To safeguard investors, the federal regulatory umbrella must cover all aspects of financial services. The financial crisis has amply demonstrated how problems in exotic products and investment firms that cater to sophisticated investors can ripple throughout the markets, causing harm to all investors.
Unregulated trading in over-the-counter (OTC) derivatives contracts, especially credit default swaps, was at the heart of the global financial crisis. The global OTC derivatives market is huge and exempt from virtually all regulation under the Commodity Futures Modernization Act of 2000. Prices are hidden, speculation is rampant and leverage is high. Derivatives contracts can help manage risk. But they can also be used for turbo-charged speculation that multiplies risk, increasing the possibility of enormous financial damage. That’s why financier Warren Buffett has called derivatives “financial weapons of mass destruction.”
Standardized and standardizable OTC derivatives contracts should trade on regulated exchanges. That's the best way to ensure effective government oversight and a stable trading environment. Exchange trading provides the transparency that lets investors comparison-shop and ultimately pay lower fees. Every company has a seemingly good reason why its contracts are exceptional “customized” products that should trade privately. In reality, most derivatives contracts are standardized, or standardizable, and can trade on exchanges just fine.
Decisions about what should be cleared centrally should not be left to clearinghouses. Some of these facilities are owned by banks that have strong incentives to maximize their profits by pushing derivatives contracts into the shadows. The financial institutions whose reckless trading brought the U.S. financial system to the brink of disaster should not be allowed to dictate how trading is regulated.