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E-MailThe US Congress is currently grappling with the issue of whether and how to regulate the market for financial derivatives. In my testimony before the Senate Committee on Agriculture yesterday (for historical reasons, the Agriculture Committee has jurisdiction over derivatives trading), I explored the theory and history of derivatives and derivatives trading. The full text of my testimony is available here.
My analysis leads to four conclusions. First, despite industry claims, derivatives contracts are not new and are not particularly “innovative.” Derivatives trading in the US dates back at least to the 1800s, and in other countries goes back much further. Second, healthy economies regulate derivatives trading. The only time a significant US derivatives market has been “deregulated” was during the eight years following passage of the Commodities Futures Modernization Act of 2000, which deregulated over-the-counter financial derivatives. Third, although the derivatives industry routinely claims that derivatives trading provides social benefits, virtually no empirical evidence supports this claim. At the same time, history and recent experience both confirm that unregulated derivatives trading is associated with pricing bubbles, added market risk, reduced investor returns, and increased fraud and manipulation.
Fourth and finally, as a historical matter derivatives regulation generally has not taken the form of either a heavy-handed ban on trading, or oversight by an omniscient regulator tasked with intervening on an ad hoc basis. Rather, derivatives markets have been successfully regulated through a web of ex ante procedural rules that include reporting requirements, listing requirements, margin requirements, position limits, insurable interest exceptions, and limits on enforceability. This traditional approach has a long track record of success.
2 Comments
Dr. Stout,
I was intrigued by your testimony yesterday. To follow up on one of Sen. Chambliss’ questions, what would be an example of a useful OTC derivative? Is it your position that the economic benefits of derivatives do not accrue to society at all? Is it your position that the negatives (e.g., AIG) outweigh the positives? I would agree that if the “derivatives industry” touts the societal benefits of derivatives, it is incumbent upon them to prove those benefits; however, do you have specific evidence that proves that they do not have societal benefits?
Thanks,
Sam
I agree with Dr. Stout’s testimony. As a risk manager, I do believe that derivatives do accrue benefits to society but it maybe difficult tangibly measure. Yes, derivatives can be used to hedge risks that a company wishes to not take and can thus reduce their cost of obtaining capital and also derivatives are a cheaper way of hedging when compared to goingout to find an asset outright that reduces a companies exposure. The idea is that these cost savings allow companies to operate more efficiently and thus focus on risks that it is better prepared to take and therefore the benefits to society comes in the form of economic prosperity. However, derivatives can be dangerous if used inappropriately (either known or unknown due to the complexity of the instrument). If you don’t know the risks you might as well be speculating and speculation can be devastating to an economy when our bets are wrong(as we have seen). Therefore, I do believe derivatives should be regulated. The problem lies in how one uses derivatives, whether or not it is being used appropriately, and how to monitor. For example, just as a knife is useful in the kitchen to prepare meals, it should be used carefully and not carried around in public or allowed on airplanes. Also, speculation is required for derivative markets to exist (2 sides are needed to complete a bet), but when the number of speculators dramatically outweigh the hedgers, asset bubbles are created and it shouldn’t be surprising when markets crash and the whole society pays to clean up the mess.