Derivatives, risk and regulation: chaos or confidence?

There has been an extraordinary increase in the use of financial derivatives in the capital markets. Consequently derivative instruments can have a significant impact on financial institutions, individual investors and even national economies. This relatively recent change in the status of derivatives has led to calls for regulation. Fears that using derivatives to hedge against risk carries in itself a new risk was brought sharply into focus by the collapse of Barings Bank in 1995. The principal concerns of regulators about how legislation may meet those concerns are the subject of current debate between the finance industry and the regulators. Recommendations have been made and reviewed by some of the key players in the capital markets at national and global levels. There is a clear call for international harmonization and its recognition by both traders and regulators. There are calls also for a new international body to be set up to ensure that derivatives, while remaining an effective tool of risk management, carry a minimum risk to investors, institutions and national/global economies. Having reviewed derivatives and how they work, proceeds to examine regulation. Finds that calls for regulation through increased legislation are not universally welcome, whereas the regulators’ main concern is that the stability of international markets could be severely undermined without greater regulation. Considers the expanding role of banks and securities houses in the light of their sharp reactions to increases in interest rates and the effect their presence in the derivatives market may have on market volatility. Includes the reaction of some 30 dealers and users to the recommendations of the G‐30 report and looks at some key factors in overcoming potential market volatility.