Regulation, Roles, and Structures of Financial Derivatives: A Comprehensive Overview

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Derivatives: Their Role and Regulation

Financial derivatives serve dual purposesspeculation and hedging investmentsand are securities whose value is derived from one or more underlying assets. These financial instruments form the basis of a contract between parties, which fluctuates in line with changes to their asset's price. They encompass stocks, bonds, commodities, currencies, interest rates, market indexes, and more.

Derivatives can be traded privately over-the-counter, OTC or on established exchanges. The larger part of existing derivatives are OTC, yet they are unregulated while standardized derivatives traded on exchanges offer less risk to counterparties compared to their OTC counterparts.

Common Derivative Structures:

1. Collateralized Debt Obligations CDOs: Structured financial products backed by pools of debt obligations.

2. Credit Default Swaps: Agreements that transfer the credit risk of a debt instrument or loan from one party to another, essentially betting on default events.

3. Forwards and Futures: Non-standardized contracts with agreements for future delivery at specified prices.

4. Mortgage-backed Securities MBS: Derivatives backed by mortgages, providing alternative investment options that dep on mortgage payment streams.

5. Options: Financial contracts that grant the holder an option to buy or sell underlying assets within a specific timeframe and price limit.

6. Swaps: Agreements between two parties where one party exchanges a cash flow with another based on each other's obligations.

Regulation of Derivatives:

In 2000, the Commodity Futures Modernization Act CFMA was enacted by Congress to provide clarity for swap agreements and notably excluded the U.S. Securities and Exchange Commission SEC from regulating OTC derivatives markets except for security-based swapscredit default swaps being one example. This meant that while the SEC was empowered with antifraud provisions, it lacked tools to prevent fraud across swap markets.

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 addressed this regulatory gap by establishing a comprehensive framework for OTC derivatives regulation.

Regulatory Assignment:

• CFTC: Primary oversight responsibility for most non-security-based swaps, including commodity and agricultural swaps.

• SEC: Authority over security-based swapsthose involving securities or narrow-based indicesand mixed swaps that intersect with commodities.

• Prudential Regulators: Such as the Federal Reserve Board, play a pivotal role in setting capital requirements and margin norms for swap entities within their purview.

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