Page 15 - DMGT512_FINANCIAL_INSTITUTIONS_AND_SERVICES

Financial Institutions and Services

Notes Financial Derivatives

A financial derivative is a financial instrument that is linked to another specific financial
instrument, indicator or commodity and through which specific financial risks (such as interest
rate risk, foreign exchange risk, equity and commodity price risk) can in their own right, be
traded in financial markets. The value of a financial derivative comes from the price of an
underlying item such as an asset or index. Financial derivatives can be used for risk management,
hedging (protecting) against financial losses on commercial transactions and financial instruments
and arbitrage between markets and speculation. There are two distinct classes of financial
derivatives — forwards and related instruments, and options. The most common forward
instruments are forward contracts, futures contracts, Forward Rate Agreements (FRAs) and
Interest Rate Swaps (IRS). Financial derivatives are traded over-the-counter, in which case they
are customised and can be purchased from financial institutions or are standardised products
which are traded on organized exchanges.

Payment and Settlement Infrastructure

One of the most important functions of the financial system is to ensure safety and efficiency in
payments and securities transactions. Financial infrastructure refers to the different systems that
provide for the execution of both large-value and small-value payments. Payment and settlement
systems enable the transfer of money in the accounts of financial institutions to settle financial
obligations between individuals and institutions.

Case Study Should Financial Systems be Rule-based?

A emerging that the financial system should be more rules-based.
fter evaluating the pitfalls and advantages of both the systems, there is a view

The recent global meltdown has proved one thing: Neither a rules-based regulatory system
nor a principles-based regulatory system is a guarantee against bank failure. However,
after evaluating the pitfalls and advantages of both the systems, there is a view emerging
that the financial system should be more rules-based; this is especially true in the UK.
In contrast, two committees set up in India - the Percy Mistry Committee (2007) and the
Raghuram Rajan Committee (2008) - to look into financial sector reforms have
recommended that India's regulatory regime should move from rules-based to a principles-
based one.
Principles-based regulation (PBR) implies moving away, wherever possible, from
dictating, through detailed prescriptive rules and supervisory actions, how firms should
operate their businesses. Rules-based regulation, it is pointed out, is too rigid and
prescriptive, and often the regulator and the regulated adopt adversarial and antagonistic
postures. Some of the countries that follow principles-based regulatory systems are the
UK, Australia, Canada and Ireland. Some of the leading countries whose regulatory regime
is based on rules are the US, Spain and India.
However, as noted in the Turner Review, banks in countries following either of the
systems have failed. For example, banks have failed in the US and the UK. So in a way,
neither of the regulatory systems has proven to be robust. One way to draw lessons from
the crisis would be to examine what countries such as India, Spain and Canada did right to
insulate their financial systems from succumbing to the global crisis.
Contd...

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