Time to Regulate Derivatives (Like Every Other Financial Instrument)

What is it about derivatives that makes otherwise rational humans become so damned stupid? There is no need to over-complicate this; a rather simple series of steps can be undertaken to bring the most dangerous of derivatives out of the shadows and into light of day.

Radical derivative deregulation had a bastard birth: On the eve of a holiday break, Texas Senator Phil Graham attached a budget bill rider titled the Commodity Futures Modernization Act of 2000. This was done at the behest of his wife Wendy, who was a member of the Board of Directors of Enron.

What the CFMA did was create a unique financial product. Derivatives and Swaps entered a world where they were treated very differently from all other financial products. Stocks, bonds, options, futures all follow specific rules. Securitized derivative products  (collaterallized paper such as CDOs, CMOs, CLOs, etc.) and Credit Default Swaps (CDSs) do not.

Consider for example these characteristics of most financial instruments:

-They trade on an exchange; -Participants have sufficient capital to engage in trading; -Counter-parties disclosure is known (at the least to the exchange) -Potential future payments require capital reserves to meet obligations; -The full amount of traded instruments is transparently disclosed; -There is a regulator in charge of insuring the above rules are followed.

Derivatives had none of those. Indeed, the CFMA specifically exempted derivatives not only from these items, but added they were exempt from state insurance regulators.

Let’s not over-complicate this: We need to do 3 things to rein in the worst aspects of derivatives, and dramatically reduce the systemic risk they present, while retaining their ability to be a valid financial instrument for hedging risk:

1. Repeal the Commodity Futures Act of 2000

2. Treat Derivatives like all other financial instruments: All of the above elements need to be derivative requirements;

3. Give the Commodity Futures Trading Commission full oversight and the teeth to enforce the rules.

Wall Street and the banks will fight this tooth and nail, as they are reaping billions in derivative trading profits. Never mind that whole 2008-09 meltdown thingie — that’s ancient history.

This is simple, folks: Derivatives should not receive special treatment — they need to be regulated the way most other financial products in the world are.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.