o Regulatory issues relative to the underlying interest characteristic of derivatives tend to center on fairness and efficiency, concentration of positions, and the delivery process including allocation of deliveries or exercise in the case of options.

o When the underlying interest is traded in a jurisdiction other than the one where the derivative instrument is traded, or identical derivative products are traded in two jurisdictions, there may be concern that increased potential may exist for fraud or manipulation because of the likely inability of a regulator in one jurisdiction to monitor market activity directly and/or to conduct complete investigations of market activities in another jurisdiction. This may create a need for increased cross-jurisdictional communication and cooperation. Legal and regulatory issues relating to the transfer of rights across international boundaries also may be raised.

On organized exchanges derivatives are, by design, standardized or fungible. Such standardization together with the interposition of a clearing house or the exchange itself as a counterparty or guarantor permits multilateral offset and random assignment of delivery notices (although these features are not exclusive to derivatives). In futures, although not necessarily in options, for example, a price movement increases the value of one position while reducing the value of the opposite position by an equal amount. Thus, derivative trading generally is said to be zero sum.

The interposition of a clearing house (or an exchange) and the requirement to post standing or initial margins is intended to eliminate counterparty credit risk. (In some markets, price limits or capital-based position limits are also used to address financial risk.) Margin posted on derivatives generally is analogous to a performance bond rather than a down payment. As such, margin is intended to cover the potential failure due to default to meet settlement variation prior to liquidation of a position. The level of margin also affects the degree of leverage associated with a contract.

Ordinarily, the daily gain or loss on a position is marked-to-market and, in most markets, the difference is collected by the clearing house and may be transferred from the losing to the gaining position holders through the clearing house. For options, in most markets but not all markets, the writer/seller only is required to post margin which is marked-to-market each day but not passed through the market.

o Because the clearing house or exchange is interposed as the buyer to the seller and the seller to the buyer, the identity of other market participants is less material. Such clearing arrangements enhance confidence and liquidity in exchange-traded derivatives.

o It is important that the exchange and/or clearing house set margin levels which are sufficient so as not to imperil the financial integrity of the market and which do not adversely affect liquidity.

o The distribution, to customers, of a generic risk disclosure statement is often required before trading is undertaken. The notification of risk relative to futures and options trading is not unique to derivatives and does not imply a negative judgment by the regulator regarding trading in those instruments.

Derivatives facilitate risk shifting and may assist in price discovery for the underlying interest. Prices from derivative markets may have an effect on the price in the market for the underlying interest and vice versa.

Prices in the derivative market may be influenced by a concentration of positions, both in the derivative instrument and the underlying interest. Economic inefficiencies may arise if trading occurs at artificial or distorted prices. When physical delivery of the underlying interest is specified in the derivative contract, issues relating to delivery may arise. These may include the definition of acceptable commodities or instruments, the appropriateness of alternative delivery locations and media, the operation of warehouses, or the timing of delivery.

o Due to these factors, regulatory or enforcement mechanisms may be employed to deter manipulation and the undisclosed concentration of positions. Regulatory methods may include large trader reporting, position limits, hedge limit determinations, monitoring, and/or moral suasion. To the extent trading is centralized or is reported to a centralized source, compliance monitoring is facilitated. Enforcement methods involve, at a minimum, the prosecution of fraud and manipulation.

o In some jurisdictions, to assure maintenance of a centralized market, certain off-exchange transactions are precluded; in those jurisdictions where such transactions are permitted, often they must be reported to a central authority (such as the exchange).

o The ultimate value of the rights or obligations conferred by derivatives may be heavily dependent on developments in the underlying market. Derivatives differ from their underlying interest; these differences may have regulatory implications. On the other hand, there is a fundamental relationship between the market for the derivative and the market for the underlying interest. The nature of this relationship will depend on the rights and obligations covered by the derivative instrument and may also have regulatory implications.

o Particular characteristics of derivatives may raise possible regulatory issues. Alternative regulatory responses may be designed or may have evolved to address such characteristics in different markets.