In the paper Derivatives and the Legal Origin of the 2008 Credit Crisis (published in the inaugural issue of the Harvard Business Law Review), I argue that the credit crisis of 2008 can be traced first and foremost to a little-known statute Congress passed in 2000 called the Commodities Futures Modernization Act (CFMA). In particular, the crisis was the direct and foreseeable (and in fact foreseen, by myself 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.
Derivatives contracts are probabilistic bets on future events that can be used to hedge (which reduces risk) but also provide attractive vehicles for speculation on disagreement (which can increase risk). The common law recognized the differing welfare consequences of hedging and speculative trading in derivatives by applying a doctrine called “the rule against difference contracts” to discourage derivatives that did not serve a hedging purpose by treating them as unenforceable wagers. Speculators responded by shifting their trading onto organized exchanges that provided private enforcement mechanisms, in particular clearinghouses through which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives speculation risk. In the twentieth century, the common law rule was replaced by the federal 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 also kept derivatives speculation from posing significant problems for the larger economy.
These traditional legal restraints on off-exchange derivatives speculation were systematically dismantled during the 1980s and 1990s, culminating in the 2000 enactment of the CFMA. This revolutionary 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 accompanied by an equally dramatic increase in systemic risk, culminating in 2008 with the spectacular failures of several systematically important financial institutions and the near-failures of several others.
In the wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Much of the Act is devoted to turning back the regulatory clock by restoring legal proscriptions on speculative derivatives trading outside a clearinghouse or organized exchange. However, the Act 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.