The Commercial Advantages of Regulating Derivatives

In the debate over financial regulatory reform--and especially with respect to the introduction of substantial regulation in the derivatives market--it's important to keep in mind that integrity and honesty have commercial value. You see this in the automobile market, where certain brands are heavily favored due to their quality and reliability. These products pretty much work as expected; unpleasant surprises are uncommon. Consumers pay a premium for these cars. Other makes, with lesser reputations, sell at discounts and often require heavy rebating before they can be moved off dealer lots.

The same could be said for the stock markets. For decades after World War II, the American stock markets were by far the largest and most liquid. Investors ranging from large institutions and multimillionaires to those modestly well-off invested in stocks. This was true even before the advent of the 401(k), which only increased stock market participation across the populace. The U.S. stock markets were also much more heavily regulated than European and Asian stock markets. The high degree of regulation no doubt increased Wall Street's costs of doing business. But it also gave investors confidence that they would get a fair shake. People will plunk down their money if they think they'll be treated fairly.

In the last twenty years, European and Asian nations have strengthened the regulation of their financial markets, adopting structures that often mimic the U.S. regulatory structure. At the same time, the U.S. has allowed its financial markets to deregulate to a large degree, with much of the banking system sliding into the unregulated derivatives market. The quality of the work of American regulators has also slipped, with the Federal Reserve and other bank regulators missing the boat on the mortgage mess and the SEC failing to catch Bernie Madoff. The result has been a financial crisis and the Great Recession, which unfortunately began in the U.S. financial markets. Many Americans have pulled back from the stock markets. In spite of the recent bull market, a lot of long term investors remain on the sidelines and the market surge is driven by day traders, momentum traders and other diverse and sundry forms of short termers. It seems that owners of capital really dislike being misled and cheated; they're funny that way.

Wall Street and large European banks are fighting the regulation of derivatives. However, financial markets need investor money to function--we won't have a healthy financial system if banks simply trade with each other. And investors, so recently burned, would like an environment where government watch dogs pace restlessly.

There has been a lot of debate and pushback in Europe about regulating derivatives there. It's unclear how the European regulators will proceed, and they may tread more lightly than the Obama administration. This should be viewed as an opportunity. If the American derivatives markets acquire a reputation for fairness and integrity, they will attract investor funds. Let Europe operate derivatives casinos. Many more people put money into federally insured deposit accounts than on red or black in Las Vegas.