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Obama Pushes Broad Rules for Oversight of Derivatives (STEPHEN LABATON and JACKIE CALMES, 5/13/09, NY Times)

The administration is seeking the repeal of major portions of the Commodity Futures Modernization Act, a law adopted in December 2000 that made sure that derivative instruments would remain largely unregulated.

The law came about after heavy lobbying from Wall Street and the financial industry, and was pushed hard by Democrats and Republicans alike. It was endorsed at the time by the Treasury secretary, Lawrence H. Summers, who is now President Obama’s top economic adviser.

At the time, the derivatives market was relatively small. But it soon exploded, and the face value of all derivatives contracts — a measure that counts the value of a derivative’s underlying assets — outstanding at the end of last year totaled more than $680 trillion, according to the Bank for International Settlements in Switzerland. The market for credit default swaps — a form of insurance that protects debtholders against default — stood around $38 trillion, according to the international swaps group. That represents the total amount of insurance that has been written on various kinds of debt, but the amount that would have to be paid out if the debt went into default is considerably less.

As the credit crisis has unfolded, trading in credit default swaps has cooled, market participants said. The collapse of A.I.G. took a huge player out of the market and banks, hobbled by loan losses, have curbed their activities in the market. Still, derivatives trading desks have been one of the few profit centers at major banks recently.

The biggest banks and brokerage firms like JPMorgan Chase, Citigroup and Goldman Sachs, as well as major insurers, are all major players in derivatives.

Derivatives are hard to value. They are virtually hidden from investors, analysts and regulators, even though they are one of Wall Street’s biggest profit engines. They don’t trade openly on public exchanges, and financial services firms disclose few details about them. The new rules are meant to change most, but not all, of that opacity.

Used properly, they can reduce or transfer risk, limit the damage from market uncertainty, and make global trade easier. Airlines, food companies, insurers, exporters and many other companies use derivatives to protect themselves from sudden and unpredictable changes in financial markets like interest rate or currency movements. Used poorly, derivatives can backfire and spread risk rather than contain it.

The administration plan would not require that custom-made derivative instruments — those with unique characteristics negotiated between companies — be traded on exchanges or through clearinghouses, though standardized ones would. If approved, the plan would require the development of timely reports of trades, similar to the system now used for corporate bonds.

Used properly the derivatives need not be so opaque. The ever increasing complexity--so complex that even the guys designing them couldn't explain them to the guys selling them, nevermind the ones buying them--was apparently driven more by the desire to make them unique and thus more easily sold than by any desire to make them perform their core functions better. Since, as a society, we have a vested interest in having the derivatives function but none in having them be exotic, why not just require that the precise formula by which they were derived be public information and not subject to copyright protection?

Posted by Orrin Judd at May 13, 2009 8:35 PM