Acton Commentary

Derivatives regulation: Understanding the Rules of the Game


In a recent meeting on financial system reform, President Bush defended "free markets, free enterprise and free trade." Very well. But one must not forget that without moral principles and virtue, freedom is but a mask for iniquity. This has been clearly seen in the market for complex financial derivatives.

Advocates for the deregulation of financial derivatives argue that it encourages innovation, which is good for the economy. That may be so. However, not all innovation is helpful. The atomic bomb was an incredible technological innovation. Incidentally, investor Warren Buffett's 2003 quip about the latest generation of financial derivatives was all too revealing: he called them "financial weapons of mass destruction."

The law has two basic tasks in society: to coordinate the activities of persons and communities, and to educate them in the virtues. The latter is especially important if man is to order his legitimate freedom correctly, for his true good and the good of others. This is true in financial markets too.

Not all uses of financial derivatives are bad. Forward and futures contracts, for example, can be valuable risk management instruments. The trouble is that derivatives are increasingly employed for purposes of "regulatory arbitrage" -- to enable investors and institutions to avoid regulations and taxes, or make investments they would otherwise not be permitted to make. They are also frequently used by individual employees to gamble at the expense of their employers.

The law cannot prohibit all vice, St. Thomas Aquinas observed, lest the people revolt and things become even worse. But neither can it permit manifest injustice that would give rise to a law of the jungle and threaten the peace of society. Unfortunately, just that has happened with financial derivatives.

As experts have testified, derivatives are widely used to avoid taxes and obtain more favorable accounting treatment. Swaps are an example. Swaps are private agreements to exchange cash flows at certain times according to a prearranged formula. There is nothing sinister about that in principle, but as swaps according to the current rules of the game do not have the same balance sheet implications as cash trades, they enable companies to side-step regulatory constraints, conceal risks, and hide losses.

Enron is a case that readily comes to mind. Admittedly Enron had an awful culture of greed (in which it, coincidentally, competed with many Wall Street investment banks). Yet what enabled "the world's greatest company" to deceive so many people was its skilful use of complex financial instruments involving swaps, off balance sheet partnerships, and all manner of special purpose entities.

The most ardent advocates of deregulation might respond: Enron was a unique case, but generally, all the better if derivatives enable companies to avoid silly regulations. One must admit that sometimes regulations are unreasonable, and taxes too high. However, there is a prima facie moral obligation to obey the just laws of the nation, even if they are not perfect.

Besides, many regulations are necessary for the common good. Investment restrictions are a good example. Often they have nothing to do with "government meddling" with the economy. Such restrictions are imposed by companies and financial institutions themselves to control their risk exposures in accordance with the nature of their business and the needs of their clients.

With the advent of misregulated financial derivatives, that has become increasingly difficult. Numerous employees have been tempted to gamble with dubious derivatives in the hope of larger personal gains and bonuses, knowing that the downside risk will be borne by the employer. The legendary case of an escalating gamble for life (at least according to the official story) was that of Nick Leeson of Barings in 1995. The gamble failed, and the venerable British bank went bankrupt.

Other times investment restrictions are imposed by public authorities, pension funds being a good example. This too may be necessary, as we have all been witnessing. The safety of pension wealth is of paramount importance to dignified living in old age, but most pension savers have neither the skill nor the incentive to actively monitor their fund policies closely enough.

In the absence of prudential investment criteria -- and of sufficient regulation of financial derivatives -- some institutions may be tempted to offer higher rates of return without disclosing the risks they are taking. Numerous cases could be cited from the 1990s (the Orange County fiasco was just the tip of the iceberg), and the ongoing financial fiasco will provide many more examples.

What to do then? The principles are clear, but their application is more challenging. Some things are certain, however. We must continue the battle to improve the quality of regulation and to remove harmful regulatory red tape. We must keep demanding a simpler and lighter tax system. These steps will diminish the attraction of complex financial derivatives and channel their use to legitimate purposes.

Better prosecution of complex financial fraud is needed, and tougher penalties. In the 1990s, numerous "rogue traders" went practically scot-free, and others received a slap on the wrist, such as a two-year exclusion from working in the banking industry. In the case of manifest fraud, why not impose an exclusion for life?

The rules of the game must become more principled, so they cannot be side-stepped by a new round of innovative financial wizardry. Tougher penalties should be coupled with public campaigns, because only what is in the mind has an influence on behavior.

Financial education must also bear its responsibility. Let Harvard and Stanford replace "greed is good" with Aristotle and Aquinas. Couple that with voluntary work among the elderly. Moral virtue and reasonableness are not innate, but are acquired through education and the repetition of good acts.

How to bring that all about is a different story, but the key to that story is to prevent the capture of regulation and legislation by powerful Wall Street interest groups such as the International Swaps and Derivatives Association (ISDA), which has a reputation for blocking meaningful reform in the past. Unfortunately, democratic control of the system will likely become increasingly difficult as the proposed global financial authority becomes a reality.

Trained in law and economics, Oskari Juurikkala is completing a PhD on the regulation of financial derivatives.