The three broad goals of regulation have been discussed above. This section takes a closer look at the issues which should be addressed in order to reach these goals.
Market Efficiency and Integrity
1. Product Design. Any product must be designed in a way which meets the needs of customers if it is to be successful. A derivatives contract is no exception, and many derivatives contracts in many markets have failed because they have not passed this test. This by itself is not a matter of regulatory concern, but regulators are concerned about whether a contract is subject to manipulation and whether it is likely to have an adverse impact on the underlying cash market. Thus, regulators are concerned about such items as the relationship of the contract to the underlying market, whether futures and cash prices will converge as the contract expires, and the procedures for delivery or cash settlement.
Some regulators and market participants have been especially concerned about the design of stock index futures and options and the impact of these derivatives on the underlying market. As a result of this concern, the IOSCO Technical Committee has produced a useful report on the design of stock index futures. This report deals with the following aspects of the design of these products: method of calculation, number of component stocks, liquidity of component stocks, dispersion of component stocks within or across business sectors, replacement of component stocks, selection of component stocks, and clearance and settlement.
2. Order Execution. Market integrity depends in part upon fair and efficient execution of orders. This in turn means that rules governing order priority, the responsibilities of market makers (if any), transparency and off-exchange transactions (if permitted) must be clearly defined and applied consistently. All market participants should be able to know exactly what these rules are.
3. Surveillance. One of the most important ways of protecting market integrity is market surveillance - monitoring the market on a regular basis for any potentially manipulative behavior, such as the accumulation of unusually large positions, especially near the expiration of a contract. There is nothing inherently wrong with large positions, but they provide a warning signal for further investigation or closer surveillance and monitoring. Requiring market participants to report large positions is one way of facilitating surveillance.
4. Operational Capacity. An exchange cannot guarantee that a market will be liquid, but it should be able to guarantee that it will have the capacity to handle any expected order flow. Thus, it should be able to process orders and record transactions rapidly. It should have adequate capacity on the trading floor or in the electronic trading system.
Financial Safety and Integrity
1. Capital Standards. Each financial intermediary should have sufficient capital to preserve the safety and soundness of the financial system. Firms that hold funds which belong to others should have adequate capital to ensure that they can meet their obligations at all times, including periods of high market volatility. In derivatives markets, this means that clearing members and the firms that accept funds from customers must always meet certain capital standards. These standards should reflect both the amount of funds belonging to others which are held by the firm and the risk inherent in the different types of assets owned by the firm. Provisions should also be made to ensure that firms which do not meet or are in danger of not meeting their capital requirements notify the appropriate persons when this happens.
2. Clearing Facility. Clearing houses essentially perform two functions: trade clearing (the process of collecting trade information, matching trades, and interposing the clearing house as a counterparty to each trade) and trade settlement (the process whereby final payments are collected and distributed). The establishment of a clearing facility (which may be part of an exchange or an independent entity) is essential to the success of an exchange derivatives market. The benefits of a clearing house include the reduction of counterparty credit risk (through the exchange guarantee) and the efficient processing of trade information, including the process of marking to market all positions on a daily basis.
3. Margins. Margins underlie the safety provided by the clearing house. Their purpose is to reduce or eliminate the risk of default by customers, by those who handle customer orders and by clearing members. Typically, daily variation margin is established at a level which covers at least one day's possible loss and is generally based upon an assessment of historical and projected price volatility. The setting of margins entails balancing the benefits of preventing default and the cost of the funds used to make the margin payments. If margins are too low, the risk of default is too high. If margins are too high, the cost of entering into derivatives contracts will be unnecessarily high. As a result, there will be less use of derivatives, markets will be less liquid and risk management will be more difficult for some firms and individuals.
The setting of margin levels, involving analysis of historical price moves and assessments of future price volatility, has been generally been viewed as a function that is best performed by exchanges. Regulators do have a role to play, however, by exercising oversight and reviewing exchange rules related to the establishment of a margin system. They may also maintain emergency authority to intervene under certain defined "emergency" conditions.
