Smart or Not So Smart Money; The Limits on Derivatives and Regulating Them

Deven Desai

Deven Desai is an associate professor of law and ethics at the Scheller College of Business, Georgia Institute of Technology. He was also the first, and to date, only Academic Research Counsel at Google, Inc., and a Visiting Fellow at Princeton University’s Center for Information Technology Policy. He is a graduate of U.C. Berkeley and the Yale Law School. Professor Desai’s scholarship examines how business interests, new technology, and economic theories shape privacy and intellectual property law and where those arguments explain productivity or where they fail to capture society’s interest in the free flow of information and development. His work has appeared in leading law reviews and journals including the Georgetown Law Journal, Minnesota Law Review, Notre Dame Law Review, Wisconsin Law Review, and U.C. Davis Law Review.

You may also like...

4 Responses

  1. Mike Zimmer says:

    In the comments to the linked article, a commentator describes credit default swaps this way: “you and I could contract for payments between each other depending on almost any third referent, exchange rates coffee prices etc. Neither you nor I have to actually own any foreign currency or coffee however.”

    As I understand, these type contracts are free of federal regulation, accomplished by Wall Street during the Clinton era. But, isn’t this a gambling contract? How is this different than you and me contract on the third referrant — the outcome of the Monday Night NFL game — over which neither of us have any direct interest? Wouldn’t normal state anti-gambling laws make this illegal and thus unenforceable? Did Congress, in freeing this stuff from federal regulation, also preempt state anti-gambling laws?

  2. Nate Oman says:

    Deven: a CDO is a kind of derivative, but not all derivatives are CDOs. A CDO entitles its holder to a fractional share in the income stream generated by a pool of financial assets. It is thus a derivative in that the value of the CDO is dependent on, i.e. derivative of, some underlying financial asset. On the other hand, a CDS is also a derivative. In this case A promises to make a payment to B if there is a shift in the value of some referenced financial asset. The value of the CDS is dependent on, i.e. derivative of, the referenced financial asset. On the other hand, the payouts under a CDS do not come directly from the financial asset as in the case of a CDO.

    Mike: If a CDS is a gambling contract, so are virtually all commodity futures contracts, which also consist of cash payments based on market price flucuations in an underlying asset which needn’t be owned by either part to the contract. Indeed, if you know anything about the history of the law of contracts treatment of futures contracts in the 19th century, there is a weird feeling of deja vu in the rhetoric surrounding CDSs. One can use a futures contract to simply place a bet. One can also use a futures contract to hedge against risk. Today, we don’t try to draw a distinction between which way a party is using the future contract. Rather than condemning the contract as a gambling device, we create regulatory mechanisms — essentially clearing house rules — to deal with counter-party risk, short-squeeze risk and the like. Solving these problems is not rocket science. It seems to me that problem with CDS is not in the contracts themselves, but in the regulatory and — far more importantly importantly — the political and monetary environment in which institutions could play in the CDS market. The culprit here is not a liquid market in credit risk. Rather, the culprits are lax capital requirements, loose monetary policy, and a bail-out political culture with huge moral hazards.

  3. Mike Zimmer says:

    Thanks, Nate, for your clear explanation.

  4. Mike Zimmer says:

    Thanks, Nate