Thursday, June 4, 2009

Derivatives regulation - CFTC on a war path

From the New York Times:
"The new chairman of the Commodity Futures Trading Commission will ask Congress on Thursday to impose substantial new costs and restrictions on large banks and other financial institutions that deal in the complex and largely unregulated financial instruments known as derivatives. "

"Complex and largely unregulated financial instruments known as derivatives” - scary stuff. Well the CFTC and the SEC are doing a great job “regulating” and keeping these scary derivatives away from the poor retail investor. Let’s take a look at some things that trade on the NY Stock Exchange. Here is an example: ticker symbol RFN: Rydex Inverse 2x S&P Select Sector Financial ETF. Nice.

RFN “seeks to provide investment results that match 200% of the inverse performance of the Financial Select Sector Index, before fees and expenses, on a daily basis.” Not a derivative.

Here is a statement from Rydex:
Inverse and leveraged ETFs may not be suitable for all investors. The more an ETF invests in leveraged instruments, the more the leverage will magnify any gains or losses on those investments. Inverse ETFs involve certain risks, which include increased volatility due to the ETFs’ possible use of short sales of securities and derivatives, such as options and futures. The ETFs’ use of derivatives, such as futures, options and swap agreements, may expose the ETFs’ shareholders to additional risks that they would not be subject to if they invested directly in the securities underlying those derivatives. Short-selling involves increased risks and costs. You risk paying more for a security than you received from its sale. Leveraged and inverse ETFs seek to provide investment results that match the performance of a specific benchmark, before fees and expenses, on a daily basis. Because the ETFs seek to track the performance of their benchmark on a daily basis, mathematical compounding, especially with respect to those ETFs that use leverage as part of their investment strategy, may prevent a ETF from correlating with the monthly, quarterly, annual or other period performance of its benchmark. Due to the compounding of daily returns, leveraged and inverse ETFs’ returnsover periods other than one day will likely differ in amount and possibly direction from the benchmark return for the same period. Investors should monitor their leveraged and inverse ETFs’ holdings consistent with their strategies, as frequently as daily. For those ETFs that consistently apply leverage, the value of the ETF’s shares will tend to increase or decrease more than the value of any increase or decrease in its benchmark index. For more on correlation, leverage and other risks, please read the

So no “complex derivatives” on the New York Stock Exchange under the watchful eye of the SEC. Or maybe it’s all "safe" because it’s all regulated?

With the SEC guarding against derivatives in the retail market, CFTC better not let those banks get away with trading credit default swaps, interest rate swaps, and God forbid, FX forwards. Derivatives caused this financial crisis after all (not the Fed, the securitization practices, the rating agencies, or the overlevered homeowner.) Pushing for sound margining practices and control on the overall leverage is way too simple and common sense to help get sexy headlines and build political careers.

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