Monday, August 31, 2009

Helpful Hints for the New Derivatives Regulators

Posted on FinReg21 by Adam W. Glass:

Early commentary on the Obama proposal for regulation of OTC derivatives tended to focus on the difference in treatment of standardized and non-standardized OTC derivatives. Some politicians stated that only standardized OTC derivatives should be legal, and others appeared to score points against testifying administration officials by challenging them to come up with a definition of “standardized” on the fly (they couldn’t).

With this issue, there is both less and more than meets the eye. The impossibility or difficulty of defining “standardized” is a red herring, because “standardized” in this context necessarily means “sufficiently standardized to be cleared and settled by a central counterparty.” Central counterparties have bureaucratic and profit motives to clear and settle as many products as possible, so they will be motivated to include as many derivatives in the “standardized” category as possible. So long as the central counterparties are not controlled by the swap dealers (a big “if,” as the leading contender to clear credit derivatives in the United States, ICE Trust LLC, is so controlled), the presumption that the Obama administration has said will be written into law (and has included in its draft bill, the Over-the-Counter Derivatives Markets Act of 2009)—that a type of credit derivative is presumed to be standardized if any derivatives clearing organization has accepted contracts of that type for clearing and settlement—should be sufficient to separate standardized from unstandardized contracts.

This suggests that the definition of “derivatives clearing organization” should, in this context, be interpreted to include central counterparties based outside the United States, to catch the broadest possible range of OTC derivatives as “standardized.” It also suggests that regulators should have a strong interest in making sure that a U.S. competitor to ICE Trust flourishes, so that the swap dealers are not able to prevent the central clearing of standardized products by stunting the growth of the central counterparty.

Some politicians have called for outlawing all unstandardized contracts (or for requiring all OTC contracts to be cleared and settled through central counterparties, which amounts to the same thing, as CCPs cannot clear and settle unstandardized contracts). For the same reason that mass-produced, standardized products or services do not occupy the entire field in other areas (think legal or medical services, home building, food preparation, entertainment), it is unlikely that all derivatives can be standardized or that this would be a good thing. The call to outlaw unstandardized contracts appeared to market practitioners to be confined to the legislative lunatic fringe, until Barney Frank gave it legitimacy by commenting that it was “definitely on the table.” It may be, as a bargaining chip. But don’t expect to see Congress outlaw customized OTC derivatives when the dust settles.

As discussed in a previous article (Regulation AB and Swap Provider Disclosure: (Part 1, Part 2, Part 3) , the stated goals of the Obama administration are hard to argue with in the abstract: reduction of systemic risk; more efficiency and transparency; reduction of market manipulation, fraud, and other market abuses; and curtailment of inappropriate marketing to unsophisticated parties. They have also been stated at a level of generality that does not allow for significant substantive comment, both in Treasury Secretary Geithner’s May 13 summary letter to Congress and in the 85-page financial regulation proposal released by the Obama administration on June 17. Even the 115 pages of the Over-the-Counter Derivatives Markets Act leave important questions open, such as what an “alternative swap execution facility” (the only alternative to trading on a designated contract market for standardized OTC derivatives under the bill) is, exactly, and whether it would permit bilateral contract formation or would require posting of multiple bids and offers and anonymous contract formation in the manner of an exchange.

It is also not certain whether the Administration proposal is the draft law most likely to resemble what is adopted by the Congress.

Given the possibility that proposals in their current form may very quickly become obsolete, I will make a few practical suggestions whose implementation by regulators is a prerequisite to the effective functioning of any derivatives regulatory framework, rather than attempt to guess what portions of the draft legislation submitted so far are likely to survive and comment on those. The absence of these components in the implementation of any OTC derivatives regulation framework that is adopted will imply that we have made insufficient progress in ensuring that the debacles of Long-Term Capital Management in 1998 and credit default swaps on subprime RMBS in the recent past will not be repeated.

1. Hire Experts
In an article in The New York Times, “Derivatives Tug of War Takes Shape,”[1] Floyd Norris made the point that the contribution of derivatives and hedge funds to the financial crisis were predicted by experts like Richard Bookstaber, who wrote about the inevitability of the financial crisis in 2006 in his book, “A Demon of Our Own Design.”[2] Norris contended that the federal regulators will not have begun to set things right until they hire experts like Bookstaber, who understand how the games are played. England’s Financial Services Authority appears to understand this, having recently committed to increase the number of on-staff derivatives experts from 500 to 700, according to the International Finance Review.

Recent press coverage of the delicate mating dance of the SEC and the CFTC over who will govern what portion of the OTC derivatives market under a new derivatives regime has given readers a good feel for the nuances of regulatory turf battles. The media has described the vested interests of politicians in maintaining the status quo of separate agencies to regulate securities and exchange traded futures and options, even though majority expert opinion is that this separation does not make sense from a functional viewpoint, and the public interest would be better served by merging the two organizations.

What the press has done less well is explain to the public why neither agency has credible capability to understand, let alone regulate, the OTC derivatives market. As I have written before, the SEC has consistently avoided building up expertise in OTC derivatives during the last 30 years, preferring to stick to its mandate of securities regulation. After all, it is the Securities and Exchange Commission, not the Securities, Swaps, and Exchange Commission. For many years, when queried by structured finance lawyers about the necessary amount and type of disclosure that should be included in prospectuses for asset-backed securities where OTC derivatives contributed a portion of the contractual cash flows, the SEC staff had no better answer than “We don’t know.” The speed with which the SEC has responded to financial innovation outside the familiar framework of corporate stocks and bonds can be shown by the time it took to adopt formal disclosure rules for asset-backed securities. The first of these were issued in 1978 (private label mortgage pass-through certificates created by Bank of America and underwritten by Salomon Brothers). The SEC did not publish Regulation AB covering these types of securities, and the myriad variations that had been created and flourished in the interregnum in the Federal Register until January 7, 2005.

Regulation AB also contained the SEC’s first published pronouncement on disclosure requirements for swap providers to ABS securities (Item 115 of Regulation AB).

The CFTC is in a not much better position, even though the commodity options and futures they currently regulate are nominally “derivatives” and for that reason bear a greater family resemblance to OTC contracts than securities do. The exchange traded commodity options and futures the CFTC regulates can be highly volatile and risky, but all of them bear more predictable price relationships to changes in the value of the “underlyings” from which they derive their value than is the case for OTC derivatives. The value of the exchange-traded derivative is always a linear function or a simple non-linear function of the value of the underlying. For OTC derivatives, on the other hand, the value is a complex non-linear function of the value of the underlying, with the result that only those who have invested substantial financial, technological, and intellectual capital in developing pricing models for OTC derivatives—typically the swap dealers and their larger hedge fund clients—are able to profitably trade and hedge them.

The CFTC has at least approved the applications of offshore swap clearing arrangements for OTC derivatives, such as SwapClear for interest rate swaps, to obtain “derivatives clearing organization” status in the United States, requiring some familiarity with OTC derivatives documentation and value and volatility modeling practices. But this is a far cry from being positioned as a “turnkey” regulator.

The press has captured the drama of entrenched bureaucracies jockeying for position, but has failed to get across that OTC derivatives cannot be understood by analogy with securities or exchange-traded derivatives—they are created for different purposes and behave differently. Thus, when the SEC and the CFTC begin to regulate OTC derivatives, if they are to have any hope of success, they will need to hire in the financial and legal talent to allow them to understand what they are regulating. It is really a question of building a capacity from scratch—not rearranging existing resources.

As far as I can tell, for their understanding of the OTC market, the agencies currently rely largely on the swap dealers they are supposed to be regulating, on “loaner” employees from the Fed and the Treasury, and on independent academics. Until they can add their own internal expertise—a third leg to the stool—they will be condemned to being reactive rather than proactive and will effectively be captives of the greater expertise the industry can bring to bear.

