Over the Counter Derivatives Regulation

The derivatives markets all over the world have been under fire after the 2008 crisis. There is increasing clamor and an increasing number of people are asking for the regulation of derivatives. In this article, we will study about the efforts undertaken to bring about this regulation as well as the challenges that are faced by such regulation.

The No Regulation Point of View

The modern day derivatives were introduced into the financial system around the 1980’s. However, derivatives have not faced any meaningful regulation ever since. The over the counter derivatives markets have eluded regulation for over three decades. The reasons that they gave for eluding this regulation are as follows:

  • The first and foremost point given in the favor of non regulation was that derivatives markets are for wealthy and sophisticated investors. It is the common retail investor that needs protection. This is because retail investors often do not know the intricacies of the deal that they are getting into. The sophisticated investors on the other hand are well versed with the products and with the marketplace. Hence these sophisticated investors are good enough to look out for themselves. Therefore, the derivatives market needs no regulation.

  • The second reason given to avoid regulation was that the whole process was unnecessary. This is because the institutions offering derivatives were already heavily regulated. Hence bringing in regulation for derivatives would be duplication of effort and wastage of money since the same institutions would be regulated at two levels. However, time provide that this was not the truth. The banking and insurance companies that usually traded in derivatives products were indeed regulated. However, their subsidiaries which did offer derivatives products were not regulated.

  • Thirdly, it was believed that derivatives were way to be complicated to be brought under some sort of common exchange and be standardized. Stocks are fungible i.e. each and every stock of the same company can be exchanged for another. This is not the case with over the counter derivatives and hence centralized clearing maybe very difficult, if not outright impossible to achieve.

  • Fourthly, it was believed that all the participants in the derivatives markets are self interested. They are therefore aware of the counterparty risks. Hence, they will insist on credit quality i.e. sound credit backing for a product from an entity or via collateral. However, this also turned out to be false in the 2008 crisis.

  • Lastly, the derivatives players played the countries off against each other when trying to avoid regulation. Their rhetoric was that the derivatives markets in other parts of the world are not regulated and hence if any single country were to go ahead with this regulation, they would simply end up ruining their market and exporting the same abroad to other countries which offer a more conducive environment.

All the reasons that were used by the derivatives markets to avoid regulation had simply fallen apart during the period of crisis. It was during this time that the voices to increase the regulation started being raised one more time.

Why Regulation is Required in Derivatives Markets ?

The first question that arises is that banks, insurance companies and other financial services companies that offer derivatives are under regulations that mandate them to have minimum capital requirements met. Then why is that more regulation is required for derivatives markets?

There are two primary reasons for this:

  • Firstly, the exotic derivatives products that have been created in the recent past do not have any regulation. The regulators were simply not able to foresee such products being created and as such regulation failed to deliver

  • Secondly, the minimum capital rules have certain complex provisions which can be circumvented using derivative products like credit default swaps etc

Therefore, the regulation of derivatives markets in the world is a much needed phenomenon.

Why is Regulation Challenging ?

The biggest challenge facing derivative regulation is the complexity of the products being offered. In most countries where any form of legislation has been enforced on derivatives, it is suboptimal and non transparent. This is because the regulators have to understand complex products and the complex models that are used to value these products at different time intervals. Once these models are created, the difficulties related to collating of data in the over the counter market also arises. Then the regulators would be expected to undertake real time measures to prevent any crisis from arising. All these factors combine to make regulation of derivatives so challenging.

Proposed Regulations for Derivatives

Some of the proposed measures for regulating derivatives are as follows:

  • Reporting: Critics want to ensure that all the derivatives being traded are reported to a central body. By using this information they can obtain data regarding the buildup of systemic risk because of the risky behavior of a single institution or a group of institutions. They believe that reporting is the single best way of avoiding a systemic crisis.

  • Clearing: The regulators also want all the derivatives transactions to be routed via an exchange or some central body wherein their clearing is done centrally. This would once again utilize the exchange mechanism of margin money and prevent the collapse of entities which pose systemic risks.

The regulation of derivatives is thus a burning issue. However, there is a lot of complexity that needs to be surmounted before anything meaningful is achieved. At the present moment, the achievements are negligible.

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