Derivative Markets and Financial Risk
Financial Economists Roundtable
Statement on Derivative Markets and Financial Risk
September 26, 1994
Observers recently have expressed heightened concern that derivatives may undermine the stability and efficiency of our financial markets and institutions. Firms increasingly are using forwards,futures, options and swaps, and various combinations of these fundamental derivative instruments both to manage or reduce risk and to increase returns. Current concern about derivatives centers on the expanding use of customized off-exchange (or OTC) derivative instruments, the largest component of which are interest rate and currency swaps. Although acknowledging that the growth of derivatives isa reflection of the market's demand for better instruments with which to manage risk, both the Congress and regulators remain uneasy about the misuse of derivative instruments and the potential consequences that might flow from a major default in derivatives markets. This concern, no doubt, partly stems from the sheer size of derivatives markets in general and to the ballooning OTC derivativesmarket in particular. The General Accounting Office (GAO) reports that at year-end 1992 the notional value of outstanding futures, forward, options and swap contracts alone totalled more than $17 trillion, up from $7 trillion in 1989. Another reason for concern about derivatives is the seemingly impenetrable complexity of some of these instruments. This complexity has created an aura of mystery aboutderivatives markets, and has fostered a fear that a miscalculation by someone, or an undetected but vital flaw in the market or regulatory system, could trigger failures cascading into a financial market meltdown. Several studies of OTC derivatives markets in the last few years by the Bank for International Settlements (the "Promisel" Report), the Bank of England, the Group of Thirty, the Officeof the Comptroller of the Currency, the Commodity Futures Trading Commission, and the Government Accounting Office reflect these concerns. The GAO Report, the latest of these, contains the most provocative policy recommendations. The GAO Report recommends additional regulation of both derivatives dealers and end-users of derivatives. The study concludes that OTC derivatives could pose a systemicrisk to financial markets if a major OTC dealer were to default on its counterparty (or contractual) obligations. It also finds that certain "unregulated" dealers, such as those affiliated with securities and insurance firms, have created a potentially dangerous "regulatory gap" that needs closing. The Report recommends bringing these dealers under federal government supervision and imposing onthem capital adequacy standards similar to those now imposed by federal regulation on bank OTC derivatives dealers. In addition, the GAO Report recommends that the Congress give the Securities and Exchange Commission (SEC) power to oversee the use of derivatives by all major end-users of complex derivative instruments. Finally, the Report calls for improved accounting and disclosure principles forderivatives for both dealers and end-users and recommends market-value accounting for all financial instruments, but stops short of spelling out how it can be implemented. In response to the GAO Report, Rep. Edward Markey (D., Mass.) has introduced legislation that would require unregulated derivatives dealers, such as those affiliated with securities and insurance companies, to register with theSEC. The SEC would set capital and other standards for these dealers, conduct inspections or examinations of the dealers, and receive periodic financial reports from them. In addition, by amending the definition of the term "security" to include derivatives based on the value of any security, this bill would enlarge the SEC's regulatory purview. Other proposed legislation, introduced by Rep. Henry...
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