Fortunately, in this economy, the regulators should be able to find plenty of qualified traders, investment bankers and lawyers with the necessary expertise who are willing to work for reasonable rates—an opportunity that they need to take advantage of.

2. Understand ISDA
The International Swaps & Derivatives Association is much more than the trade association for the swap dealers and, to a lesser extent, their “end-user” corporate and investment fund clients. It is the forum in which the swap dealers and other market participants create and administer the terms and conditions of every major class of OTC derivative. It publishes and updates standard contract terms, takes positions or seeks outside counsel on interpretive questions under those standardized terms, and, in the case of credit derivatives, is single-handedly responsible for rewriting the standard terms of credit derivatives, and changing the market practices under which they are traded and settled, to make them suitable for clearing though central counterparties—a major goal of regulators in the U.S. and abroad (the changes necessary to accomplish this being collectively referred to in shorthand as the “2009 Definitions”).

ISDA has a permanent staff and offices around the world, but its real strength lies in the volunteer labor committed by its swap dealer and other members. An in-house credit derivatives lawyer at a swap dealer, during the time the 2009 Definitions were being developed, might have regularly spent 10, or more hours a week on industry conference calls discussing the resolution of nuts and bolts questions about how the new world order would be implemented. The most involved professionals would have spent much more time than that. Moreover, ISDA does not just aggregate legal expertise and views from its most prominent members, the major swap dealers. On its “trader calls,” it collects the views of the most influential business persons in the OTC derivatives world, those with profit and loss responsibility for the OTC books at each of their institutions, highly paid, bright, and impatient individuals who can very rarely be wrested from their trading floors where they carry out the all-important task (in good years) of minting money for their employers and themselves. A lawyer at an outside firm would generally never speak to one of these individuals, as their time is too important to be spent with $900-an-hour flunkies—they have teams of structurers, in-house lawyers, and transaction managers for that. But they make time for ISDA’s trader calls, where the rules by which they operate are hammered out and which they cannot afford to ignore.

ISDA is not a public benefit corporation, but a self-interested lobbying group for a particular portion of the financial sector. Yet, because it is not just a lobbying group, but also the forum in which the contractual terms and trading practices for the OTC derivatives market are established, it has many of the benevolent features of a public utility, but under private control.

ISDA’s awareness of, and pride in, this “public utility” role may have blinded the organization to the significant role that OTC derivatives developed and promoted by ISDA played in exacerbating the current financial crisis, chiefly by increasing speculation in the subprime mortgage market, increasing the size of financial losses when it crumbled, and making it too easy for insurers and their affiliates to assume, and for investment banks to retain, exposure to subprime.

That said, an OTC derivatives regulator cannot afford to be without a thorough understanding of the pervasive role played by ISDA in every aspect of the OTC derivatives market.

3. Join ISDA
It should be obvious from the description of the extensive participation of swap dealer personnel in ISDA meetings and conference calls that the regulators will not be able to gain sufficient knowledge of the market without listening in to those meetings and calls. Regulators need to see the sausage being made to understand it well enough to regulate it. This suggestion may horrify ISDA and some of its members, but it follows logically from the notion that ISDA functions in some respects as a public utility. It is too late to argue that ISDA and its members can avoid posing risks to the financial system through self-regulation. Once the two trillion dollars the U.S. government has infused into the financial markets to replace private sector liquidity has been repaid, the derivatives regulators could entertain proposals to return ISDA to its status as a fully private body closed to regulators.

4. Develop Appropriate Skepticism
In his brilliant and informative November 2008 article in Conde Nast Portfolio, “The End of Wall Street’s Boom,” Michael Lewis quotes Danny Moses, a trader at one of the funds that saw the subprime debacle coming and profited by going short the market, as saying that he would never participate in a transaction with Wall Street unless he could understand how Wall Street was planning to screw him.[3] Regulators should develop a sufficient expertise (perhaps by hiring former Wall Street talent) to be able to figure out, on their own, how Wall Street is planning to take advantage of its customers—or its accountants, risk managers, senior management, or regulators—with various derivative products. For example, on the subject of derivatives transparency, they need to understand that the same ISDA that mouths proprieties about “the good of the market” is composed of members actively searching for ways to exploit peculiarities in the market that will cause the value of a credit derivative to be much more, or much less, than the value of a debt obligation of the same issuer—looking for that elusive Freddie Mac bond that is trading at 50 when all the other debt is trading at 98, for example, to deliver into a CDS contract. Preserving the ability to profit by being extra clever, and producing an economic result from a credit derivative settlement that is not a proxy for the economic loss the holder of a typical bond would experience, is very important to ISDA’s members.

By hiring industry experts, taking the effort to understand ISDA’s role in the OTC derivatives market, auditing ISDA member and trader calls as necessary, and leavening its appreciation of the positive economic contribution of OTC derivatives with a healthy skepticism about their disclosed and undisclosed purposes and consequences, a U.S. derivatives regulator will go a long way towards equipping itself to meaningfully reduce the probability of another system-threatening OTC derivatives debacle.


[1] Norris, Floyd. “Derivatives Tug of War Takes Shape.” New York Times, 25 June, 2009.
[2] Bookstaber, Richard. A Demon of Our Own Design. (New Jersey: John Wiley & Sons, 2007)
[3] Lewis, Michael. “The End of Wall Street’s Boom” Conde Nast Portfolio (November 2008): available from

A New Foundation for OTC Derivatives?

Posted on FinReg21 by Edmond J. Curtin:

The U.S. Department of the Treasury (the “Treasury”) in its recent white paper (the “Paper”) Financial Regulatory Reform – A New Foundation: Rebuilding Financial Supervision and Regulation proposes (among other things) the “comprehensive regulation of all over-the-counter [OTC] derivatives.” The second part of this note contains a brief discussion of these proposals. It includes a brief analysis of the legal relationship arising from an OTC derivative. In part, this analysis is merely explanatory; it is intended to help remove the taint of toxicity that attaches to OTC derivatives. The discussion also contains a brief analysis of OTC derivatives within the U.S. regulatory regime for financial markets. In part, this analysis is merely explanatory too. It is intended to show the practical difficulties that may arise in regulating OTC derivatives. The first part of this note is slightly more abstract and considers the relationship between regulation and financial stability.

Regulating Financial Markets
Regulation in financial markets comprises two things: firstly, the creation of a legal category (being the thing regulated); and secondly, the making conditional of the lawful privilege to transact in, or in respect of, that thing. Those conditions themselves may fall into two categories: firstly, variations of, or supplements to, the legal relationship between the transacting entities (for example, the imposition of the duty to prepare a prospectus in respect of a public offer of securities); and secondly, the imposition of duties and liabilities on certain participating entities (for example, the imposition on banks of the duty to maintain regulatory capital). The primary purpose of those entity-level conditions is to ensure that the entity concerned may in fact perform its payment duties as they fall due.

The recent (and prevailing) financial crisis manifested itself acutely among entities that are traditionally highly-regulated (for example, banks and investment banks) and in transactions that are traditionally highly regulated (for example, residential lending and public securities). A sceptic might conclude, therefore, that there is positive correlation between regulation and financial crisis. A cynic might conclude that there is causation between regulation and financial crisis. Unsurprisingly, proposals for reform (particularly in relation to OTC derivatives) tend to reject such scepticism and cynicism in favor of further regulation in furtherance of financial stability, among other things. This appears to be the case notwithstanding that the OTC derivatives market itself has operated efficiently during the crisis.

