On Derivatives and markets

I learned finance within the listed derivatives market, having the distinct privilege in having my second financial markets job be at The Options Clearing Corporation. The OCC (not to be confused with the other OCC - Office of the Comptroller of the Currency) is the clearing house for listed equity derivatives, primarily, but not limited to, stock and stock index options. OCC is a not-for-profit, self regulatory organization, wholly owned by the derivatives exchanges for which it clears. The OCC is designed to eliminate risk by ensuring the capital adequacy of participants, known as clearing members, who legally hold the positions that result from trading options (and certain futures products).
It is from this bias that I looked upon the significantly larger over the counter derivatives markets. There is no central counterparty for OTC derivatives. There is no authoritative source of price discovery. There is only complex instruments that are defined using master agreements created by the International Swaps and Derivatives Association (ISDA).
When I was in graduate school, there was frequent debate over certain OTC forward contracts as to whether they were standardized enough to be considered Futures contracts (a forward contract is an agreement to buy or sell something at a future date - a futures contract is a forward contract that has standardized delivery date and standardized delivery) and if so should they be regulated by the CFTC and traded on a Futures Exchange.
The tide turned in the later 1990s and into the 2000s along the following lines. The SEC and CFTC would continue to protect the small investor, while at the same time freeing up the sophisticated professional market participants who did not require regulation. Under this laissez-faire environment entirely new financial innovations and structures were created including hedge funds, credit derivatives, and securitization. The Glass-Steagall Act enacted during the great depression that created a firewall between investment banking and commerical banking was repealed using the argument that America could not be competitive in the global banking arena with such arcane and outmoded regulation.
An article appeared in Atlantic Monthly entitled The Market as God - convincingly showing how we had deified the market place as being both omniscient (all knowing) and omnipotent(all powerful).
By 2006, the amount of leverage held by banks was absurd. Each major investment bank controlled trillions dollars in assets based upon a meager amount of equity in the neighborhood of 30 billion dollars. There were no longer any controls and worse yet the commercial banking sector was no longer immune to this speculation.
Which leads me back to the initial concept - my bias and view that an effective self regulatory structure can work if done properly. And from my perspective, the structure created for the US listed options markets, which has been replicated globally, can serve as the effective model for appropriate governance and controls without creating an inefficient over regulated market place that cannot thrive.

John Lothian's newsletters featured this perspective using quotes from industry titans...

Hard look at legacy

Alan Greenspan championed derivatives and rejected regulation, an approach some blame for the current crisis.

"Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient." -- Alan Greenspan, then Federal Reserve chairman, 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives "because we don't really understand how they work."

Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential "hydrogen bombs."

And Warren Buffett presciently observed five years ago that derivatives were "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."