Article Review: Derivatives: A Twenty-First Century Understanding

Derivatives are an oft-maligned and dangerous yet misunderstood and critical part of the modern financial system. While many Americans rightfully place some of the blame for the housing bubble on a system which could enable and even facilitate the creation of highly-rated credit default swaps on blocks of almost worthless debt, it is also true that derivatives allow companies and investors to manage risk and protect value. Like so many things from the financial markets to everyday life, derivatives can be very useful when properly utilized and exceptionally destructive when they aren't.

Unfortunately most of the policy-makers who have oversight over these instruments have little idea how they work, leading to disruptive under-regulation. Or at least that is the theory of one individual, Professor Timothy E. Lynch. In a recent article which appears in the latest Loyola University Law Journal, Lynch outlines some of the problems with derivatives and explains what he describes as a modern framework for derivatives. Under this framework, derivatives, which Lynch argues are defined both over- and under-inclusively currently, would be more appropriately redefined. In Lynch's estimation, this would ensure that policy can properly match the challenges presented by the myriad structures which exist. From the abstract:

"Derivatives are commonly defined as some variation of the following: a financial instrument whose value is derived from the performance of a secondary source such as an underlying bond, commodity or index. But this definition is both over-inclusive and under-inclusive. Thus, not surprisingly, derivatives are largely misunderstood, including by many policy makers, regulators and legal analysts. It is important for interested parties such as policy makers to understand derivatives, because the types and uses of derivatives have exploded in the last few decades, and because these financial instruments can provide both social benefits and cause social harms. This Article presents a framework for understanding modern derivatives by identifying the characteristics all derivatives share.


All derivatives are contracts between two counterparties in which the payoffs to and from each counterparty depend on the outcome of one or more extrinsic, future, uncertain event or metric and in which each counterparty expects such outcome to be opposite to that expected by the other counterparty. The framework presented in this Article will facilitate the development of more rational and comprehensive derivatives regulations, including (i) those required under the recently enacted Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) and (ii) those addressing the particular risks associated with “purely speculative derivatives,” (those in which neither party is hedging a pre-existing risk)." (emph. added).

Throughout the article, Lynch describes different types of derivatives and tries to speak to an 'everyman' audience with analogies centered mostly around fairly common Super Bowl bets. The article is quite readable and doesn't present any incorrect information. In short, Lynch has written a very good primer on derivatives for anyone with a cursory understanding of these admittedly complicated products.

However, in suggesting that he has created a new framework for understanding derivatives, Lynch has reached too far. Nothing that he discusses in the article will be new or surprising for anyone with a better-than-average knowledge of financial market transactions. Market observers have been discussing the rise of interesting and unique instruments, including derivatives based on everything from box office receipts to weather events, for years. Political junkies have known for some time now that they can put cash down on elections. None of this is novel.

Where Lynch does discuss some more interesting, if not necessarily novel ideas, including his suggestion that derivative regulation should borrow from/contrast with both insurance products and gambling, the analysis is light and obvious avenues to contemplate further go unexplored as 'beyond the scope of the paper.' It is also not clear how he thinks, as a practical political matter, that responsibility for insurance contracts and gambling could be shifted to the realm of the commodities world, but perhaps I quibble.

It almost seems as if in identifying derivatives as a problem for America, Lynch has created a straw man to attack in the form of a lack of knowledge. Most market observers would agree that it isn't a lack of knowledge among politicians, but instead the political process itself which has led to the current state of regulatory affairs. Even taking a neutral stance on the question of whether or not more regulation is necessary, it is clear that it is the lobbying efforts of the financial industry and special interests which have led to the current regulatory regime, not an inability of regulators and congressional leaders to understand derivatives.

In short, to the extent that financial reform is necessary in America, and to the extent that derivatives should be some part of this reform, it surely isn't a lack of understanding and classification of financial products which has led to this necessity. Perhaps the best proof of this is information on some of the recent rule makings which have been handed down in connection with the very legislation Lynch claims requires clarification. It seems as if the respective agencies have a fairly good grasp of what derivatives are all about after all.

