When I spoke out a decade ago about the dangers posed by the rapidly growing and unregulated over-the-counter derivatives market, I did not do so in expectation of award or praise. On the contrary, I was aware that powerful interests in the financial community were opposed to any examination of that market. Yet I spoke out because I felt a duty to let the public, the Congress and the other financial regulators know that that market endangered our financial stability and to make every effort I could to address that problem.
My voice was not popular. The financial markets had been expanding, innovation was thriving, and the country was prosperous. The financial services industry argued that markets had proven themselves to be self-regulating and that the role of government in market oversight and regulation should be reduced or eliminated.
All of us have now paid a large price for that fallacious argument. We are in the midst of the most significant financial crisis since the Great Depression, and regulatory gaps including the failure to regulate over-the-counter derivatives have played an important role in the crisis.
It is now critically important to identify and eliminate these regulatory gaps and to strengthen our financial regulatory structure. Without significant regulatory reform, our financial system will be exposed to continuing dangers and repeated crises.
No federal or state regulator has market oversight responsibilities or regulatory powers governing the over-the-counter derivatives market or indeed has even sufficient information to understand the market’s operations. The market is totally opaque and is now popularly referred to as “the dark market.” It is enormous -- the reported size of the market as of last June exceeded $680 trillion dollars of notional value, more than ten times the amount of the gross national product of all the countries in the world.
While over-the-counter derivatives have been justified as vehicles to manage financial risk, they have in practice spread and multiplied risk throughout the economy and caused great financial harm. They include the credit default swaps disastrously sold by AIG and many of the toxic assets held by our biggest banks. Warren Buffett has dubbed them “financial weapons of mass destruction.”
We now have a unique opportunity -- a narrow window of time -- to fashion and implement a comprehensive regulatory scheme for these instruments. Existing U.S. laws governing the futures and options markets provide a model for regulating the closely related instruments traded in the over-the-counter derivatives market. The new regulatory scheme should provide that the instruments must be traded on regulated derivatives exchanges and cleared by regulated derivatives clearing houses to the extent feasible. This would allow government oversight and enforcement efforts, insure price discovery, openness and transparency, reduce leverage and speculation, and limit counterparty risk. If any residual over-the-counter market is to be permitted, it must also be subject to robust federal regulation.
These measures would go far toward bringing this enormous and dangerous market under control. They must be adopted and implemented if we hope to avoid future financial crises caused by this market. Special interests in the financial services industry are beginning to advocate a return to business as usual and to argue against any need for serious reform. We have to muster the political will to overcome these special interests. If we fail now to take the remedial steps needed to close the regulatory gap, we will be haunted by our failure for years to come.
Friday, May 29, 2009
U.S. Economy: "A Narrow Window"
Care about whether or not Washington is facing up to the recession? Then you need to read Brooksley Born's assessment: