There is widespread agreement that market integrity and efficiency, financial safety and integrity, and customer protection (fair treatment of customers) are critical to the success of any financial market. Anyone responsible for operating such a market, therefore, has strong incentives, independent of external regulation, to ensure that these conditions are present and that these conditions are apparent to all actual and potential users of the market. Some market participants, nevertheless, have incentives to take actions which compromise these goals. Both theory and experience show that regulation, properly implemented, can improve the probability that the desired levels of integrity and customer protection will be reached and maintained. Experience also demonstrates that a successful regulatory system can complement the incentives for self-regulation while reducing the incentives and opportunity for behavior which threatens the success and integrity of the market.

Market Integrity and Efficiency

Derivatives exchanges serve three important economic purposes: risk shifting, price discovery, and enhancing efficiency by providing a focal point where buyers and sellers can easily meet. None of these purposes can be properly served if prices on the exchanges do not accurately reflect the forces of supply and demand. Nor can they be served if buyers or sellers do not have confidence that prices do reflect these forces. That is, people will be unlikely to use the market if they do not believe in its integrity.

An obvious threat to market integrity is manipulation - a deliberate attempt to distort the market price. Many people also believe that prices in derivative markets can be excessively volatile or that they can increase the volatility of prices in the cash market. Historically, futures and options exchanges and their regulators have devoted substantial resources to ensuring that prices reflect supply and demand and to assuring market users that adequate safeguards exist against manipulation and other practices which may distort prices, the market's depth and liquidity, or market positions (such as fictitious trades and wash trades).

Financial Safety and Integrity

One of the distinctive features of a centralized derivatives exchange is that the exchange (or the exchange's clearinghouse) acts as a counterparty to every trade. Thus, those who use the exchange do not have to worry about the creditworthiness of the counterparties to their trades. In order to fulfill its responsibilities as a counterparty the exchange must establish a system for financial integrity and other means for guaranteeing trades which ensures that it has the financial capacity to satisfy its obligations to fulfill the terms of the contract. needed to make the payments it has promised to make. As in the case of market integrity, it is clearly in an exchange's self interest to establish a reputation for financial integrity. Otherwise, it will be difficult to attract customers. Regulatory oversight of the exchanges' activities in this area can ensure that the proper systems are in place, and it can give customers additional confidence in the exchange's financial integrity.

Another reason for regulatory attention to financial integrity is that financial problems on an exchange can have systemic (i.e., spillover) effects. That is, they can affect the integrity of the financial system. The failure of an exchange to guarantee performance on contracts may result in defaults on other exchanges and in other financial institutions. Thus, it is in the public interest to ensure that each derivatives exchange has taken the appropriate measures to ensure its own financial integrity.

Customer Protection and Fairness

Customers trading on derivatives exchanges entrust their funds to financial intermediaries. They receive information about the nature of the risks of these transactions from those with an interest in inducing customers to engage in such transactions. Accordingly, firms, exchanges, self-regulatory agencies and governmental regulators must establish regulations addressing customer protection and fairness. These regulations typically include procedures to ensure the fitness and competency of those who deal with customers, appropriate disclosures to customers, documentation to ensure customer authorization for transactions, sales practice rules intended to prohibit misleading sales conduct, segregation rules which require the separation of customer funds from the funds of the firm and rules which require that customers' orders get priority over firm orders.

Exchanges and firms that want to attract customers clearly have incentives to ensure customers that they will be treated fairly. Those with good reputations are more likely to be successful than those with reputations for mistreating customers. But customers may not always know a firm's reputation and firms sometimes have difficulties in monitoring their own employees. Additionally, the ability of a firm or a self-regulatory organization (SRO) to discipline those who commit fraud is limited. Even in jurisdictions with a vigorous self-regulatory program, the existence of a governmental regulator as overseer of that program ensures greater accountability.