Derivatives Reform: You Want This!

With health insurance reform now in the win column, Congress and the President are turning to financial reform. There will be a lot of moving parts to this legislation—you just can't govern the world's biggest economy on slogans and one-page bills. Among the essential moving parts: derivatives reform.

President Obama is vowing to veto any financial reform legislation that does not include regulation on deriviatives. His chief economic advisor, Christina Romer, backs him up:

What is needed is a new set of rules of the road for our financial system, greater accountability for Wall Street, and increased protections for consumers. Those rules include a comprehensive regulatory framework where capital and liquidity requirements control excessive risk-taking and where regulators consider risks to the system as a whole and not just to individual institutions. They involve putting complicated financial products such as derivatives onto exchanges and into clearinghouses so that risks are known and values are clear [Christina D. Romer, "Back to a Better Normal: Unemployment and Growth in the Wake of the Great Recession," address to the Woodrow Wilson School of Public and International Affairs, Princeton University, 2010.04.17].

Now before my conservative friends buy into the Senate Republicans' political line that regulation is bad, consider why derivatives matter. The collapse of credit default swaps, one flavor of derivatives, forced us to bail out AIG to the tune of $180 billion. That was arguably a greater intrusion on the free market than any specific regulation.

Five banks, including our friends at Citicorp, constitute "a kind of cartel that controls all the trading and information" on derivatives. That's not a free market when a handful of players with vested interests monopolize information.

Regulation of derivatives doesn't put anyone out of business. It simply puts this particular financial "product" on the same footing as stocks, which are traded quite happily and successfully on open, regulated exchanges. Regulation hasn't killed the stock market; it has made the market healthier and safer. Regulation would do the same for derivatives. Secretary Geithner explains:

Transparency will lower costs for users of derivatives, such as industrial or agriculture companies, allowing them to more effectively manage their risk. It will enable regulators to more effectively monitor risks of all significant derivatives players and financial institutions, and prevent fraud, manipulation and abuse. And by bringing standardized derivatives into central clearing houses and trading facilities, the Senate bill would reduce the risk that the derivatives market will again threaten the entire financial system [Secretary of the Treasury Timothy Geithner, "How to Prevent America's Next Financial Crisis," Washington Post, 2010.04.13].

Regulating derivatives shifts risk back to where it belongs in the market: on informed investors who can cover their bets.

If you don't like bailouts, if you don't like recessions, if you don't like losing your job because Wall Street fat cats crashed the global economy, then you do like derivatives regulation and the full financial reform package working through Congress.

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To understand derivatives, try this explanation from Prof. Michael Greenberger. The professor notes that when AIG went bust, it had over 20 divisions. On September 16, 2008, AIG's regulated divisions were humming along nicely with $20 billion in reserves. AIG's one derivatives subdivision was not regulated, held no reserves, issued insurance policies worth double the company's value, and sunk the company.