noncash assets as collateral in their OTC deal-making.

ENRON LOOPHOLE – allows futures contracts to be traded on exempt electronic platforms, like the IntercontinentalExchange (ICE.N: ) Inc, with little government oversight, unlike the heavily regulated New York Mercantile Exchange, which is owned by CME Group Inc (CME.O: ). Congress had empowered the CFTC to look at contracts to close the loophole.

FLASH ORDERS – Stock exchanges send buy or sell orders to a select group of traders fractions of a second before revealing them publicly. Critics say flash orders give some traders an unfair advantage over others.

HEDGING – a position taken to offset exposure to price fluctuations, or risk, in the cash or physical market. Hedging can be done through exchange-traded futures and options, over-the-counter derivatives, or insurance policies.

For example, corn farmers wanting to “lock in” a price for their crop ahead of harvest could sell corn futures that would establish they deliver a fixed number of bushels at a fixed price and a certain date in the future. They would then offset their position by buying futures when they deliver their physical crop.

HIGH-FREQUENCY TRADING – banks, hedge funds and proprietary firms use computer algorithms to buy and sell shares at lightening speed. They use high frequency trading to exploit minute movements in stock prices and quickly trade huge blocks of stock through complex computer algorithms.

The rapid trades account for an estimated 60 percent of all U.S. stock trading.

Major U.S. exchanges defended high-frequency trading this week, which has been blamed for exacerbating the brief market plunge on May 6. Supporters say high frequency trading keeps markets liquid. Critics say high frequency traders have an unfair advantage over retail investors.

NAKED SWAP – involves selling a call or put option to a buyer who does not hold the underlying security and therefore has no risk exposure to the instrument. A naked CDS contract is typically a bet taken by investment firms such as hedge funds that the bond will end up on the rocks.

OVER-THE-COUNTER – also known as off-exchange, OTC trading is a transaction for bonds, stocks, commodities or derivatives that occurs between two parties with specific details on how the agreement will be settled at some point in the future.

The CFTC estimates the market is worth $300 trillion in the United States alone, but others estimate it at $450 trillion.

The market is not regulated. Congress plans to change that after certain types of OTC derivatives were blamed for helping accelerate the recent financial crisis.

Some have estimated up to 80 percent of OTC derivatives are standardized and could trade on exchanges or public platforms. The rest are highly customized to the particular needs of the buyer.

POSITION LIMITS – a cap or limit on the number of futures contracts that can he held in a particular commodity. The CFTC proposed in January a crackdown on excessive speculation in energy trading by restricting the holdings of big players. . It also is considering similar curbs in the metals arena.

Gensler, under mounting political pressure, has pledged to be more aggressive on position limits. But the industry has lobbied against them, and some of the five CFTC commissioners are worried limits could push speculators to unregulated or overseas markets.

SWAPS – the exchange of one asset or liability for a similar asset or liability for the purpose of lengthening or shortening maturities, or otherwise shifting risks. Swaps, which are usually traded OTC, have grown in popularity as a way to avoid big ticket margin calls on futures exchanges while still obtaining a hedge for bank financing.

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(Sources: CFTC, Reuters stories)

(Compiled by Christopher Doering; Editing by Alden Bentley)

Factbox: Naked swaps, flash trading and other key terms