In the paper Derivatives and the Legal Origin of the 2008 Credit Crisis (published in the inaugural issue of the Harvard Business Law Review), I argue that the credit crisis of 2008 can be traced first and foremost to a little-known statute Congress passed in 2000 called the Commodities Futures Modernization Act (CFMA). In particular, the crisis was the direct and foreseeable (and in fact foreseen, by myself and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivatives contracts are probabilistic bets on future events that can be used to hedge (which reduces risk) but also provide attractive vehicles for speculation on disagreement (which can increase risk). The common law recognized the differing welfare consequences of hedging and speculative trading in derivatives by applying a doctrine called “the rule against difference contracts” to discourage derivatives that did not serve a hedging purpose by treating them as unenforceable wagers. Speculators responded by shifting their trading onto organized exchanges that provided private enforcement mechanisms, in particular clearinghouses through which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives speculation risk. In the twentieth century, the common law rule was replaced by the federal Commodity Exchange Act (CEA). Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. This regulatory system also for many decades also kept derivatives speculation from posing significant problems for the larger economy.

(more…)