Defusing Derivatives

Warren Buffett saw it coming. In 2002, he called derivatives “weapons of financial mass destruction.” They made bankers billions of dollars before helping to blow up the global economy in 2008. After the crash, regulators set to work to make them less dangerous. That also made them less profitable. Regulators say they succeeded in fundamentally altering the $633 trillion over-the-counter derivatives market, moving most of the trades onto open exchanges that take the place of the private dealing that was the norm. Critics say the new trading structure isn’t as competitive as the government first hoped. And nobody knows whether the dangers were truly put to rest or just shifted elsewhere.

U.S. President Donald Trump came into office vowing to repeal Dodd-Frank, the 2010 financial reform bill that set in motion a large-scale revamping of the often-opaque derivatives markets. He promoted Commodity Futures Trading Commissioner J. Christopher Giancarlo to be acting head of the commission, which wrote many of the Dodd-Frank rules, and nominated him to be chairman. A former executive at a swaps brokerage, Giancarlo has opposed several recent efforts to tighten regulations and has blamed swaps-trading regulations for fracturing global markets. A prime goal of the Dodd-Frank reforms was for regulators to be able to know what derivatives are trading, who is trading them and what the potential risks are. In the U.S., beginning in the fall of 2013 most derivative trades were shifted from phone calls or instant messages onto open, regulated exchanges or similar systems called swap execution facilities; the trades are publicly recorded in what are called data warehouses. Most contracts are now also backed by clearinghouses that require traders to post money as a cushion against losses, and mandate that clearinghouse members, mostly banks, set aside sufficient capital to share the risk. The European Union didn’t compel banks to clear their trades until June 2016. Overall, the changes did not lead to a big drop in the market share of the largest banks.