Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 355instruments, futures markets benefit from an appropriate regulatory and legal infrastructureand from regulatory support. Moreover; in some circumstances, because themarkets involve pricing contracts among members who otherwise would be competitors,a government predicate is essential to avoid conflict with fair trading or antitrustlaws.IOSCO (1998, 2002b) points out that the basic objectives of securities regulation—customerprotection; fain efficient, and transparent markets; and reduction ofsystemic risk—apply equally to derivatives. Such objectives also generally are the objectivesof market participants, creating an identity of interests between regulatingauthorities and users of the markets.Typically, even the markets that are self-regulatedrealize that to prosper they must provide fundamental assurances that the rules ofthe game are fair and will be equitably applied and that obligations undertaken or fiduciaryresponsibilities assumed will be enforced. Where local law enforces exchangeand clearing rules, more specific law may not be necessary for a market to develop.However, if the desire is to attract the largest potential user base, international acceptanceof the market, or international credit enhancements, then the regulatoryframework becomes critical to pursuit of that strategy. In Brazil, for example, selfregulationwas deemed insufficient to address the manipulation of the futures marketby Naji Robert Nahas; similar reasons were cited for establishment of the U.K. FinancialServices Authority (FSA),that is, that self-regulation without regulatory backbonewas insufficient.An additional argument for appropriate infrastructure is that futures marketregulation begins by assuming that pricing in exchange derivatives markets has commercialuses and, therefore, is of relevance to the real economy. A principal purposeof the regulation of these markets is to protect price integrity and prevent cash marketdistortions. It is critical that derivatives markets are protected from manipulationof prices and market abuses. Such abuses prevent the appropriate functioning ofthe market and its risk management uses (hedging, facilitating financing, improving themanagement of production, and distribution). Such abuses also may compromise thecash market that developing market authorities are hoping to improve. If the derivativesprices are related to indigenous commodities or assets, the regulatory authoritycan be called on to provide confidence that the derivatives price achieved in the marketis not distorting cash prices.Reliable, continuous functioning is critical to such markets; it permits reliableshifting of risks rather than exacerbation of risk If the risk of transacting in the marketand shifting risk is greater than holding the risk, obviously the market will not beused. Derivatives markets only shift risk, that is, transfer it from one group to another.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub