In every major financial centre on this planet, intense study is occurring on how to avoid a recurrence of both the surprise and the depth of the recent financial crisis.

One US senator estimated in November that over-the-counter derivatives had ballooned to $600tr in notional value since the adoption of the Commodity Futures Modernization Act (CFMA) of 2000. Whether that is true or not, the problem is anything but trivial.

Numerous pieces of legislation have been introduced in the US Congress on this subject by the Obama administration and various members of the House of Representatives and Senate.

Three thorny issues that surround these bills are: whether tighter regulation would in fact be helpful for OTC derivatives; whether end users should be exempt from some of the controls that may be imposed on dealers and other big participants; and whether it is wise to try and distinguish between standardised and bespoke derivatives, and if so, who should do the deciding.

I have some personal thoughts on these subjects, held independently from any employer or client.

Hopes of freedom die hard

AIG’s foray into unregulated credit default swaps has cost the American taxpayer nearly $200bn – just part of the cost for bailing out transactions that, thanks to the CFMA and other “pro-business” actions, have flourished in the unsupervised shadows of the economy.

Meanwhile, in the futures and options markets, no bailouts have been required, largely because activity is conducted visibly and credit is abhorred.

Every transaction is publicly reported in all detail except party identities. And, from the humble trader through each of its successive brokers to the multi-billion dollar coffers of the clearing house, the message is the same: “Pay up or get out.”

Amazingly (or amusingly) this transparency and curbs on credit are often cited by champions of OTC derivatives as a reason not to impose regulation.

There remain staunch supporters of dark pools and flash orders, of transactions reliant on long chains of uncollateralised credit or rating agencies’ assessments. I estimate their chances of prevailing to be the worst among all who oppose aspects of the proposals in Congress today.

On the other hand, what might happen if they succeed? One senator has proposed that derivative markets should be put under state-level authorities, some of which might brand their activities as gambling and therefore criminal.

Which would you prefer: regulation or incarceration? Operating within a set of rules, or not operating at all? Be careful what you wish for.

Sauce for the goose ain’t sauce for the gander

End users such as hedgers often prefer OTC transactions for two reasons: privacy and cash management.

Privacy (read: opacity) keeps the competition guessing. Cash management means that promises to pay such as lines of credit are less costly than actually having to deposit cash or other valuable assets to guarantee obligations. Of course, these two phenomena proved to be the system’s Achilles’ heel when the financial meltdown occurred.

Are end users less of a threat than professional swap dealers? If so, that could justify different treatment. End users do not generally have market exposures nearly as large as those of swap dealers or other enterprises where large net swap positions are routinely maintained. But, unlike those participants – for which registration, capital requirements and other burdens would be imposed under the legislation – end users are more likely to carry the bulk of their derivatives on one side of the market.

While dealers may try to maintain a balanced book of trades so that incoming funds are available to meet outgoing payment obligations, end users tend to be either long or short, so that adverse market movements can deplete their resources far faster.

The boundary of standardisation

The obvious fault with distinguishing between fungible and bespoke instruments is that it would incentivise users to customise trades, so as to avoid pesky regulation, exchange execution and costly clearing.

Risks that might readily be hedged with the plainest of plain vanilla futures or options could be transformed easily into one-of-a-kind deals by tweaking here or there.

A reason why the regulators want to decide what risks can only be addressed with specially designed derivatives is to prevent this outcome. And a reason why the clearing organisations are apprehensive about giving that power to the regulators is the latter’s incentive to force clearing of products that are not truly fungible enough to offset each other economically, amplifying the cost to the clearing organisation of defaults.

So, here is my suggestion. For decades, farmers have been content to use fungible agricultural futures, the energy community did nicely with standardised crude oil or natural gas futures, and banks did not complain about uniform interest rate products. The need for customised derivatives is a more recent revelation.

I recommend that each risk be evaluated in a two step process:

· How much of the risk can be managed with standardised instruments traded and cleared on a regulated market?

· Allow OTC customised products only for any remaining risk.

This approach assumes, of course, that the analytical tools exist to perform those calculations. The corporate world abounds in jobs called things like “risk manager” and we presume that there are reliable methodologies to genuinely measure and hedge risk exposures. If so, my approach should be feasible.

If not, the financial community has a far bigger problem than I thought.

Philip McBride Johnson is head of the exchange-traded derivatives law practice at Skadden, Arps, Slate, Meagher & Flom in Washington. He was chairman of the Commodity Futures Trading Commission from 1981 to 1983.