A Primer on the Trade and Regulation of Derivative Instruments

By Joseph L. Motes III
Vol 49 Southern Methodist University Law Review, No. 579
March / April, 1996

LENGTH: 20789 words

… These instruments generally fall into one of four categories: foreign exchange, interest rate, commodity, and equity derivative instruments. … Mortgagor A’s mortgage has a floating interest rate, and A is sure that interest rates will rise. … In this case each mortgagor believes his position would be enhanced if only his mortgage carried the form of interest rate (a type of periodic payment) held by the other. … The nature of the bank’s business makes it an interest rate sensitive entity. … In this transaction, one party makes periodic payments of a specified currency at a fixed interest rate, and the other party makes periodic payments (of the same currency) at a floating rate which is subject to regular adjustment. … The second party’s payments are based on the excess, if any, of an agreed-upon floating rate (interest rate cap) or commodity price (commodity cap) over a specified interest rate (in the case of an interest rate cap) or commodity price (in the case of a commodity cap). … One party makes payments based on the floating rate or commodity price in excess, if any, of a specified rate or price (cap), and the other party makes payments on the excess, if any, of a specified interest rate or commodity price over a floating rate or commodity price. …


A. Background
Over the past decade, the financial world has been revolutionized by an exponential increase in the use of complex financial tools known as derivatives. The term “derivatives” is used to describe a diverse and rapidly evolving array of privately negotiated over-the-counter (OTC) and exchange-traded financial instruments. 1 These sophisticated instruments are, in essence, financial contracts whose values are linked to (or “derived” from) the value of one or more underlying assets, such as stocks, bonds, or commodities. 2 Derivatives have most often been employed as a sort of “insurance,” protecting investors’ positions through allocation of risk, but the instruments have also been used to generate profits through speculation on market positions.

While the simpler components of these instruments have existed for hundreds of years, relatively recent innovations in computer and communications technology, coupled with advances in finance theory, have propelled these complex tools into the mainstream of the increasingly mathematics-based world of finance. 3 These improvements in theory and technology spurred unprecedented growth in the derivatives market by facilitating the customization of instruments to meet market players’ demand for sophisticated risk-management tools, thereby helping investors compete in the increasingly globalized (and more volatile) financial market. 4

The majority of growth in the derivatives market has come about since the mid-1980s, when the use of OTC derivatives began to catch on. To- [*581] day, the notional value 5 of the derivatives market is an estimated sixteen trillion dollars, more than double the gross domestic product of the United States. 6 In the words of one commentator, the financial world has now entered the “Age of Derivatives,” as it moves from “long-term hedging to on-line risk management.” 7

Not everyone, however, is bullish on the widespread use of derivatives. Many believe that the rapid movement of derivatives to the forefront of financial markets has brought with it the potential for a market disaster of systemic proportion; one that could make the recent savings and loan debacle seem tame by comparison. 8 In addition to the sheer magnitude of the derivatives market, a number of other factors raise legitimate concerns, including the interrelation of markets and institutions derivatives create, inadequate disclosure of risks to investors, inadequate assessment of risk by institutional managers who lack the expertise required to truly understand these complicated instruments, and an increasing pressure on fund managers to produce profits through speculation. 9

Over the past few years, the debate has intensified between those enjoying the benefits of derivatives and those who feel the instruments threaten global financial stability. The debate eventually reached the floor of the U.S. Congress, as spectacular, high-profile, derivatives-re- [*582] lated losses drew the regulatory attention of several congressional committees. The principal players in this controversy now include derivatives market users and trading organizations, federal regulatory agencies, and the U.S. Congress.

The market users and derivatives trading organizations argue that the industry is already adequately regulated, and that any additional congressionally sponsored regulatory action would be not only unnecessary, but devastating to both issuers and users of the instruments. 10 Surprisingly, the majority of federal regulatory entities – including the Securities and Exchange Commission (SEC), Federal Reserve Board (FRB), Commodity Futures Trade Commission (CTFC), and the Office of the Comptroller of the Currency (OCC) – agree that the current regulatory framework, properly applied, is sufficient to safeguard the financial system and the U.S. taxpayer from a derivatives-induced financial crisis. 11 Standing in sharp contrast to the positions taken by industry players and many federal regulators are a number of key members of Congress, particularly those serving on the House Banking Committee. 12 Anxious to avoid another savings and loan-type regulatory disaster, and spurred on by a series of highly publicized losses in the derivatives market, 13 the last two congressional sessions witnessed more than a half-dozen derivatives-related bills, each aimed at clamping down on the derivatives market through increased regulation and oversight.

