Sharon Epperson: We're talking about transforming regulation. Are we close to being able to regulate what has been such a fast-changing and innovative industry in the last several years?
Blythe Masters: What we have in Dodd-Frank is the beginnings of a respectable regulatory framework if done properly should end "too big to fail." Mandated central clearing should in theory reduce inter-connectivity across counterparties, that was part of the contagion effect. Then there's a bunch of other things that have nothing to do with anything - banning propriety trading, mandating exchange trading of certain types of contracts irrespective of whether they really lend themselves naturally to that, and some other things. But the big, big changes were resolution authority and central clearing.
On balance, 80 to 90 percent of what was encapsulated in Dodd-Frank and the corresponding pieces of regulation around the world are responsive to the causes of the financial crisis. But there are lots of gaps. We still haven't reformed the regulation of housing or mortgage business properly in the United States. The rest of the world has not yet caught up with what the United States is doing either. There are enormous inconsistencies in what is currently being contemplated in Europe vis-a-vis what is being contemplated in the United States. A lot of things that are currently proposed within Dodd-Frank and other similarly minded pieces of regulation will result in significant increases in cost that will have to be necessarily transmitted to end users of otherwise socially useful activities like derivatives. Yes, I'm sorry but derivatives are socially useful activity. They helped defray risk, they help businesses grow, and they help those businesses employ people as a result. When poorly used and when used with inadequate control they can also blow people up, and that's part of what we experienced in the financial crisis.
So there are some big gaps between what has been done and what were the causes of the financial crises. And there are other areas where there are real seeds of possibility. (Read More: Dodd-Frank Won't Prevent Another Financial Crisis—Pros)
Epperson: What are some of your concerns with reform?
Masters: I personally am most concerned about the risk of creating a bigger or a different "too big to fail problem" through the mandate of central clearing by virtue of inadequate regulation and inadequate transparency amongst the central clearers who now have a government-endorsed mandate to require central clearing. Privately owned enterprises with a profit motive will be essentially concentrated into what used to be thousands of bilateral relationships between individual firms into one place.
By channeling so much activity through central counterparties, it's unclear whether they'll have access to central sources of liquidity. It's unclear whether they'll be subject to the market disciplines associated with risk management concerns on the part of their members. Today a JPMorgan or any other firm in the marketplace has to make its individual decisions about whether or not to take counterparty risk. When all of that is centralized through a central place and you don't have the same information as you previously had, yet you have no alternative other than to conduct your business through this channel, essentially your risk management disciplines is at serious risk of being weakened.
There are some pretty big existential questions out there whether or not Dodd-Frank and other companion pieces of regulation actually will improve the world in the long run or whether they may actually inadvertently become the sources of the next crisis.
Epperson: Do you think it's stifled in some ways innovation on one hand and market participation on the other?
Masters: Yes and yes. First of all, many of these issues are not yet binding. What we're dealing with right now is just epic levels of uncertainty. And the fact that a number of institutions in the market have capital problems and need to re-capitalize themselves and need to liquefy themselves as a result of damage done by the financial crisis and the new forward looking requirements of Basel III etc., all of that translates into certain things that are already influencing markets: people withdrawing, becoming less competitive and so on. But many of these rules are still pending and still subject to clarification so the real impact hasn't hit the markets.
We had a little preview of it on October 12th when some of the U.S. regulations - CFTC regulations relating to external business conduct which have been since deferred—resulted in the withdrawal of foreign counterparties dealing with U.S. institutions because of the potential consequences of an uncoordinated starting date of some of those rules. We have all of that still yet to come. So all of the rules that had been deferred from October 12th which were deferred too late and so you saw some of the beginnings of an impact, now have been deferred to December 31st.
So there's a risk of a train wreck pending in the derivatives space associated not with the big picture of what is trying to be achieved, but the practical operational realities of how it's being done. It's very unfortunate especially for an economy on the scale of the United States and the sophistication of the institution at play here—that should not be happening.
—By CNBC's Sharon Epperson; Follow her on Twitter: @sharon_epperson