Regulation and derivatives

The Goldman Sachs fraud case seems to hinge pretty heavily on this question:  Is there a presumption that a product marketed to investors is designed to be a long capital market product?  If a product has been designed as a short vehicle, is that inherently a material fact?  Because the world with credit derivatives is a very new one, these are legal issues that have yet to be resolved.

In terms of regulation the brouhaha over the case leads me to think that we are faced with two possibilities:

(i) Return to the traditional legal framework where OTC derivatives were “legally enforceable only if one of the parties to the bet was hedging against a pre-existing risk”  (quoting from Prof. Lynn Stout here).  This view was relevant in a world where investment was viewed as necessarily a long exposure and shorts/speculation were discouraged, or

(ii) Recognize that capital market vehicles can be designed to be either short or long.  Then the long vs. short structuring of every product must be an important part of its marketing.  And fraud must be severely punished.

Personally I think that difficulties of policing fraud will mean that choosing (ii) is more likely to destroy capital markets — by scaring all the real money investors away from a rigged game — than to save them.

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