Out of the Black Hole: Reining in the Reckless Market in Over-the-Counter Derivatives

Article excerpt

In September 2008, the United States faced what President Barack Obama called the "most profound economic emergency since the Great Depression." A mortgage crisis begat a credit crisis, shaking the entire financial system and sending the U.S. economy into what has been called the Great Recession.

This crisis was caused in large part by the opaque and unregulated over-the-counter (OTC) derivatives, or "swaps," market, which was then estimated to have a value of almost $600 trillion, or 10 times the world's gross domestic product. Approximately one-tenth of the unregulated OTC market was made up of the now-infamous credit-default swaps, a product that Wall Street sold to "insure" sub-prime mortgage investments but which lacked regulation and, therefore, the capital required to support these "guarantees" When sub-prime investments failed, the "insurance" payments were triggered. Only the multitrillion-dollar U.S. taxpayer interventions to save Wall Street prevented a worldwide depression.

This crisis was the direct result of the deliberate dismantling of regulatory safeguards. After the collapse of the equity markets and then the banking system between 1929 and 1933, the Roosevelt administration drove the passage of the Securities Acts of 1933 and 1934 to regulate securities, and the Commodity Exchange Act of 1936 to regulate futures transactions. These landmark legislative efforts established eight classic regulatory norms to prevent systemic financial collapse in financial markets, including transparency of prices, record-keeping, capital adequacy, full disclosure, anti-fraud and anti-manipulation prohibitions, regulation of intermediaries, private enforcement through litigation, and the federally supervised self-regulation of financial exchanges.

These eight guidelines still govern ordinary stock markets today, and K is noteworthy that malpractices in conventional securities played no role in the 2008 systemic worldwide collapse. These norms had governed the futures markets until 1993 when Wall Street insisted that OTC derivatives be exempt from those traditional regulations. In that year, an accommodating Commodity Futures Trading Commission (CFTC) created an exemption for a limited class of OTC derivatives from classic market regulation.

However, Wall Street almost immediately became dissatisfied with the constraints of the 1993 exemption. Wall Street wanted to sell a far broader range of profitable swaps that could not meet the 1993 restrictions. By 1998, the market grew to over $80 trillion, with swaps dealers conducting most of that business in complete disregard of controlling law.

As a result, in May 1998, the CFRC, under the leadership of then-Chair Brooksley Born, issued a "concept release" inviting public comment on how this multitrillion-dollar unsupervised and opaque market should be regulated. The release was premised on several systemically destabilizing events that had been caused by unregulated OTC swaps.

At the behest of Wall Street, a Republican-controlled Congress passed legislation enjoining Born from this work and then, on the recommendation of the senior Clinton economic team including among others then-Secretary of the Treasury Larry Summers and Fed Chair Alan Greenspan, rushed through a 262-page rider to an 11,000-page omnibus appropriations bill on Dec. 15, 2000--the last day of a lame-duck session. The rider, the Commodity Futures Modernization Act (CFMA), removed what was by then the $94 trillion OTC-derivative market from all federal regulation.

In one fell swoop, the OTC market was exempt from the traditional market regulatory controls, including capital-adequacy requirements; reporting and disclosure; regulation of intermediaries; supervised self-regulation; and bars on fraud and manipulation. Overnight, the entire OTC market was legitimized as a private market, wholly opaque to financial regulators and market observers.

To understand the central role played by OTC derivatives in the recent meltdown, a review of sub-prime securitization is necessary. …