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The OTC derivatives deregulation debate

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At the recent Democratic National Convention, both President Obama and former-president Bill Clinton made it plain that the regulation of some of Wall Street’s more exotic financial instruments, particularly ‘over-the-counter’ (OTC) derivatives, is back on the political agenda. As Clinton said in his barnstorming speech, “They [the Republicans] want to get rid of those pesky financial regulations designed to prevent another crash and prohibit federal bailouts.”

I’m not surprised that this is a hot topic. OTC derivatives were the supposedly clever devices that turned a financial problem – the sudden collapse of U.S. housing prices at the end of a classic boom – into a global financial crisis from which we have all yet to fully recover.

Clinton should know about the deregulation of derivatives, because he was the President who signed into law the Commodity Futures Modernization Act (CFMA)  of 2000, which allowed consenting parties to set up OTC contracts that would avoid all of the dull paraphernalia of a Futures Exchange: all of that reassuring stuff about keeping a daily track of how derivatives are currently valued and of moving margins from one party’s deposit to another to ensure that neither defaults when the day of reckoning arrives. Clinton now regrets his decision to allow this deregulation, which was based on advice given in a 1999 report written by, amongst others,  Secretary of the Treasury Larry Summers, and Chairman of the Federal Reserve Alan Greenspan, which argued that “the sophisticated parties that use OTC derivatives simply do not require the same protection [...] as those required by retail investors.”

These people, it was argued, know what they are up to. They wouldn’t do anything stupid.

Funnily enough, after the passage of CFMA, the newly unregulated ‘sophisticated parties’ immediately rushed out and did something so stupid that it nearly destroyed the global financial system.

See also: Greenspan to Wall Street: Drop dead

Sophisticated parties make bad decisions, too Before we remind ourselves exactly how they did this, let me make my main point: these so-called ‘sophisticated parties’ are not, in my humble opinion, any more sophisticated than other human beings, like you and me. They make just as many bad decisions, often driven by the same instincts of which they are barely conscious. They are swept up in booms and rushes; they find it almost impossible not to want a share of whatever particularly exciting piece of action happens to be going down at the moment. Why would they not? When everyone else is grabbing their share of some good thing, you’d be foolish not to try to get your own. Their bosses make decisions in exactly the same way, and corporations (banking firms, for example) worry about getting their share of a good thing just as much as any individual does. It is, after all, a jungle out there.

See also: Why you shouldn’t trust Washington or Wall Street

More than the entire world’s assets One of the problems with derivative contracts is that the sums of money involved are potentially, quite literally, limitless. A recent report by the consumer advocacy organization Public Citizen, called Forgotten lessons of deregulation, makes this point very forcefully. “Over-the-counter derivatives trading grew dramatically in the years following passage of the CFMA,” the report states. “The notional value of such trades [...] increased from $95.2 trillion in 2000 to $672.2 trillion in 2008 — a more than seven-fold increase. By contrast, the entire world’s assets in 2008 added up to only $178 trillion.”

Wow. So the trade in OTC derivatives in 2008 amounted to more than the assets of the entire world. This, of course, is quite possible, because a derivative is a contract that derives its value from some underlying asset, and more than one party can have a derivative position on the same underlying asset. But it makes you think, doesn’t it?  Maybe these things really should be, you know, regulated?

Some people still don’t seem to think so, and a number of bills currently in Congress seek to undo the regulation that was put in place in 2010, as the world stood in the still-smoldering ruins of a global credit crunch brought about by – you guessed it – OTC derivatives. The fact that a number of people think that derivatives don’t need to be regulated is surprising, because it is generally accepted that Stock and Futures Exchanges and the financial industry as a whole do indeed need to be highly regulated.

Ah – but OTC derivatives are bought and sold by “sophisticated parties.”

Let’s remind ourselves what the sophisticated parties were up to in the years leading up to the financial meltdown of 2008.

Hedging every bet America’s housing market was booming, as low interest rates and a flood of overseas investment created a classic, but supersize, property boom. The hot ticket of the day was to package up mortgages of very variable quality into “bonds” and to sell these, mainly to overseas investors. The bonds were supposed to be safe, because they were composed of many mortgages, and it was not imagined that large numbers of mortgage holders would default at the same time (as in the apparently unimaginable scenario of a sharp fall in house prices, for example). Then somebody had a new idea: the magic of derivatives could be used to sell “insurance policies” (Credit Default Swaps) on these bonds.  If your bond goes bad, the Default Swap pays up; your bets are hedged!

Because these bets were over-the-counter derivatives traded by sophisticated parties, they were not subject to any regulation. In other words, no one checked to ensure that the person covering the bet should have enough money in the bank to cover future pay-outs. To make things worse, other parties were also able to buy “insurance policies” on assets that they did not even own: like being able to insure your neighbor’s house. Some speculators took out massive bets that mortgage-based bonds were about to go bad. To add to the fun, Wall Street packaged up these “insurance policies” (bets) into a whole new kind of synthetic bond to sell to investors, all of which was supposed to represent a healthy spreading of risk around the system.  Banks even bought their own “sophisticated” products in the hope that they would indeed be a kind of insurance policy. As Wall Street flooded the market with cash to buy mortgages to turn into bonds, lenders threw money at increasingly insecure borrowers.  When the bubble burst, the holders of now worthless mortgage-based bonds wanted to collect on their insurance policies, as did the speculators who had bet against the bonds.

Due to the lack of regulation of this market, the main issuer of Credit Default Swaps, AIG, had not been required to hold sufficient capital to cover all of the contracts it had entered into. It couldn’t pay up. All of those sophisticated hedging bets were now worthless. AIG was bailed out by the U.S. government to the tune of $150 billion of tax-payers’ money to avoid a complete market collapse. Even then, a global credit crunch kicked in, as banks realized that nobody could be certain just how toxic were the contracts engaged in by virtually every major financial institution.

The moral of the story: None of us is very sophisticated. We all make mistakes; it’s only human. When mistakes can be made with contracts whose value exceeds the word’s entire assets, it’s probably a good idea if our decisions are subject to a bit of oversight.

See also:

Why you shouldn’t trust Washington or Wall Street

3 fiscal storms brewing

Greenspan to Wall Street: Drop dead


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