My Twisted Idea of Fun

An email I wrote debating a test question with my financial planning professor (all in good fun):

Prof. [Removed],

Regarding the regulation of derivatives trading, you referred me to the Commodity Futures Modernization Act of 2000. It is important to understand that this act addresses *OTC derivatives.* Because these transactions between "sophisticated parties" are not regulated under the Commodity  Exchange Act, and because of their role in the financial meltdown, they have been at the center of a significant amount of media coverage and public debate. This is part of what has led to the all-too-common misconception that the SEC is charged with regulating securities but not derivatives.

I selected the SEC as my answer on the test, citing some options (e.g. puts and calls) that it regulates. Other derivatives, like swaps and futures in Chicago, are regulated by the CFTC. If the CFTC had been an option (pun intended), I probably would have chosen that instead of the SEC.

The following is copied from the well-regarded blog of a finance lawyer in New York (Jun 4, 2009): 

http://economicsofcontempt.blogspot.com/2009/06/yes-sec-regulates-derivatives.html

The SEC does, in fact, have the authority to regulate derivatives. It regulates options (e.g., calls, puts, straddles) on individual securities, options on certain indexes of securities, such as the S&P 100, and exchange-traded options on foreign currency. Options are unquestionably derivatives.

What Salmon and Klein probably meant was that the SEC doesn't have the authority to regulate swaps. But swaps aren't the only kinds of derivatives by any means. Confusing swaps and derivatives is what leads idiot journalists* to constantly mislabel derivatives as "unregulated financial instruments." (If journalists think derivatives are all unregulated, then I'm curious what they think the Commodity Futures Trading Commission does?)

And here is the response of the Reuters journalist regarding his mistake (Jun 4, 2009):

http://blogs.reuters.com/felix-salmon/2009/06/04/when-the-sec-regulates-derivatives/

Economics of Contempt labels me an “idiot journalist” for saying that the SEC is charged with regulating securities but not derivatives. As he points out, the SEC does too regulate securities — specifically, it regulates options on stocks, which are certainly derivatives, as well as exchange-traded options on foreign currency.

My bad. When I think derivatives, I think of swaps and futures in Chicago, rather than exchange-traded stock options — basically, I think of the kind of things which are either regulated by the CFTC, or not regulated at all (like CDS). But yes, there are some derivatives which are regulated by the SEC. My feeling is that all derivatives should be regulated, and that none of them should be regulated by the SEC, which should stick to securities. But of course I shouldn’t get ahead of myself, and for the foreseeable future it is indeed the SEC, and not the CFTC or anybody else, which is in charge of regulating a large chunk of the options market.

I hope that this helps to clear up the issue!

All the best,

Nathaniel

UPDATE: The Prof. confided after class today (3/11) that I was right and he was wrong, but because it was a test and "no one else caught that" he wouldn't give the points back. Oh well...