Derivatives Before Breakfast

This post by Jill Schlesinger originally appeared on CBS'

My first job out of college was as a derivatives trader on the floor of the Commodities Exchange in New York (COMEX). I was in the gold options pit, where investors bet on the direction of gold futures (a derivative of the physical metal). I had the opportunity to discuss derivatives before breakfast with CBS3 in Philadelphia.

When I traded derivatives back in the late 1980's, nobody really talked about them-they seemed like an esoteric creation of math-heads in Chicago. Now derivatives have become "weapons of mass destruction," the complex financial instruments that nearly brought down insurance giant AIG and are at the center of the SEC charges against Goldman Sachs.

For clarification, a derivative is a contract that derives its value by reference to "something else." That something can be an index, rate, stock or commodity. But not all derivatives are created equal. Listed options that are traded on the world's exchanges are regulated vehicles and aren't part of the current debate. The current regulatory reform movement is taking aim at over-the-counter derivatives.

An over-the-counter derivative is a subset that includes the now-infamous "credit default swap" market, as well the interest rate and foreign exchange derivatives markets. The key defining characteristic of an OTC derivative is that it is entered into directly between the parties, not traded on a public exchange.The current regulatory reform bill that's being considered would require that OTC derivatives be traded on exchanges.

Some banks object to this, claiming that it limits their ability to create vehicles for their clients, but my guess the real objection is that when these instruments come into plain view, it's likely that they will become more efficient...and less profitable for the banks.

In this morning's FT, George Soros takes derivatives reform one step further, by advocating not only trading and clearing, but registration as well.

Derivatives traded on exchanges should be registered as a class. Tailor-made derivatives would have to be registered individually, with regulators obliged to understand the risks involved. Registration is laborious and time-consuming, and would discourage the use of over-the-counter derivatives. Tailor-made products could be put together from exchange-traded instruments. This would prevent a recurrence of the abuses which contributed to the 2008 crash. Requiring derivatives and synthetic securities to be registered would be simple and effective; yet the legislation currently under consideration contains no such requirement.

This interesting idea is unlikely to be included in this round of legislation, but is worthy of consideration as lawmakers try to overhaul the current regulatory regime.

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Jill Schlesinger is the Editor-at-Large for CBS Prior to the launch of MoneyWatch, she was the Chief Investment Officer for an independent investment advisory firm. In her infancy, she was an options trader on the Commodities Exchange of New York.
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    Jill Schlesinger, CFP®, is the Emmy-nominated, Business Analyst for CBS News. She covers the economy, markets, investing and anything else with a dollar sign on TV, radio (including her nationally syndicated radio show), the web and her blog, "Jill on Money." Prior to her second career at CBS, Jill spent 14 years as the co-owner and Chief Investment Officer for an independent investment advisory firm. She began her career as a self-employed options trader on the Commodities Exchange of New York, following her graduation from Brown University.