Goldmark: Without regulation, derivatives will sink us again

Imagine there are no official stock exchanges. Anybody can cook up shares in a company and try to sell them to you. There is no Securities and Exchange Commission to require corporations and brokers to be honest with shareholders. There are no disclosure laws that require stock issuers to share basic information about their business.

The world of stock issuance and trading did once function that way. But it was full of fraud and too many people got hurt, so gradually rules and public stock markets evolved and regulatory bodies were created to enforce minimum standards of transparency and accountability.

But today there's a parallel universe of financial derivatives -- little more than third-party bets, however complex, on underlying securities or events. This universe functions in the Wild West style of the bad old days, before public stock markets and government regulation. And no one is doing much about it.

Dennis Kelleher, the head of Better Markets, a nonprofit that promotes intelligent regulation of the financial sector, says derivatives are the financial equivalent of nuclear weapons in their potential for economic destruction.

The wanton use of derivatives helped cause the financial collapse of 2008. And the economies that collapsed -- primarily those of the United States and Europe -- have not taken decisive action to limit the destructive consequences of derivatives by requiring that they be described fully and traded openly on regulated markets so that everyone can see what is happening. So, while both the United States and Europe struggle along the long road back from near disaster, an ugly question raises its head: Will their failure to regulate derivatives cause another disaster and set them even further back?

In the age of complex computer operations and instant transactions, these exotic financial instruments rocket around the world through unmonitored chains of trades and contingencies that regulators cannot track. Derivatives are so complicated that few understand them, and they're often sold from "dark pools," so called because no one can see what's going on below the surface. The widely reported JPMorganChase derivatives trading blowup in May -- originally seen as a $2 billion loss and now reported to be approaching three times that -- still has not "closed" because no one really knows where the end of the chain of ownership and liability is.

In the crazy, unregulated world of derivatives, an even worse accident is inevitable. It's as if you let a vast fleet of 18-wheelers wander Nassau County in the dark without speed limits or traffic lights. The only question is when disaster will strike.

The aim of regulating the derivatives market is not to turn financial speculators into saints. As soon as you have rules, some operators will figure out how to turn them to advantage. The point is simply to put a policeman on the beat, and to make it much more dangerous and expensive for those who sell derivatives not to explain clearly what they're selling -- and to make them liable for misrepresentation and malfeasance. This would force most derivative traders to play by some simple, commonsense rules, push the less scrupulous derivatives traders to the margin, and deter some of their shenanigans by threat of fines or prison.

England is now in its most serious recession since the Great Depression, and the United States is wobbling. Nearly half of Europe is on the economic critical list, with no sign that the end of the euro crisis is near. In other words, there is little margin for error. Western nations need to bring trading in derivatives under the umbrella of full financial regulation before another runaway chain reaction brings the global economy to the brink of collapse again.

Peter Goldmark, a former budget director of New York State and former publisher of the International Herald Tribune, headed the climate program at the Environmental Defense Fund.