With reference to this objective of financial stability, perhaps we are all Minsky-ites now – at least in the sense that recent experience has made us more willing to accept the hypothesis that financial markets tend towards instability. Nonetheless, we tend to assume too (perhaps at some inarticulate level) that all effects have causes and, in particular, that this effect (financial crisis) has a cause. (That is, but for some factor “X” this effect would not have occurred.) Some would designate “regulatory failure” as that cause. This idea of “regulatory failure” itself perhaps embraces two separate ideas: firstly, the idea that there was some want in the authority granted to regulators by the legislature; and secondly, the idea that there was some want in the exercise by regulators of the authority granted to them by the legislature.

Explicit in this designation is the hypothesis that Government, through regulation, can in fact preclude that tendency of financial markets towards instability. While this hypothesis may seem intuitively correct, it is difficult to verify (or, indeed, falsify). Thus, for example, we cannot rerun the history of the twentieth century without the Glass-Steagall Act to determine what the outcome of that history would have been “but for” that Act. Nor can we rerun the recent history of the twenty-first century to determine what the outcome of that history would have been “but for” the Gramm-Leach-Bliley Act. Thus, reasonable people may disagree on the question whether “regulatory failure” caused this financial crisis. This disagreement is one of philosophy (or politics, if one prefers) rather than science.

To designate “regulatory failure” as the cause of financial instability is to chastise legislators or regulators or both. For example, Richard Posner (writing extra-judicially, in The New York Times) chastises those regulators who were asleep at the switch, oblivious to the housing bubble and the rapid deterioration of the finance industry. [1] Implicit in this chastisement is the disappointed expectation that regulators can and should prevent financial crises. One who has expectations lower than Judge Posner’s might not be so easily disappointed. Such lower expectations might be well-grounded in the belief that it is as difficult for regulators and legislators, as it is for participants in financial markets, to divorce themselves from the prevailing narrative of the market cycle. That is, in the long run at least, regulation tends to become pro-cyclical.

Crudely, the prevailing narrative in the immediately preceding market cycle was “innovation in financial markets.” (Equally crudely, perhaps the prevailing narrative in the current market cycle is “conservatism in financial markets.”) Thus, perhaps, our regulators and legislators were in fact alert at the switch, but alert to what were (in retrospect) the wrong ends. No doubt they too, like most participants in financial markets, will cleave to the new “conservatism” narrative; and, perhaps, at some point in the distant future, will be chastised afresh for doing so after this market cycle has ended. In terms of immediate regulatory reform, perhaps too the mere cleaving of regulators to this new narrative might itself be a sufficient reform of the regulation of financial markets.

The Treasury Proposals
The Paper reflects three separate, but related, ideas in relation to OTC derivatives as follows. Firstly, that there is an “unregulated” “space” in financial markets known as the OTC derivatives market. Secondly, that “space” should be reduced by moving trading in certain “standardized” contracts from this over-the-counter-market to regulated exchanges (or, at least, regulated electronic trade execution systems). Thirdly, that “space” should cease to be “unregulated” and become “regulated.” Within this third idea (the move from “unregulated” to “regulated”), there are six further ideas as follows:

(i) Market access regulation: Certain market participants shall lose their existing privilege under the law to enter into OTC derivatives.

(ii) Dealer regulation: OTC derivatives dealers shall become subject to certain new or enhanced duties, including duties as to recordkeeping and reporting.

(iii) Credit regulation: OTC derivatives dealers shall become subject to conservative requirements relating to initial margins on counterparty credit exposures.

(iv) Position limits regulation: OTC derivatives dealers shall become subject to position limits.
(v) Market regulation: Participants in the OTC derivatives market shall become subject to new market abuse rules.

(vi) Clearing regulation: Insofar as market participants continue trading in “standardized” derivatives in the over-the-counter market, those market participants shall become subject to a legal duty to “clear” those derivatives through a regulated central counterparty (“CCP”).

OTC Derivatives
What is an OTC derivative? An OTC derivative is a bilateral contract – that is, a privately negotiated legal relationship between two parties pursuant to which each party assumes in favor of the other party certain payment or delivery duties. These duties (and their correlative claims) may be conditional ones. (In addition, the quantum to be paid or delivered may itself be variable.) For example, in the case of a credit default swap that is physically settled, one party assumes the duty to deliver to the other party certain debt obligations against payment by the other party of the principal amount of those obligations. These duties are conditional upon (among other things) a credit event having occurred subject to and in accordance with the terms of the contract.

Each party to the contract is subject to the risk that the other party may fail to perform its duty when it falls due. This performance risk may be acceptable to the party who bears it. If not, the contract may impose on the other party the duty to provide collateral (usually cash) as security for that future performance duty. The duty to provide collateral may be unconditional and therefore required to be discharged immediately upon entering into the contract. Alternatively, the duty to provide collateral may itself be conditional. (For example, it may fall to be discharged if that other party is subject to a ratings downgrade.)

Furthermore if, as is usually the case, the parties enter into multiple OTC derivatives under a single master agreement (such as the ISDA Master Agreement), these multiple derivatives may be self-collateralizing. That is, upon a termination of that agreement by a party (for example, following a default by the other party) an account is taken of the prevailing values of the respective payment (or delivery) duties and claims of that party under all outstanding OTC derivatives covered by the master agreement, the consequent net amount being the subject of a payment duty owed by one party to the other. Thus the risk of non-performance is regulated under the terms of the contract. Specifically, it is regulated through the creation under contract of a single net payment duty in respect of the outstanding OTC derivatives between the parties due, upon termination, by one party to the other.

Neither party has the power to transfer either its duties or its claims under the contract. If a party had the power to transfer its duties, it might thereby unilaterally cause the remaining party to face an incoming party in respect of whom the risk of non-performance is greater that the outgoing party. If a party had the power to transfer its claims, it might thereby reduce for the remaining party the self-collateralizing benefits of the master agreement. Accordingly, the general contractual rule is that the outgoing party requires the consent of the remaining party in order to affect such a transfer.

OTC derivatives may be “bespoke” in two senses: (i) as regards the terms of the particular OTC derivative being entered into between the parties; and (ii) as regards the terms of the credit relationship between the parties (reflecting their respective tolerances to the risk of non-performance) – whether in relation to that particular OTC derivative or the broader relationship arising under the master agreement. With reference to the first sense, it is this very facility – the parties’ broad privilege to condition payment and delivery duties inter se on factual predicates designated by them, circumscribed only by public policy – that distinguishes OTC derivatives from more traditional financial instruments. It also makes placing OTC derivatives in a regulatory system that is premised on more narrowly-defined financial instruments problematical. (This is discussed further below.)

CCPs and OTC Derivatives
An OTC derivative may be privately negotiated yet cleared through a CCP. Implicit in the operation of the CCP is the idea of contractual novation. That is, the parties to the OTC derivative terminate that contract between them, each entering into new but equivalent contracts with the CCP. In consequence, each party has a claim on the CCP for performance of the respective duties formerly embodied in their OTC derivative and not on each other. Thus, the risk of non-performance is not eliminated but moved. Indeed, the total risk of non-performance has been increased as there are now two contracts falling to be performed whereas before there was one. Of course, to what extent the risk of loss is mitigated in consequence will depend on how effectively the CCP manages those risks of non-performance, whether through margin requirements or otherwise.

The Regulated “Space”
In the United States, both participants in financial markets and the transactions they enter into are subject to regulation. However, the authority to regulate (and the scope of that authority) is premised upon (and defined by) legal categories relating to transactions. Thus, broadly, transactions “for the purchase or sale of a commodity for future delivery” (and those who enter into them) are regulated by the CFTC pursuant to the Commodity Exchange Act and related law; and transactions in “securities” (and those who enter into them) are regulated by the SEC pursuant to the Securities Act and related law. Neither of these legal categories contains OTC derivatives. Although, insofar as the parties to an OTC derivative may create between themselves some or all of the attributes of a transaction in securities or commodities for future delivery, OTC derivatives may be said to contain those legal categories.

