Financial derivatives: governments as end users.

• Position: Survey - Includes related article

Two surveys of state and local government's use of derivative products shed light on how these tools are being used in the public sector. The GFOA's policy position on regulation of derivatives is highlighted.

In the past two decades, fundamental changes in global financial markets--particularly the increased volatility of interest rates and currency exchange rates--have prompted a number of public and private institutions to develop and use derivatives. Derivatives use was accelerated by the continuing globalization of commerce and financial markets and by major advances in finance, information processing and communications technology. The total value of worldwide derivatives outstanding as of year-end 1992 was estimated to be at least $12.1 trillion in terms of the notional, or principal, amount of derivatives contracts.

The term "derivatives" refers to a wide array of financial products that are dependent for their value on (or "derived" from) an underlying financial instrument (e.g., stocks, bonds or foreign currencies), a commodity, or an index representing values of groups of such instruments or assets. Some of the most commonly used derivatives are swaps, options, futures, forwards and a variety of structured securities.

Participants in derivatives markets include dealers and end users, the entities that use derivatives to manage (hedge) their financial risks or to speculate. Among the active end users are financial institutions, commercial firms, mutual funds and pension funds. Some state and local governments also are end users. Two surveys of state and local government officials have recently shed light on the extent and nature of the use of derivatives in the public sector--one conducted by the U.S. General Accounting Office (GAO) reporting on FY1992 financial transactions and one conducted in early 1994 by the Government Finance Officers Association (GFOA). This article summarizes data from those surveys and discusses a policy statement concerning federal regulation of derivatives adopted by the GFOA in June 1994. A statement of recommended practice in the use of derivative products was approved by the GFOA at the same time; it is discussed in an article which begins on page 42.

The GAO Survey

The rapidly spreading use of financial derivative products and their complexity have raised concerns among some regulators and members of Congress that market participants may not be adequately apprised of various risk factors inherent in derivative transactions. In June 1992, the House of Representatives Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce launched an investigation into financial derivatives markets. As part of its initial fact-finding, the subcommittee asked the GAO to report on how well institutions using derivative products manage the related risk and how well regulators identify any gaps in regulation among the dealers and users of these products.

One of the subcommittee's concerns was that derivatives may be used inappropriately by a variety of state and local governments, as well as by public and private pension plans. To explore the nature and extent of the use of derivative products by these end users, the GAO surveyed more than 4,600 state and local government entities that are members of the Government Finance Officers Association (GFOA). The survey instrument, developed in consultation with GFOA members and staff, was distributed with the cooperation of the GFOA. Conducted from April through August 1993, the survey asked details of derivative product usage during fiscal year 1992. The GAO also included the 156 largest private pension plans in the United States in this survey. The survey had a response rate of 81 percent.

Results of the survey were published by the GAO in May 1994, as an appendix to its lengthy report to the subcommittee, Financial Derivatives: Actions Needed to Protect the Financial System. This comprehensive...