Derivative traders have huge scope for skirting disclosure rules, and it terrifies regulators. Attempts by the Securities and Futures Commission (SFC) to control over-the-counter (OTC) trading are long overdue. The business sees price-sensitive deals conducted, largely off-shore, with just a handful of traders in on the game. New rules will see derivative banks report their OTC exposure on a monthly basis. To date, they have traded with near impunity with deals booked through off-shore subsidiaries outside the regulator's control. The OTC derivative market is huge, although giving a figure for typical turnover is impossible. Secrecy is everything. A small group of traders at international banks run the business with a handful of broking firms like Prebon Yamane and Tradition playing the discreet intermediary. Hong Kong regulators are especially attuned because of the structure of the market. Frequently top tycoons are seen dealing OTC options ahead of major corporate announcements in activity that is insider trading by another name. The local giants reportedly have run option exposures on their own stock that exceeded $2.5 billion. Such positions force counter-party banks to trade substantial amounts of stock for hedging cover. The losers in this closed information loop are, of course, small investors. Southeast Asia provides a fertile ground for derivative banks because of the owner-manager arrangements at most ethnically Chinese listed firms. Often violent movements at the expiry of such option contracts result from both parties trying to influence the closing price. Such activity is commonplace in the purely inter-bank currency and interest rate markets, but cannot be justified when the underlying security is a locally traded equity held by retail investors. The move is in line with directives from the Bank of International Settlements and International Organisation of Securities Commissions, but has been an on-going policy issue for the SFC. Few practitioners think the OTC business will be thrown open to full scrutiny any time soon. Banks are only being forced to reveal their positions on a monthly basis and retain the ability to book trades outside of the regulator's investigative ambit. The industry thinks of itself as the best regulator of good practice. Indeed most OTC derivative activity is conducted inter-bank with parties fully aware of the risks being taken. With significant exceptions, like the Barings collapse, the industry has not subjected underlying equity markets to intolerable systemic risk. The familiar traders' line of derivatives not so much creating risk - or volatility - but spreading it around, still holds water. Still, if major shareholding changes must be disclosed under SFC rules there is a strong moral, if not legal, case that the public should know about price sensitive derivative positions held by banks and other interested parties. Similarly, offshore issuance of warrants in lightly regulated markets such as Luxembourg explain dramatic movements in many second-line stocks. It is common practice for company chairmen to sell warrant issuing banks substantial blocks of stock as the necessary hedge to issue warrants. The Hong Kong investing public simply sees increased trading activity and a sharply rising share price. Unlike locally listed warrants, OTC issues are not required to be disclosed to either the exchange or SFC. The regulator's move to control OTC activity comes as it tussles with the Hong Kong Monetary Authority over who should regulate banks' securities dealing activity. The authority has moved to police the risk-taking practices of banks dealing derivatives in recent years, performing regular checks on the risk management systems in place. It is to be hoped the SFC can bring greater transparency to a market where it is clearly in the public interest for more information to be revealed.