The Unregulated “Space”
In the U.S., there is no corpus juris equivalent to these securities laws and commodities laws for OTC derivatives and this, perhaps, is what one may have in mind if one describes OTC derivatives (and those who enter into them) as “unregulated.” This is not to say that OTC derivatives (and those who enter into them) are wholly unregulated. One may say that OTC derivatives (and those who enter into them) are regulated as follows:

(a) OTC derivatives are subject to generally applicable rules relating to legal relationships (specifically, the rules relating to the constitution and enforcement of contractual relationships).

(b) Those banks and investment banks that are dealers in OTC derivatives, and insurance companies who are end-users of OTC derivatives, are themselves regulated entities by virtue of their banking, securities and insurance businesses, respectively.

(c) The SEC has the residual authority to apply certain securities laws, anti-fraud provisions and anti-manipulation provisions to certain OTC derivatives.

(d) The CFTC has the residual authority to apply certain commodities laws, anti-fraud provisions and anti-manipulation provisions to certain OTC derivatives.

(e) OTC derivatives are regulated outside the United States. For example, within the European Union the Market Abuse Directive and the Market in Financial Instruments Directive are sufficiently broad to cover transactions in OTC derivatives generally.

The Significance of Categories
In the Paper, the Treasury reminds us of the significance of the legal categories “securities” and “commodity futures” (or “contracts for the purchase or sale of a commodity for future delivery”). With reference to the respective regulatory authorities of the SEC and the CFTC, the Treasury writes – In many instances the result of these overlapping yet different regulatory authorities has been numerous and protracted legal disputes about whether particular products should be regulated as futures or securities. These disputes have consumed significant agency resources that otherwise could have been devoted to the furtherance of the agency’s mission. However, these legal categories were significant, not only in relation to inter-agency disputes, but also in relation to legal certainty. An argument in those disputes, articulated at varying times with varying degrees of force, was that swaps and other OTC derivatives fell (or may fall) within the definition of “contracts for future delivery.” The implication of this argument is that those derivatives that fall within the legal category “contracts for future delivery” are unlawful to that extent, as they are not traded on an approved exchange. This argument is now largely of historical interest (if any) following the Commodity Futures Modernization Act of 2000 (“CFMA”), at least in the case of OTC derivatives between “eligible contract participants.”

Nonetheless, that argument continues to reveal an important distinction between the respective authorities of the CFTC and the SEC. Both have the authority to regulate the public markets for which they are responsible and the essential mechanism for exercising that authority, in each case, is ensuring (through various means) that there is information symmetry between the participants transacting in that public market and by sanctioning those who, with an information advantage, would transact in those markets. The SEC however does not require all transactions in securities to be executed on a public market. That is, parties have the privilege of transacting freely but privately in securities outside of the scope of the SEC’s authority (subject to the anti-fraud standard set out in Rule 10b5). (This is not to suggest that the frontier between public and private is anything but plastic.) In contrast, the CFTC’s authority is antagonistic to private transactions in “commodities for future delivery.” The premise of its authority is that such transactions should be executed on an approved exchange and, to the extent that they are not, they are unlawful. This antagonism forms the background to the CFMA.

This background too perhaps allows one to abandon the popular narrative that the history of OTC derivatives is a history of regulatory arbitrage. The better narrative is perhaps the search for legal certainty in respect of bona fide financial transactions and the vindication of the principle pacta sunt servanda (agreements must be kept). If that history of OTC derivatives is written, it may also be recorded in this connection that (alongside this search for legal certainty) there was perhaps what might be described as a cultural-reluctance on the part of those dealers to come within a regulatory regime that has its roots in agricultural products.

Emerging Issue
Explicit in the Paper is a distinction between “customized” OTC derivatives and “standardized” OTC derivatives. Implicit in the Paper too perhaps is the assumption that there is a prior legal category “OTC derivatives” that may be circumscribed by definition, which is an assumption not without difficulty. The Treasury proposes in relation to “standardized” OTC derivatives that (a) trading in respect of them should move to regulated electronic trade execution systems; and (b) that “clearing” in respect of them should be through regulated CCPs. Our key emerging issue in this connection is whether there is now to be two new legal categories (standardized OTC derivatives and customized OTC derivatives, respectively) and, if so, the implications of the same.

In a different connection, the International Swaps and Derivatives Association (“ISDA”) has written as follows: The subtle reality is that mature derivative markets consist of a continuum, from highly bespoke to more economically standardized instruments.[2] If there is such a continuum, what is the point (if any) at which one moves from the highly bespoke (or customized) to the standardized instrument? The Paper proposes a presumption – that is, if an OTC derivative is accepted for clearing by a CCP, it is presumed to be “standardized” and (accordingly) subject to the duty that it should be cleared through a CCP. Furthermore, the Paper proposes an anti-avoidance provision – that is, a customized OTC derivative may not be used solely to avoid the duty to clear the standardized OTC derivative through a CCP.

In relation to this, one may say the following. Firstly, yes, there would be two new legal categories (standardized OTC derivatives and customized OTC derivatives, respectively). The applicable legal rule would be that each OTC derivative would fall within one of these legal categories and the legal duties to which the parties thereto would be subject will depend on into which legal category the OTC derivative fell.

Secondly, the distinction between these two legal categories is, in the first instance, not based in abstract legal analysis but rather in concrete factual analysis (contrast, for example, the question “what is a security?”). That is – one would ask the following question: does a regulated CCP accept this contract (or contracts of this type, perhaps) for clearing? If this factual predicate exists, then this OTC derivative is presumed to be a standardized one.

Thirdly, is this presumption subject to rebuttal? If the presumption were subject to rebuttal, then one might search for a legal theory pursuant to which such an ostensibly standardized OTC derivative should not be considered “standardized” for the purposes of the rule. For example, what if the CCP would accept the contract but would reject the parties as customers? What if one party does not wish to assume further risk of non-performance by the CCP? Does the contract remain “standardized” for the purposes of the rule in that instance?

Fourthly, how is the anti-avoidance provision to be applied? That is, at what point does “customization” become avoidance? Is this to be determined with reference to the motivation of the parties? If so, what if one party only was motivated by avoidance? If not, what are the criteria that are characteristic of the category “customized”?

Finally, what is the sanction for non-compliance with the rule (that is, what if the parties do not “clear” a “standardized” OTC derivative through a regulated CCP?) If the sanction is that the OTC derivative is void or unenforceable on grounds of illegality, then there is a new derogation from the principle pacta sunt servanda and questions of legal certainty in relation to particular transactions might begin to re-open.

One may be tempted to see, in these proposals for reform, the famously false syllogism that proceeds as follows: (a) “we must do something;” (b) “regulation is something;” (c) “therefore, we must regulate.” If so, perhaps the question to be asked of these proposals (and other similar ones) is whether they risk causing more harm than good. In this regard, one may have to wait to see the detailed rules to be promulgated by the SEC and the CFTC in respect of OTC derivatives and, in particular, whether those rules will be antagonistic towards the ongoing existence of privately negotiated "customized" OTC derivatives (and, more specifically, whether questions of legal certainty are to be reopened). Legal certainty should, of course, be the key part of any “new foundation” for OTC derivatives.

