Financial Derivatives

Trading by corporations, banks, and governments in derivatives--financial contracts based, or derived from, an underlying market, such as stocks, bonds, or currencies--has expanded rapidly around the globe. Derivatives have enabled corporations to better manage the financial risks associated with doing business internationally and have provided opportunities to profit from swings in interest rates. However, much derivatives activity in the United States is concentrated among 15 major U.S. dealers who are extensively linked to one another and their customers. The sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and pose risks to the others, including federally insured banks and the financial system as a whole. Federal intervention could involve industry loans or a financial bailout paid for by taxpayers. Concerns about derivatives have been heightened by recent reports of huge losses by some derivatives end-users. Comprehensive industry or federal regulatory requirements are lacking to ensure that U.S. over-the-counter derivatives dealers follow good risk-management practices. In such a rapidly growing and dynamic industry, new participants are likely, some of whom may not be as knowledgeable as current dealers or who may take on unwarranted risks in an attempt to gain market share or increase profits. In either case, systemic risk could increase. Federal regulators have begun to address derivatives activities, but significant gaps and weaknesses exist in the regulation of many major over-the-counter derivatives dealers. Further compounding the regulators' problems and contributing to the lack of knowledge by investors, creditors, and other market participants are inadequate rules for financial reporting of derivatives activity. In GAO's view, the issue is how to allow U.S. financial services to grow and innovate while protecting the safety and soundness of the nation's financial system. GAO makes several recommendations designed to help Congress, the regulators, and the industry address this issue. GAO summarized this report in testimony before Congress; see: Financial Derivatives: Actions Needed to Protect the Financial System, by Charles A. Bowsher, Comptroller General of the United States, before the Senate Committee on Banking, Housing, and Urban Affairs and before the Subcommittee on Telecommunications and Finance, House Committee on Energy and Commerce. GAO/T-GGD-94-150, May 19, 1994 (eight pages).

GAO found that: (1) the outstanding amount of derivatives at the end of 1992 was at least $12.1 trillion; (2) the rapid growth and increasing complexity of derivatives activities increase risks to the financial system, participants, and U.S. taxpayers; (3) relationships between the 15 major U.S. dealers that handle most derivatives activities, end users, and the exchange-traded markets makes the failure of any one of them potentially damaging to the entire financial market; (4) the Group of Thirty has proposed benchmark risk management practices, and regulators have issued guidelines for bank dealers, but there are no comprehensive industry or federal regulatory requirements to ensure that U.S. derivative dealers follow good risk-management practices; (5) significant gaps and weaknesses in federal regulation of derivatives dealers include limited regulatory authority over security and insurance firms' derivatives activity, insufficient risk-disclosure requirements, inadequate information collection standards, inadequate documentation and testing of internal controls, and inadequate rules for financial reporting of derivatives activity; and (6) regulators are attempting to improve derivatives regulations and accounting rules, but the complexity of derivatives makes the task difficult.

Recommendations

Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.

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