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By Root 822 0

That report found that “to promote innovation, competition, efficiency, and transparency in OTC derivatives markets, to reduce systemic risk, and to allow the United States to maintain leadership in these rapidly developing markets,” derivatives should be exempted from all federal regulation.22 The following year, Congress overwhelmingly passed the Commodity Futures Modernization Act, which expressly forbade the CFTC from regulating derivatives, and expressly exempted derivatives from any other state law. Not surprisingly, as Gillian Tett describes, “the derivatives sector was jubilant.”23 But as the Financial Crisis Inquiry Commission concluded, the legislation “was a key turning point in the march toward the financial crisis.”24

It’s not clear that anyone had a clue about how big this market would be when the government first chose to ignore it. Professor Frank Partnoy has tried to characterize the scale of the regulatory change in a way that even lawyers can understand. As he explained to me, whereas in 1980, close to 100 percent of the financial instruments traded in the market were subject to the New Deal exchange-based regulatory regime, by 2008, 90 percent of the financial instruments traded in the market were exempted from it. If, as David Moss put it, “the simple truth [was] that New Deal financial regulations worked,” they were not going to work for almost 90 percent of the assets traded in our financial markets. We had flipped from a presumptively public market of exchange to a market where only insiders knew anything real about how the market worked, or what the assets were worth. That was great for the insiders, giving them enormous power to leverage into extraordinary profits.25 It was awful for the rest of us.

The decision to allow this economy of derivatives to run in secret was extraordinarily silly. For not only would secrecy weaken the efficiency of the market as a whole (since the public signal of price helps discipline a market),26 but it would also lead to a kind of regulatory arbitrage: because regulation is costly, deals that were subject to the New Deal regulations would be recast into a form that could evade those regulations. Indeed, that’s what happened: financial instruments that were “economically equivalent to many other financial instruments”27 were substituted for those “other financial instruments,” because unlike those “others,” they were unregulated. As the Financial Crisis Inquiry Commission concluded, “[G]iven these circumstances, regulatory arbitrage worked as it always does: the markets shifted to the lowest-cost, least-regulated havens.”28

Evading regulation has its own value. This led Nobel Prize–winning economist Merton Miller to the “insight” that “companies would do swaps not necessarily because swaps allocated risk more efficiently, but rather because they were unregulated. They could do swaps in the dark, without the powerful sunlight that securities regulation shined on other financial instruments.”29 Thus “much of the $600-plus trillion derivatives market exists,” finance professor Frank Partnoy calculates, “because private parties [were] doing deals to avoid the law.”30

A speed limit that applies to black cars only will not only incentivize the sale of colorful vehicles, it will also be a boon to the paint departments of auto body shops everywhere. That’s the story of Wall Street in the 2000s: While some portion of the market for derivatives was no doubt driven by a genuine need for the particular flexibility of a derivative, a huge proportion was simply black cars being painted red. The winners in this new market were the drivers of these freshly painted cars, and the firms that had done the paint jobs (aka Wall Street). The losers were—surprise, surprise—the rest of us.

To say that the financial sector escaped the government’s regulation, however, is not to say that the sector escaped regulation. As Alan Greenspan put it: “It is critically important to recognize that no market is ever truly unregulated…. The self-interest of market participants generates private market