Following the publication in draft of the proposed Over-the-Counter Derivatives Markets Act of 2009 we have a clearer idea perhaps of what the regulatory regime for OTC derivatives might comprise, although further rule-making under that Act is contemplated. OTC derivatives would be divided into two new legal categories (“swaps” and “security-based swaps”) with the CFTC and the SEC having respective authority in these areas. Both “dealers” in, and those end-users who are “major participants” in, “swaps” or “security-based swaps” would subject to registration duties. There would be a comprehensive regime under which inter alia (i) those transactions that are “standardized” would have to be executed, at least, via a registered “alternative swap execution facility” and centrally cleared; (ii) if the transaction is not centrally-cleared, the parties would have a duty to report it to a central “swap repository”. Those registered dealers and major participants would be subject to specific duties relating to (i) capital requirements, (ii) initial and variation margin, (iii) disclosure, (iv) business conduct, (v) confirmation, processing, netting, documentation and valuation procedures, (vi) maintenance of books and records, and (vii) management of conflicts of interest. Powers relating to the establishment of position limits are contemplated. Inevitably, the question of legal certainty arises in relation to the new legal category that is premised on characteristic “standardized”. How certain can the parties be that they have characterised their transaction correctly at the beginning? If they proceed on the basis that it is not “standardized”, will the party who is subsequently “out-of-the-money” have the option of challenging that transaction as an unlawful “standardized” transaction?


[1] Richard Posner, Our Crisis of Regulation, New York Times. Op-Ed; June 24, 2009
[2] Richard Metcalfe, Head of Policy ISDA, to David Cook, London, 18 June 2009,

Sometimes Too Great a Notional:Measuring the “Systemic Significance” of OTC Credit Derivatives

Posted on FinReg21 by Margaret Blair & Erik Gerding:

The Obama Administration’s Financial Reform Proposal rightly places regulating systemic risk at the center of reform efforts. It proposes giving the Federal Reserve power to regulate any large financial institution that has “systemic significance,” no matter whether that institution is currently regulated as a bank, insurance company, or some other regulated entity, or is largely unregulated.[1] But the Administration’s proposal fails to address two major problems satisfactorily. First, what are the criteria for determining which financial institutions are systemically significant? The Administration’s proposal vaguely describes “systemically significant” institutions as “any financial firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed.” To implement this, it proposes complex tests like the so called “stress tests” that the Administration applied to large banks this spring. Yet, such tests are difficult to administer, opaque, and therefore add uncertainty to financial markets.

The second problem is how will reforms address the counterparty risk and systemic risk posed by over-the-counter (OTC) derivatives generally and credit derivatives particularly? The Treasury Department’s initial May 13th proposal for regulating OTC derivatives appeared to encourage derivative trading activity to move to exchanges, where transparency, market pricing, and clearing services provided by the exchange can mitigate counterparty risk. But this part of the proposal contains an enormous loophole: it only seeks to encourage “standardized” derivative contracts to trade on exchanges.[2] Most derivative contracts are highly customized, however, and thus cannot be traded on an exchange. Meanwhile, the proposal fails to articulate incentives for derivative counterparties or dealers to standardize derivatives so they could be traded on an exchange. Derivatives such as “credit default swaps” (CDS), the financial instruments that were heavily implicated in last fall’s credit crisis, would remain outside of exchanges.[3] In August, the Administration sent legislative language to Congress on OTC derivatives that improved upon its earlier proposal. This language would give the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) a mandate to promulgate regulations requiring that counterparties to OTC derivatives maintain regulatory capital or post collateral to cover their obligations.[4] Although these regulations would play a valuable role for the reasons explained in this article, financial institutions promise to oppose fiercely this type of legislation and regulations.

We propose the following simple rules that would simultaneously help identify systemically risky institutions and discourage use of OTC derivatives:

¶ The Federal Reserve (or other systemic risk regulator) should require that financial institutions publicly disclose detailed information on the size, counterparties, and closing dates of credit derivatives in their portfolio on a regular and frequent basis, such as at the close of business each business day. This information would include disclosure on the notional value of the institution’s credit derivative contracts. The notional value of credit derivatives provides a gauge of the maximum amount that the seller of the derivative might have to pay to the buyer if the underlying credit instrument defaults. Although the notional value is not a good indicator of the market value of a derivative (because it is unlikely that each contract in the portfolio would have to be settled for the full notional amount), the notional value of all the derivative contracts in an institution’s portfolio is a powerful indicator of the systemic risk posed by that institution’s investments because it is the maximum amount the institution could owe to (or be owed by) other financial institutions in an extreme event such as the credit freeze that hit financial markets last fall.

¶ The government should use this regular disclosure on derivatives to identify which financial institutions are “systemically significant.” Any institution with a portfolio of credit derivatives whose notional value exceeds a certain amount, say $1 trillion,[5] for a certain number of days would be regulated for several subsequent years as a “Tier 1 Financial Holding Company” (Tier 1 FHC) under the Administration’s proposal.

¶ Finally, exchange-traded derivatives should not count in the notional value threshold for systemic significance. This would create a strong incentive, otherwise missing from the current Administration’s reform agenda, for derivative counterparties to move their OTC contracts to exchanges.

These policies provide the marketplace with a better gauge of the risks posed by an institution’s credit derivative portfolio. The incentive to move OTC derivatives to exchange trading further enhances the transparency of risk. To the extent that potential counterparties understand how much risk an institution has already taken on, they should be able to apply “market discipline” that will help prevent institutions from getting themselves into overly risky positions again. Moreover, these policies promote government transparency to help ensure that decisions of the regulatory authority about which institutions pose systemic risk will be economically and legally principled.Our proposals focus on credit derivatives because these contracts play a significant role in systemic risk. In this article, we first explain how derivatives generally may contribute to systemic risk. Then we examine how the complex nature of credit derivatives, including credit default swaps, frustrate the accurate pricing of risk. We then outline how credit derivatives helped to increase market-wide leverage and thereby overstimulate financial markets through the “shadow banking system” in the years leading up to the current financial crisis. Next, the article explains how exchange trading, and not just centralized clearing, is a vital tool for mitigating systemic risk. The article then elaborates on the details of our proposal and explains why notional value is an important metric. Finally, we outline some other key pieces to the regulatory reform puzzle with respect to credit derivatives.

Systemic Risk and the Problem of Opacity in Derivatives
The phrase “systemic risk” – so important in the context of the current financial crisis – has been used to mean different things. We define “systemic risk” as the possibility of significant losses across entire financial markets at the same time. Owing to its market-wide scope, systemic risk cannot be readily mitigated through diversification. Kaufman and Scott describe two ways in which systemic risk can manifest itself. First, systemic risk describes the risk of a failure of one institution leading to the domino failure of other firms that are creditors or counterparties of that institution. Second, systemic risk may describe the risk of multiple firms failing simultaneously for a common reason. When numerous financial institutions have similar portfolios, risk exposures, and trading strategies, the possibility is increased that an external shock can threaten the simultaneous failure of multiple institutions.[6]

The opacity of OTC derivatives exacerbates both of these manifestations of systemic risk. For example, parties to a derivative contract face counterparty risk, or the risk that the other party to the contract will default on its obligations. Any one financial institution may be party to multiple derivative contracts, and thus the insolvency of that institution (or any default on an array of its derivative contracts) may threaten the solvency of its counterparties. The failure of parties to reveal their positions in a timely way makes it impossible for potential counterparties to gauge how much risk a given institution is bearing.

The trading, and re-hedging, of existing derivative contracts further complicates the problem. A party to a derivative contract (Party A) cannot adequately assess its counterparty risk in a derivative contract with Party B if Party B can offload some of its risk on the contract to Party C through assignment of the risk to C, or subsequent hedging of the contract with new derivatives. Party C can in turn offload part of its risk through the same devices. Frequent off-loading of risk to other parties means that Party A needs to worry not only about the creditworthiness of Party B, but also the creditworthiness of subsequent risk transferees. Party A may not even be aware of those subsequent risk transfers, let alone of the identities of the transferees. This hidden “interconnectedness” created by OTC derivatives can translate counterparty risk into systemic uncertainty.

