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Monday, April 19, 2010

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.

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.


  1. I don't want it. It just institutionalizes and protects the biggest banks. Crony capitalism at its worst.

    We need to break up the big banks and return to Glass Steagal, to allow competition from small and regional financial players.

    There is nothing in this bill which decreases teh odds of what happened in 2008 from recurring. It only increases the exposure to the taxpayers.

  2. Troy, I can certainly live with breaking up big banks on top of derivatives reform. But back to that question: what part of regulating derivatives and putting them on an open exchange, just like stocks, is a bad thing?

  3. Government regulation gives the appearance of safety which is misleading in this situation.

    Derivatives are a lubrication to the system's liquidity (a good thing). Regulation will make the oil thicker and less fluid.

    Regulators couldn't discover something as egregious as Madoff. Regulation and oversight will provide absolutely no protection to investors from fraud but regulation will result in excessive costs.

  4. Hold on—derivatives and Madoff are two different things. Yes, fraud will always be with us, just like the poor, but is that really an argument not to regulate? You really think regulation will provide "absolutely no protection" against fraud, or even questionable financial products pushed by over-eager big-bank whiz kids?

    The video above makes a pretty clear point that at AIG, the regulated divisions were in the black; one unregulated division, dealing with derivatives, sunk the whole show and triggered the bailout. The stock market shows that trading financial products on an open exchange, where we can get information about the product from someone other than the immediate seller, does not produce excessive costs or stifle economic growth.

    Are you really saying, Troy, that unregulated derivatives, with speculators placing bets that they can't cover, are a necessary lubricant to the economy?

  5. Yes, I am.

    The connection between Madoff and derivatives is regulation doesn't solve the problem but gives the illusion of safety that doesn't exist which allows more leverage and risk.

    With regards to putting derivatives on an open exchange opens them up to a new class of investors who no matter how much disclosure you have will be unintelligible to most investors.

    While I'm trained and work in the financial sector, I would be hard pressed to be able to assess the risks of derivatives. I guarantee you and most others will find it impossible.

    I don't have time to go into it but your understanding of AIG is incomplete.

    In the end, you have more faith in regulation than is deserved by history and the speed at which derivatives diversify risk in certain financial transactions.


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