Why should financial markets be regulated?

Why should Financial Markets be regulated?

Financial markets have a significant contribution to the economy, helping in economic growth through investment activities, and capital allocation. The unique characteristics including systemic risks, information asymmetries, and externalities of the financial markets often constitute chances for failures of market and social costs. Therefore, financial markets' underlying complexities and possibility of instability postulate financial market regulation as it is essential for the fairness, integrity, and stability of the financial system:

Information Asymmetries: The primary reason to regulate the financial market is the existence of issues related to information asymmetry. This issue relates to a situation wherein one party possess more information as compared to the other party while doing the financial transaction. This situation in the financial markets could contribute towards misrepresentation, fraud, and various vicious activities. For example, in insider trading, people having inside business operations information could trade on that information before it goes public. On the other hand, manipulative or uninformed practices could exploit consumers and investors in the fields of financial products, securities trading, and insurance. Regulations could serve to deal with these problems by demanding corporations to reveal pertinent information, additionally, regulations could help to fight fraudulent practices and misleading information.

Externalities: The presence of different externalities in the financial market also requires regulations. Externalities take place whenever economic activity impacts parties having no direct involvement in the financial transactions including systemic risk, social impact, and environmental degradation. It has been evidenced that the collapse of a big financial institution has contagious implications for the overall economy, which has contributed to losses of jobs, reduction in consumer spending, and prevailing social agitation. Regulation could facilitate to control of these externalities by enforcing safe products and regulations about requirements of capital from financial institutions to minimize the potential of failure. Additionally, regulations related to terrorist financing, and money laundering could help to control the externalities related to them. Moreover, regulations could incentivize sensible investments in fields such as sustainable technologies and renewable energy.

Systemic Risk: It refers to the likelihood of the whole financial system collapsing owning to the interconnectedness of financial institutions. In the unregulated markets, the practices of leverage and excessive risk-taking enhance the chances of such occurrences as was witnessed in the global financial crisis of 2008, which was started as a result of the subprime mortgage meltdown and rapidly dispersed to other financial systems. Rigorous regulation could assist in precluding this by necessitating institutions to uphold enough capital buffers, stress testing, restraining their vulnerability to risky assets, and enforcing resolution mechanisms to manage the failing institutions to avoid the implications on the whole system.

Derivatives should either be Banned or Strictly Controlled

Derivatives, including options, swaps and futures are financial instruments which drive their value from underlying financial assets, have become very popular among investors and traders, used to hedge against risk, making investments more accessible as they allow for greater liquidity in the market. For example, when purchasing stock, one cannot invest directly without being exposed to the uncertainty of future cash flows. Derivatives in this regard could help to reduce this unpredictability, reducing fluctuations in prices, and offering greater transparency. Thus, derivatives can act as a form of insurance against any losses due to volatility. Because derivatives are usually more liquid than traditional bank products, they make it easier to move money around quickly without the possibility of exchange rate fluctuation. Thus, derivatives could increase market efficiency by rendering risk transfer and price discovery mechanisms.

However, despite having numerous advantages, derivatives also come with significant systematic risks. One of the most notable issues is that they can trigger major events such as panic selling, which can lead to loss of purchasing power and overall economic implications. Another problem is that derivatives are highly dependent on economic conditions, which means that any sudden change in those conditions will impact the price of the product. Another drawback linked with derivatives is moral hazard, which could urge financial institutions to adopt reckless behavior to offload their exposure towards others, could increase leverage, and could lead to drastic and sharp price movements which could disturb the whole financial system. Thus, in the trading of derivatives, the counterparty default risk to honor its obligations could lead to a chain of defaults.

Owning to associated benefits, there is a need to follow strict regulations to mitigate the risk of derivatives trading instead of making them banned. Firstly, there is a need to enforce transparent terms and conditions of derivative contracts, which would help the investors assess the associated risks. Secondly, there would be margin requirements to ascertain that parties could meet obligations. Third, more strict regulations would be imposed on the derivatives having excessive risks. Fourth, there would be central clearinghouses and lastly, the stress tests could be used to see the capacity to absorb the potential shocks.