Politics hampers effort to reform the $450 trillion derivatives market

Wednesday, April 14, 2010

"DERIVATIVES" is the financial industry's fancy term for contracts that market participants make with one another to profit from, and protect against, various kinds of risk. A grain futures contract helps a farmer hedge against an unexpected drop in the price of his crop; a credit default swap enables a bond buyer to insure against a corporate failure. Derivatives, therefore, are wonderful; they grease the wheels of capitalism by promoting economically rational risk-taking. And derivatives can be terrible; they induce investors to take too much risk by giving them a false sense of security. A major cause of the recent financial crisis was AIG's sale of credit default swaps to big banks, without enough collateral to back them.

In its financial regulatory reform effort, Congress must improve federal supervision of the $450 trillion derivatives market to protect against systemic risk without negating the useful functions that derivatives perform. Fortunately, everyone in the debate -- from the Obama administration to Wall Street -- agrees with that proposition, at least in theory. Not so fortunately, that's as far as agreement goes: Consequently, the administration, Democrats and Republicans in the Senate, and a host of lobbyists are wrangling over where to draw the line.

A basic distinction is between derivatives that commercial firms buy to hedge actual risks to their own business plans -- a utility's purchase of natural gas, for example -- and a financial firm's speculative trading in, say, credit-default swaps for Greek government debt. The former should be more lightly regulated than the latter. The House adopted a bill last fall that would regulate trades by "major swap participants" that "could have serious adverse effects on . . . financial stability." That standard looks too permissive to us: too hard for regulators to interpret, and thus too easy for financial firms to exploit.

Improving on it shouldn't be so hard, but -- it may not surprise you to learn -- partisan politics is getting in the way. Republican leaders, eager to deny the Obama administration any accomplishment, walked away from negotiations on financial reform in the Senate Banking Committee that had brought both sides 95 percent of the way to a deal. Now the White House, convinced that it has a winning issue -- go ahead, Republicans, side with Wall Street if you dare -- is discouraging Democratic senators from working with any Republicans who might still be so inclined. The risk is that the mudfight will keep Congress from doing the essential business: bringing most of the derivatives market into the sunlight.

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