The Securities and Exchange Commission project to evaluate the use of derivatives by mutual funds, exchange-traded funds and other investment companies, is an overdue step that should lead to more transparency and accountability to the derivatives market.
The use of derivatives has been growing. Andrew J. Donohue, director of the SEC's Division of Investment Management, expressed concern about this trend in a speech a year ago in Vancouver, noting that the leveraging of an investment company portfolio magnified the size of potential gains, but also the size of potential losses.
The initiative — including the suspension of consideration of applications for new ETF funds that would make significant investments in derivatives — is worthwhile to gain a greater understanding of the use of derivatives and risk exposure, including disclosure to investors. The SEC should have undertaken such a study long ago and should have updated it regularly.
The study should encompass the entire use of derivatives by all investment management firms. Unfortunately, the study should have come before Congress considered financial regulatory overhaul proposals. Better late than never, however, and the results of the study eventually might lead to revisions of whatever financial reform law emerges from Congress.
The SEC should work together with the Federal Reserve to conduct a similar examination of use of derivatives by banking and other financial services companies. Such a comprehensive review should serve as a focal point to provide a framework for any new regulation.
A key objective of any such regulation should be to bring greater transparency to derivatives. That disclosure should include periodic reporting of positions, short or long, by type of derivatives. In addition, disclosure should include information on procedures for valuing derivatives, on internal risk management structures and methods for controlling counterparty risk, as well as determining the risk exposure and reserves of counterparties. Also, it should include descriptions of the purposes of derivatives strategies, and lines of accountability from staff to management to a firm's board.
The derivatives market lacks the transparency of the equity market. The use of derivatives for leverage and other strategies is growing among institutional investors. But the reporting requirements have not kept pace.
The SEC should expand the form 13F reporting — filed by investment management firms every three months for equity holdings, purchases and sales as well as for options in the recent quarter — to require investment managers report their derivative positions. Such expanded disclosure should also include the reporting of short positions in stocks and fixed income.
An expanded 13F will help investors and regulators gauge investment management firm risk, counterparty risks and systemic risks. At the same time, state legislatures ought to require public employee retirement systems provide similar regular reporting to reveal their risk exposure.
Such reporting would provide investors and regulators greater information to assess risk at a particular firm and systemic risk.
Although they didn't cause the recent financial crisis, derivatives worsened it by promoting complacency among investors and counterparties about the safety of assets, and encouraging ill-founded risk taking. While derivatives provide a cost-efficient means to gain exposure, or to hedge risk temporarily, they can serve as powerful instruments for manipulation or excessive risk taking.
Better transparency will help investors and regulators gauge risk exposures. It will bring more stability to the markets without inhibiting innovation or hampering the advantageous use of derivatives for asset allocation and hedging.