OpEd: A Long Road to Regulating Derivatives

Editorial
A Long Road to Regulating Derivatives
Published: March 24, 2012 (New York Times)

If there is one lesson from the financial crisis that should be indelible, it is that unregulated derivatives are prone to catastrophic failure. And yet, nearly four years after the crash, and nearly two years since the passage of the Dodd-Frank law, the multitrillion-dollar derivatives market is still dominated by a handful of big banks, and regulation is a slow work in progress.
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That means Americans, and the economy, remain at risk. Properly regulated, derivatives — financial instruments that hedge risk — help to stabilize the economy. Unregulated, they are all too easily converted into tools for vast speculation, as demonstrated by their role in inflating the real estate bubble, amplifying the bust and provoking the bailouts. Unreformed, they will cause havoc again.

Even if they don’t cause a meltdown, unregulated derivatives are still an economic threat. That’s because derivatives have become deeply embedded in the economy. Pension systems use them to hedge investment risk. Food companies use them to lock in crop prices. Airlines and manufacturers use them to lock in prices for fuel or metal. But because there is no central exchange where derivatives’ prices are listed, no one knows if the prices banks charge are reasonable.

What is known is that the banks make billions of dollars a year on derivatives deals — lush profits that are surely higher than they would be if the market were transparent and competitive. Overcharging means that bankers are enriched with money that companies could otherwise invest in their businesses and that consumers could otherwise keep in their pockets.

The Dodd-Frank law charged two agencies with writing a broad range of new rules to rein in derivatives — the Commodity Futures Trading Commission, which oversees derivatives linked to oil, crops and other commodities, and the Securities and Exchange Commission, which oversees securities-based derivatives. There has been progress. The C.F.T.C, in particular, has moved ahead with sound rules to create competition, promote safety, increase transparency and tame speculation. But some of the toughest rules are languishing — like the crucial Dodd-Frank requirement that most derivatives be traded on an open exchange, with prices visible before deals are made.

That would minimize the practice of trading derivatives as private bilateral contracts, in which the price is whatever the bank says it is. Over a year ago, the C.F.T.C. sensibly proposed a system in which buy and sell offers would be electronically posted and widely accessible. In response, industry lobbyists and some lawmakers have made the absurd argument that open trading would hurt banks’ flexibility to continue doing business as usual.

Unfortunately, in today’s political environment, even absurd arguments have the power to delay or derail vital reforms. Republican lawmakers, with some Democratic support, have proposed legislation to roll back the rules on open trading even before regulators have finalized them. Rules that have been finalized are increasingly subject to protracted legal challenges by the financial industry. And regulators are routinely reduced to pleading with Congressional appropriators for chump change to carry out their duties.

It is up to President Obama, who takes credit on the campaign trail for reforming Wall Street, to provide full-throated support for implementing and enforcing the Dodd-Frank rules. Otherwise the law will be a reform in name only.