Document Type

Article

Publication Date

Fall 2009

Keywords

OTC derivatives, Over-the-counter derivatives, Speculation, Hedging, Credit markets, Derivatives regulation

Disciplines

Banking and Finance | Corporation and Enterprise Law | Securities Law

Abstract

When credit markets froze up in the fall of 2008, many economists pronounced the crisis inexplicable and unforeseeable. Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, knew better.That's because the roots of the catastrophe lay not in changes in the markets, but changes in the law. In particular, the credit crisis can be traced to Congress's 2000 passage of the Commodity Futures Modernization Act, which radically altered the traditional legal approach to financial derivatives.

This shift in the legal treatment of financial derivatives has brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG's trading losses in the new and rapidly growing market for credit default swaps (CDSs), a kind of derivative bet that issuers will not default on their bond obligations. Because AIG was part of an already enormous and poorly understood web of CDS bets and counter-bets among the world's largest banks, investment funds, and insurance companies, when AIG collapsed, many of those firms worried that they too might soon be bankrupt. Only a massive $180 billion government-funded bailout of AIG prevented the entire system from imploding. This could have been avoided if we had kept the traditional approach to derivatives regulation.

Wait a minute, some readers might say. What do you mean, traditional approach to derivatives regulation? Aren't derivatives some new, modern financial "innovation" that has never been regulated?

Well, no. Derivatives have a long history that offers four basic lessons. First, derivatives contracts have been used for centuries, possibly millennia. Second, while derivatives can be useful for hedging, they are also ideal instruments for speculation. Third, excessive speculation is linked with a variety of economic ills, including increased systemic risk when derivatives speculators go bust. Fourth, derivatives speculation traditionally has been "regulated" not through heavy-handed bans on trading, but through a curious but effective rule that protected and enforced derivative contracts used for hedging purposes while declaring purely speculative contracts to be legally unenforceable wagers. This rule of unenforceability encouraged speculators to rely on private ordering and to develop and police their own private markets (exchanges). Exchanges in turn limited systemic risk.

Comments

This article predates the author's affiliation with Cornell Law School.

Publication Citation

Published in: Regulation, vol. 32, no. 3 (Fall 2009).