Derivatives may also exacerbate systematic risk when multiple financial institutions have derivative portfolios with similar risk profiles. For example, numerous firms in the current financial crisis faced similar exposures to rising interest rates, falling housing prices, and defaults on mortgage-back securities (MBSs) or collateralized debt obligations (CDOs). This similarity prompted firms that suffered losses as the crisis began to conduct fire sales of similar assets simultaneously, which sent markets into a tailspin and created a liquidity crisis. Yet addressing excessive “homogeneity” of risk profiles presents an anti-coordination game: no party can effectively ensure that its risk profile does not dangerously mirror the risk profiles of many other institutions in the marketplace without timely disclosure of the derivative portfolios of other institutions.[7]

Credit Derivatives: Further Problems with Pricing Risk
Credit default swaps (CDSs) highlight additional problems with pricing risk. In a typical CDS, Bank D, who has purchased some risky “X bonds,” may want to mitigate the risk of those bonds defaulting. Bank D then enters into a “swap” with Institution E in which it pays E a premium in exchange for E agreeing to pay D the value of the X bonds should they default. D has essentially purchased an insurance contract (except that, thanks to the craft of lawyers, CDSs are not regulated as insurance). E could then pass on its obligations to other parties, often without D’s knowledge. Or E could decide to hedge its risk of having to pay D by entering into a second CDS with another counterparty F. F could then hedge with yet another CDS with G.

At the same time, the X bonds may pay out based on the performance of other securities (for example, a pool of different assets, including mortgage-backed securities), which in turn may be backed by other assets (for example a pool of mortgages). This can create a long chain (or more accurately a tangled web) that stretches from the original underlying cash-producing assets (like mortgages) all the way to CDSs that hedge other CDSs. As many scholars have noted, information on credit quality of the original underlying assets is progressively lost or destroyed the further one goes in the chain from the underlying assets.[8] For example, the transfer of risk may dull the incentives of parties to accurately assess credit risk and transmit that assessment to transferees, as in the case of mortgage originators who originated low documentation loans.

The chain of risk transfers also poses subtler and more technical challenges to pricing CDSs accurately. As Coval, Jurek, and Stafford have demonstrated, small errors in modeling the risk of underlying assets (like mortgages) are compounded at each subsequent stage of those assets being securitized or hedged. So a small error in modeling the risk of a pool of mortgages at the beginning of the chain may lead to a severe error in pricing the risk of a CDS at the end of the chain. Correctly pricing a CDS for risk may be further frustrated when there is a high correlation among losses on the underlying assets.[9] In most other forms of insurance, say fire insurance, losses on insured assets are not highly correlated across the class of assets, and thus mistakes in estimating loss on one asset is likely to be offset by other assets not suffering losses. Losses on pools of mortgages, bonds, and other financial instruments, by contrast, may be highly correlated, and correlations may increase unpredictably.[10]

Credit Derivatives, Leverage, and the Shadow Banking System
Thus far we have examined how the price of credit default swaps and other credit derivatives may fail to capture systemic risk. But these derivative contracts also tend to create and increase risk by making it easy for nonbank financial institutions to take on too much debt, thereby overstimulating financial markets and precipitating financial crises. The current crisis provides a stark example. To see why, one needs to understand the important role that credit derivatives played in what has come to be known as the “shadow banking system.”[11]

The phrase “shadow banking system” describes how the securitization process has allowed investors in capital markets to perform many of the same lending functions traditionally provided only by banks. The shadow banking system is a network of financial institutions that uses issuances of securities in the capital markets and a chain of intermediaries to finance loans to disparate borrowers. When they lend to their customers, banks perform the same inherently risky credit function by accepting demand deposits (short-term liabilities from the point of view of the bank), and making long-term business and consumer loans. By contrast with bank lending, the “lending” that occurs in the shadow banking system is less regulated and less transparent. In addition, the funds that investors invest in asset-backed securities are not protected by federal deposit insurance.

Here is how the shadow banking system works: A mortgage lending firm such as Joe’s Mortgage Co. (JMC) negotiates to provide mortgages for several hundred homebuyers. As soon as each mortgage is closed, JMC sells the mortgage to some other financial institution such as Major Giant Mortgage Assurance Inc. (MGMA, or “Maggie Mae”) so that JMC gets its funds back and can turn around and lend to more home buyers. Maggie Mae, in turn, “securitizes” the mortgages. To do this, Maggie creates a new shell business entity (a “special purpose entity,” which we will call MaggieSPE). Maggie bundles together hundreds or thousands of mortgages and puts them into MaggieSPE, which in turn sells bonds that are backed by the mortgages to institutional investors.[12] And voila! By this alchemy, Maggie transforms the payments on the mortgages into securities.

MaggieSPE then uses the funds it raises this way to pay off Maggie so that the process can start over again. Maggie can use the cash to purchase more loans for new securitizations, and this additional cash funds additional lending to consumers and other borrowers. Greater demand by investors for asset-backed securities can thus fuel greater consumer lending. This securitization process effectively channels money from institutional investors in capital markets to loans to borrowers. By holding securities, institutional investors enjoy a greater liquidity than banks, which hold loans funded by customer deposits. Those banks must negotiate the mismatch that occurs with having short-term liabilities (deposits from their customers) but long-term assets (mortgages and other loans).The shadow banking system effectively skirts the stringent banking laws that would apply if the money was being loaned directly by bank depositary institutions. These banking laws are designed to protect against banks taking on excessive risk from non-performing loans. Significant defaults on bank loans could threaten not only the bank’s solvency and depositors, but other banks in the financial system as well. The shadow banking system does not eliminate the risk of loans defaulting, but instead spreads that risk to multiple parties, and gets it away from the watchful eye of regulators.An investor who purchases asset-backed securities may be worried about defaults on underlying loans leading to defaults on their securities. This investor can purchase a CDS from some other institution to hedge this risk. In the months and years leading up to the current financial crisis, numerous financial institutions borrowed ever more money to invest ever more funds in risky securities that were based on bundled mortgages or consumer loans or business loans. These institutions were operating with very high effective “leverage” ratios (the ratio of debt to equity or debt to total assets), because this magnifies earnings in good times. They were able to do this because they were lightly regulated (or completely unregulated in the case of hedge funds), and, in any case, they thought they were protected by the CDS. But they were not protected, and, as has become clear, leverage magnified losses when housing prices began falling and mortgage default rates started rising.

Meanwhile, the counterparty to the swap might commit very little money upfront to cover the risk it assumes.[13] This represents pure leverage in the sense that the CDS issuer takes on a large potential liability in exchange for very little money up front. This leverage allows more money to be loaned earlier in the chain. By hedging part of their risk, investors purchased more asset-backed securities, which provided more money to lenders such as JMC, who then loaned more money at lower interest rates to borrowers of mortgages, credit cards, and other loans. This orgy of borrowing in the system, helped drive asset prices higher. Thus by increasing leverage in the shadow banking system, credit derivatives helped ease credit, increase the effective money supply, and fuel booming housing and securities markets. This increased apparent household wealth, further encouraging consumption and investment in risky assets.

