Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives

Abstract

In May of 1998, the Commodities Futures Trading Commission (CFTC) announced its intention to review whether it should regulate financial derivatives under the Commodities Exchange Act (CEA). Applying the CEA to derivatives would render much, if not most, derivatives trading illegal absent CFTC approval. The CFTC's announcement accordingly has unsettled the multi-trillion dollar derivatives industry. In response, Congress is now considering legislation that would block the CFTC from taking action by explicitly exempting financial derivatives from the CEA.

This article offer insights into the impending battle over derivatives by addressing the fundamental link between derivatives and speculation. The CEA is at heart an antispeculation law, part of a network of legal doctrines dating back to the earliest days of the common law that systematically discourages speculative trading and confines it primarily to the stock market and the regulated futures exchanges. This longstanding pattern of legal hostility towards speculators appears to enjoy little support from economic theory. According to the prevailing risk hedging and information arbitrage models of speculative trading, speculation promotes economic efficiency by reducing risk and increasing the accuracy of market prices.

The article argues that the apparent conflict between economic theory and legal tradition can be resolved by considering an alternative model of speculation that focuses on traders' heterogeneous expectations as a cause of trading. This heterogeneous expectations approach provides theoretical support for antispeculation laws by explaining how some forms of speculation can inefficiently increase risk, erode returns, and trigger speculative price bubbles. It also suggests an alternative to the apparently binary choice now available to lawmakers (i.e., either apply the CEA to derivatives, or exempt them). That alternative would be to permit traders to deal in OTC derivatives without the CFTC's approval under the CEA, but return to the common law rule that viewed such contracts as legally unenforceable. A heterogeneous expectations analysis suggests that this time-honored strategy, which requires traders to rely on private ordering and especially reputation to enforce their deals, may discourage welfare-reducing speculation while protecting more beneficial forms of derivatives trading. It also suggests that any proposed legislative"reform" that declares derivatives exempt under the CEA may, by resolving existing legal uncertainty about OTC derivatives' enforceability, have the undesirable and unintended consequence of increasing the incidence of welfare reducing derivatives speculation.

JEL Classification: G13