A variable that is closely linked to the level of standardisation of a market is the level of regulation prevalent in a market. Regulated markets offer investors standardised products, accessible trading platforms with certain rules and regulations and are monitored by independent bodies. Regulated markets generally increase the safety and protection of investors (Bloss et al. 2008:6). For the purpose of this study the level of regulation is referred to as the degree to which a market offers protection for investors, thus making trading safer and reducing the risk of default of counterparties.
As mentioned before, markets, such as the South African Futures Exchange and the Johannesburg Stock Exchange, that offer standardised products tend to increase the safety for investors, as such markets are transparent and offer products whose features are known. Standardised products diminish the uncertainty of investors in two ways. With standardised products the issuer and trader of the security is known. Standardised products have similar contract features, e.g. the date to maturity, strike price or underlying asset and investors generally know how those products work as they are less complex than individual constructed securities.
An important aspect of regulation in a market is the trading platform’s clearing house. The clearing house of the stock exchange monitors every trade and the solvency of investors in order to identify potential risks of default. Other important tasks of the clearing house include the processing, back-up and settlement of transactions (Bloss et al. 2008:20). Monitoring trades and solvency of investors is of utmost importance with derivative trading, as investors can experience high potential losses, especially with futures trading.
The Johannesburg Stock Exchange and South African Futures Exchange have a clearing house that monitors trade in the South African derivatives market, thus making it safer and easier for investors to trade derivative instruments as potential risks, especially limiting counterparty risks. Clearing houses which protect and assist investors in their trading are not available in over-the-counter markets. This makes trading in over-the-counter products more uncertain as the counterparty risks are not monitored by an independent body.
153 Credit derivatives were traded over-the-counter prior to the 2008/2009 global financial crisis. The only reliable source providing information relating to the counterparty and default risks involved in such products, were rating agencies. As the information was not correct and unreliable it led to a major breakdown in the credit derivatives market and economies across the world.
It is important for financial markets to have independent bodies governing them. Such governing bodies as the Financial Services Board (FSB) in South African or the Securities and Exchange Commission (SEC) in the USA are watchdogs that ensure that investors are protected. They also impose trading rules and investigate abnormal trading behaviour.
South African investors are generally well protected as a recent Global Competitiveness survey undertaken by the World Economic Forum shows. South Africa performed better than developed economic powerhouses, such as USA, UK, France and Germany in terms of financial market security. Of note is the fact that South Africa was ranked second in this survey in terms of regulation of securities exchanges and fourth in financing through local equity markets (Bisseker 2010a:44- 45). In the same survey, South African banks were ranked sixth in terms of general health and soundness of their balance sheet, whereas most banks from developed countries were ranked at the bottom half (Bishop 2010:17).
As a result of the 2008/2009 global financial crisis, governing bodies across the world are now enforcing stricter rules and regulations on derivatives markets. In Germany naked short sales, which are prohibited in South Africa, were suspended by the German banking and financial market regulators until March 2011 (Frankreich irritiert über deutsches Leerverkaufsverbot 2010).
Banks and governments are trying to find ways to regulate the large over-the-counter asset-backed securities and credit derivatives markets, as they became highly complex and risky, not only for investors but for entire economies and states. As a result, the European Union introduced a central clearing house that monitors over- the-counter derivatives and increases transparency in these over-the-counter products. Furthermore, financial institutions are obliged to register short sales with
154 market regulators and have to provide evidence that they are in the possession of the underlying assets they sell short (EU-Kommission will Spekulanten zügeln 2010).
According to studies conducted by Faerman, McCaffrey and van Slyke (2001:372- 388) as well as Michie and Grieve Smith (1995:224-228), the ultimate goal of tighter rules and regulations is to avoid hidden counterparty risks, protect investors even more, and prevent financial markets from possible futures collapse. Thus, the following proposition can be made:
P12: Investors are more likely to use derivative instruments in well-regulated markets.
Another variable identified during the pilot study and literature review that possibly influences investors’ decision-making process towards derivative instruments in their portfolios is the extent to which information regarding derivative products is available and the transparency of price determination of these products.
4.3.4 The level of information available on derivatives and the transparency of