Derivatives

Individual investors are becoming much more savvy in the financial market. Not long ago, investors had to rely on financial advisors to make simple buy-and-sell trades. Now, more investors are getting involved in more complex financial transactions. These include trading options and other kinds of derivatives.

There are risks associated with any financial market investments. It is important to understand derivative regulations to protect your financial investments. If you have any questions about derivatives and security law, talk to a derivatives attorney for legal advice.

What Is a Derivative?

A derivative is a financial instrument based on the performance of an underlying security or asset. A derivative is a type of financial contract. Two or more parties agree on the price of an underlying asset performing in a certain way. Assets can include securities, stocks, bonds, and interest rates. These are often broker-dealer over-the-counter (OTC) trades.

A derivative transaction is different from a security. When you have a security interest, you have an ownership interest in the assets. A derivative contract is based on the performance or benchmark of the security interest.

For example, if you buy a share in a racehorse, when the horse wins a race you may get a share of the purse even if the horse doesn’t get first. A derivative product is more like betting on the horse at the racetrack. If you bet on a horse to win and the horse comes in third, you don’t get anything.

What Are Different Types of Derivatives?

There are four common types of derivatives. These include call options, forwards, futures contracts, and swaps. However, new derivative instruments are always developing.

• Options: An option is a contract to buy or sell for a set price at a future date. As the term suggests, it is not a requirement to buy the asset, only an option.
• Futures contracts: Futures are an agreement on the price of an asset at some future date. These trade on an exchange. This is a way to hedge risk based on the rise or fall in the market value of an asset in the future.
• Forward contracts: Forwards are like futures but can be more customizable. Forwards can also carry more risk than standard futures.
• Swaps: Swaps involve transactions of one type of security, loan, or cash flow with another. Examples include security-based swaps, interest rate swaps, and credit-default swaps.

How Are Derivatives Regulated?

Derivative securities are generally regulated by the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act divided the regulatory authority of OTC derivatives between the SEC and CFTC. Both regulate mixed swaps, the CFTC regulates swaps and swap dealers. The SEC regulates the remaining swaps.

The SEC, CFTC, and other federal laws regulate the trade of derivatives and how investment companies manage derivative markets. Financial institutions and mutual funds exchange-traded funds (ETFs) need to have certain programs in place for investor protection.

What Rules Do Funds Have to Follow For Derivatives?

In 2020, the SEC adopted Rule 18f-4 to regulate how mutual funds and other investment institutions can trade in derivatives. These rules are intended to protect investors and provide transparency in risk management.

• Funds have to follow certain value-at-risk-based limits.
• Funds generally have to put in place a derivatives risk management program to manage derivatives risks.
• The derivatives risk manager must provide reports on the use of derivatives, test results, and the effectiveness of the program protections.

How Can a Securities Lawyer Help With Derivative Questions?

Investors can get burned by derivatives but many assume it was just a risk of the transaction. Some derivative losses can be related to securities fraud. If you have questions about derivatives and security law, talk to a derivatives attorney for more information.