Derivatives and Deregulation

Russel Funk and Daniel Hirschman, both PhD candidates at the University of Michigan, have just released an interesting paper entitled "Derivatives and Deregulation: Financial Innovation and the Demise of Glass-Steagall."  In the paper, they look closely at the first major currency swap in history, a 1981 exchange between IBM and the World Bank, and trace how this financial innovation (swaps primarily) literally drove the demise of the firewall between commercial and investment banks established in the 1933 Glass-Steagall Act. 

Here is the 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 undermined 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 can be downloaded here.