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Who's in charge of derivatives in the new era of climate risk?

One quadrillion dollars are at risk. A new proposal aims to regulate derivatives in the climate age.

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New York Stock Exchange image via Shutterstock/orhan akkurt.

Originally published on Climate & Capital Media.

Credit-default swaps. Short selling. Collateralized debt obligations. Readers of "The Big Short" will recall a bewildering glossary of terms for new products and strategies that in 2008-2009 resulted in the biggest global financial crisis since the Great Depression. Financial institutions and regulatory agencies were caught on the wrong side of that unprecedented meltdown, suffering the consequences of their ill-conceived practices and inadequate oversight. 

All these exotic financial instruments fall under a broader cache called derivatives. The derivatives market is gigantic — estimated at over $1 quadrillion. Some market analysts even place the size of the global market at more than 10 times that of the total world gross domestic product. They are a linchpin of global financial markets but have also been called "weapons of mass destruction" by Warren Buffet. 

Today, there is a new risk: climate change. And many of those same players burned by the financial crisis — and the regulators who managed that crisis — are considering policies that would proactively regulate derivative investments in climate-related issues to avoid catastrophic risk and to make progress in the transition to a clean energy future. 

Derivatives are a linchpin of global financial markets but have also been called 'weapons of mass destruction' by Warren Buffet.

Key among the many governmental bodies charged with regulatory oversight is the Commodities Futures Trading Commission (CFTC), a little-known but major agency created in 1974 to regulate trading in derivatives markets: futures; swaps; and options. In the 1970s, these were mostly centered around agricultural products (the CFTC’s statutory authority rests on the Commodities Exchange Act of 1936). Since then, the agency’s areas of oversight have grown exponentially to include regulatory governance over Big Short-era complex financial instruments and are being extended to fintech and cryptocurrency. It is charged with oversight of much of the U.S. derivatives markets, valued at more than $350 trillion.

What can this obscure but vitally important regulatory agency do to monitor the derivatives market so that the worst effects of climate change can be mitigated and effective progress can be made? The Center for American Progress thinks it has the answers in a recent paper issued by the independent public policy research and advocacy organization.

The report, "A Climate and Competition Agenda for the Commodity Futures Trading Commission," makes two big points about what’s at stake: Derivatives will play a large role in helping companies adapt to a carbon-neutral or carbon-negative economy but derivatives trading can also cause significant harms to the real economy in the absence of strong regulations — as seen with the 2008-2009 global financial crisis.

The report proposes reforms to help derivatives markets withstand the risks from climate change, be transparent and equitable, and provide for a resilient and stable market structure to facilitate the transition to a net zero economy and ensure competition between traders and platforms. 

The focus on climate-related derivatives is being led by CFTC Chair Rostin Behnam, who, while serving as a CFTC commissioner, established the Climate-Related Market Risk subcommittee to analyze climate-related impacts on the derivatives market. That group published "Managing Climate Risk in the U.S. Financial System," a first-of-its-kind statement from a U.S. government entity. 

Derivatives will help companies adapt to a carbon-neutral or carbon-negative economy but derivatives trading can also cause significant harms to the real economy.

The CFTC has company among agencies and stakeholders in stepping up the regulation of derivatives from a climate perspective. The agency is a voting member agency of the Financial Stability Oversight Council (FSOC), a committee of regulators chaired by the Secretary of the Treasury, Janet Yellen. Other voting members include leaders from the Federal Reserve, Federal Deposit Insurance Corporation, the Consumer Protection Bureau and the Securities and Exchange Commission (SEC). The current SEC chair is Gary Gensler — who just happens to have been the CFTC chair during the 2008-2009 financial crisis. Gensler was instrumental in leading reforms of the $400 trillion swaps market under the Obama administration. At the SEC, he is spearheading the development of a major new climate change rule that would require U.S.-listed companies to provide investors with detailed disclosures on how climate change could affect their businesses. 

All of this activity by the CFTC, FSOC and SEC is part of the Biden administration’s effort to address climate change and cut greenhouse gas emissions by 50 percent by 2030. Achieving that ambitious goal requires an "all-of-government" effort, one reaching across institutional boundaries to bring the full weight of policy to bear in driving progress. The leadership seems to be in place to execute effective action on climate change. That would be a welcome change in itself.

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