What is a derivative?
A derivative is a financial instrument the value of which is based upon the value of an underlying asset.
Why should you use derivatives?
Depending upon the derivative transaction you are entering into, as well as the motivations regarding a specific transaction, derivatives have been entered into for a variety of reasons, including:
1. manage risk;
3. gain access to cash;
4. leverage; and
5. comparative advantage.
What types of derivative products are available?
1. Options. A contract that gives the buyer the right, but not the obligation, to buy or sell a specified asset at a specified time and at an agreed price.
2. Forwards. A contract to buy or sell an asset at a specified time in the future at a price agreed today. Unlike an option, the buyer and seller must fulfill the transaction on the date specified in the contract.
3. Swaps. A transaction in which two parties exchange at regular intervals one stream of cash flow against another stream of cash flow, at least one of which will be determined by reference to an underlying asset (ie. interest rate, foreign exchange rate, equity price or commodity price)
What are the main swap products available?
The main classes of swaps available include:
1. foreign exchange transactions;
2. interest rate swaps;
3. credit default swaps;
4. commodity swaps; and
5. equity swaps.
Within the derivatives market, foreign exchange transactions and interest rate swaps make up the majority of the derivative market.
How are derivatives being regulated?
Federal Government of Canada
The federal government has proposed a new Securities Act (Canada) which provides for the regulation of exchange traded and OTC derivatives. A reference case is currently before the Supreme Court of Canada to determine whether the Federal Government has the power to pass such a bill.
Province of Ontario
On November 18, 2010 the Province of Ontario introduced Bill 135, Helping Ontario Families and Managing Responsibly Act, 2010, which, if passed into law, would amended the Securities Act (Ontario) to establish a regulatory framework for trading in derivatives and grants the Ontario Securities Commission the power to develop and implement rules regarding the regulation of derivatives.
Province of Quebec
The Province of Quebec was the first province in Canada to enact legislation dealing with the regulation of derivatives entitled the Derivatives Act (Quebec), which regulates both over-the-counter and exchange-traded derivatives, with carve-outs for certain “accredited counterparties”.
The Dodd-Frank Wall Street Reform Act and Consumer Protection Act is a federal statute which was signed into law on July 21, 2010. The statute gives broad power regarding the regulation of derivatives to the U.S Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission, who are currently developing regulations related to derivatives.
Worldwide effort to regulate derivative transactions, similar in nature to the Dodd-Frank Wall Street Reform Act and Consumer Protection Act.
What are the impact of the new regulations?
1. Restrict trading to sophisticated parties. Thresholds establishing who can transact in derivatives products.
2. Better risk management practices. Mandatory retention of portion of a derivative.
3. Increased call for margin. Greater use of the ISDA credit support annex.
4. Central clearing and exchange trading of derivatives transactions. Establishing and forcing specific bilateral derivatives contracts onto exchanges in an effort to reduce systemic risk.
5. Increased transparency. Mandatory reporting and monitoring of derivatives transactions to regulatory authorities.