Financial Derivatives under MiFID Framework

Recent events and initiatives by the media have drawn the public’s attention to one of the most complex and innovative branches of the financial market, that of derivative contracts.
Market deregulation, growth in global trade, and continuing technological developments have revolutionized the financial marketplace during the past two decades. A by-product of this revolution is increased market volatility, which has led to a corresponding increase in demand for risk management products. This demand is reflected in the growth of financial derivatives from the standardized futures and options products of the 1970s to the wide spectrum of over-the-counter (OTC) products offered and sold in the 1990s.

Financial derivatives are broadly defined as instruments that primarily derive their value from the performance of underlying interest or foreign exchange rates, equity, or commodity prices.These financial instruments come in many shapes and forms, including futures, forwards, swaps, options, structured debt obligations and deposits, and various combinations thereof. Some are traded on organized exchanges, whereas others are privately negotiated transactions. Derivatives have become an integral part of the financial markets because they can serve several economic functions. Derivatives can be used to reduce business risks, expand product offerings to customers, trade for profit, manage capital and funding costs, and alter the risk-reward profile of a particular item or an entire balance sheet.
Although derivatives are legitimate and valuable tools for banks, like all financial instruments they contain risks that must be managed. Managing these risks should not be considered unique or singular. Rather, doing so should be integrated into the bank's overall risk management structure. Risks associated with derivatives are not new or exotic. They are basically the same as those faced in traditional activities (e.g., price, interest rate, liquidity, credit risk). Fundamentally, the risk of derivatives (as of all financial instruments) is a function of the timing and variability of cash flows.

There have been several widely publicized reports on large derivative losses experienced by banks and corporations. Contributing to these losses were inadequate board and senior management oversight, excessive risk-taking, insufficient understanding of the products, and poor internal controls. These events serve as a reminder of the importance of understanding the various risk factors associated with business activities and establishing appropriate risk management systems to identify, measure, monitor, and control exposure.

Otherwise, not only banks and corporations have experienced large losses by using financial derivatives. Retail customers, all size companies and local authorities have been suffering heavy losses for years due to their uncontrolled use too.

The purpose of this work is to provide a general update on the regulations in force (in particular MiFID) and scope of their activity, to define the spheres of operation and the tasks of the supervisory authorities (like for ex. Financial Services Authority-FSA and the Bank of Italy).