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Robert Merton on Regulating Derivatives

January 26, 2010

by Dan Richards

Congress and the media have called for greater vigilance on the part of regulators, perhaps stronger central regulatory bodies, over options and derivatives.  In your view, would that be healthy?

We certainly need to reform the regulatory process.  I am concerned on two points. One, we are putting too much reliance on the regulators.  Whenever we have a tough problem, we say, “let’s have the regulators look at it,” as if they were omniscient, omnipotent and all-powerful.  They are limited like the rest of us in what they can do.

What’s worse than being uninsured is to think you are insured when you are not.  If we simply say, “let’s turn this over to a new set of regulators and a new set of regulations and then we will be okay,” then it creates a set of expectations that I don’t think are achievable.  There are limits to what we can do, and we have to do the best that we can.

The other consideration is – and I am not quite sure why – at least in the US and it looks like in Europe, the legislatures appear to be distrustful of the regulators.  This is because the kinds of legislation they are attempting to pass – and we don’t know what will be passed (that’s another issue) – are very micromanaged.  There are specific rules that are absolute, instead of saying the principles we are trying to establish here in these markets are x, y and z.  These regulators are charged with the task of meeting these principles and they pass whatever rules or actions are necessary.  The legislatures want to specific types of micro rules – you will do this and you won’t do that.  That is just a prescription for a mess.

You cannot take something as complex as the global financial system and pass simple rules from Washington or Brussels or wherever that will be adequate to meet the needs.

One of the things we learned is that there are unintended consequences of social actions.  We may be looking at one thing, and say we passed legislation to protect that.   At the same time we may be having effects on others.  Those are my worries.

We need to have good regulation.  It’s also important to note that, for the most part – and this is a broad statement – the existing regulatory agencies – the Fed, the SEC, and the CFTC in the US and the FSA in the UK – had enormous powers.  They had whatever power they needed. For whatever reasons, they didn’t succeed in averting this crisis.  So one has to ask the question, “Is passing more regulations, if you can’t even enforce the ones you have, a useful answer?”  

The financial system is very important to us, as individuals and as nations.  We must have the ability to transfer risk efficiently and deal with the problem of funding for retirement. 

All these problems are going to require a well-functioning financial system to solve.  We all have a big stake in seeing that regulation is done right.