Regulating Derivatives : A Fundamental Rethinking

The conventional wisdom is that derivatives are exotic and uniquely risky, although innovative, financial instruments. That perception has given rise to a regulatory patchwork described as confusing, incomplete, and contradictory. This article rethinks how derivatives should be regulated. It begins by de-mystifying derivatives. In contrast to the industry-derived categories, the article shows that derivatives can be deconstructed more intuitively, by their economic functions, into two categories of traditional legal instruments—option contracts and guarantees. Being neither exotic nor uniquely risky, most derivatives should be regulated like those traditional instruments. The article then explains why at least one subset of guarantees—financial guarantees with systemically important counterparties, which are epitomized by credit-default swap (CDS) derivatives—can seriously threaten economic stability, and why the absence of an insurable-interest requirement can further magnify that threat. Finally, the article examines how to design regulation that efficiently targets that threat