Monday, May 10, 2010

Are Secret Derivative Trades a Fundamental Right?

I’m pleased to see that the subject of transparency in derivatives has become part of the current political conversation, even in the Senate, where amendments on the subject are being debated. Part of the discussion is the question of how much people who engage in derivatives trades should have to disclose.

Some people on the other side of the question have been arguing that derivatives trades are covered under the basic right of business secrecy. A business can keep its business deals secret, up to a point, so why shouldn’t the derivatives be included in that veil of secrecy?

The answer, quite simply, is that some things involve the public too directly to be a secret. If you own real estate, if you file a patent claim, if you take one of your customers to court — it is well accepted that there is no right of secrecy in any of these actions. If you sell stock in your business, or if you have a license to operate a bank or insurance company, you have to disclose your financial condition and results in considerable detail. I have yet to hear anyone present a convincing case that derivatives trades are any less a public concern than any of these matters. It is impossible to tell whether any business is solvent or insolvent without knowing the totality of its outstanding derivatives. If a business is insolvent, that will shortly become a legal matter in which the right to business secrecy disappears. Yet we have seen one business after another disguise its insolvency for two or three years by issuing or trading in derivatives — AIG being the most prominent current example, but this is a practice that goes back a generation. More than a fourth of the banks in the United States, I am told, have used derivatives to take assets off balance sheet in order to disguise their true financial condition. There should not be any right of secrecy in any such arrangement.

Businesses also use derivatives for reasons other than misleading people — yet who is to say what the meaning or purpose of a derivative is if it is kept secret from the business’s stockholders or creditors? If a business depends on derivatives as part of the normal course of business, that should be disclosed in full — because when the derivatives contracts fail, as happened on a large scale in 2008, it affects the stockholders and creditors.

I have said it before, but I will repeat it here: we will not have any idea of the true state of the financial system, or of any corporation, until its derivatives are known. The rule should be simple: any derivative that is not published can’t be enforced. I don’t believe that any exceptions are needed. Secrecy in derivatives trading is not a fundamental right — rather, it is a recipe for exploitation and deception. All derivatives should have been published five years ago when it became clear that they were at the heart of the financial sector’s troubles. That is still true today.