Previous sections of this book have set out extensively the economic functions and implications of derivatives. This concluding chapter attempts to distil the economic theory and experience to propose some practical guidelines for policy making and regulation relating to derivatives. The recommendations in this chapter are in two parts, covering structure and philosophy respectively.

Regulatory structures and rules

This part makes some specific recommendations on regulatory rules and structures.

Insurable interest and reserve requirements for credit derivatives

It was seen earlier that a CDS is not really a swap but in substance an insurance contract. CDS is ‘neither fish nor fowl; it trades like a financial product but is not a security; it is designed to hedge future prices but is not a futures contract; it pays off in the event of a specific loss-causing event but is not an insurance policy’. The Kazakhstan case in Chapter 12 was an example of the moral hazard that can result from the use of CDS for speculation.

On the principle of substance prevailing over form, regulators must require the principle of ‘insurable interest’ (not necessarily using that term) to apply to all purchasers of Credit Derivatives. This would imply that any party seeking protection from credit risk must stand to suffer if the risk actually materializes. Also, sellers of swaps should be required to hold suitable reserves against them.

Centralized clearing for all derivatives which have a secondary market

Exchange listing and trading sheds light on the pricing model, brings about standardization and uniformity and improves liquidity. Besides ensuring that the Exchange stands behind the contracts, it also ensures that regulators will be able to respond more readily and easily to instances of abuse and violations of fair trading on the part of financial institutions.