Financial Derivatives: Actions Needed to Protect the Financial System

GAO discussed federal oversight of derivatives activities. GAO noted that: (1) derivatives activities grew to at least $12.1 trillion by the end of 1992; (2) the rapid growth and increasing complexity of derivatives activities increase risks to the financial system, participants, and U.S. taxpayers; (3) most of the over-the-counter (OTC) derivatives activity in the United States is handled by 15 major U.S. dealers who are extensively linked with each other, end-users, and the exchange-trading market; (4) dealer failure or abrupt withdrawal from trading could disrupt markets and expose other financial entities to risk, but the federal government would likely intervene to keep the financial system functioning in cases of severe financial stress; (5) although an international financial organization and federal regulators have issued guidelines to enhance derivatives dealers' risk-management practices, there is no regulatory mechanism to ensure their compliance with the guidelines; (6) there are significant gaps and weaknesses in dealer securities regulation, financial reporting, information disclosure, and internal controls; (7) regulators must strike a proper balance between allowing the U.S. financial services industry to grow and innovate and protecting the safety and soundness of the financial system, which will require international cooperation among all interested parties; and (8) Congress needs to require federal regulation of U.S. derivatives dealers and review the need to overhaul the entire U.S. regulatory system.