With respect to lawmakers, I agree that there may be some individuals in the Halls of Congress who don't sufficiently understand supply and demand, never mind derivatives. However, they aren't typically on financial committees and subcommittees. Nor are they involved with enforcement. And, even if one grants that a lack of knowledge has contributed to gaps in financial system regulation and enforcement, a paper which advocates for including a wider array of financial products in the commonly-used definition of derivatives doesn't seem to be the solution. It rather seems almost naive to think that gaps in the understanding of financial instruments could be filled by morphing definitions in an attempt to help usher in a new era of regulation and enforcement; surely the American financial system is in even greater danger than many already fear if that is the case.

Now, as noted, it seems as if the intended audience for this piece might be the average American. If this is the case, Lynch has come closer to identifying a group with a knowledge gap. But to the extent that he feels that grassroots understanding of financial markets will lead to substantive change, he is certainly contemplating a long-term and difficult battle.

To be fair, this paper has a companion piece referenced in the footnotes in which Lynch discusses purely speculative derivatives contracts further. As per several footnotes, he makes some policy arguments suggesting that such contracts without 'social benefit' should, to a large extent, be eliminated. Therefore, though we did not have an opportunity to review that paper, it is possible that the 'framework' described in Derivatives: A Twenty-First Century Understanding is fleshed out a bit elsewhere. He does make some note of this in the present paper. From the conclusion:

Appreciating this framework will also readily allow us to better differentiate between socially beneficial derivatives and those that are more problematic. Such problematic derivatives contracts include those in which both counterparties to the contract are mere speculators. These purely speculative derivatives contracts do not offer the risk-hedging value for which derivatives are rightly touted and are not used to facilitate any commercial transaction in the real economy. They are mere bets. And, as I argue elsewhere, the social benefits of PSD contracts rarely outweigh their costs. Therefore, except for limited circumstances, PSD contracts should be void for public policy reasons.

And here, finally in the conclusion of the paper, we may be getting to what Lynch seems to want to say all along; he is presenting this paper not as a way to better define derivatives as a mean to educate lawmakers and regulators, but as a way to capture certain activities which he finds objectionable and regulate them out of the market. If he is trying to say that speculative transactions should be regulated out of the market, that is fine, and its certainly a supportable assertion.

However, it is not what this paper set out to do, and it points to a lack of organization/structure between this paper and its companion piece. If Lynch's intent was for this paper to serve as an introduction to the companion, I believe that he could have dispensed with his conclusions far more perfunctorily and posted the work together. At the least he could have made the link between the two papers more explicit, including noting the relationship in the introduction rather than in a maze of footnotes. If indeed his purpose was to 'change' the definition of derivatives in an attempt to make a policy argument that many derivatives should be legislated away, again, this point should have been clearer, and not saved for the conclusion. That, as I have noted, is a supportable assertion, and there is no reason to obfuscate it in a re-working of definitions.

In any case, and whatever Lynch's intentions may have been, the title described herein does not live up to the lofty goals which the author set out for it. As a standalone, it is an entertaining read and could potentially serve as an introductory chapter in a resource for law students or novices desirous of an introduction to derivatives. As noted, it might also have served in a scaled-down form as the introduction to its companion piece, which again, I have not had the opportunity to review. Lynch also makes very good arguments about the system itself, noting that the 'multiplicity' of statutory and regulatory regimes make enforcement difficult. However, in its current form, it is not a new blueprint for understanding derivatives, and it is decidedly not the solution to financial system woes.


Editor's Note: This review was undertaken at the invitation of the editors of the Loyola University Law Journal, the journal which is publishing Professor Lynch's article. They provided a link to an early version of the article here, which will help them to track interest in the article. However, anyone more interested in reading a copy that is relatively free of distracting errors and less interested in having their page views tracked can read the article here.