Monday, April 26, 2010

The Congressional Debate Over Derivatives

I recall Congress debating derivatives several years ago.  Listening to members talk about them was painful.  One member even discussed them as if Congress was discussing mathematical derivatives (such as that above) and asked why Congress thought it could regulate mathematics.  Needless to say, nothing was done at the time.

With the financial crisis and the role that derivatives well publicized (if not totally agreed upon), it appears Congress is now ready to tackle them.

Derivatives (as in the financial type - no the mathematical) are simply agreements for party A to pay party B some money if something else happens (interest rates go up, the price of wheat falls, the dollar rises against the ruble).  For many parties, such as farmers and manufactures, its a useful tool to "hedge" against a risk that party doesn't want to bear.  In current parlance, hedgers are known as "end users" and are generally thought to be ok sorts of folks.  The other guys are the "speculators" or those who create them to speculate rather than hedge any risk that derives from their business operations.  These are mainly Wall Street types.

The main questions being debated: to what extent must derivatives be standardized and traded through exchanges (with the exchange serving as a middleman) rather than customized and traded "over the counter" directly between two parties?  Next, to what extend should financial institutions need to segregate their derivatives trading from other financial activities?

These topics are way to complex to do justice to them in a blog, but I'll try to post some links to useful sources for those who want to learn more soon.

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