Regulation of Derivative Markets

Regulation of Derivative Markets

Over-The-Counter Derivatives markets operate at a lower degree of regulation and oversight as compared to the exchange traded derivatives markets. Up and until 2010, the OTC derivatives market in Kenya was unregulated. The transactions would be executed with only minimal oversight through laws that regulated the parties themselves but not the specific instruments. Following the financial crisis that begun in 2007, new regulations were set and the OTC markets became regulated but not to the extent of the exchange traded market.

Purpose of Regulation

1.       Market Integrity

To ensure that prices on the exchange properly reflect the demand and supply of the underlying asset market.

2.       Prudential regulation

Ensuring players in the market are financially sound and are able to market obligations.

3.       Business conduct

Protect consumers especially retail clients

4.       Business growth

By promoting innovation and allowing new markets to develop.

5.       Market stability

Criticism or Misuse of Derivatives

There are three principal arguments against derivatives

1.       It is seen as a form of gambling

Due to its speculative nature it is seen as a permitted or legalized form of gambling

2.       Destabilization of markets

Opponents of derivatives markets claim that the very benefits of derivative/low cost and low capital requirements results in an excessive amount of speculative trading that brings destability.

They argue that speculators use a large amount of leverage thereby subjecting themselves and their creditors to substantial risk if the market does not move in their direction.

3.       Complexity

Derivatives are seen a complex financial instruments that require a high level of understanding of mathematics thus making many distrust derivatives and the people who deal in them.

Recap

There are two general classes of derivatives: Forward Commitment Derivatives and the Contigent Claim

There are three types of forward commitments: forwards; futures and swaps. This type provides the parties the ability to lock in a price at which they will transact at a future date.

The contingent claim class includes options which are categorized into call and put options. This class provides the right to one party (holder) to buy or sell an underlying asset at a future date at a price fixed during the initiation of the contract.