Deregulation, Derivatives & The Threat Of Mass Destruction
The following is an abridgement of Chapter 9 of my second book, The Corruption of Capitalism. It was published in 2009.
…derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
A quadrillion of anything must be dangerous. The global derivatives market grew in size from $10 trillion in 1990 to $760 trillion in June 2008—equal to the value of everything produced on earth during the previous 20 years. If its growth had continued at that rate, it would have topped a quadrillion dollars ($1,000,000,000,000,000) in 2010 and $1 quintillion (add three more zeros) before 2020. Instead, the derivatives market imploded, triggering a systemic crisis throughout the world’s financial industry. Derivatives are largely unregulated, and 90% of all transactions trade over the counter. Forget about global warming: our civilization is at much greater risk of being wiped out by these financial instruments of mass destruction than by melting polar ice caps. This chapter describes how deregulation of the financial industry undermined the global economy by dismantling the safeguards put in place after the Great Depression. It also explores the possibility that the derivatives market may be history’s greatest Ponzi scheme.
The Commodity Exchange Act of 1936 required that all futures and commodity options be regulated and traded on organized exchanges. The purpose of that law was to ensure transparency and to prevent the manipulation of commodity prices. In the late 1990s, the Act came under attack.
In November 1999, a report of the President’s Working Group on Financial Markets recommended that the Act be amended to allow derivatives to trade over the counter and to free them from the regulatory jurisdiction of the Commodity Futures Trading Commission. The report, titled “Over-the-Counter Derivatives Markets and the Commodity Exchange Act”, was signed by Fed Chairman Alan Greenspan, Treasury Secretary Larry Summers, Securities and Exchange Commission Chairman Arthur Levitt, and William Rainer, Chairman of the Commodity Futures Trading Commission. The introduction to the report stated:
“The Working Group has concluded that under many circumstances, the trading of financial derivatives by eligible participants should be excluded from the [Commodity Exchange Act]. To do otherwise would perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States.
…Although this report recommends the enactment of legislation to clearly exclude most OTC financial derivatives transactions from the CEA, this does not mean that transactions may not, in some instances, be subject to a different regulatory regime or that a need for regulation of currently unregulated activities may not arise in the future.”
The following year, Congress passed the Commodity Futures Modernization Act of 2000 (CFMA), which revised the Commodity Exchange Act to allow many types of financial derivatives to legally trade over the counter. It also removed such over-the-counter derivatives transactions from the jurisdiction of the Commodity Futures Trading Commission, leaving them largely unregulated. CFMA was the last piece of legislation required to set the stage for the Great Meltdown of 2008. The bill was signed into law by President Clinton on 21 December 2000.
Greenspan, Summers, Levitt and Clinton are all intelligent men. Given that unregulated derivatives trading nearly destroyed the world fewer than eight years later, how could they all have made such a terrible mistake in supporting its deregulation? These comments by Greenspan shed light on the question:
“It should come as no surprise that the profitability of derivative products has been a major factor in the dramatic rise in large banks’ noninterest earnings and doubtless is a factor in the significant gain in the overall finance industry’s share of American corporate output during the past decade. In short, the value added of derivatives themselves derives from their ability to enhance the process of wealth creation.”
That quote was from a speech made way back in March 1999, when the derivatives market was a mere $100 trillion in size. Between the passage of CFMA and the systemic financial-sector crisis, that market would become eight times larger.
Of course, that is only the notional amount. The actual amount of money at risk is a much smaller figure—at least so long as none of the counterparties go bankrupt. Unhappily, in 2008 numerous large counterparties either went bankrupt or would have done so, had the government not propped them up with capital injections or outright nationalization. Problems with subprime loans may have been the spark, but derivatives were the combustible material that incinerated the global financial system. It is naïve to think otherwise.
The age of derivatives
By 2008, only around 10% of all derivatives traded on exchanges. The other 90% ($684 trillion) traded over the counter. The average daily turnover of the 10% that were exchange-traded amounted to $4.2 trillion in April 2007 (the most recent data available). The turnover of the remaining 90% of derivatives that trade over the counter is unknown. It may or may not have been nine times greater (in proportion to its relative size), but if it were, then the average turnover of the entire derivatives market each day would have been $42 trillion, or the equivalent of about 75% of what the earth produces each year.
