Derivatives in the world of finance are financial instruments or agreements between two parties that has determined the value of something by its estimated future value. More simply put, it is the bet that a certain asset will be worth a certain price in the future. For example, a derivative might say if this group of houses is worth $1 billion, then Party A will pay Party B a certain amount of money. It was the derivative markets that sank AIG and Bear Stearns because they were unable to use bankruptcy to stop their derivative creditors from demanding payment or cancelling their contracts. Under normal circumstances when a company files for Chapter 7 bankruptcy or Chapter 11 bankruptcy, their creditors are not allowed to demand payment or terminate a contract immediately; but derivatives are not subject to this rule. Due to a series of changes to the bankruptcy laws starting in the 1980's, companies filing bankruptcy have very little protection from their derivative creditors. Some analysts believe this should change.
Simply flipping the switch and giving derivatives the same treatment as other contracts in bankruptcy could break the impasse on derivatives regulation. With bankruptcy as a more effective backstop for financial institutions in distress, lawmakers wouldn't need to force every derivative onto an exchange. And if the framework left enough flexibility in the derivatives market for both plain vanilla and more specialized contacts, there would be less need for the financial services industry to fight reform tooth and nail.
Perhaps best of all, these simple changes would reduce the need for bailouts. If Bear Stearns or AIG had been able to stop their derivatives creditors from demanding collateral or cancelling their contracts by filing for bankruptcy, there would have been much less reason for regulators to step in with a taxpayer bailout.
Giving special treatment to certain creditors during bankruptcy and/or allowing them the power to demand payment from the bankrupt debtor defeats the purpose of the bankruptcy process. Such a situation has already left taxpayers holding the bill. So maybe we should seriously consider treating derivatives the same as other creditors during bankruptcy.