When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That’s because they were economists, not lawyers.

Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) [1] That’s because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress’s decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000.

It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG’s losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won’t default on their bond obligations. Because AIG was part of an enormous and poorly-understood web of CDS bets and counter-bets among the world’s largest banks, investment funds, and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt. Only a massive $180 billion government-funded bailout of AIG prevented the system from imploding.

This could have been avoided if we had not deregulated financial derivatives.

Derivatives “De”regulation?

Wait a minute, some readers might say. What do you mean, “de”regulated derivatives? Aren’t derivatives new financial products that have never been regulated?

Well, no. Derivatives have a long history that offers four basic lessons. First, derivatives contracts have been used for centuries, possibly millennia. Second, healthy economies regulate derivatives markets. Third, derivatives are regulated because while derivatives can be useful for hedging, they are also ideal instruments for speculation. Derivatives speculation in turn is linked with a variety of economic ills—including increased systemic risk when derivatives speculators go bust. Fourth, derivatives traditionally are regulated not through heavy-handed bans on trading, but through common-law contract rules that protect and enforce derivatives that are used for hedging purposes, while declaring purely speculative derivative contracts to be legally unenforceable wagers.

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