Commodity Futures Modernization Act of 2000
The Commodity Futures Modernization Act of 2000 (CFMA) significantly altered the regulatory landscape for over-the-counter derivatives, allowing sophisticated parties to trade these financial instruments without the constraints of existing laws. Over-the-counter derivatives include a variety of complex contracts, such as futures, options, and swaps, which derive their value from underlying assets and are not traded on public exchanges. By exempting these transactions from traditional regulatory oversight, the CFMA facilitated exponential growth in the derivatives market, particularly among investment banks and hedge funds, leading to record profits in the short term.
However, the act also contributed to increased risks within the financial system, as the inherent dangers of these products were not fully understood. The lack of regulation became particularly problematic during the economic downturn that began in 2007, when the collapse of the real estate market and high levels of mortgage defaults highlighted the vulnerabilities created by credit default swaps and other derivatives. Many analysts argue that the unregulated nature of these financial instruments played a crucial role in the financial crisis, raising questions about the balance between innovation in financial markets and the need for effective oversight.
Commodity Futures Modernization Act of 2000
The Law: Federal law that changed the regulation of complex financial products called “derivatives”
Date: December 21, 2000
Also Known As: CFMA
The Commodity Futures Modernization Act of 2000 dramatically changed the way that certain financial instruments collectively known as “over-the-counter derivatives” are regulated. It stated that so-called sophisticated parties were free to engage in derivatives trades without adherence to existing laws such as the Commodities Exchange Act of 1936 or to the Securities and Exchange Commission. Although it received almost no public attention at the time, the new law was a factor in the economic bubble of the early 2000s and the recession that began in 2008.
Over-the-counter derivatives are a diverse set of complicated financial instruments, all of which derive value from underlying assets. They are essentially contracts between buyers and sellers, not traded on public securities exchanges. This wide set of financial instruments has several subsets. Futures are agreements to buy or sell something at a later date for a price set in the present. Options are agreements to allow the choice of whether or not to buy something in the future for a set price. Swaps are agreements to make payments based on the underlying or estimated future value of an asset.
Since the 1980s, derivatives grew in importance to financial markets. They provided ways for investment firms to make small adjustments, often called hedges, to their investment positions. In theory, this meant that derivatives could be used to reduce downside, or risk, for large financial transactions. However, the risks of derivatives themselves have never been fully understood. What the CFMA did was to say that the traditional regulatory agencies should not be responsible for understanding these inherent risks, since this was best left to the presumably sophisticated parties that trade them.
Impact
The CMFA effectively removed the last major regulatory barrier to the free use of derivatives. At the same time, new players such as investment banks were allowed to participate in derivatives trading due to contemporary legislation, such as the Financial Services Modernization Act of 1999. As a result, the use of derivatives increased exponentially and took on innovative forms. In the short term, this led to record profits for investment banks and hedge funds that traded them.
However, some of the new uses for derivatives proved to be extremely risky. For instance, the recession that began in 2007 was triggered by a fast downturn in real estate prices and by record levels of mortgage defaults. Credit default swaps, derivatives in which sellers agree to pay buyers in case of bond or loan defaults, had become common and lucrative products for investment banks. Their hugely expanded use wreaked havoc on the financial sector when the real estate market plummeted. Many analysts consider the widespread use of under-regulated derivatives to have been a key factor in the crisis.
Bibliography
Butler, Brian, David Butler, and Alan Isaacs. A Dictionary of Finance and Banking. Oxford: Oxford UP, 1997. Print.
Greenberger, Michael. “The Role of Derivatives in the Financial Crisis: Testimony of Michael Greenberger, Law School Professor, University of Maryland School of Law.” Financial Crisis Inquiry Crisis Commission Hearing. Washington, DC: US Senate, 30 June 2010. PDF file.
Leising, Matthew. “Credit Markets Safest Since 2008 as Derivatives Migrate to Clearinghouses.” Bloomberg. Bloomberg, 5 Aug. 2011. Web. 7 Dec. 2012.