R.C. Lim, Attorney and Counselor at Law

Derivatives, Bankruptcy, and Wall Street

Reading this op-ed in the WSJ today left me scratching my head.

Evidently, prior administrations — Dem and GOP — took the position that derivative contracts needed a special set of rules and considerations in bankruptcy. Their chief fear seems to be that not doing treating them as having special considerations might rattle derivatives markets. Strange!

Now President Obama does not want to sign any new financial reform legislation that does not include some regulation of the derivatives market. This is evidently so important that he has threatened to veto any legislation that does not include provisions accomplishing as much.

President Obama forever the seeker of compromise has now evidently found a cause that he believes in. And this time, he’s flat wrong! Presumably prior administrations were eager to go along with bad policy because they were worried that the derivatives market was sufficiently complex that there was much that they did not understand. Most people’s eyes glaze over when the Black-Scholes equation and all of that icky math enters the picture. Finally, President Obama shows a spine, but it’s on an issue where he gets it exactly wrong!

The missing fact that President Obama is ignoring is that the majority of the derivatives market is compromised of individualized contracts between two parties that are peculiar to the situation and so cannot regulated as if they were traded on an exchange. Moreover, he fails to recognize that trading risk in this fashion accomplishes a good. Namely, risk is spread throughout the system. The dispersion of risk throughout the economy, when it is not in the exceptional circumstance of placing the entire economic order at risk of collapse, is a public good and needs to be encouraged by the government and not discouraged.

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