Following the collapse of Long Term Capital Management more than 10 years ago, a government report called for derivatives market reform. The report, issued by the President's Working Group in April 1999, noted that “market history indicates that even painful lessons recede from memory with time”. Sure enough, once the LTCM headlines disappeared, the impetus for reform vanished.
Today we face a similar challenge – to not let time, a rebound in the market or lobbying efforts of derivatives dealers obscure the need to reform the over-the-counter derivatives market.
Derivatives serve a vital purpose in our global economy. They help institutions manage balance-sheet risk and cut the cost of capital, which in turn spurs investment. However, today's bilateral market has created a dangerous web of obligations between financial institutions. A collapse of one entity can render risk unmanageable throughout the financial system, felling other institutions with domino-like speed. Last year this phenomenon forced the government to intervene in the private sector, critically damaging a fundamental tenet of capitalism – that the uncompromising hand of the market punishes bad decisions.