The financial community generates fees for trading derivatives as well as for creating and “structuring” them. These fees vary, and no official statistics on the totals are available. But it seems fair to assume that the aggregate fees earned from a $760 trillion market turning over as much as $42 trillion a day would range between mindblowing and astronomical. Derivatives explain why the financial sector’s share of corporate profits became so much greater than normal after CFMA was passed.
Greenspan finds a flaw
Why are 90% of derivatives traded over the counter, rather than through exchanges? Exchanges impose transparency and security. Counterparty risk is eliminated or at least very considerably reduced when trades are conducted on exchanges and settled through clearing houses, because the exchange itself is a counterparty to each trade. The exchange requires traders to maintain minimum margin requirements that are always sufficient to cover any potential losses. If the position moves against a trader, reducing his margin, the exchange demands that he put up additional margin. If he fails to do so, then the exchange closes out the position before it results in a loss that exceeds the margin (for if the loss did exceed the margin, the exchange could have to bear that loss).
Chairman Greenspan was an enthusiastic proponent of derivatives. He saw them as “an increasingly important vehicle for unbundling risks. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it”. However, Greenspan had considerable reservations about the desirability of government regulation. Given the tremendous influence he wielded during his reign as the longest-serving Fed chairman, his views on these issues warrant consideration in some depth.
Greenspan’s views on regulation were particularly peculiar for a central banker. They also turned out to be particularly dangerous. For instance, he told an audience from the Futures Industry Association:
“The greater use of [over-the-counter] derivatives (as opposed to exchange-traded ones) doubtless reflects the attractiveness of customized over standardized products. But regulation is also a factor; the largest banks, in particular, seem to regard the regulation of exchange-traded derivatives, especially in the United States, as creating more burdens than benefits. As I have noted previously, the fact that the OTC markets function quite effectively without the benefits of the Commodity Exchange Act provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives.”
Two years earlier, in a talk entitled “Government regulation and derivative contracts”, he had explained:
“A second imperative, once public policy objectives are clearly specified, is to evaluate whether government regulation is necessary for those purposes. In making such evaluations, it is critically important to recognize that no market is ever truly unregulated. The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is whether government intervention strengthens or weakens private regulation. If incentives for private market regulation are weak or if market participants lack the capacity to pursue their interests effectively, then the introduction of government regulation may improve regulation. But if private market regulation is effective, then government regulation is at best unnecessary. At worst, the introduction of government regulations unavoidably involves some element of moral hazard [author’s emphasis]—if private market participants believe that government is protecting their interest, their own efforts to protect their interest will diminish to some degree.
Whether government regulation is needed, and if so, what form of government regulation is optimal, depends critically on a market’s characteristics. A “one-size-fits-all” approach to financial market regulation is almost never appropriate. The degree and type of government regulation needed, if any, depends on the types of instruments traded, the types of market participants, and the nature of the relationships among market participants.
Recognizing that a one-size-fits-all approach is seldom appropriate, it may be useful to offer transactors a choice between seeking the benefits and accepting the burdens of government regulation, or forgoing those benefits and avoiding those burdens by transacting in financial markets that are only privately regulated. In such circumstances, the privately regulated markets in effect provide a market test of the net benefits of government regulation. Migration of activity from government-regulated to privately regulated markets sends a signal to government regulators that many transactors believe the costs of regulation exceed the benefits. When such migration occurs, government regulators should consider carefully whether less regulation or different regulation would provide a better cost-benefit tradeoff without compromising public policy objectives.”
Later in the speech, he observed that
“Institutional participants in the off-exchange derivative markets also have demonstrated their ability to protect themselves from losses from fraud and counterparty insolvencies….[They] also have demonstrated their ability to manage credit risks quite effectively through careful evaluation of counterparties, the setting of internal credit limits, and the judicious use of netting agreements and collateral. Actual losses to institutional counterparties in the United States from dealer defaults have been negligible.
