Don’t be scared to learn about American finance
By: Alex Freeman
The Commodity Futures Trading Commission (CFTC) is “the most important organization you’ve never heard of.”
The financial market is, by nature, complex. The people who make the rules and jargon keep it that way on purpose. They don’t want you—or any of the American electorate—meddling in their affairs. Unless you’re doing it on their terms. Press releases. News conferences. Podcasts. These are a sampling of vehicles through which financial analysts and the institutions for which they work want you to learn about them. The last thing they want, though, is the lay person reading and comprehending the labyrinthine rules and regulations that govern how they make their fortunes.
So, ideally, regulatory agencies like the CFTC keep these financial institutions in check for us. They’re not perfect at their job. But in an ideal world, the CFTC works in collaboration with other regulatory agencies to ensure financial institutions and the products they offer do not pose as a systemic risk to our economy—and tangentially, the world economy. The CFTC and its sister regulatory agencies write complex rules to govern even more complex financial products to ensure that simple people aren’t exposed to unnecessary market risks in their daily lives.
The financial products regulated by the CFTC have some intimidating names, so bear with me. They oversee stock swaps. They monitor price formation. And they monitor derivative markets.
Let’s explore the latter product. Derivatives.
You care about these—even if you don’t know it. There are lots of reasons why you (or someone you know) endured financial devastation in 2008, but derivatives had a disproportionately large role in accelerating and magnifying that erasure of global wealth.
A derivative affords an investor to “invest on a leveraged basis in the market,” according to a Drake University graduate at the CFTC. If you’re confused, the financial industry has achieved its objective. Big banks hope your confusion will spur your general disinterest in the topic and allow you to go back to your simple life on Main Street.
So stay with me. Keep reading.
“Invest” means to put money into something. “Leveraged” means that invested money doesn’t belong to the person investing it—it’s borrowed from some other fund or institution. And “in the market” means in the place where people who trade stocks and financial products come together to do it. See? It’s simple. Wall Street hates that you can understand it.
In 2008, these derivatives were largely off the radar at the CFTC and other regulatory institutions. Big banks leveraged money at rates of nine, ten, and upwards of twenty to one vis-à-vis their own capital investment. This is the equivalent to you borrowing ten dollars from a friend to invest in something, and only using a dollar or so of your own. If you win, you owe your friend their ten bucks, plus a small fee. It’s an easy formula to win big. And lose big. Think about it, if you “leverage” and lose, once, you’re out some cash. Lose twice, and you’re hurting. Lose 10,000 times, and you’re done for.
This is a tremendously simple way of explaining a major factor in the 2008 crisis, and why it went global. All of the world’s banks were “leveraging” with each other’s money in really, really, shaky investment products called mortgaged backed securities. For now, just know these securities were bad news from the start (watch The Big Short to learn more about them). Banks lost on bets with other peoples’ and institutions’ money on a massive scale, and none of them could afford to repay their creditors. Banks in Europe had leveraged money from banks in America. And the opposite was true as well. None of them could afford their obligations. It was, well, a mess.
Here’s where the CFTC fits into the picture. It’s their duty to ensure financial institutions don’t go leverage-crazy or otherwise become too risky in their investment strategy insofar as to pose systemic risks to Main Street. They’ve been taking their job a little more seriously since 2008, to say the least.
One result of increased regulatory efforts is called the Dodd-Frank Act. It attempts to ensure greater transparency in derivative markets, limit leveraging, and ensure that banks have more of their own money in their possession at any given time in the event they need it to pay back entities they owe money. The legislation is woefully ineffective, but some argue it’s a step in the right direction toward preventing another financial meltdown.
That, in short, is a story of the CFTC and a blip about the 2008 financial crisis. Yet if there’s one thing I took away from my visit to the CFTC today, it’s that the financial industry is a deliberately constructed puzzle. The first step toward putting the pieces together? Understanding the basics of how Wall Street interacts with Main Street—and having the vocabulary necessary to understand those interactions.