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Copyright (c) 1997 University of Iowa (The Journal of Corporation Law)
The Journal of Corporation Law

ARTICLE: Financial Derivatives and the Costs of Regulatory Arbitrage

Winter, 1997

22 Iowa J. Corp. L. 211


Frank Partnoy *


I. Introduction

In recent years, financial instruments called "derivatives" 2 have generated increasing losses, staggering in number and cost. 3 These losses spurred attempts by legal scholars to explain what derivatives are, 4 to analyze the international web of derivatives regulation, 5 and to discuss derivatives litigation in the aftermath of these losses. 6 These efforts continue.

Until recently, most scholars, commentators, and regulators have presumed--despite these losses--that derivatives are, on balance, "good." 7 Derivatives, the argument goes, allow corporations, governments, financial firms, and others to:

(1) reduce or hedge exposure to fluctuations in interest rates, foreign exchange rates, equity and commodity prices, and other financial variables; (2) speculate in a less costly and more efficient manner; and (3) capture arbitrage opportunities and thus reduce funding and other financial costs. In the most optimistic 8 scenario, derivatives benefit the entire financial system by "completing" markets (offering investors and traders risk and return patterns that previously were either unavailable or too costly 9 ), by reducing transaction and agency costs, and by increasing liquidity. 10 Certainly, derivatives have been one of the most dynamic forces in financial markets since the 1970s. 11 Likewise, the derivatives market is by far the largest market in the world, financial or otherwise. 12

The other side of the derivatives debate--the minority--includes commentators who argue, at least under certain limited circumstances, that derivatives are, on balance, "bad." 13 At minimum, this argument asserts that the purported benefits of derivatives must be balanced ...
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