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Forgotten Lessons of Deregulation

Rolling Back Dodd-Frank’s Derivatives Rules Would Repeat a Mistake that Led to the Financial Crisis

By Taylor Lincoln

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Although debate continues over some of the root causes of the 2008 financial crisis, there is little dispute that inadequate regulation of derivatives was a major contributor. In admissions of the sort not often heard in Washington, many of the policy makers who supported derivatives deregulation in the late 1990s now acknowledge that they were wrong. They include former President Bill Clinton, former Federal Reserve Chairman Alan Greenspan, and, with more nuance, two former Treasury secretaries.

In the first decade of the 2000s, derivatives issuers used their regulatory exemption to take enormous risks. Derivatives buyers, in turn, drew a false sense of security from the promises laid out in the contracts they purchased. This illusion of security spurred a lending binge that caused housing prices to soar. After the housing bubble burst, the inability of derivatives issuer American International Group (AIG) to make good on its obligations threatened to cause cataclysmic failures among financial institutions. This was largely responsible for prompting the federal government to authorize hundreds of billions of dollars in bailouts. The combination of the financial crisis and a devastated housing market caused a recession from which the nation has yet to recover.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 addressed many of the shortcomings in derivatives oversight. But, now, at least nine bills are pending in Congress that would erode the derivatives’ reforms in Dodd-Frank. Some of these bills seek to exempt large classes of derivatives trades from the law’s requirements that such trades be transparent, guaranteed by centralized clearing organizations, and accompanied by adequate collateral. Other bills would impose additional burdens on agencies’ ability topromulgate financial services regulations, including those regarding derivatives. Each of the seven derivatives bills introduced in the House of Representatives has at least been approved by a committee and three have passed the full House. [See Appendix] The push to roll back the reforms in Dodd-Frank comes amid news that JPMorganChase, the nation’s largest bank, lost at least $2.3 billion—and may eventually lose more than $4 billion—from recent derivatives trades gone awry.

The effort to exclude certain derivatives trades from public oversight is reminiscent of the campaign to deregulate derivatives in the late 1990s. Americans should reject such appeals this time around.