Derivative Regulation Contest Entry

Its looking like one of the most certain things to come out of this financial crisis is more regulation. I have spent a fair amount of time imagining how derivatives would be regulated.

Looking at the extremes, "outlawing" derivatives seems reasonable to consider. Assuming that this is enforceable, it would surely meet with lots of resistance from Wall Street. Discredited as it is, Wall Street still has most of the money, and most of the ears of our representatives.

It is my impression that laws like this often don't work. Companies have incentives to find ways to get around them, and will do so, just like people find ways around other prohibited, but attractive, activities. And there are all sorts of things that derivatives can provide that are useful in certain situations. If they are banished outright, I could imagine an underground economy that trades them.

Here is another idea.

The government could require that all financial companies publish their coefficients of risk. This data would be made available by the banks, to the government, daily. Since this is in the public trust, the numbers would have to be available publicly. That is, the banks would make public heretofore private information.

A consortium would be formed that would

1. choose a risk model
2. determine the important attributes and measurements to be reported
3. create a "reference implementation" that measures, calculates, stores, and publishes the risk data of the banks. In addition suites of acceptance tests that would validate other implementations
4. create another reference implementation that collates the daily data as reported from all the banks, and plugs it in to a meta-risk model that balances the risk of the banks together
5. choose limits on acceptible values for the bank's reported risk coefficients. This would include values derived from the data of a single bank. If a bank reported values that violated thes ranges, then the bank would suffer a penalty of some sort. The penalty should be substantial (such as losing management control) to discourage risky behavior.

The software would be freely available in source code form. All interfaces would be public. Thse data would be freely available via web services, hosted by the federal government. Anyone could read the interface documentation and create a web application.

Open source, open data, this makes sense since it is a public risk that is being regulated, like levels of Carbon emissions. Encourage other countries to use the software and contribute to its development.

A high profile government sponsored open source software project of this magnitude and this importance would attract the best minds in the country. Just in case the open source development model does not work for getting the project done, though, the government could also solicit bids for alternate implementations. Several companies could be hired to implement the project. There could even be a contest to create the best implementation.

In fact the whole project could be a contest. Offer a million dollar prize to the best proposal for a system to essentially manage the risk of the nations financial system.



So here's my entry.