Today President Obama addressed the titans of Wall Street and asked them to join hands and take preemptive measures to avoiding another financial collapse.  As usual, the delivery was eloquent and the message was clear; if you aren’t going to support this reform, then you must be doing something you don’t want regulators to see.

This fails to address the main concerns of many financial minds.  It isn’t that every bank is instituting wildly risky trading schemes or hedging their entire book value on the outcome of a Yankees game, and they don’t want regulators to know.  The issue is that regulation is rarely done well, and usually put into motion by people that don’t have the slightest idea what they are talking about.  For the purposes of this article, I want to discuss derivatives.

If Congress institutes sweeping financial reform it will most likely involve some sort of restriction on derivative creation and trading.  This could be in the form of more transparency, tighter valuation rules or limiting what derivatives can actually derive value from.  Some congressmen would have them banned altogether!  This is not in interest of maintaining efficient markets.  However, Congress believes that this is exactly what restricting derivatives will do.

On the contrary, derivatives provide very real benefits to markets in the form of efficient pricing, removing arbitrage opportunities and allowing parties to hedge risk.  The problem comes about when institutions and traders begin to layer their risk to such an extent that they cannot see what they are actually doing.  Is there a way to implement regulations that can let derivatives provide value to the market without removing most of their functionality?  I’m sure there are experienced derivatives traders who have excellent ideas about that.

Unfortunately, there is no incentive for intelligent minds to become the instigators of actual, material reform.  What incentive would an ambitious trader have to help Congress develop regulations that could potentially restrict his or his firm’s profits?  The money usually provides motivation for people to figure out how to beat the system.  So instead, we have politicians spewing partisan rhetoric at each other from both sides of the aisle.

Another issue is that regulation tends to swing wildly from one extreme to the next, and most financial institutions anticipate the pendelum swinging violently against them as a result of this reform.  This will lead them to be combative from the start.  Financial firms have had it good in the immediate past in terms of regulations being lifted and the markets generally being let loose.  The result, however, was not so beneficial to the world as a whole.  I anticipate that the initial financial reform put into place will be too restrictive for it’s own good, and end up strangling some of the functions of the financial system.

One of the quotes from President Obama is strangely applicable to both the financial collapse and process of over adding/removing regulations.  He said that “it is essential that we learn the lessons from this crisis, so we don’t doom ourselves to repeat it. And make no mistake. That is exactly what will happen.”  He should heed well those words as he begins to tackle the issue of financial reform, and make sure he does not implement changes too sweeping and broad to let the financial system operate at all.  If he does, we may find ourselves peeling the regulations back in ten years and fighting the same forces at work today.  Good luck, Mr. President.

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