The Legal Origin of the 2008 Credit Crisis
Lynn A. Stout
Cornell Law School - Jack G. Clarke Business Law Institute
February 25, 2011
UCLA School of Law, Law-Econ Research Paper No. 11-05
Experts still debate what caused the credit crisis of 2008. This article argues that dubious honor belongs first and foremost to a little-known statute called the Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis was not due primarily to changes in the markets, it was due to changes in the law. The crisis was the direct and foreseeable (and in fact foreseen by the author and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.
Derivative contracts are probabilistic bets on future events. They can be used to hedge, which reduces risk, but they also provide attractive vehicles for disagreement-based speculation that increases risk. Thus the social welfare consequences of derivatives trading depend as an empirical matter on whether the market is dominated by hedging or speculative transactions. The common law recognized the differing welfare consequences of hedging and speculation through a doctrine called “the rule against difference contracts” that treated derivative contracts that did not serve a hedging purpose as unenforceable wagers. Speculators responded by shifting their derivatives trading onto organized exchanges that provided private enforcement through clearinghouses in which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives risk. In the twentieth century, the common law was replaced by the Commodity Exchange Act (CEA). Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. This regulatory system also for many decades kept derivatives speculation from posing significant problems for the larger economy.
These traditional legal restraints on OTC speculation were systematically dismantled during the 1980s and 1990s, culminating in the 2000 enactment of the CFMA. That legislation set the stage for the 2008 crises by legalizing, for the first time in U.S. history, speculative OTC trading in derivatives. The result was an exponential increase in the size of the OTC market, culminating in 2008 with the spectacular failures of several systematically important financial institutions (and the near-failures of several others) due to speculative derivatives losses. In the wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Title VII of the Act is devoted to turning back the regulatory clock by restoring legal limits on speculative derivatives trading outside a clearinghouse. However, Title VII is subject to a number of possible exemptions that may limit its effectiveness, leading to continuing concern over whether we will see more derivatives-fueled institutional collapses in the future.
Number of Pages in PDF File: 33
Keywords: Commodities Futures Modernization Act (CFMA), Dodd-Frank Financial Reform Bill, OTC Trading
Date posted: February 28, 2011 ; Last revised: March 9, 2011
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