By Damian Cox, ContributorTHE continued liberalisation of the Jamaican economy as a result of the removal of existing trade barriers through the Free Trade Area of the Americas (FTAA) and the Caribbean Single Market and Economy (CSME) will integrate the country further into the global economy. These developments will increase the demand for risk management through derivative instruments.
There is at least one major financial institution that has stated publicly its intention to deal locally in derivatives subject to regulatory approval. Financial institutions are the most important participants in the derivative industry.
A derivative is a financial instrument that derives its market value from some other underlying asset or index or other reference value. Derivative is a general term and does not refer to a specific financial instrument.
TYPES OF DERIVATIVES
Derivatives normally take the form of one or more of the following financial instruments: (1) Forwards, (2) Futures, (3) Options and (4) Swaps. Christopher C. Nicholls in his book, Corporate Finance and Canadian Law (2000) describes the instruments as follows: 'A forward' is a sale contract between two parties. One party agrees to buy an underlying asset. The other party agrees to sell. The price to be paid is fixed on the date the contract is entered into.
The seller doesn't deliver the asset (and the buyer doesn't pay) until the future date specified in the contract. The underlying 'asset' can be just about anything - including foreign currency. A forward is a private contract negotiated between two parties. It is an example of an over-the-counter ('OTC') derivative. 'A futures contract' is a standardised contract that may be bought and sold on an organised exchange (similar to a stock exchange). Thus, when one purchases a futures contract, the other party to the contract is the exchange itself, not a dealer.
WHAT'S AN OPTION?
'An option' is a contract between two parties. Under this contract, one party (the 'Optionholder') obtains the right but not the obligation to buy (or sell) an underlying asset at a specific price often called the 'exercise' or 'strike price'. The other party (the seller or 'Option Writer') is subject to the obligation to buy or sell the underlying asset if, but only if, the Optionholder decides to exercise his or her option. 'A swap' is a complex contractual arrangement entered into with a financial intermediary (a commercial bank or investment bank) by two parties designed to simulate the economic position the parties would have been in if they in fact had traded assets or obligations.
They can be used to dump or acquire financial exposures to equities or credit risk.
The main risks of derivative instruments to businesses are market risk (i.e., that the value will be diminished by negative market changes), credit risk or default risk (i.e., that the financial intermediary will not be able to complete because of default), operational risk (i.e., risk of loss due to insufficient supervisory or systems controls) and legal risk (i.e. the risk that the derivative contract may be held to be legally unenforceable). The main concerns for regulators are that derivatives:
1. Are not strictly 'debt' or 'equity' and are often used to manipulate a company's balance sheet.
2. Make the solvency and liquidity of a company more difficult to monitor.
3. Make it too easy for companies to avoid their obligations to the revenue and their creditors.
4. Are complex financial instruments and that buyers of these instruments may not know what they are buying and may be at the mercy of investment bankers and other suppliers of these instruments.
REGULATORY REQUIREMENTS
The regulatory framework required for the development of a derivatives market does not currently exist in Jamaica. The regulatory regime must address the integrity of financial statements, market efficiency and investor protection. The first step is the establishment by the regulators at the Financial Services Commission (FSC) and the Jamaica Stock Exchange (JSE) of a committee with the participation of the financial sector to address these concerns. Regional dialogue would be beneficial within the context of the proposed regional stock exchange since the 'take-off' of a domestic derivatives market will need substantial figures in terms of transaction value and volume not present on the local stock exchange.
The bankruptcy and insolvency laws will need to be amended to give clear rights to securities holders on the winding up or on insolvency of intermediaries. There will need to be clear tax and accounting rules that will foster the participation in the market of institutional investors.
UNDER THE LAW
The Income Tax Act will need to be amended to make specific provision for the taxability of income from derivatives. Derivatives will need to be declared securities under the relevant Jamaican legislation to ensure that the regulatory framework applicable to ''securities' trading would be applicable.
Contracts should only be legal and valid in Jamaica if they are traded on a recognised stock exchange and settled in the exchange's clearing system in accordance with its rules and by-laws. However, the trading of over-the-counter derivatives must not be precluded.
The insider-trading and disclosure provisions will need to be enhanced. Foreign Institutional Investors (FIS) and Mutual Funds should be permitted to trade in all exchange traded derivative products. A minimum contract size must be fixed (India's fledgling derivatives market has set the limit at the equivalent of $250,000.) for all derivatives that will effectively bar small investors from venturing into derivative contracts.
As stated by Christopher C. Nicholls, "Derivatives are among the most important and exciting of modern financial tools. However, although they offer corporations unique opportunities to hedge risk and tailor financial exposures, they also present challenges to securities and financial institution regulators."
Damian Cox is a student at the Norman Manley Law School who is doing his in-service training at DunnCox, attorneys-at-law, 48 Duke Street, Kingston.
