This week “60 Minutes” highlighted an obscure statute that some say is at the root of the recent market meltdown: the Commodity Futures Modernization Act of 2000. The CFMA exempted certain derivatives from existing state and federal regulation. But “60 Minutes” failed to ask the most interesting question: Why was the exemption needed?
The short answer is that both federal and state law banned many useful financial transactions. The problem wasn’t regulation, it was prohibition. The only way to avoid the bans was to get out from under the statutes. So financial firms sought, and got, an exemption, creating an unregulated market.
Derivatives are financial instruments whose value is based on the price of a specified transaction (such as the price of oil in June). Credit Default Swaps (CDS) are derivatives whose value is based on whether specified bonds or other debt will be paid off (think Lehman Brothers). Over-use and under-pricing of CDS contributed to the financial problems at AIG, Bear Stearns, Lehman, and elsewhere.
Even in the wake of the global financial crisis, almost no one is calling for a ban on CDS: the instruments can act as a useful insurance policy for bond buyers. There are now various proposals for disclosure, regulation, and limits on the use of CDS. But regulation was not the option in 2000.
The first challenge in 2000 was the 1936 Commodity Exchange Act, which requires all commodity transactions to be made on approved exchanges. Unlike stocks, which are traded widely, but not exclusively, on exchanges, over-the-counter (direct) futures trades are illegal. This requirement was written with highly standardized products in mind: barrels of oil or bushels of wheat. But CDS instruments often are highly customized, even more so in their infancy in 2000 than today. There was no way to create an exchange market for a brand new, not yet standardized product.
The second challenge to the CDS market was the one mentioned on 60 Minutes: state “bucket shop” laws passed in response to a 1907 stock market crash. Assuming those laws apply, they also ban rather than regulate CDS. As a practical matter, securing state-by-state adoption of a uniform exemption for a new product whose contours, use, and application were unclear would have been impossible.
The state laws, now over a century old, and a federal statute past 70 were reactions to prior market crises. But the over-breadth and inflexibility of the laws proved too constraining for a modern economy. Because laws and regulations are notoriously difficult to change, financial firms found a way around them. Inflexible regulations ultimately backfired. Rather than limiting risk, the overly-strict regulations magnified it by forcing non-compliant activity out of the regulated sphere. Since the activity made economic sense, private parties found ways to conduct it, but without the transparency and stability that a sound regulatory scheme can provide.
The clear lesson is that, in the wake of a market crisis, over-regulation can be more dangerous than under-regulation. Not only will over-regulation tend to slow economic recovery, it may even sow the seeds of a subsequent crisis.