Thus, there appears to be no need for government regulation of off-exchange derivative transactions between institutional counterparties.”
Had the speaker been an investment banker, such opinions might not have been all that surprising. But for the world’s most powerful central banker to make the case for “private market regulation” of financial markets over government regulation was peculiar indeed. Did he really say “the introduction of government regulations unavoidably involves some element of moral hazard”? And did he really propose giving market participants a choice as to whether they would be regulated or not?
When private market regulation was put to the test following the passage of the CFMA, the consequences were catastrophic. A systemic crisis overwhelmed the financial sector and the economy spiraled down toward depression. That collapse eventually led Greenspan to the realization that his world view was flawed. On 23 October 2008, he admitted to the House Oversight Committee, “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”
He was not let off lightly. In close questioning, Congressman Henry Waxman, the panel chairman, gave the former Fed chairman the opportunity to elaborate on his mistaken presumptions:
Rep. Waxman: Dr. Greenspan, I want to start with you. You were the longest-serving chairman of the Federal Reserve in history, and during this period of time you were perhaps the leading proponent of deregulation of our financial markets. Certainly you were the most influential voice for deregulation. You have been a staunch advocate for letting markets regulate themselves.
Let me give you a few of your past statements. In 1994, you testified at a congressional hearing on regulation of financial derivatives. You said there is nothing involved in federal regulation which makes it superior to market regulation. In 1997, you said there appears to be no need for government regulation of off-exchange derivative transactions. In 2002, when the collapse of Enron led to renewed congressional efforts to regulate derivatives, you wrote the Senate: “We do not believe a public policy case exists to justify this government intervention.” And earlier this year, you wrote in the Financial Times: “Bank loan officers in my experience know far more about the risks and workings of their counterparties than do bank regulators.
And my question for you is simple: Were you wrong? Would you be sure the mike is turned on?”
Mr. Greenspan: I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.
Rep. Waxman: Dr. Greenspan, I’m going to interrupt you just—the question I have for you is, you had an ideology, you had a belief that free, competitive—and this is your statement—“I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We’ve tried regulation. None meaningfully worked.” That was your quote.
…Do you feel that your ideology pushed you to make decisions that you wish you had not made?
Mr. Greenspan: Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to—to exist, you need an ideology.
The question is whether it is accurate or not.
And what I’m saying to you is, yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact. But if I may, may I just answer the question—
Rep. Waxman: You found a flaw in the reality—
Mr. Greenspan: Flaw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak.
Rep. Waxman: In other words, you found that your view of the world, your ideology was not right. It was not working.
Mr. Greenspan: Precisely. That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.
Excerpts from a speech Greenspan gave in London in September 2002 illustrate how extreme his ideology was—and, perhaps, how gullible the public was to accept it:
“But let us consider now another aspect of market regulation efforts: transparency. There should not be much dispute that markets function best when the participants are fully informed. Yet, paradoxically, the full disclosure of what some participants know can undermine incentives to take risk, a precondition to economic growth.”
Greenspan then gave an example of a property developer who would not be able to buy land at a price that would make his project profitable if the landowners were fully aware of the returns he expected to earn if he could get the land cheaply. Greenspan went on:
“An example more immediate to current regulatory concerns is the issue of regulation and disclosure in the over-the-counter derivatives market. By design, this market, presumed to involve dealings among sophisticated professionals, has been largely exempt from government regulations. … But regulation is not only unnecessary in these markets, it is potentially damaging, because regulation presupposes disclosure, and forced disclosure of proprietary information can undercut innovation in financial markets just as it would in real estate markets.
To require disclosure of the structure of the innovative product either before or after its introduction would immediately eliminate the quasi-monopoly return and discourage future endeavors to innovate in that area. The result is that market imperfections would remain unaddressed and the allocation of capital to its most-productive uses would be thwarted. Even requiring disclosure on a confidential basis solely to regulatory authorities may well inhibit such risk-taking. Innovators can never be fully confident, justly or otherwise, of the security of the information.”
By the way, Greenspan was in London to receive an honorary knighthood from Queen Elizabeth II in recognition of his contribution to global economic stability. Really.
