The derivatives deregulation bills that a few members of Congress are franticly rushing through the legislative process are seriously flawed.
This is a huge market - the Bank of International Settlements recently estimated it at $190 trillion worldwide - but there has been scant public debate about deregulating it. Arguments for doing so have gone unchallenged.
Public debate is not only essential to democracy on principal, but also serves the practical purpose of ferreting out policy errors and omissions.
Two very similar bills would affect the regulation of derivatives markets.
In the Senate, S 2697, co-sponsored by Sen. Richard Lugar, R-Ind., and Sen. Phil Gramm, R-Tex., has been reported out of the Agriculture Committee and awaits action from the Banking Committee.
In the House, Rep. Thomas Ewing, R-Ill., has authored HR 454, and slightly modified forms of the bill have been reported out of three committees - Agriculture, Banking, and Commerce.
All these versions of the legislation would exclude over-the-counter derivatives from government regulation and radically reduce the level or surveillance and supervision on futures exchanges.
The proponents of deregulation build their case on three points:
- Financial markets are so large that they are not susceptible to manipulation.
- There is no price-discovery process in over-the-counter derivatives markets, so there is no public-interest concern.
- The OTC derivatives markets are made up of sophisticated investors who do not need to be protected from fraud and the failure of others.
Let me point out the problems with these premises.RISK OF MANIPULATION
The world's largest and most liquid market is the one for foreign exchange. Yet the Quantum Fund hedge fund operated by George Soros is widely credited - or blamed - for moving the market to devalue the British pound in September 1992.
The market for U.S. Treasury securities, with its $600 billion in daily trading volume and another $1 trillion in repurchase agreement transactions, is the world's premier market in terms of efficiency and sophistication. Yet this market has been the subject of manipulation several times in recent years:
- The prestigious bond trading firm of Salomon Brothers was found to have cornered the bond market in 1992.
- In 1996 the investment bank Fenchurch was found to have corned the 10-year note market in order to manipulate the futures market.
- Last December the head of the Federal Reserve Bank of New York's bond trading desk warned about repeated incidents of manipulation in the markets for repurchase agreement on Treasury securities.
PUBLIC INTERESTThe prices and rates established in OTC derivatives markets are, in fact, regularly reported as the reference prices and rates for other markets throughout the economy. Information about rates and spreads in the interest rate swaps market is critical to those for home mortgages and corporate bonds.
This leading role is all the more important in light of the possible demise of the U.S. Treasury securities market as federal government surpluses continue to shrink that market.
The forward and swap rates on foreign currency are regularly and widely reported, and they are critical to international trade and cross-border investments. This is not an incidental part of the OTC derivatives markets. Interest rate swaps, forward rate agreements, and foreign exchange forwards and swaps make up 77% of the volume in the OTC derivatives markets, according the Bank for International Settlements.
The role of these markets in establishing prices used throughout the economy has long been the basis for regulatory oversight. As the Commodity Exchange Act states:
"The prices involved in such transactions are generally quoted and disseminated throughout the United States and in foreign countries as a basis for determining the prices to the producer and the consumer of commodities, and the products and byproducts thereof, and to facilitate the movements thereof in interstate commerce." These markets "are affected with a national public interest" making it "imperative" that the federal government take actions to detect and prevent market manipulation and fraud.
SOPHISTICATED INVESTORS
Defining "sophistication" as having substantial wealth is not a good enough measure. Moreover, requiring that investors be sophisticated is in practice not enough to assure safety and soundness.
Imagine an investment firm with $5 billion in capital and management made up by the former head of the top bond trading firm on Wall Street and a couple of economists who received Nobel prizes for developing derivative pricing formulas.
This combination of capital, financial market experience, and intellectual brilliance is at the very highest standard for market sophistication. Yet these attributes, plus $1 trillion in derivatives, were the state of Long Term Capital Management.
These sophisticates orchestrated such an enormous failure that they lost not only 90% of their investors' money but also disrupted market activity and threatened the solvency of many of the largest financial institutions. Sophistication is clearly not enough to assure that derivatives market do not threaten the rest of the economy.
In light of these problems with the premises underlying the broad-reaching deregulation of derivatives, lawmakers should halt their frantic rush to cut them loose from regulatory oversight.
Instead they should pursue a deliberate course to determine the appropriate level of regulation.
Mr. Dodd is a director of the newly created Derivatives Study Center at the Economic Strategy Institute, a nonprofit public policy research organization founded in 1989 in Washington.