B. Purpose of Comment

This Comment examines derivative instruments on two distinct levels. The first section serves as a primer on the nature and function of derivatives, explaining what they are as well as how and by whom they are used. In spite of the important role derivatives now occupy in the financial markets, the instruments are, in general, poorly understood, even among many industry participants. The purpose of the first section, then, is to provide a basic understanding of derivatives in language which is comprehensible to the financial market layperson. The second section is a review of the explosive development of the derivatives market, looking at the important role it has come to play in today’s global financial markets, and examining how changes in the economic environment recently resulted in [*583] spectacular losses for investors who, knowingly or not, invested in derivatives. The section also examines the various arguments put forth in the debate over regulating the derivatives market and explores the potential character of derivatives legislation, which will almost certainly be passed in the near future.
n16. Mortgage-backed securities and collateralized mortgage obligations are financial instruments that make up the secondary mortgage loan and capital markets. The originator of mortgage loans (such as a commercial bank, mortgage banker, or savings and loan institution) will often place groups of loans having similar characteristics in a pool and “securitize” them. The loans, then, become the collateral for securities which the originator or loan assignee issue and sell in the capital markets. These mortgage-backed securities are sold to attract funds from investors who would otherwise be unlikely to invest directly in an individual mortgage. The funds are then used by the issuer for further mortgage lending. In the standard mortgage-backed security, each investor is the holder of a pro-rata share of all scheduled payments on the securitized mortgages. However, just as the OTC market innovated new products to satisfy the customized needs of individual investors, issuers of mortgage-backed securities began to divide securities issues into classes (or “tranches”) that repay investors over different time periods or based on different components of the mortgage debt. For example, the interestand principal components of mortgage-backed securities are often stripped apart, allowing the securities to be divided into “interest-only” (IO) and “principal-only” (PO) classes. The term “collateralized mortgage obligations” refers to mortgage-backed securities that have been divided in this manner. Grant S. Nelson & Dale A. Whitman, Real Estate Transfer, Finance and Development 905-06, 947-50 (4th ed. 1992). Although seemingly straightforward in nature, these financial instruments are considered to be some of the most complex ever created. Michael Carrol & Alyssa A. Lappen, “Mortgage-Backed Mayhem,” Institutional Investor, July, 1994, at 81.

n233. See Penny Lunt, How Are Mutual Funds Changing Banks?, A.B.A. Banking J., June 1, 1993, available in 1993 WL 3004317. In 1993, Concord Holding Corp, which had been created in 1987, was administering and distributing mutual funds for banks. At that time, it was handling over $ 36 billion in assets. There were some 16 similar firms that were operating mutual funds for banks in order to avoid Glass-Steagall prohibitions on banks underwriting activities. See Alyssa A. Lappen, “Fund Follies,” Institutional Investor, Oct. 1, 1993, available in 1993 WL 12229261. Mellon Bank acquired Dreyfus and became the largest bank manager of mutual funds. It was also the second largest asset manager in the United States. See Spiegel, Gart & Gart, supra note 177, at 300. For descriptions of other bank mutual fund arrangements, see Marcia Parker, Crains New York Business, 1993 WL 2989529 (Apr. 19, 1993); Stan Hinden, Banks Picking Mutual Funds Face Questions on Disclosure of Risks, Washington Post, Mar. 24, 1993, at F3.

First Union bought Lieber & Co. in 1993. It was the manager of $ 2.2 billion dollars of Evergreen Mutual Funds. See Jane Bennett, Banks Using Mutual Funds to Keep Customers, The Jacksonville Business Journal, Dec. 31, 1993, available in 1993 WL 3026956. First Union announced in 1996 that it was seeking to have $ 100 billion in mutual fund asset sales by the year 2000. See Introduction, 1 N.C. Banking Inst. xiii, xix (1997). First Union had earlier announced that it was training 2,600 employees to sell mutual funds including 12 of its own funds by the end of 1994. In the following year, NationsBank added 11 mutual funds to its 28 mutual funds that were already under its management. See Rick Brooks, Banks Rush to Offer Blitz of Mutual Funds, Charlotte Business Journal, July 12, 1993, available in 1993 WL 2988430. Citibank was selling a family of mutual funds, after regulatory changes allowed the banks to use their names in selling such securities. See Julie Creswell, Citibank Fund Group to Get a Change of Name, But Will It Help Returns?, Wall St. J., Feb. 17, 1998, at 8B.

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Alyssa A. Lappen is a U.S.-based investigative journalist. She is currently Managing Editor at the Leeb Group. A former Senior Fellow of the American Center for Democracy (2005-2008); she is also a former Senior Editor of Institutional Investor (1993-1999), Working Woman (1991-1993) and Corporate Finance (1991). She served six of her 12 years at Forbes (1978-1990) as an Associate Editor. Ms. Lappen was also a staff reporter at The New Haven Register (1975-1977). During a decade as a freelance, her work appeared in Big Peace, Pajamas Media, Front Page Magazine, American Thinker, Right Side News, Family Security Matters, the Washington Times and many other Internet and print journals. Ms. Lappen also contributed to the Terror Finance Blog, among others. She supports the right of journalists worldwide to write without fear or restriction on politics, governments, international affairs, terrorism, terror financing and religious support for terrorism, among other subjects. Ms. Lappen is also an accomplished poet. Her first full-length collection, The Minstrel's Song, was published by Cross-Cultural Communications in April 2015. Her poems have been published in the 2nd 2007 edition of Blood to Remember: American Poets on the Holocaust and both 2007 issues of Wales' award-winning Seventh Quarry: Swansea Poetry Magazine. Dozens of her poems have appeared in print and online literary journals and books. She won the 2000 annual Ruah: A Journal of Spiritual Poetry chapbook award and has received a Harvard Summer Poetry Prize and several honorable mentions. Alyssa A. Lappen can be reached at alyssaalappen@alyssaalappen.org

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