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.