The explosion of new financial products that we have seen over the past several years include many that are based on financial instruments called derivatives. Derivatives add complexity, opacity and risk to investments. Investors and their advisers need to be very careful when confronted with alternative investments that may contain them.

The U.S. Securities and Exchange Commission defines the term “derivatives” as follows: “Derivatives are financial instruments whose performance is derived, at least in part, from the performance of an underlying asset, security or index. For example, a stock option is a derivative because its value changes in relation to the price movement of the underlying stock.” As the SEC’s definition suggests, an option is one type of derivative. Other types of derivatives include forward or futures contracts and swaps.

Some derivatives are regulated, exchange-traded, standardized contracts and that provide pricing transparency. Other derivatives are traded on the “over the counter” (OTC) market, which is largely unregulated, non-standardized and lacks transparency.

Derivatives can be used for hedging or speculation. Hedging allows a person who owns an asset to transfer the risk of price uncertainty to another party. Parties who do not own a particular asset can buy or sell derivatives as a way to speculate on price movements of that asset. Hedging is essentially defensive and conservative while speculation is offensive and risky.

Over the past several years, individual investors have largely either stayed on the sidelines or been persuaded to invest in a broad array of financial products known as alternative investments. Many alternative investments, from exchange-traded funds to structured notes, contain derivatives.

Derivatives reduce the transparency of the pricing and holdings of many alternative investments and increase risks of tracking errors and counterparty default. Derivatives introduce complexities that ordinary investors and brokers do not fully understand. These “synthetic” (or derivatives-based) products are typically designed for very short term trading (“day trading”) and produce unexpected outcomes if held for longer periods.

OTC trading in a type of swap called credit default swaps by large financial institutions played an important role in the financial crisis of 2008-2009. Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC and the Commodities Futures Trading Commission (CFTC) were explicitly prohibited from regulating the OTC swaps markets. Dodd-Frank was enacted in part to regulate the OTC swaps markets.

As of July 10, 2012, the SEC is still requesting public comment on its plan to phase in rules to regulate OTC swaps pursuant to the Dodd-Frank Act.

In the meantime, large financial institutions continue to use derivatives for risky speculation. One example involves JPMorgan’s reported $9 billion loss from trading credit derivatives. The magnitude of the loss has rekindled debate over how derivatives trading by large financial institutions should be regulated.

If you have investment losses or problems involving derivatives, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).