Credit Derivatives and the Current Crisis
In this way, credit derivatives played an important role in stimulating the housing and securitization booms at the heart of the current crisis. In the current crisis, credit derivatives and other elements of the shadow banking system also formed parts of a vicious feedback loop that sowed the seeds of their own initial success and ultimate destruction. Lenders issued increasingly risky loans with more exotic features such as adjustable rates and zero down payments. But these mortgages had a binary nature; borrowers could only afford to repay these mortgages once their interest rate reset after a low teaser period by refinancing or selling the property. These exit options for borrowers, however, depended on housing prices continuing to increase. Prices did in fact continue to increase thanks to the growing supply of credit provided by the shadow banking system. Until they didn’t. When housing prices stagnated, this feedback loop in the leverage machine suddenly whirled into reverse. Unable to pay mortgages at the reset rate, mortgage borrowers began defaulting on their mortgages. This translated into defaults on mortgage-backed securities and similar instruments, which caused losses for credit protection sellers in credit default swaps. These losses on securities and derivatives caused credit in the shadow banking system to dry up suddenly and catastrophically, further worsening defaults on mortgages.

Economists regard this vicious feedback loop as the de-leveraging stage in the leverage cycle.[14] The feedback loops of leveraging and de-leveraging affected financial markets in sudden, nonlinear, and unexpected ways. This nonlinearity, combined with the fact that the credit derivatives and shadow banking system lacked transparency, prevented market participants and regulators from anticipating risk adequately. The risks created by credit derivatives in the shadow banking system then triggered the forms of systemic risk mentioned above. Severe losses threatened the solvency of several financial institutions that were credit protection sellers – Bear Stearns, Lehman Brothers, and AIG – which in turn threatened the solvency of many of their derivative counterparties. Moreover, many financial institutions faced similar exposures to the same underlying risks of widespread mortgage defaults.

The Benefits of Exchange Trading and Clearing
Since many of the systemic risks posed by credit derivatives stem from their opacity, greater transparency can mitigate systemic risk by providing regulators and the marketplace more information on the risks that financial institutions assume through derivatives. One means to greater transparency is through the constant price discovery that occurs when derivatives are traded on an exchange. Exchange trading means that errors in the initial pricing of derivatives can be remedied by constant repricing. This price discovery sends clear signals of the risk involved in derivatives not only to the counterparties, but to all other institutions in the market place as well. OTC derivatives, which are not traded at all, or are only traded in occasional private transactions, do not benefit from this transparent pricing and repricing.

With respect to OTC derivatives, the Administration’s financial reform proposal focuses on developing central clearing of OTC derivatives and not on creating incentives to move OTC derivatives to exchanges. Clearing, however, addresses only some of the potential sources for systemic risk outlined above. For example, clearing does mitigate counterparty risk by inserting a clearing company as a middleman, or central counterparty, to all derivative contracts. The clearing company then must periodically assess the counterparty risk of each institution (or “member”) whose contracts it clears. If the risk increases, the clearing company may require a trading institution to post additional collateral or “margin.” The clearing company thus centralizes counterparty risk.

But centralizing counterparty risk only mitigates systemic risk if a clearing company’s margin requirements are sufficient and sufficiently up-to-date. Without an exchange-generated market price, these margin requirements may need to rely on complex financial modeling to measure risk.

Our Proposal
We believe that reliance on complex financial models rather than exchange prices, as in the current reform proposals, is suboptimal. Reliance on complex, opaque models to price derivatives or measure risk has proven seriously flawed in the current crisis. This was partially due to the fact that financial models failed to measure risk adequately. The complexities in measuring risk in the credit default swap market discussed above gives but a flavor of such “model risk.” Moreover, models can be gamed by self-interested actors in financial institutions looking to earn extra profits, increase compensation, and evade risk management controls.

Why Notional Value is a Useful Metric for Systemic Risk
Our proposal addresses this problem by requiring financial institutions to continuously disclose the notional value of the credit derivatives they hold. This disclosure would give the marketplace valuable information about the maximum risk posed by the institution’s credit derivative portfolio. It would also provide regulators with a clear metric to determine when a derivative portfolio is systemically significant. Furthermore, seeing the total notional amount of credit derivatives will give regulators, particularly the Federal Reserve, a sense of how much credit the derivatives market may be pumping into the shadow banking system

Financial institutions required to reveal their positions will undoubtedly complain that notional value is the wrong metric because the parties to a credit derivative are rarely called upon to pay the notional amount. But it is precisely in those (hopefully) rare situations when an institution is called upon to pay the notional amount that systemic risk is most problematic. In September 2008, for example, the CDS that AIG had sold to its counterparties obligated it to pay hundreds of billions of dollars in notional value to its counterparties once the underlying assets began to default. The Bush Administration apparently feared that if AIG had been allowed to default, this could have triggered default by dozens of other financial institutions. While, arguably, notional values overestimate the risk posed by OTC credit derivatives, in the situation of a systemic meltdown, the notional amount owed by firms on their credit derivatives becomes highly relevant. Moreover, without an exchange generated price, regulators lack better options.

Transparency for Regulators Too
The current crisis also demonstrates how ill-equipped regulators are to audit financial institution risk models or to develop their own models. Regulator measurements of OTC derivative risk in the current crisis has been the opposite of transparent, as witnessed by the still perplexing decision of federal regulators to bail out Bear Stearns and AIG while allowing Lehman Brothers to fail. The Administration’s proposal for how regulators would measure the systemic risk of OTC derivatives seems to call for more of the opaque stress tests that the Treasury Department conducted on banks earlier this spring.

Reliance on opaque models—whether developed by financial institutions or regulators – creates great uncertainty in the marketplace. Reliance on models also undermines another policy objective in the Administration’s proposal – coordinating international regulation. Regulatory cooperation depends on national regulators building collective trust that each of them is regulating their home country banks effectively and evenhandedly. Reliance on complex, opaque models to measure systemic risk is antithetical to building that trust. Opaque regulations raise the specter of a national regulator allowing its home country institutions secretly to take on extra risk and reap additional profit.

A requirement that financial institutions report the notional amount of the credit derivatives they hold does not solve all of these problems but it at least provides a simple, transparent metric for systemic risk that is relevant precisely when it is needed most.

Encouraging Exchange Trading
Again, our proposal would exempt exchange-traded credit derivatives from calculations of whether a firm’s derivatives portfolio reaches a threshold of systemic significance. This would create an incentive for firms to move credit derivatives to exchanges. As noted above, exchange trading would mitigate counterparty risk and promote transparency. It would also address the liquidity risk that arises when firms with derivative instruments cannot readily find new counterparties to unwind their positions.

Many financial firms have contended that the customized nature of credit derivatives makes them unsuited for exchange-trading and that rules that would curb non-exchange traded derivatives would deprive market participants of the benefits of highly customized financial instruments. We find these arguments overstated for several reasons. First, if many asset-backed securities can be traded on exchanges and alternative trading systems, it would seem that standardized credit derivatives related to these same securities could trade alongside them. Second, bond insurance policies issued by so-called monoline insurance firms serve as a ready substitute for OTC credit derivatives. Imposing costs on the use of OTC derivatives would encourage greater use of regulated insurance products.

What Still Needs To Be Done
Of course, notional value is of little use in determining whether a financial institution is “systemically significant” if the threshold is set too low for when the total notional value of a firm’s portfolio raises systemic risk concerns. We propose a trigger of $1 trillion for discussion purposes. If the notional value of an institution’s credit derivative portfolio would exceed this threshold for several days, then the institution would be regulated as a Tier 1 Financial Holding Company and would lose this status only after its notional value drops below that threshold for a set period of time. Likewise, moving OTC derivatives to exchanges or clearing companies means that regulators must pay close attention to the rules of those exchanges or clearing companies. Otherwise, regulatory reform will only succeed in centralizing and concentrating systemic risk. Thus operating rules must be developed for such exchanges or clearing firms.