As shown above, Alan Greenspan had virtually led a crusade to persuade the public that derivatives should be allowed to trade over the counter and with as little regulatory oversight as possible. After much of the financial system had collapsed, he found a flaw in his free-market ideology. How much better it would have been if he had found it sooner—or if he had never been Federal Reserve chairman at all, so he would not have been in the position to disseminate his flawed ideology with such damaging effect.
What lies beneath?
The exchange between Congressman Waxman and Greenspan, then aged 82, suggests it is never too late to confess a mistake or abandon a false ideology. However, by the time the former Fed chairman saw the light, a great deal of (possibly irreparable) damage had already been done. More than $600 trillion-worth of derivatives contracts are still being traded in an unregulated, completely opaque over-the-counter market. That market’s size has made all its major participants too big to fail. Its fragility has required the US government to intervene in myriad unprecedented ways and on a previously unimaginable scale to prevent the world’s entire financial superstructure from disintegrating. Who can say—who dares imagine—what losses may still be concealed within it?
The consumer protection group Public Citizen has charged that the unregulated electronic trading of energy futures made legal by the CFMA allowed Enron to manipulate the energy market in California and was responsible for the rolling blackouts and price spikes that occurred in that state during 2001. If that is true, could over-the-counter derivatives not also be used to manipulate the price of other commodities, such as oil?
In the opening paragraph of a report entitled Blind Faith: How deregulation and Enron’s influence over government looted billions from Americans, Public Citizen rightly points out: “The three principles of transparency, accountability and citizen oversight—all removed under deregulation—are necessary elements for a market system to function properly.” Nowhere can those principles be more lacking than in the derivatives markets. With contracts measured in trillions of dollars anonymously changing hands daily, are there any markets that could not be manipulated? Who can say?
Credulity must now give way to angry mistrust. Common sense and recent experience both strongly recommend that the entire derivatives industry be treated with a great deal of skepticism and fear. AIG had to be nationalized because one of its divisions had written $440 billion worth of credit default swaps (CDS) and its failure to pay would have threatened the solvency of many of the counterparties to those trades. As Fed Chairman Bernanke explained on 60 Minutes:
“I understand why the American people are angry. It’s absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets, that was operating out of the sight of regulators, but which we have no choice but to stabilize, or else risk enormous impact, not just in the financial system, but on the whole US economy.”
In other words, the government was forced to take financial responsibility for AIG’s CDS losses in order to prevent a derivatives Armageddon. So far, $182 billion of taxpayers’ money has been made available to AIG, and $15.7 billion has been paid out to the top 10 CDS counterparties as follows: Société Générale, $4.1 billion; Deutsche Bank, $2.6 billion; Goldman Sachs, $2.5 billion; Merrill Lynch, $1.8 billion; Calyon, $1.1 billion; Barclays, $0.9 billion; UBS, $0.8 billion; DZ Bank, $0.7 billion; Wachovia, $0.7 billion; and Rabobank, $0.5 billion.
Looking beyond AIG, there is no reason for optimism that the threat posed by derivatives has even been contained. The potential for losses in that market far exceeds the losses the financial industry has reported thus far on nonperforming loans. A 1% loss ratio on the $700 trillion worth of derivatives contracts that trade over the counter would amount to $7 trillion; a 10% loss ratio, $70 trillion. There is a terrifying possibility that the entire industry is a Ponzi scheme on a scale that would make Bernie Madoff look like a small-town rascal.
The derivatives industry must be investigated and controlled
Derivatives were one of the main causes of the New Depression and they continue to pose an enormous threat to society. An in-depth public investigation is required to shine a spotlight on this unregulated can of worms. In the United States, a citizens’ committee that excludes bankers, lobbyists and government officials should be empowered to hold hearings and determine the answers to the following questions:
- Were derivatives the principal cause of the US financial sector’s systemic collapse?
- What percentage of derivatives is used for hedging and what percentage is used for speculation?
- Which activity—hedging or speculation—has cost US taxpayers more to clean up so far?
- Who are the top 500 speculators?
