Changes in global financial markets have led both the private and public sectors to search for new methods to protect against risks associated with foreign exchange and interest rates as well as equity and commodity prices. In order to address this demand, many institutions are using derivative products. Derivatives are financial instruments created from, or whose value depends on (is derived from) the value of an underlying asset, reference rate or index.

Participants in the derivatives markets are dealers and end-users. End-users include financial institutions, businesses, mutual and pension funds and government entities. Dealers are usually large commercial banks or securities firms and insurance companies and their affiliates. Derivatives can be traded through established exchanges. Derivatives can also be traded through contracts negotiated privately between two parties, called over-the-counter (OTC) derivatives. While payments between counterparties of exchange-traded derivatives are guaranteed, those between counterparties of OTC derivatives are not.

Recent reports about losses by some derivatives end-users have raised numerous issues of concern to state and local government finance officers. These include concerns about the risks incurred with the use of derivatives, such as legal, credit, market, settlement, interest rate, and operating risks, as well as concerns regarding the appropriate use of derivative products and the marketing of these products. Indeed, some public jurisdictions have already experienced losses because of their use of derivative products.

The Government Finance Officers Association (GFOA) is concerned about the increasing complexity of new derivative products used for debt, cash and pension management purposes. There are various vehicles available to address these concerns, including legislation, regulation, better enforcement of existing rules, improved oversight and educational initiatives. Accordingly, GFOA supports appropriate federal action that would accomplish the following:

• Close regulatory gaps related to securities firms and insurance companies that are dealers of derivative products. While financial institutions are subject to periodic regulatory examinations regarding their use of derivatives, there are no federal regulations regarding derivative activities by securities and insurance firm affiliates, and there is little or no state oversight of derivatives activities of insurance company affiliates. In addition, while banks and affiliates of securities firms are required to submit reports to regulators on their derivatives activities, there is no independent reporting requirement for insurance company affiliates. Closing these gaps will result in greater assurance that potential problems will be identified and addressed on a timely basis.
• Ensure investor protection by clarifying suitability rules for derivatives brokers, dealers, and investment managers and promulgating new rules as necessary. State and local governments must be assured that the product recommended for their use is appropriate and that the broker or dealer has disclosed his or her own position with regard to the derivatives contract.
• Accelerate the Financial Accounting Standards Board (FASB) accounting standard-setting process for derivative products and disclosure by derivatives brokers and dealers. Investors, creditors, regulators and other users of financial reports must be able to rely on consistent reporting of material information. Lack of accounting rules can result in inconsistent and misleading reporting on derivative products.
• Examine and set reasonable capital requirements for derivative brokers and dealers. Capital requirements are imposed to provide protection from unexpected losses, reduce the likelihood of failure of an institution or firm, and protect clients and creditors. Currently, only banks have capital requirements. There are no capital requirements for securities firms or insurance companies affiliate derivative dealers.

GFOA believes that greater federal government involvement in the regulation of derivative products is warranted to avoid market disruption and the loss of scarce taxpayer funds.

• Publication date: June 1994