Regulate OTC Derivatives by Deregulating Them

As a result of the current financial crisis, there have been multiple calls for strict new regulation of over-the-counter (OTC) financial derivatives. In a new article entitled Regulate OTC Derivatives by Deregulating Them, I propose instead that we consider returning to the common law approach to “off-exchange” derivatives—“deregulate” them by refusing to allow traders who use OTC derivatives contracts only to speculate, and not to fulfill a bona fide hedging purpose, to enforce their contracts in the courts. After all, there is no cheaper form of government intervention than refusing to intervene at all, even to enforce a deal.

The common law treated purely speculative derivative transactions in which neither party was hedging against a preexisting economic risk as legally unenforceable “gambling” contracts. This rule, a version of which still survives today in the form of insurance law’s requirement of “insurable interest,” forced would-be derivatives speculators to either investigate whether their counterparty was truly hedging, or to trade on an organized exchange where the rule of unenforceability did not apply. Exchange trading, however, was subject to member-imposed margin requirements, netting requirements, and disclosure rules that kept excessive speculation in check. As a result, the common law rule kept derivatives speculation from contributing excessively to systemic risk.

The common law rule against “off-exchange” derivatives speculation eventually morphed into elements of the Commodities Exchange Act which were repealed by the Commodity Futures Modernization Act of 2000. This change in the law was directly responsible for the subsequent explosion in OTC derivatives trading and dramatic increase in systemic risk. Logic and history accordingly both suggest that a return to the common law approach might be an effective policy response to the problem of systemic risk.

The full article is available for download here. The article is followed by comments from Jean Helwege, Peter Wallison, and Craig Pirrong, as well as my response to these comments.

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