Derivatives Reform: Like Shoveling Water

Anyone who has ever tried to shovel a pool of water with a broom knows it is a frustrating task. In the water is in a hole, gravity takes over to make it an almost fruitless task.

Derivatives reform is like shoveling water.

There is so much money involved due to the leverage and geometric payouts, combined with the esoteric instruments and strategies, that new regulatory reform will take years to implement. It should then arrive just in time to be ineffective.

It took almost 20 years to reform the nation's futures exchanges which traded plain vanilla futures, and later options on futures. The most effective lobby in the financial services business easily stiff-armed reform for years. It was only the pressure from institutional investors, combined with rising risk, which pushed electronic trading ahead over open outcry.

That was a contentious internal exchange battle, pushed by a publicized, but ineffective FBI sting operation, which tilted the argument in favor of electronic trading. Then, the members saw that their way out was to go public.

A similar story happened at the NYSE as a little-know day-trading firm, Archipelago, worked a miracle play to do a reverse buy-out of the NYSE. An amazing story.

Back to the Future
Exotic derivatives are more complex and traded by fewer people than what transpired on any exchange. The entire OTC derivatives market is small, perhaps less than 5,000 real players in the US, with another powerful group in London. Look at the membership roster at ISDA.

Worse, the new regulations could easily be way off-the-mark depending on who is writing the new regulations. Finally, the damage has been done, so what's the point?

Like most calls for new laws, further examination shows that if the existing laws or regulations were enforced, there would not be any new need for new regulations. There are 50 state attorney generals and an army of state insurance commissioners who could have taken a role in investigating mortgage fraud. Where were they? The answer: They are working for the insurance companies and mortgage firms, not the citizens.

I asked this at an insurance seminar and a state regulator said they spend most of their time on auto insurance scams. Now, with so many people living in their cars, they can combine the two investigations and say it is auto-home fraud.

As for the reform of exotic derivatives, hurry up and wait. The legislators and regulators don't know where to begin.

--Chuck Epstein
cepstein@prodigy.net