NEW YORK – Goldman Sachs, we can be sure, will vigorously contest the civil suit brought against it by the United States Security and Exchange Commission (SEC). But, regardless of the eventual outcome, the case has far-reaching implications for the financial reform legislation that the US Congress is now considering.

Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security that was derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralized debt obligation (CDO) did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst. The primary purpose of the transaction was to generate fees and commissions.

This is a clear demonstration of how derivatives and synthetic securities were used to create imaginary value out of thin air. Indeed, more triple-A CDOs were created than there were underlying triple-A assets.

This was done on a large scale, despite the fact that all of the parties involved were sophisticated investors. The process continued for years, culminating in a crash that caused wealth destruction amounting to trillions of dollars.

Such activity cannot be allowed to continue. The use of derivatives and other synthetic instruments must be regulated, even if all the parties are sophisticated investors. Ordinary securities must be registered with the SEC before they can be traded. Synthetic securities need to be similarly regulated, although the task could be assigned to a different authority, such as the Commodity Futures Trading Commission.

Derivatives can serve many useful purposes, but they also contain hidden dangers. For instance, they can pile up hidden imbalances in supply or demand, which may suddenly be revealed when a threshold is breached. This is true of so-called “knockout options,” used in currency hedging. It was also true of the portfolio insurance programs that caused the New York Stock Exchange’s Black Monday of October 1987. The subsequent introduction of circuit-breakers tacitly acknowledged that derivatives can cause disruptions, but the proper conclusions were not drawn.

Credit default swaps (CDS) are particularly suspicious instruments. They are supposed to provide insurance against default to bondholders. But, because they are freely tradable, they can be used to mount bear raids – a type of stock market strategy by which a trader (or group of traders) attempts to force down the price of a stock to cover a short position. In addition to insurance, they also provide a license to kill. Their use ought to be confined to those who have an insurable interest in the bonds of a country or company.

It will be the task of regulators to understand derivatives and synthetic securities, and to refuse to allow their creation if they cannot fully evaluate the systemic risks. That task cannot be left to investors, contrary to the diktats of the market fundamentalist dogma that prevailed until recently.

Derivatives traded on exchanges should be registered as a class. Tailor-made derivatives would have to be registered individually, with regulators obliged to understand the risks involved. Registration is laborious and time-consuming, and would discourage the use of over-the-counter derivatives. Tailor-made products could be put together from exchange-traded instruments. This would prevent a recurrence of the abuses that contributed to the 2008 financial crisis.

Requiring derivatives and synthetic securities to be registered would be a simple and effective measure; yet the legislation currently under consideration in the US contains no such requirement. The Senate Agriculture Committee proposes blocking deposit-taking banks from making markets in swaps. This is an excellent proposal that would go a long way in reducing the interconnectedness of markets, thereby preventing financial contagion, but it would not regulate derivatives.

Moreover, the five big banks that serve as market makers and account for more than 95% of over-the-counter transactions in the US are likely to oppose the proposal, because it would hit their profits. It is more puzzling that some multinational corporations are also opposed. The only plausible explanation is that tailor-made derivatives can facilitate tax avoidance and manipulation of earnings. Of course, these considerations ought not to influence the legislation.