Post-Crisis Derivatives Regulation: What Went Right (And What Went Wrong)

Abstract

This Article rethinks how derivatives should be regulated. Adapted from Regulating Derivatives: A Fundamental Rethinking, 70 DUKE LAW JOURNAL 545 (2020) for publication in the SCIENCES PO LAW REVIEW’s January 2023 biennial issue (a symposium on “Financial Regulation after the 2008 Crisis”), the Article argues that the conventional wisdom that derivatives are complex, exotic, and uniquely risky financial instruments has given rise to a flawed post-crisis regulatory patchwork. The Article challenges that wisdom, showing that derivatives can be deconstructed, by their economic functions, into two categories of traditional legal instruments—option contracts and guarantees, and it argues that most derivatives should be regulated like these traditional instruments. The Article explains why the potential for derivatives to create serious risk is primarily limited to credit-default-swap (“CDS”) contracts, the category of derivatives that function as financial guarantees. It also explains why financial guarantee risk, and thus CDS risk, is magnified when the contract has one or more systemically important counterparties, which is typical of CDS contracts. Moreover, the absence of an insurable-interest requirement under some CDS contracts can even further magnify the risk. Finally, the Article discusses how regulation could more efficiently target these risks.

Keywords: derivative, CDS, credit derivative, credit default swap