REGULATING DERIVATIVES: OPERATOR ERROR OR SYSTEM FAILURE? Available to Purchase

In the wake of substantial losses suffered by derivatives dealers and end users in recent years, questions are being raised about the type of regulatory structure needed to monitor and control the use of derivatives. Financial institutions believe that the issue can be resolved by tighter internal controls, whereas regulators believe there is a need for more direct oversight. The conventional view is that derivatives are highly useful instruments which simply need to be handled with care. In this paper, it is argued that this belief is misplaced and, although useful for hedging, derivatives are a high risk technology which pose inherent difficulties for regulation and control. As suggested by Perrow, where the environment of such technologies is both complex and tightly coupled, such that any significant failure cannot be contained, the potential for catastrophe is significant. The foregoing analysis shows that derivatives operate in a complex and tightly coupled environment, posing a significant threat to the financial system. Regulatory reform would require much greater cooperation between regulators and a proactive approach to regulation rather than a reactive one.