Derivatives: Why They Matter for Financial Reform

Examining their role in banking and the big crash

Derivatives, a special kind of investment, played a key role in the financial crisis and generated $20 billion for Wall Street last year. They are also central in President Obama's push for financial reform. Because the value of derivatives is pegged to the future price of other events or instruments, they have been negatively compared to bets. They also play a role in the case against Goldman Sachs. Here's an overview of why derivatives matter, and how they figure into the ongoing push for financial regulatory reform.

• Bill Will 'Spin Off' Derivative Traders  The Wall Street Journal's Greg Hitt and Damian Paletta say the regulatory reform bill "would potentially force banks to spin off their operations that trade the exotic financial instruments." However, a version of the bill put forward by the Senate Agriculture Committee "could hand control over the derivatives market into just a few companies, such as hedge funds, over which regulators have less control."

• How One Kind of Derivative Extended the Recession  ProPublica's Jesse Eisinger and Jake Bernstein report on hedge fund Magnetar, which typified the abuse of a type of derivatives called collateralized debt obligations (CDOs). By taking out CDOs that bet the housing market would fail, Magnetar not only profited from but significantly worsened the housing crisis and following recession.

Magnetar wasn't the only market player to come up with clever ways to bet against housing. ... Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding. Magnetar's approach had the opposite effect -- by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn't alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

• Regulate Them Like Commodities  In the Wall Street Journal, Chairman of the Commodity Futures Trading Commission Gary Gensler explains that masses of unregulated derivatives, in which banks place bets on other bets, "has created a system where financial institutions are deeply interconnected. If a derivatives dealer fails today it can have severe economic implications across the entire financial system." That's why the reform bill "would require standard over-the-counter derivatives to be cleared by central clearinghouses. This will greatly reduce risk, interconnectedness and the need for future bailouts. Financial institutions would be freer to fail with limited effects on the broader economy."

• The Downside of Blocking Derivatives  The Atlantic's Daniel Indiviglio warns, "While it sounds like a fine idea for banks to simplify their businesses by not dealing derivatives, the provision would harm the market." The appetite for derivatives isn't going away. Thus, "non-U.S. banks that are still permitted to deal derivatives will have a significant advantage for this reason. If a derivatives desk doesn't have a bank behind it with lots of capital to better ensure its survival, the market will become less efficient."

• Focus on Derivatives Risks Missing Real Culprit  Mother Jones' Kevin Drum writes, "the real issue is that predatory lending on a large scale helped to massively inflate the housing/credit bubble of the aughts. If the home loan market had been regulated stringently enough to keep mortgage lending relatively sober, the bubble most likely would have been half the size it ended up at, the credit derivative tidal wave never would have picked up a lot of steam, the bursting of the bubble would have kicked off a normal-sized recession instead of a near-depression, and the banking system would have survived without massive government intervention."