Derivatives regulations aim to increase transparency in trading complex securities, with the SEC and CFTC enforcing rules in the US. Policymakers call for further protection for larger companies, while evolving regulations limit banks’ use of proprietary trading to minimize financial failures.
Financial regulation around the world continues to evolve through changing economic conditions. Following a financial crisis, for example, as happened in 2008 and 2009, stricter regulations were increased for all financial markets, including regulations on derivatives. Derivatives regulations are largely about transparency in the trading of these complex securities which are sometimes used by professional managers, such as hedge fund managers, who adhere to only light regulation in the financial markets.
Derivatives are sophisticated financial instruments that allow traders to speculate on the prices of stocks and commodities, for example. Investors use derivatives in an attempt to hedge against price swings in other trading positions due to changes in interest rates or commodity prices. In the United States, there are two major governing bodies that enforce derivatives regulations, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Derivatives regulation gives the SEC the authority to oversee financial instruments, known as swaps, based on securities, while the CFTC oversees the trading of most other financial swaps. The value of derivatives is based on the price of other financial securities, and a swap is a contract containing a commitment to buy or sell a security at a pre-determined price at a future point in time.
As regulation of derivatives continues to evolve, some policymakers are calling for different requirements that would further protect some of the larger companies that trade these securities. For example, in the United States, some companies may be required to place certain financial guarantees against all derivatives trades executed on over-the-counter (OTC) markets, which is an informal trading platform where prices they can be opaque. Industry practitioners continually argue that the more derivatives are regulated, the more likely traders are to choose to execute these transactions in other regional markets.
Financial institutions, including some insured by a regional government, have historically invested from company balance sheets in an effort to generate profits at these banks in an activity known as proprietary trading. Evolving derivatives regulations limit the money that banks can use to trade these risky securities in an effort to minimize any financial failures that could affect not only the financial institution, but potentially the broader financial markets. Some regulators prefer derivatives to be traded on official exchanges rather than OTC markets because the values of the securities are more transparent in the former, but there is no general regulation on these parameters.
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