4. Protection of Customer Funds. Derivatives brokers will generally hold funds belonging to their customers as a result of margin payments and customers' gains from their derivatives contracts. In order for customers to be willing to provide these funds to their brokers they must be confident that the funds will be properly handled. One method of accomplishing this is to require that these funds be held in separate or segregated accounts. In any event, the way in which their funds will be treated as well as the existence or non-existence of any guarantee fund or insurance should be made clear to customers. Appropriate recordkeeping rules are also vital.
5. Default, Insolvency or Bankruptcy Provisions. Many of the items discussed above are designed to minimize the probability and effects of a default, but this risk cannot be entirely eliminated. Thus, it is necessary to have rules to minimize or contain the effects of such an event. Rules establishing procedures for the transfer of positions and funds from a defaulting firm should be made clear to market participants. It is also essential that there be rules establishing the priority of customer claims in the case of bankruptcy or default and that these rules are known to all in advance of any possible default.
6. Market Disruptions. Margin requirements and regular (at least daily) valuation of contracts (marking to market) are designed to protect the financial integrity of the system against price volatility. But special measures such as price limits or circuit breakers may be considered desirable in times of market disruption or abnormal volatility. Well-established channels of communication among exchanges (including cash market exchanges) and among exchanges, clearing houses and regulators can be critical in times of market disruption. The Technical Committee of IOSCO has produced a very useful document concerning open and timely communication in periods of market disruption. This issue is addressed more fully in the section below on Regulatory Coordination and Cooperation.
7. Financial Recordkeeping. Rules governing the creation, maintenance and retention of financial records are clearly an essential element in the maintenance of financial integrity. While each country may have its own rules and accounting systems, international cooperation and surveillance would be enhanced by the use of accounting methods which are internationally recognized.
Customer Protection and Fairness
1. Authorization / Registration / Licensing. One method of increasing the probability that customers will be treated fairly is to ensure that all those who deal with customers meet certain standards concerning their knowledge of the industry. This knowledge can be demonstrated by such methods as completing the appropriate course of instruction or passing qualification examinations. A complement to this is to prohibit those who have a history of fraudulent treatment of customers or other illegal behavior from continuing to deal with customers. These standards can be imposed by various forms of licensing or registration of firms and their employees.
2. Order Execution. Rules which establish the priorities by which orders are executed are essential to provide fair execution for customers and to prevent fraud. Items to be considered in this regard are order size, type of customer, and whether some participants can act in a dual capacity. The rules for order execution are typically designed to ensure competitive execution of orders. If orders are executed electronically, care must be taken to ensure that the algorithm for such execution conforms to these rules. The role of market makers must be addressed in these rules as must the treatment of off exchange transactions, if they are permitted.
3. Recordkeeping. In order to determine whether the order execution rules have been followed, records of all transactions should be kept. An audit trail for each transaction from the time an order is placed until it is executed will permit resolution of issues concerning whether a customer has been treated fairly and can serve as evidence in proceedings on this issue. Rules concerning how long records should be retained are also needed.
4. Sales Representation and Disclosure. Those who use derivatives should realize the risks inherent in some transactions. Rules to ensure that potential customers are advised of these risks and to prevent unrealistic sales representations are important aspects of customer protection.
5. Product Design. Product design is an important aspect of both market integrity and customer protection. With respect to the latter, questions such as the procedures for delivery and for establishing settlement prices must be addressed.
6. Dispute Resolution Programs. Programs which provide fair and expeditious resolution of disputes over how a customer has been treated should be established. Such programs may take various forms, such as mediation, arbitration, or judicial proceedings.
Compliance and Enforcement
1. Compliance. The adoption and implementation of rules are of little use unless firms and markets comply with these requirements. This means that there must be an effective program to secure compliance with the rules established by the regulatory agency and the SROs. This program includes regular monitoring of all parties, both regular and unannounced audits of parties' financial, trading and other records, and adequate surveillance of market activity. Accordingly, the agency and SROs must establish procedures for detecting instances of non-compliance with the rules they have established.
2. Enforcement. A vigilant enforcement program (both regulatory and self-regulatory) against those who attempt to manipulate the market or engage in other rule violations is an essential component of a sound regulatory system and is critical to ensuring market integrity, financial integrity and customer protection. Regulatory authorities should have the necessary authority to detect, investigate, prosecute and sanction the law and regulatory requirements. If appropriate penalties for violations of the rules are lacking, the rules will have little impact.