While affirming the importance of the estimated $12 trillion market in financial derivatives, a government study released Wednesday found “significant” gaps in regulating that fast-growing business.
Much of the 196-page report by the General Accounting Office focused on so-called over-the-counter derivatives traded by a network of banks, securities firms and insurance companies, as opposed to those traded on exchanges such as the Chicago Board of Trade and the Chicago Mercantile Exchange.
The report, commissioned two years ago by Congress, said much of the off-exchange derivatives activity in the U.S. is concentrated among 15 big dealers that are linked to one another and to derivatives users and the exchange markets.
It raised the possibility that failure or abrupt withdrawal from trading of any of the big dealers could “pose risks to the others, including federally insured banks and the financial system as a whole.”
On its most basic level, a derivative is simply a financial tool that “derives” its value from the value of something else, such as a commodity, a currency, a stock or a bond.
The derivative, however, requires far less upfront cash to acquire. It can be used to bet on a favorable price move in the underlying item or as insurance against an unfavorable move. Some derivatives are traded on exchanges; others exist only between participants in the deal.
A futures contract to buy corn is a derivative. So is an option to buy IBM stock. If the current price of corn changes, the contract’s value changes with it. If the price of IBM stock changes, the option’s value changes, too.
Companies and big banks and brokers often use derivatives to protect themselves against unexpected changes in interest rates. To do so, they will “swap” the interest payments they make on huge debts.
One side has a fixed rate, the other an adjustable one. And, as with a home mortgage, the value changes with current rates. In swapping payments, the players in this game have different expectations of where they expect rates to go and want to bet on or hedge their forecasts.
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A well-fashioned derivatives strategy, supporters say, can protect a company’s investment no matter what happens.
A company, of course, also can be a risk-taker in these deals, using its investment strategies as a revenue producer. Some companies have had success doing so; others have bet wrong, suffering big losses and vowing never to play this game again.
In theory, derivatives agreements can be as complicated as the people who devise them. In some cases, they are tailor-made to accommodate specific needs of an individual company or investor.
Such unregulated agreements, for example, can “derive” their value from the price of gold on a given day, the cost of oil, the exchange rate between the yen and the dollar or even the amount of rainfall in Iowa.
But in the end, the simple and complex use of derivatives comes down to one thing: the ability and willingness of participants in the deal to honor their commitments. Some regulators and members of Congress worry that the participants in certain arrangements are so few and the amounts of money so large that a single default could explode throughout the financial system.
The GAO report is expected to be studied by lawmakers to decide whether to impose more supervision on derivatives. Congressional hearings will take up the topic as early as next week.
According to the GAO, derivatives serve an “important function.” But the report found that “significant gaps and weaknesses exist in the regulation of many major OTC derivatives dealers.”
While bank regulators look at financial institutions, dealer affiliates of securities or insurance companies, a rapidly growing part of the business, are largely unregulated.
The GAO recommended that Congress require regulation of all OTC derivatives dealers. It suggested the Securities and Exchange Commission might be assigned this responsibility.
The GAO also recommended that Congress address the need to revamp and modernize the entire U.S. financial regulatory system.
Leaders of the CBOT and the Merc noted that the report did not find inadequacies in regulation of exchange trading.
Exchange-traded derivatives already are regulated and have some credit guarantees against default that make them less risky than OTC transactions.
“It is important to note that the GAO did not identify any gaps or weaknesses in the regulation of exchange trading of derivatives,” said Patrick H. Arbor, CBOT chairman.
“The GAO has produced a thorough, thoughtful report,” said Merc Chairman John F. Sandner. But Sandner said he hoped the report would “not be used to impose costly new regulations on the off-exchange derivatives markets.”
Noting that the derivatives industry is young and still evolving, he said the GAO was trying to look at a “moving target.” Many off-exchange dealers are instigating policies that would make regulation unnecessary, he said.
Several financial and bank trade groups voiced strong opposition to recommendations for more oversight.
The Securities Industry Association, the Public Securities Association, the American Bankers Association, the Futures Industry Association, the Bankers Roundtable and the International Swaps and Derivatives Association said in a joint statement that the proposed recommendations would increase the cost and reduce the availability of derivatives and overall “harm the American economy.”
Separately, Securities Industry Association President Marc E. Lackritz said the GAO report fails “to consider the disclosure, internal controls and improved risk-management techniques during the past two years.”
“Legislation is not needed,” said Public Securities Association Chairman Fenn Putman of Lehman Brothers. “Regulators agree they have appropriate tools at their disposal to deal with practices in the derivatives market.”
SEC Chairman Arthur Levitt seemed to concur.
“I’m not prepared to go out and call for more government regulation today,” he said in Washington. Levitt said he would like to see more disclosure of corporate derivatives activities.
WATCHING RISK-TRANSFER GAME FROM THE STANDS
Though derivatives are becoming increasingly complex as investing and money-management tools, the principles behind them remain the same.
Think of it like buying tickets to a Chicago Bulls game.
A week ago, say, when the Bulls were down two games to none in their NBA playoff series with the New York Knicks, you made a deal with a friend: If you paid him $5 now, he later would sell you tickets to Friday’s game for $50. (Maybe you didn’t have 50 bucks with you at the time.) You would buy the tickets Friday night-and you had to buy them even if the Bulls had been eliminated from the playoffs and the game was never played.
You took a risk. Your friend got $5 and was assured of $50 more.
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But with each Bulls victory, the value of the tickets increased-yet you still had the right to buy them for only $50. You won the gamble.
If there were a derivatives market in basketball ticket futures, you could sell that right for many times your $5 “investment.” You might sell your agreement to someone else or even back to the person who sold it to you.
And that person, in turn, might sell it back and forth or to someone else many more times until tipoff.