Coming Up Short: The United States' Second-Best Strategies for Corralling Purely Speculative Derivatives
78 Pages Posted: 28 Jan 2015 Last revised: 11 Dec 2015
Date Written: December 1, 2014
Purely speculative derivatives (PSDs) are derivatives in which neither counterparty is engaged in hedging. Unless used for entertainment purposes, PSDs are irrational, less-than-zero-sum transactions. Entities that engage in PSDs jeopardize their stakeholders and increase systemic risk. PSDs can also increase moral hazard, be used for regulatory arbitrage, and redirect resources away from efficient allocation of market capital. PSDs should be unenforceable, void for public policy reasons, except where expressly permitted to provide gambling entertainment, enhance price discovery, or increase liquidity for hedgers. In the U.S., however, PSDs are often legal and enforceable, even after the financial crisis of 2008 that was exacerbated by PSDs. Several provisions of the Commodities Exchange Act (CEA) and the Dodd-Frank Act indirectly address some of the threats of PSDs. These strategies include increased clearing requirements, increased capital and margin requirements, required information reporting, elimination of previous regulatory exemptions, prohibition against proprietary trading for certain commercial banks, and a declaration that no bailout financing will be given to financial entities speculating in derivatives. These strategies, however, do not eliminate PSDs or their problems. At best, they discourage firms from entering into PSDs. The extent of discouragement, however, is unclear. At worst these second-best strategies do little to decrease PSD costs and risks. There is statutory space within the CEA, however, to allow courts and federal regulatory authorities to aggressively restrict PSDs while permitting them where socially beneficial. This space is a function of themes permeating the CEA — the disfavorable treatment of over-the-counter (OTC) derivatives, the concern for the public benefit, the favorable treatment of hedging transactions, the disfavorable treatment of speculating transactions, and the promotion of price discovery and hedger liquidity. Appropriate regulation of PSDs would help avert future financial disasters and foster the efficient allocation of capital.
Keywords: Purely speculative derivatives, derivatives, commodities, hedging, speculation, Commodities Exchange Act, Dodd-Frank Act, price discovery, behavioral finance, systemic risk, commodities exchanges, Commodity Futures Trading Commission, CFTC, SEC, securities, counterparty risk, synthetic risk
JEL Classification: E44; E52; E53; E58; E62, E65; G24; G28; K20; K22
Suggested Citation: Suggested Citation