Though seemingly obscure financial instruments, derivatives form a key part of the economy. In part because of their complexity, derivatives exchanges and markets are regulated by federal law and self-regulated organizations. The expectation for anyone trading derivatives is that they are sophisticated investors and aware of the risks and liabilities involved. Accordingly, understanding derivatives law requires niche legal experience. If you are involved in derivatives markets, a derivatives lawyer from the Priori Network can help you understand the legal implications of the financial products you’re working with.
Derivatives are investments that derive their value from the performance of an underlying asset, index, or interest rate. Unlike traditional investments directly in assets, derivatives are contract-based obligations that can be traded like securities. The following are common types of derivatives traded in the U.S.
Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) in which investors are paid based on the cashflows the CDOs collect from the pool of bonds or other debts held within. Mortgage-backed securities are among the most common of these CDOs, but they can also derive income from student loans, credit card debt, and car loans, as well as basically any structured debt. Generally, CDOs are structured into tranches based on risk, and investors contract to a certain risk level in exchange for returns.
Options contracts, called options for short, are derivatives that detail a possible future transaction on a specified underlying asset at a pre-established price. An option contract allows the holder to buy or sell an underlying security at the pre-established price if the holder deems it desirable, regardless of the market price of the underlying asset when the options is exercised.
Futures and Forwards
Futures contracts, also called futures, are derivatives based on agreements to buy or sell a particular commodity, financial instrument, or other underlying asset at a pre-determined price in the future. This price is payable upon delivery of the asset on a pre-established date. The quantity and quality of underlying assets, as well as the delivery date, are standardized to facilitate trading futures on exchanges. Prices on futures are often volatile. Buyer and the seller generally liquidate their long and short positions before the contract expires, sometimes trading futures many times over through multiple parties.
Forwards are similar to futures in that they contract to buy or to sell an asset at a specified future time at an established price, but they are not standardized like futures. As such, forwards are not traded on exchanges and rarely require the same complex margin calculations.
Swaps and Swaptions
A swap is a trade of two derivative cashflows, wherein parties exchange one leg of cashflow against another leg. Generally, one leg is fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price. By trading the fixed and variable legs, traders can speculate on the changing value of the underlying asset or hedge risks.
Swaptions are options contracts on swaps. Essentially, a swaption gives the buyer the right, but not the obligation, to enter into an underlying swap during a fixed period of time for a certain price.
SEC & CFTC Compliance
As derivatives employ securities in their trades, the derivatives markets fall under the general jurisdiction of the Securities Exchange Commission (SEC). Derivatives are also regulated more closely by the U.S. Commodity Futures Trading Commission (CFTC), which has jurisdiction over designated contract markets, swap execution facilities, derivatives clearing organizations, swap data repositories, swap dealers, futures commission merchants, commodity pool operators, and other intermediaries and SROs within the derivatives markets. Together, the SEC and the CFTC safeguard against disruptive and fraudulent activity within derivatives markets.
All actors within derivatives markets must comply with SEC and CFTC regulations or risk serious fines, bans, and even criminal penalties. In order to ensure that your company is fulfilling SEC and CFTC compliance obligations, it may help to consult a derivatives attorney with SEC and CFTC compliance experience to discuss any responsibilities and potential liabilities.
Key Issues in Derivatives Law
Below are a few of the key legal issues involved with derivatives:
Commodity Exchange Act
The Commodity Exchange Act was originally created to regulate commodity futures exchanges. It was later amended to create the CFTC and expanded to cover all futures and options and many swaps. The Commodity Exchange Act is now the primary federal regulation governing all commodities, options, and futures trading activities both on and off organized exchanges.
Derivatives and the Dodd-Frank Act
Title VII of the Dodd-Frank Act addressed the gap in financial regulation of OTC swaps by providing a comprehensive framework for their regulation. The SEC was given authority over securities-based swaps and the CFTC was given jurisdiction over other swap exchanges and swaptions. The Dodd-Frank Act also tightened protections against fraud in swaps, which means that swaps traders are under stricter scrutiny.
Self-regulatory organizations (SROs) in the derivatives market, such as such as derivatives exchanges and the National Futures Association, offer other regulations for compliance. In addition any traders in these markets must be members of the appropriate SRO. Each SRO has its own rules and compliance regime that must be followed.
ISDA Master Agreements
ISDA Master Agreements are standard contracts created by the International Swaps and Derivatives Association that are used in over-the-counter derivatives transactions. ISDAs outline the terms applied to any derivatives transactions between two parties, so that terms do not have to be renegotiated for each transaction, while ensuring that the risks are minimized. Traders in OTC derivatives transactions generally have detailed knowledge of ISDAs.
Are there any other legal issues I should know about when buying or selling derivatives?
Certainly. The body of law, rules and regulations concerning derivatives is extensive, complex and frequently changing. An attorney with experience with derivatives and other financial products can help you assess the specific legal issues that may apply to you.