Derivatives and stock market volatility: Is additional government regulation necessary?

To promote public confidence in the securities markets, the governments have instituted far-reaching regulations that affect both the structure of the financial services industry and the conduct of financial transations. Briefly, governments have promulgated extensive regulations that (1) mandate disclosure of information, (2) discourage trading on privileged information, (3) restrict the scope of financial transactions which different types of financial institutions can pursue, (4) specify capital requirements, (5) prescribe standards of prudence and business conduct, (6) guide the rules for operation of organized securities exchanges and the over-the-counter markets, and facilitate governmental supervision of the same. Concerns about possible adverse consequences of the rapidly growing use of over-the-counter, customized derivative securities on the stability of financial markets have initiated calls for additional regulations that are specifically tailored for dealers and end-users of derivative securities. While investor protection and solvency of financial institutions are paramount concerns underlying public regulation of securities markets, it is also evident that the regulatory framework is to a considerable extent based on the premise that unregulated securities markets are fragile and prone to inefficiencies and systemic crises. The literature abounds with theoretical arguments and lively academic exchanges about the role of public regulation in improving the operational and informational efficiency of the securities market. The purpose of this article is not to review these studies. Instead, I examine two intertwined issues that have important ramifications for formulating the nature and extent of regulatory intervention in the securities market. The first issue deals with the fragility of the securities markets. Are unregulated markets inherently prone to systemic crises, and does growing use of derivative securities increase the risk of a serious crisis in the securities markets? The second deals with the availability of nonregulatory (private) arrangements that enhance the efficiency of the securities markets and control the systemic risk in the industry.