Regulating Derivatives: A Fundamental Rethinking

by Steven L. Schwarcz

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Abstract

The conventional wisdom is that derivatives are exotic and uniquely risky, although innovative, financial instruments. That perception has given rise to a regulatory patchwork described as “confusing, incomplete, [and] contradictory.”1 This Article rethinks how derivatives should be regulated. It begins by demystifying derivatives. In contrast to the arcane industry-derived categories, the Article deconstructs derivatives more intuitively, by their economic functions, into two categories of traditional legal instruments—option contracts and guarantees. Being neither exotic nor uniquely risky, most derivatives should be regulated like those traditional instruments. The Article then explains why at least one subset of guarantees—financial guarantees with systemically important counterparties, which are epitomized by credit-default swap derivatives—can seriously threaten economic stability and why the absence of an insurable-interest requirement can further magnify that threat. Finally, the Article examines how to design regulation that efficiently targets that threat.

Regulating Derivatives: A Fundamental Rethinking

by Steven L. Schwarcz

Click here for a PDF file of this article

Abstract

The conventional wisdom is that derivatives are exotic and uniquely risky, although innovative, financial instruments. That perception has given rise to a regulatory patchwork described as “confusing, incomplete, [and] contradictory.”1 This Article rethinks how derivatives should be regulated. It begins by demystifying derivatives. In contrast to the arcane industry-derived categories, the Article deconstructs derivatives more intuitively, by their economic functions, into two categories of traditional legal instruments—option contracts and guarantees. Being neither exotic nor uniquely risky, most derivatives should be regulated like those traditional instruments. The Article then explains why at least one subset of guarantees—financial guarantees with systemically important counterparties, which are epitomized by credit-default swap derivatives—can seriously threaten economic stability and why the absence of an insurable-interest requirement can further magnify that threat. Finally, the Article examines how to design regulation that efficiently targets that threat.