‘Confederate Bonds,’ ‘General Custer,’ and the Regulation of Derivative Financial Instruments

The phenomenal growth of derivative financial instruments has sparked a near revolution in finance. These instruments take many forms and come in literally hundreds of varieties. Some, such as commodity futures and options, are heavily regulated when they are traded on organized exchanges. Other derivatives, particularly those traded over-the-counter, are subject to little regulation. Included on the list of unregulated derivatives are swap transactions. The swaps market alone is equal in size to the regulated markets with which it competes. The lack of regulation over such a large financial market and the losses suffered by some large firms in recent months has raised concerns that regulation may be needed. Numerous private and governmental studies have suggested improvements in balance sheet disclosures and some additional regulatory monitoring. Few of these reports advocate any stringent regulatory controls or even a unified regulatory approach. Yet, all seem to recognize that these instruments can pose a serious threat to the world’s financial systems. This article will explore the growth and development of unregulated over-the counter derivative financial instruments and it will suggest a methodology for imposing a regulatory system over these still untested instruments. The first part of this article explores the history and background of derivative instruments, and it reviews the considerations that led Congress to regulate many forms of these products. The second part of the article turns to the growth of the new unregulated financial instruments and describes some of the regulatory concerns they have raised. The article then focuses on the regulatory approaches that have been considered to date, some of which are as complicated as the instruments they seek to regulate. Finally, the article proposes a regulatory program that will guard against undue exposure from derivative transactions without unduly restricting the growth and operation of this very important financial market