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Regulating the Derivatives Markets

The New York Times had an excellent editorial last week titled "A Long Road to Regulating Derivatives," which discusses the progress made in regulating the types of complex securities which have been implicated in the recent financial crisis. We at SLCG feel that investors should pay close attention to the changes taking place in securities regulation as they could have a significant impact on the entire market.

Traditionally, derivatives were regulated relatively lightly, especially over-the-counter (OTC) derivatives. The Dodd-Frank law included provisions for improving the transparency and safety of these markets, and specifically tasked the Commodity Futures Trading Commission (CFTC) and the SEC with drafting new rules governing their sales and reporting. While Dodd-Frank was signed into law almost two years ago, many feel that these agencies have not made sufficient progress in reining in the market for complex derivatives, which have begun to spring up again as the fallout from the crisis fades.

According to the editorial, although the CFTC has proposed an electronic trading system which would make price information accessible to the public, some lawmakers have proposed legislation to backtrack rules on regulating derivative markets under the "fear" that such open trading system might "hurt banks' flexibility." As our own work has shown, the lackof publicly available price information for complex securities has led to numerous instances of misrepresentation and even fraud, and as long as this information remains beyond the reach of investors the opportunity for misconduct will not go away.

In essence, there is an enormous information asymmetry between banks and investors -- especially retail investors -- and a major goal for derivatives regulation would be to close that gap such that investors can make informed decisions.