Latin American Capital Markets

DESIGNING A DERIVATIVES COMPLEMENTTO CASH MARKETS 361valued using a cash market or calculated reference price.The settlement can be a cashpayment of differences in value and/or physical delivery of the reference product forcontracts held to expiration. Like any other contract, in order to know its value, marketusers need to know the contract terms and conditions. Knowing these enablesusers to determine whether the contract is likely to be favorable, how to price it, andthe consequences in the event of default. At the same time, a futures contract is a financialinstrument. Therefore, the characteristics and degree (and quality) of regulation(and/or self-regulation) of the market on which it is offered as well as the costs,conditions, and rules of trading must be accessible if users are to be capable of determiningthe contract's functionality and properly pricing it.The terms and conditions of a futures contract ordinarily are included in therules of the market in the case of membership exchanges and in the user or subscriberagreement in other markets. Direct market participants, whether acting in aproprietary capacity or as an intermediary, ordinarily agree as a condition of marketaccess to be bound not only by all the present terms and conditions of the contractand trading rules but also by any changes in those terms or rules. 38 Customers of intermediaries,who have an indirect relationship to the market, generally also mustagree to take positions subject to the rules of the marketplace or the contractual conditionsof trading. From a commonsense perspective, the ability to transfer risk bylocking in a price requires both price integrity and an understanding of how the contractterms are intended to work; that is, contractual settlement arrangements, thepricing algorithm in the case of electronic markets, and how these relate to the cashmarket.Therefore, regulators should support measures that help to fulfill users' interestin the accessibility and fair and equitable execution of market rules, including contractterms. Indeed, the enforceability of the contract can be tied to the process chosenby the regulator to permit the listing of the contracts for trading.Governance, Accountability, and IndependenceFair and Equitable TreatmentNot only legal certainty but also certainty in the fair application of rules is critical toderivatives markets. Inconsistently applied or differentially applied rules could affectboth the pricing function and the hedging function of the market Indeed, contractterms, including forms of margining, cannot readily be changed midterm for any given38 Contract terms that affect price ordinarily should not be changed (or changeable) prior to the expiration of acontract.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub