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FINANCIAL CRISIS INQUIRY COMMISSION REPORT
or event. They are not used for capital formation or investment, as are securities;
rather, they are instruments for hedging business risk or for speculating on changes
in prices, interest rates, and the like. Derivatives come in many forms; the most com-
mon are over-the-counter-swaps and exchange-traded futures and options. They
may be based on commodities (including agricultural products, metals, and energy
products), interest rates, currency rates, stocks and indexes, and credit risk. They can
even be tied to events such as hurricanes or announcements of government figures.
Many financial and commercial firms use such derivatives. A firm may hedge its
price risk by entering into a derivatives contract that offsets the effect of price move-
ments. Losses suffered because of price movements can be recouped through gains
on the derivatives contract. Institutional investors that are risk-averse sometimes use
interest rate swaps to reduce the risk to their investment portfolios of inflation and
rising interest rates by trading fixed interest payments for floating payments with
risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the
purpose of speculating, in hopes of profiting on the rise or fall of a price or interest
rate.
The derivatives markets are organized as exchanges or as over-the-counter (OTC)
markets, although some recent electronic trading facilities blur the distinctions. The
oldest U.S. exchange is the Chicago Board of Trade, where futures and options are
traded. Such exchanges are regulated by federal law and play a useful role in price
discovery—that is, in revealing the market’s view on prices of commodities or rates
underlying futures and options. OTC derivatives are traded by large financial institu-
tions—traditionally, bank holding companies and investment banks—which act as
derivatives dealers, buying and selling contracts with customers. Unlike the futures
and options exchanges, the OTC market is neither centralized nor regulated. Nor is it
transparent, and thus price discovery is limited. No matter the measurement—trad-
ing volume, dollar volume, risk exposure—derivatives represent a very significant
sector of the U.S. financial system.
The principal legislation governing these markets is the Commodity Exchange
Act of , which originally applied only to derivatives on domestic agricultural
products. In , Congress amended the act to require that futures and options con-
tracts on virtually all commodities, including financial instruments, be traded on a
regulated exchange, and created a new federal independent agency, the Commodity
Futures Trading Commission (CFTC), to regulate and supervise the market.
Outside of this regulated market, an over-the-counter market began to develop
and grow rapidly in the s. The large financial institutions acting as OTC deriva-
tives dealers worried that the Commodity Exchange Act’s requirement that trading
occur on a regulated exchange might be applied to the products they were buying
and selling. In , the CFTC sought to address these concerns by exempting cer-
tain nonstandardized OTC derivatives from that requirement and from certain other
provisions of the Commodity Exchange Act, except for prohibitions against fraud
and manipulation.
As the OTC market grew following the CFTC’s exemption, a wave of significant
losses and scandals hit the market. Among many examples, in Procter & Gamble,
