The role of derivatives in a financial market poses several difficulties that are complex when looking at the dynamics of a financial market as a whole. The paper addresses several concerns regarding the effect of introducing derivatives into a market on the financial market regulations and vice versa. With the introduction of derivatives in a market, the financial industry as a whole is seen to represent a mature economy where risk and return are high and investors are innovative in hedging risks to actually maximize their return.
The paper discusses futures as a derivative that is explicitly volatile and has caused more losses than profitability. This contradicts the whole stature of derivatives where they are supposed to have a hedging effect against steep losses and general risky investments. This is probably due to the poor implementation of regulatory framework concerning derivatives and instruments that fall under this new innovative category of investment tools. In theory, they are interesting to look at as they are a niche instrument that focuses on a unique method of hedging risks – as compared to risk diversification.
However, due to their volatility and uniqueness in nature, framework to govern the implementation of derivatives in a market – and globally – is fragmented and translates into a higher risk associated with the instrument defying the purpose of derivative trading in the market, in the first place. As a result it can be said that only major institutional investors dare venture into the uncertainty of adopting derivate instruments as their investment risk barriers.
With only a few players in the market – and those that are extremely established using them – the perception of derivative trading is further enhanced in being “foreign” and extremely risky. As expected, only major global players are able to assimilate derivative trading into their financial markets as they would be able to have a fair amount of control over the instruments as compared to financial markets still dwelling in infancy stages.
Many global markets only adopt a small range of derivative instruments into their framework to avoid general confusion, anxiety and intense speculation by investors in the market. With greater institutional and systemic risk associated with derivatives in the market, calls for a global framework governing derivative trading surfaces. Similar to general stock trading and accounting standards, the majority opinion in leading financial markets is to have an international framework that safeguards the interest of the investor.
Regulators are required to provide a hedonistic monitoring structure with respects to derivatives trading. Bearing in mind that these instruments are more complex than basic stock-trading due to their customization of transactions, there is an overall need for information transparency in terms of evaluating criteria for an investment, accounting standards and risk and returns. An example of a regulatory financial body overlooking derivatives is the Securities and Futures Authority (SFA) in the United Kingdom. The SFA identifies a range of risks associated with the derivatives market.
They are the primary requirement risk, counterparty requirement risk and position risk requirements. They are further broken down into approximately 10 different risk factors. From this mapping of risks, it is apparent that should a global framework be enacted for derivative markets internationally, it should also be flexible enough to accommodate different markets where risks vary from one another. In order to bridge the gap between regulators and industry players, major regulatory concerns emerge in the following forms: •?
The recognition of different markets and products using a set of criteria specifically tailored for the market or product in question – this will allow customized framework, per market, per product. This can be tedious and even more confusing to the investor leading to a higher level of risk in investing in the market should the guidelines be too rigid. •? Different investors, and even intermediaries, are subject to different forms of regulation. Financial intermediaries can face discrimination especially when derivatives market is perceived as a premium market for institutional investors.
•? To counter any possible discrimination, criteria should be outlined clearly and made transparent conveying credit worthy players who are allowed to enter the market – this would include material criteria (funding, financial compliance, credit background) as well as the qualitative measures (qualification, skill, conflict of interests and integrity). •? Market efficiency in coping with high levels of volatility – this is a grave concern to the market player in broaching product designs, disruption, trading rules and reporting requirements.
Derivatives should not be removed from financial markets despite concerns raised of their increase in volatility and the adverse effects it has on profitable trading. This is because derivatives represent a fill a unique niche of risk hedging as compared to general diversification of stocks. However, a regulatory framework that allows derivatives to be traded in a cocooned realm may be the solution to providing healthier and better informed investment decision making globally. Having said that though, it goes against the nature of derivatives to conform to rigidity and therefore a certain amount of flexibility and customization is required.