Derivative financial instruments have been among the fastest-growing segments of financial markets in recent decades. Proponents argued that derivatives would enhance risk management and make price discovery mechanisms more transparent. Since 2007, however, price volatility in energy and other commodities has been extraordinary, and the global financial system has become unstable. As a result, new attention has been drawn to the regulation of derivatives markets—and particularly toward the unregulated over-the-counter (OTC) derivatives market, where transactions are not made on a public exchange market and where little information on trading and prices is available. Do regulators need more information or supervisory authority over OTC derivatives? Is their existing authority sufficient to prevent excessive speculation and price volatility in the markets they do regulate? What regulatory changes, if any, would reduce risks to the financial system from derivatives trading? In the spring of 2009, the Obama Administration proposed legislative changes to overhaul regulation of OTC derivatives. A number of bills were introduced in the 111 th Congress, and several congressional committees held hearings. Derivatives are financial instruments or contracts whose value rises or falls with fluctuations in the price of an underlying commodity or financial variable. There are several forms of derivatives—the best-known are futures contracts, options, and swap agreements —but all have this common central feature: two parties promise to make a transaction (or series of transactions) in the future at a price that is agreed upon today. It is expected that the underlying price or rate will fluctuate over the life of the contract, but the price specified in the derivative instrument remains fixed. If they succeed in forecasting the direction of prices, derivatives traders will be entitled to buy the underlying commodity for less (or sell for more) than the going market price. For every winner, there is a loser. Thus, futures markets are "zero-sum"—any change in the price of the underlying commodity generates profits for some traders, and an equal amount of losses for the rest. Derivatives are sometimes described as bets on the direction of future price trends. As prices rise and fall, derivatives traders make profits or losses, even though they may never own the underlying commodity itself. Questions then arise: what separates derivatives from gambling? What public interest is served by the activity? There are two recognized benefits to derivatives trading: hedging and price discovery . Hedgers are traders who use the market to avoid price risk arising from their commercial dealings in the underlying commodity. A cattle producer, for example, can use the markets to lock in today's price for future sales of livestock, obtaining protection against the risk of falling prices. The producer may purchase futures contracts that gain value if the price of live cattle falls. If the price does in fact drop by the time the futures position expires, the producer will earn less money on physical sales, but the loss will be offset by futures contract profits. Conversely, if prices rise, the producer will lose money on the futures contracts, but gain on physical sales. Whichever way prices move, the net result is the same: the risk of unfavorable price movements over the term of the futures contracts has been eliminated, or hedged. Credit default swaps—another type of derivative contract—can also be used to hedge risk, even if the trader does not own the underlying bond. For example, a company that supplies auto parts to General Motors and depends on payments from GM might purchase a credit default swap on a GM bond to hedge against the risk of a GM default. The auto parts company would make a stream of payments to the seller of the credit default swap, and in case of a GM default, bankruptcy or other credit event, the CDS seller would pay the parts company a lump sum. If GM defaulted, the loss of payments to the auto parts company would be partly offset by the lump-sum payment the parts supplier would receive from its credit default swap counterparty. The ability to manage various forms of risk with futures, swaps, and other derivatives enables firms to budget, invest, and produce more efficiently, and provides a buffer against adverse price shocks. Who takes on the price risk that the hedger gets rid of? It will probably be a speculator who never actually handles the physical commodity, but simply seeks to profit by forecasting future prices. Most trading in derivatives is speculative; the futures exchanges are associations of professional speculators. The advantage of a large volume of trading is that hedgers can quickly find someone to take the opposite side of their trade. For instance, a firm that is at risk if energy prices rise (such as an airline or a power utility) can instantly find a counterparty who is willing to bet that prices will fall, enabling the hedging firm to lock in the current price. Price discovery is the second benefit. Centralized marketplaces like the futures exchanges are forums where all available information about supply and demand for the underlying commodity is assembled and incorporated into the price. Traders' decisions to buy or sell