- What benefits are derived from speculation in derivatives?
- What are the costs and the potential costs?
- Who receives the benefits and who pays the costs?
- Is there any good reason all derivatives should not be made to trade on regulated exchanges, with all transactions settled through clearing houses?
- If all the current outstanding derivatives contracts were cleared through an exchange, would that reveal illegal activities such as accounting fraud or securities manipulation? Would it reveal a Ponzi scheme in which new derivatives are regularly created to manipulate the value of derivatives created earlier?
- Are over-the-counter-traded derivatives being used to manipulate commodity prices or other markets in the same way Public Citizen has charged that energy futures were used to manipulate the energy market in California?
- Did the sixfold increase (to $8 trillion) in the notional amount of commodity derivatives outstanding between 2004 and 2007 explain the spike in commodity prices during that period? When the 2008 crisis erupted and trading in these contracts fell, commodity prices crashed. When trading recovered, prices picked up even though demand remained depressed and, in the case of oil, excess capacity remained very high.
- Approximately $41 trillion in credit default swap contracts remain open. Who is exposed? Are they capable of bearing the losses?
- How much profit do derivatives generate for the financial industry to structure? To sell? To trade?
- What percentage of the industry’s profits does that account for?
- How dependent has the United States become on the “wealth” generated by the financial sector’s derivatives business, or, as Greenspan put it, “their ability to enhance the process of wealth creation”?
- If the United States imposed strict regulations governing derivatives speculation, would the industry move offshore? If so, what measures could the United States take to ensure that US companies did not participate in offshore derivatives markets?
- Was the deregulation of the derivatives market the consequence of the financial sector’s undue influence over the government? If not, was it simply an honest mistake, or was there some other reason that the government has not made public why it allowed such a dangerous market to develop with practically no regulatory oversight? There is surely some less imbecilic explanation than that a quadrillion dollars worth of unregulated derivatives makes the world a safer place by spreading the risk around “to those investors most able and willing to take it”.
- Should the CFMA of 2000 be repealed so that all derivatives must be regulated and trade through exchanges? If so, who should regulate derivatives?
Until the derivatives industry is brought under control, and preferably made very much smaller, it will represent a contingent liability to the government of the United States—possibly one so large that not even the US government could honor it.
The deregulation of the financial industry has been one of the gravest policy mistakes in the history of the United States. It caused the Federal Reserve to lose control over credit creation and brought the country to the brink of a derivatives-induced financial Armageddon, where it still teeters today. As a consequence, dozens of financial institutions are now too big to fail but too leveraged to survive without government support. Deregulation allowed a few thousand individuals to amass great fortunes, but its ultimate cost to the taxpayers is very likely to be reckoned in the trillions—possibly even tens of trillions. Finally, as Chapter 10 will show, financial-sector deregulation gave rise to a culture of credit in the United States and contributed to the deindustrialization that has debilitated the nation.
 Warren Buffett, Bershire Hathaway Inc. 2002 Annual Report, p. 15.
 Report of The President’s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act, November 1999.
 Fed Chairman Alan Greenspan, “Financial derivatives” (remarks before the Futures Industry Association, Boca Raton, Florida, 19 March 1999).
 Fed Chairman Alan Greenspan, “Government regulation and derivative contracts” (remarks at the Financial Markets Conference of the Federal Reserve Bank of Atlanta, Coral Gables, Florida, 21 February 1997).
 Excerpts from the Washington Times transcript of the exchange on 23 October 2008 between Alan Greenspan and House Oversight and Government Reform Committee Chairman Henry Waxman.
 Fed Chairman Alan Greenspan, “Regulation, Innovation, and Wealth Creation” (remarks before the Society of Business Economists, London, UK, 25 September 2002).
 Public Citizen, “Blind Faith: How Deregulation and Enron’s Influence Over Government Looted Billions from Americans”, December 2001.
 Fed Chairman Ben Bernanke, interview on 60 Minutes, 15 March 2009.
 Fed Chairman Alan Greenspan, “Financial Derivatives” (remarks before the Futures Industry Association, Boca Raton, Florida, 19 March 1999).