Financial regulation around the globe continues to evolve through changing economic conditions. In the wake of a financial crisis, for instance, as was the case in the 2008 and 2009 time period, stricter regulation for all of the financial markets, including derivatives regulations, were increased. Derivatives regulations are largely about transparency in the trading of these complex securities that are sometimes used by professional managers, such as hedge fund managers, who adhere only to light regulation in the financial markets.
Derivatives are sophisticated financial instruments that allow traders to speculate on prices surrounding stocks and commodities, for instance. Investors use derivatives in attempts to protect against price swings in other trading positions due to interest rate or commodity price changes. In the U.S., there are two primary governing 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 securities based, with the SEC, while the CFTC oversees the 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 containing a commitment to buy or sell a security for a predetermined price at a future time.
As derivatives regulation continues to evolve, some policy makers call for different requirements that would further protect some of the largest companies that trade these securities. For instance, in the U.S., certain corporations could be required to place some financial collateral up against all derivatives trades that are executed in 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 traders will opt to perform these transactions in other regional markets.
Financial institutions, including some that are insured by a regional government, have historically invested from the firm’s own balance sheets in attempts 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 attempt to minimize any financial failure that could hit not only the financial institution but potentially the broader financial markets. Some regulators prefer that derivatives be traded on formal exchanges as opposed to the OTC markets because securities values are more transparent in the former, but there is no blanket regulation on these parameters.