There is little doubt at this juncture (and history is always subject to being revised) that the breakdown of derivatives markets was at the heart of the 2008 market crash and recession from which we are now, apparently barely, beginning to emerge.
In many ways the regulation of derivatives is also going to be at the heart of Dodd-Frank and it is only now that the rules for such regulation are beginning to be written and put up for comment. I think it important in this context that the broad outlines of what went wrong with derivatives and what might be done to fix it be rigorously, fairly and dispassionately examined.
Clearly part of the historic problem was that derivatives were generally considered too geeky and arcane to be bothered with. Given the vast externalities (systemic economic effects far beyond those to the persons directly involved in the transactions) of these products this bury your head in the sand mentality had to, and did, end in catastrophe.
Some of this inattention was also perhaps normal historical development. The derivatives markets started small and then grew large pretty much unbeknownst. A lack of public attention to small markets is to be expected. The time to change all of that has obviously now come. But back in the day (pre-2008) the systemic ramifications of derivatives were simply not widely understood.
The cat is now out of the bag. For example, there was an article in today's New York Times "A Secretive Banking Elite Rules Trading in Derivatives" that pointed to essentially a conspiracy among the principal bank dealers in the derivatives markets to maintain maximum control over these markets. As long as the public remains vigilant, the banks' effort is, I should think, not likely to succeed. However, on the other hand, it will not be a happy outcome if alarmist reactionism leads to over-regulation of derivatives.
The Times article also referenced "A New (dis) Order? Questioning the Self-Regulating Market", a video of a panel discussion which took place last Spring at Columbia University. In my opinion, the panel covered the broad issues involved in derivatives regulation in a very useful, level-headed fashion.
As I noted in my article titled "SEC's Initial Proposed Regulations over the Swaps Markets" (note: scroll down the page to get to the article) in this blog dated October 18, 2010, the SEC made proposals last October designed to deal with the types of conflicts of interest issues raised in the Times article, but only for "security based" swaps . See SEC Proposes Rules to Mitigate Conflicts of Interest Involving Security-Based Swaps. However, as far as I know, commodities, futures and the bespoke type swaps which are arranged on an OTC one-off basis between the bank dealers and their customers, all of which will be regulated by the CFTC, have not seen significant rule making proposals yet.
In any event, let's not throw out the baby with the bathwater in the polemic over derivatives regulation. 99.9% of us (that includes professionals inside and outside the banks but away from the trading departments who have dealt with, at times nominally supervised, but often not understood, the products) have a large learning curve to climb as to what makes derivatives tick and how derivative markets function - if we are going to participate in any productive way as to how they should be (or should not be) regulated.
The players in the derivatives markets (i.e. large dealers and major participants) who rightfully argue that financial innovation should not be snuffed out by regulation have a concomitant duty to come clean and explain how these products really work. Otherwise alarmist notions of a cruder sort may well prevail and that will be just as bad as if the bank cabalists prevail in an unmitigated "land grab" fashion.
The alarmists should realize that derivatives can be useful financial instruments and that not all involved in the business are greedy, bloated capitalists. We live in a time of global financial markets and we could easily lose the derivatives franchise to foreign competitors who do not go overboard with regulation.
Of course, the money is on the banks' side and given the realities of modern politics that is worrisome. So, it is time for our rule makers to step up to the plate and not succumb to the siren song of the armies of lobbyists who will besiege them on this issue.
In short, it would be nice for all sides of the debate over derivatives regulation to be honest with each other, walk a mile in the other guy's shoes, resist persons seeking to exericse undue influence, and refrain from overly polarizing the discussion. What makes good show business often does not make for good regulation.
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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.
Nothing is this blog is intended to or may be relied upon as specific legal advice. Securities and related laws are complex and competent counsel should be consulted
