Derivatives and Deregulation

Happy New Year! And with that new year, a new paper.

Russ Funk and I have been working on a collaborative project on law and organizations in the context of financial regulation. I’m pleased to be able to post a new working paper for the project.

Derivatives and Deregulation:
Financial Innovation and the Demise Of Glass-Steagall

Abstract: Just as regulation may inhibit innovation, innovation may undermine regulation. Regulators, much like market actors, rely on categorical distinctions to understand and act on the market. Innovations that are ambiguous to regulatory categories but not to market actors present a problem for regulators and an opportunity for innovative firms to evade or upend the existing order. We trace the history of one class of innovative financial derivatives—interest rate and foreign exchange swaps—to show how these instruments under- mined the separation of commercial and investment banking established by the Glass-Steagall Act of 1933. Swaps did not fit neatly into existing product categories—futures, securities, loans—and thus evaded regulatory scrutiny for decades. The market success of swaps put commercial and investment banks into direct competition, and in so doing undermined Glass-Steagall. Drawing on this case, we theorize some of the political and market conditions under which regulations may be especially vulnerable to disruption by ambiguous innovations.

The paper is available from SSRN or downloadable directly here. Let us know what you think!

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