First, Try Cooperation
The headlines about the downfall of the British investment bank Barings PLC and Orange County’s messy bankruptcy have put the spotlight on the arcane, sophisticated financial instruments known as derivatives. Derivatives--which derive their value from underlying assets such as stocks, bonds or commodities--have been blamed for the massive losses in both cases, but these risk-management tools in and of themselves are not the problem. It is their misuse, overuse or use without proper oversight that typically triggers such financial debacles.
Washington is now being called on to provide greater regulation. The government already has oversight of some derivatives. Derivatives that are structured as securities are subject to the authority of the Securities and Exchange Commission. Those that involve futures and options traded on exchanges such as the Chicago Board of Trade are regulated by the Commodity Futures Trading Commission.
To avoid a congressional crackdown on previously unregulated over-the-counter derivatives, the six investment firms that handle more than 90% of the derivative business have voluntarily agreed to provide federal regulators with detailed information about these specialized transactions.
Because over-the-counter derivatives are not easily structured for trade on regulated exchanges, their prices and thus their risks can be extremely hard to figure out, but the prospect of high returns makes the instruments irresistible to some investors.
The six investment firms--Goldman Sachs, Morgan Stanley, CS First Boston, Salomon Bros., Lehman Bros. and Merrill Lynch--have agreed to report their 20 largest derivative deals each quarter, the potential risks and those with whom the deals were made. The SEC and the commodity commission will track unusual activity.
SEC Chairman Arthur Levitt Jr., whose agency helped draft the new rules, welcomed the voluntary efforts. Some may view the action by the six firms as self-serving and others may wonder whether voluntary standards will deter abuse. Nevertheless, the agreement is worth a try and preferable to onerous government regulations that are out of sync with today’s rapid-fire financial markets.
