Description

19th century legislators and jurists crafted a carefully considered approach to derivatives. The principle underlying this approach was that financial contracts are legally enforceable only when they are tied to the real economy. For this reason, if (i) the intent is to deliver the underlying asset or (ii) the contract insures one party against an existing risk, the contract plays a role in distributing real economic risk and is legally enforceable. On the other hand, contracts where both parties were speculating on some future event – such as the price of an asset – were considered wagers and void.

By establishing a clear distinction between speculative derivatives and those that served an economic purpose and enforcing only the latter, 19th century jurists created a legal framework in which finance was forced to address the needs of the real economy. By contrast in the 21st century, the distinction between speculation and investment has eroded. All financial contracts are enforceable, whether or not they contribute to the real economy. I argue that this revision of the legal infrastructure supporting our financial system was a mistake.