The beauty of a pendulum is that once set in motion it can swing predictably forever. The difficulty is getting it to return to the middle. This seems to be the problem with regulation of derivatives.
In the 1990s, derivatives were widely heralded as new instruments that could improve the transference of risk. In 1999, then Federal Reserve Chairman Alan Greenspan stated: “By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives.” He went on to argue that they “enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. This unbundling improves the ability of the market to engender a set of product and asset prices far more calibrated to the value preferences of consumers than was possible before derivative markets were developed. The product and asset price signals enable entrepreneurs to finely allocate real capital facilities to produce those goods and services most valued by consumers, a process that has undoubtedly improved national productivity growth and standards of living.”
A Harmless Tool?
With general (although not universal) agreement in Washington that deregulation of financial services would benefit the economy, the Administration and Congress decided that the derivatives market should be largely unregulated. This position was codified in the Commodities Futures Modernization Act of 2000 and the Gramm-Leach-Bliley Act of 1999. Here is when the pendulum was set in motion.
Not all policymakers or investors were convinced that derivatives were harmless. Brooksley E. Born, Chair of the Commodity Futures Trading Commission, argued for tighter regulation of derivatives.In 2003, Warren Buffett famously stated that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Baily is a Senior Fellow at Brookings and the co-chair of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative. Klein is the director of that Initiative.