From Prof. Lynn Stoudt, UCLA School of Law:

Why re-regulating derivatives can prevent another disaster

When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That's because they were economists, not lawyers.

Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) [1] That's because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress's decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000.

It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG's losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won't default on their bond obligations. Because AIG was part of an enormous and poorly-understood web of CDS bets and counter-bets among the world's largest banks, investment funds, and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt. Only a massive $180 billion government-funded bailout of AIG prevented the system from imploding.

This could have been avoided if we had not deregulated financial derivatives.

Derivatives "De"regulation?

Wait a minute, some readers might say. What do you mean, "de"regulated derivatives? Aren't derivatives new financial products that have never been regulated?

Well, no. Derivatives have a long history that offers four basic lessons. First, derivatives contracts have been used for centuries, possibly millennia. Second, healthy economies regulate derivatives markets. Third, derivatives are regulated because while derivatives can be useful for hedging, they are also ideal instruments for speculation. Derivatives speculation in turn is linked with a variety of economic ills--including increased systemic risk when derivatives speculators go bust. Fourth, derivatives traditionally are regulated not through heavy-handed bans on trading, but through common-law contract rules that protect and enforce derivatives that are used for hedging purposes, while declaring purely speculative derivative contracts to be legally unenforceable wagers.

A Brief History of Derivatives Regulation

Just as derivatives have been around for centuries, so has derivatives regulation. In the U.S. and U.K., derivatives were regulated primarily by a common-law rule known as the "rule against difference contracts."

The rule against difference contracts did not stop you from wagering on anything you liked: sporting contests, wheat prices, interest rates. But if you wanted to go to a court to have your wager enforced, you had to demonstrate to a judge's satisfaction that at least one of the parties to the wager had a real economic interest in the underlying and was using the derivative contract to hedge against a risk to that interest.

Because, of course, wagers can be used to hedge against risk. For example, if you own a corporate bond and you are worried the issuer might default, you can reduce your risk by entering a CDS contract, essentially betting against the issuer's creditworthiness. If the bond decreases in value, the CDS will increase in value. Similarly, if you own a $500,000 home, you can hedge against the risk your home will burn down by making a bet with an insurance company that will pay off $500,000 if the home actually burns. (Most of us call these wagers "homeowner's insurance," although a typical Wall Street derivatives dealer might label them "home value swaps.") Using derivatives this way is truly hedging, and it serves a useful social purpose by reducing risk.

But as judges have recognized for centuries, at least until recently, derivative bets are also ideally suited for pure speculation. Speculation is the attempt to profit not from producing something, or even from providing investment funds to someone else who is producing something, but from predicting the future better than others predict it. [4] A speculator might, for example, try to make money predicting wildfires by buying home insurance on houses in Southern California without actually buying the houses themselves. Similarly, a speculator might hope to make money betting on a company's fortunes by buying CDS on the company's bonds without buying the bonds themselves. Unlike hedging, which reduces risk, speculation increases a speculator's risk in the much same way that betting at the track increases a gambler's risk. Highly-speculative markets are also historically associated with asset price bubbles, reduced returns, price manipulation schemes, and other economic ills.

Common-law judges accordingly viewed derivatives speculation with suspicion. Under the rule against difference contracts and its sister doctrine in insurance law (the requirement of "insurable interest"), derivative contracts that couldn't be proved to hedge an economic interest in the underlying were deemed nothing more than legally unenforceable wagers.

This didn't mean derivatives couldn't be used to speculate. But the rule against difference contracts forced speculators to think about how they could make sure their fellow gamblers paid their bets. The answer was for the speculators to set up private exchanges with membership requirements, margin requirements, netting requirements, and a host of other rules designed to make sure that, despite the legal invalidity of speculative derivatives contracts, speculating traders would make good on their contract promises. In the process, the exchanges kept derivatives speculation in check and under controlled conditions. Eventually, the control was increased when government regulators like the Commodities Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) were empowered to oversee trading on particular exchanges. Meanwhile, off the exchanges, the rule against difference contracts kept "over the counter" speculation in derivatives in check.

At least, it kept speculation in check until the rule was dismantled. The dismantling process began when the United Kingdom passed its Financial Services Act of 1986, "modernizing" the UK's financial laws by eliminating the old rule against difference contracts and making all financial derivatives, whether used for hedging or for speculation, legally enforceable. US regulators, worried that Wall Street banks might lose out on a lucrative new market, followed suit in the 1990s by creating ad hoc regulatory exemptions for particular types of financial derivatives like currency forward contracts and interest rate swaps. Soon the US also embraced wholesale deregulation with the passage of the CFMA in 2000. The CFMA not only declared financial derivatives exempt from CFTC or SEC oversight, it also declared all financial derivatives legally enforceable. The CFMA thus eliminated, in one fell swoop, a legal constraint on derivatives speculation that dated back not just decades, but centuries. It was this change in the law--not some flash of genius on Wall Street--that created today's $600 trillion financial derivatives market.

for the entire blog post:

http://blogs.law.harvard.edu/corpgov/2009/07/21/how-deregulating-derivatives-led-to-disaster/#more-2596