Derivatives regulations aim to increase transparency in trading complex securities, but some policymakers want further protection for large companies. The SEC and CFTC enforce derivatives regulations in the US, and some call for collateral requirements for OTC transactions. Regulations limit banks’ ability to use their balance sheets for private trading.
Financial regulation around the world continues to evolve through changing economic conditions. Following a financial crisis, for example, as was the case in the period 2008 and 2009, stricter regulation was increased for all financial markets, including regulations on derivatives. Regulations on derivatives are primarily about transparency in trading these complex securities that are sometimes used by professional managers, such as hedge fund managers, who adhere to only light regulation in financial markets.
Derivatives are sophisticated financial instruments that allow traders to speculate on the prices surrounding stocks and commodities, for example. Investors use derivatives in an attempt to hedge against price fluctuations in other trading positions due to changes in interest rates or commodity prices. In the United States, there are two main government bodies that enforce derivatives regulations, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Derivatives regulation places the authority to oversee financial instruments, known as swaps, which are based on securities, with the SEC, while the CFTC oversees trading in most other financial swaps. The value of derivatives is based on the price of other financial securities, and a swap is a contract that contains a commitment to buy or sell a security for a predetermined price at a future time.
As derivatives regulation continues to evolve, some policymakers are calling for different requirements that would further protect some of the largest companies that trade these securities. For example, in the US, certain corporations could be required to post some financial collateral against all derivative transactions executed on the over-the-counter (OTC) markets, which is an informal trading platform where prices can be opaque. . Industry participants continually argue that the greater the derivatives regulations, the more likely it is that traders will choose to conduct these transactions in other regional markets.
Financial institutions, including some that are insured by a regional government, have historically invested from the company’s own balance sheets in an attempt to turn a profit on these banks in an activity known as private trading. The evolution of derivatives regulations limits the money that banks can use to trade these risky securities in an attempt to minimize any financial failure that could affect not only the financial institution but also the broader financial markets. Some regulators prefer derivatives to be traded on formal exchanges rather than OTC markets because securities values are more transparent on the former, but there is no general regulation on these parameters.
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