The OTC derivatives deregulation debate

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?