are guided by data on current inventories and consumption, expectations about long-term supply and demand trends, macroeconomic conditions, geopolitical risk factors that could disrupt supply, assessments of market psychology, and innumerable other considerations. A central tenet of free market economics is that a competitive market, where no participant is able to manipulate or dictate prices, is the best available mechanism for determining prices that will ensure that supply meets demand and that resources are efficiently allocated. The price generated by the futures exchanges is publicly available: industrial firms, financial institutions, small businesses, and consumers may all use it to allocate their resources efficiently. However, when commodity prices show extreme volatility, as in the case of crude oil since 2007, theoretical justifications of free market dynamics are not satisfactory. At such times, policymakers may wish to examine the internal workings of the derivatives markets much more closely than under normal conditions. Derivatives markets can be divided into two classes: regulated exchange markets, where standardized contracts are traded in great volume, and the OTC market, where contracts can be (but are not always) highly customized and where deals can be made in private between two counterparties. In the United States, major derivatives exchanges are regulated by the Commodity Futures Trading Commission (CFTC, which oversees the futures exchanges) and by the Securities and Exchange Commission (SEC, which regulates stock option markets). SEC and CFTC regulation of exchanges is generally similar: federal law requires both securities and commodity exchanges to make and enforce rules to ensure fair and orderly trading and to protect public investors from fraud. Many classes of market professionals, as well as the exchanges themselves, are required to register with a federal agency or a self-regulatory organization. Data on price and trading volumes must be publicly available. The regulators may amend exchange rules, and must approve all rule changes. Both SEC and CFTC have their own enforcement powers and staff. The OTC market, by contrast, was largely unregulated until the Dodd-Frank Act. In place of exchanges, there is a system of dealers who stand ready to enter into derivatives contracts with all comers, whether the customers wish to hedge or speculate on prices rising or falling. Dealers are generally large commercial and investment banks that operate internationally—20 or 30 institutions account for virtually the entire market. These institutions may be subject to regulation, but there was no direct regulation of their OTC derivatives dealings. Neither dealers nor customers (also called end users) are required to report or make public OTC transactions: unlike exchange trading, very little information about prices, volumes, or individual positions is available either to the public or to regulators. Although the exchange and OTC markets operated in very distinct legal environments, the products they offer are economically interchangeable. Traders routinely deal in both exchange-traded and OTC contracts, often as part of a single investment strategy. For example, a hedge fund might construct an investment position that included options on a basket of stocks (SEC-regulated), futures on stock indexes (CFTC-regulated), and OTC equity swaps (unregulated). In recent years, both exchange-traded and OTC derivatives markets have experienced remarkable growth. Table 1 below shows figures for 2000 and 2008 for a number of derivatives classes. The total of OTC contracts outstanding rose by 522% over that period, whereas the number of financial futures contracts traded on exchanges rose by 425%. No single measure of market size can apply to both exchange and OTC markets. Because futures contracts are standardized instruments, the traditional measure of trading on the exchanges has been the number of contracts traded. In the OTC market, the number of transactions is not a satisfactory measure, for several reasons. First, not all swaps are identical—a single trade here may represent more economic value than half a dozen trades elsewhere. Second, it is not always clear how to define a "transaction." Typically, a master swap agreement between two counterparties may be frequently amended as to the amount at risk by adding a new figure at the bottom of the contract. Over its life, a single contract may entail numerous transactions, depending on what happens to the underlying economic variables. The standard measure of OTC market size is notional value, a concept that is explained in Appendix C . Notional value provides no information about actual swap payments; it is simply a reference number used in the calculation of those payments. It is possible to calculate a notional value for exchange-traded futures. An oil future, for example, represents 1,000 barrels of oil: the notional value of the contract is thus 1,000 times the current price per barrel. This figure, however, is of no interest to futures traders, because what concerns them is not the value of 1,000 barrels—which they will most likely never actually own—but the price changes that occur during the period that their futures position is open, which may be only a few seconds.