Latin American Capital Markets

356 A. M. CORCORAN, R. B. HOBSON, G.J. KUSERK, K. K.WUERTZ,AND QWESTThey do not eliminate risk; the resulting transferred risks must also be managed. Developerswho promise elimination of risks do a disservice to potential users. Finally,risks of distortion arising from development of derivatives markets will be greaterwhere cash markets are thin or derivatives are based on decentralized or fledglingcash markets. In such environments, it may be useful to study whether some combinationapproach to risk management is preferable to establishment of an indigenousderivatives market 23The optimal regulatory framework should be designed to ensure reliablehedging for economic exposures and price discovery. It must therefore ensure thatthe contracts that are traded in the market are valid and enforceable and that thetrading rules (which may be incorporated in an electronic algorithm) are equitablyenforced and fair Furthermore, because derivatives markets depend on credit enhancementarrangements to balance the leverage essential for their functioning, theregulatory framework must fulfill two tasks. First, it must manage the risk of the leveragethat is an essential aspect of the provision of liquidity. Second, it must support thetype of credit enhancement mechanisms embedded in the markets, including theiroperability notwithstanding the default of any participantAchieving these purposes generally requires legislative support. Therefore,the development of derivatives markets assumes applicability of the rule of law; aframework for qualifying markets, market intermediaries, and products; and regulatoryoversight to constrain manipulation, tie speculation to financial capacity, and otherwiseensure the proper functioning of the market for risk-shifting purposes. As newmarkets have emerged, privatized, and matured, a regulatory system or frameworkusually has developed contemporaneously, often drawing on private contractualarrangements already affecting market operations. 24 For example, the growth of futurestrading in the United States exploded after the creation of the CFTC. Regulation,to be helpful, also must provide confidence that government interests will notunduly tamper with the market, a particular concern in some emerging markets. 25This section examines some of the regulatory and legal preconditions for thedevelopment of a successful derivatives market, in particular, legal certainty, transparency,fair governance, risk management, and appropriate oversight.23 For example, in China, when speculation was uncoupled from cash markets and financial capacity, such marketswere considered potentially harmful to the cash markets on which they were based.24 Today more than 40 non-U.S. futures markets interactively report volume to the U.S. Futures Industry Association.All of these markets are supported by regulatory systems. The new Commodity Futures Modernization Act of 2000permits new markets to adopt a more rigorous regulatory regime than necessarily required, and some market operatorshave done so.25 In China, it was sometimes perceived that the price controls led to a market in speculation on government actionsrather than a hedging/price discovery market.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub