How Deregulating Derivatives Led to Disaster, and Why Re-Regulating Them can Prevent Another

When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That's because they were economists, not lawyers. Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) That's because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress's decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000. Prior to 2000, off-exchange derivatives contracts were subject to a common-law rule called the “rule against difference contracts” that treated derivative contracts that could not be proven to hedge against a real position in the underlying asset as legally unenforceable wagering contracts. Speculative wagers on prices could only be safely made on regulated exchanges. Congress overturned this centuries-old rule in 2000, making it legal for hedge funds, banks and insurance companies to use derivatives for speculative gambling, not just for true hedging. This led to the collapse of AIG and the 2008 credit crisis