In the long run, systemic risk regulation must also require detailed disclosure about the derivative portfolios of each systemically significant institution, each firm’s risk management policies, and the models it uses to set those policies and price derivatives. The Financial Accounting Standards Board has already made initial steps towards these goals.[15] But the various forms of systemic risk posed by credit derivatives demand still more nuanced disclosure. For example, we would like to see disclosure of whether an institution faces concentrations of exposures to specific risks,[16] and the methodologies that the institution uses to value derivatives and model their risk.

In the short run, however, disclosure of a few key simple metrics helps the market police both systemically risky financial institutions and the systemic risk regulators.


[1] U.S. Department of Treasury, 2009, “Financial Regulatory Reform: a New Foundation,” available at

[2] U.S. Department of Treasury, 2009, “Regulatory Reform: Over-The-Counter (OTC) Derivatives,” May 13, 2009, available at

[3] Journalist reports have suggested that this exception comes in the face of lobbying by a coalition of large financial institutions that constitute the major OTC derivative dealers. These dealers fear that moving derivative contracts to more transparent exchanges will prevent them from charging the additional fees they can earn on more opaquely priced OTC derivatives. Morgenson, Gretchen and Don Van Natta, Jr., 2009 “In Crisis, Banks Dig In for Fight Against Rules,” N.Y. Times, May 31, 2009, at A1.

[4] U.S. Department of Treasury, 2009, “Administration’s Regulatory Reform Agenda Reaches New Milestone: Final Piece of Legislative Language Delivered to Capitol Hill,” August 11, 2009, available at

[5] We offer this threshold number for discussion purposes. To place this number in context, we estimate that five financial institutions – JP Morgan, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup – each would have exceeded a notional threshold of just under $3 trillion in credit derivatives as of the end of their first quarter in 2009. According to a July 22, 2009 report from Fitch Ratings, these five firms accounted for 96% of all exposures from credit derivatives at the end of the first quarter of 2009 with 100 large companies surveyed. This study found that only 17 firms, all financial institutions, reported any credit derivative exposure at quarter end. The total notional value of credit derivatives for these 17 firms was approximately $36.3 trillion, and the total gross fair value of all credit derivatives for these firms was just over $4 trillion. Fitch Ratings, 2009, Derivatives: a Closer Look at What New Disclosures in the U.S. Reveal, (July 22, 2009).

[6] Kaufman, George G. & Kenneth E. Scott, 2003, “What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It,” Independent Review 7, p. 371.

[7] Gerding, Erik F., 2009, “Code, Crash, and Open Source: the Outsourcing of Financial Regulation to Risk Models and the Global Financial Crisis,” Washington Law Review 84, pp. 127-198.

[8] Buiter, Willem H., 2007, “Lessons from the 2007 Financial Crisis,” Centre for Economic Policy Research Policy Insight 18, (Dec.) available at

[9] Coval, Joshua, Jakub Jurek, and Erik Stafford, 2009, “The Economics of Structured Finance,” Journal of Economic Perspectives 23, pp. 3-25.

[10] Hellwig, Martin, 2008, “Systemic Risk in the Financial Sector: an Analysis of the Subprime-Mortgage Financial Crisis,” Max Planck Institute for Research on Collective Goods Bonn 2008/4316 (Nov.) available at

[11] This section discusses credit derivatives that are used to hedge an underlying risk. As explained below, by allowing one party to offload credit risk from asset-backed securities, such credit derivatives enable that party to make additional investments in those securities.

Other credit derivatives may represent pure speculation in that neither party to the contract is using the agreement to mitigate preexisting risk. Other scholars have noted that this purely speculative use of derivatives is a zero sum game that provides no insurance benefit but instead resembles pure gambling. Stout, Lynn A., 1999, “Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives,” Duke Law Journal, 48, 701.

[12] Different classes of securities are usually issued in securitizations so that senior classes can be marketed to institutional investors who are often restricted by regulation to investing in investment grade debt. To ensure that these senior classes receive an investment grade rating from a credit rating agency, the designers of securitizations use several tools. Most notably, the senior classes of securities enjoy a priority right to payments on the underlying assets compared to more junior classes. This makes senior classes less risky and junior classes more risky. Senior classes of security may also benefit from credit support devices such as guarantees or bond insurance.

[13] AIG played the role of counterparty to hundreds of billions of dollars of CDS. Although AIG is a regulated U.S. insurance company, its CDS business was largely conducted by lightly regulated offshore entities, which made it possible for AIG to engage in CDS trades without setting aside sufficient capital to cover widespread losses, such as happened in 2007 and 2008.

[14] Geanakoplos, John, 2009, “The Leverage Cycle,” Cowles Foundation Discussion Paper No. 1715 (July) available at

[15] FASB’s new Statement 161(Issued March 19, 2008), which requires quarterly disclosure of notional value and other information on derivatives, represents a vast improvement on previous accounting rules on derivative disclosure. But its requirements give firms considerable discretion in the format for reporting derivatives exposures, frustrating comparisons among firms. It also does not require enough detail from firms with respect to the models they use to calculate the “fair value” of derivatives. Understanding these models and their assumptions is critical for understanding the true risk that a firm faces from its derivatives. Finally, derivatives disclosure would benefit from requirements that firms provide a sensitivity analysis of how their portfolio value and risk exposure would change under different scenarios, such as an x% change in interest rates.

[16]This might include required disclosure on a firm’s exposure to particular
¶ types of instruments covered by credit derivatives;
¶ sponsors of asset-backed securities;
¶ lenders whose loans are being securitized; or
¶ counterparties to derivative contracts.

Derivatives Regulation: Financial Innovation versus Systemic Stability

Posted on Fin Reg21 by Emilios Avgouleas:

Derivatives trading has been a very useful and integral part of our financial system and should remain so in the future. However, the derivatives industry has not fallen on hard times for no good reason. It is difficult not to agree with the conclusion of influential regulatory and international policy body reports that much of financial innovation of the past decade was pure social waste (UNCTAD 2009, UN Commission of Experts 2009). Furthermore, the use of derivatives fostered by the development of the shadow banking sector eventually became a menacing threat to global systemic stability; for example, American International Group’s (AIG) gigantic credit default swaps (CDSs) portfolio literally threatened the global financial system with collapse. In many ways the use of the highly opaque CDSs amounted to no more than wild bets on the continuation of the housing boom in the U.S. and other western countries, perennial economic growth, and low interest rates.

However, misuse of financial innovation was in many ways more the result of disastrous government policies, incomprehensive capital adequacy regulations (Brunnermeier et al. 2009, Hellwig 2008), and global macroeconomic conditions, and less the by-product of the industry’s customary pre-occupation with short-termism and mega-profits. This essay attempts to highlight the underlying causes that led derivatives trading to become a source of systemic instability. It argues that, if these causes are properly identified, then the international regulatory and investment communities can move away from both the pack of naysayers within their ranks and the crowd of witch hunters, setting instead for themselves the sober task of devising regulatory reforms that would make financial innovation less threatening to systemic stability and more welfare enhancing.

The Global Financial Crisis and Derivatives Markets
The excessive use by financial (mostly banking) institutions of maturity transformation (Hellwig 2008, FSA 2009) mainly through the use of the originate to distribute model to fund their asset book, the use of credit derivatives to, inter alia, replicate the risk distribution effects of securitization (so-called synthetic securitizations), and the explosion of shadow banking vehicles meant that inadequately managed and monitored credit risk was massively sold and transferred to global capital market investors (Lo 2009). Capital market investors were ill-equipped to properly manage this amount of credit risk both because of lack of information and relative lack of quantitative skills. However, actions that preceded the above developments set the groundwork for the disastrous proliferation of the use of derivatives in those contexts. These actions were the deregulatory laws of the 1990s, the flawed monetary policies of this decade, and global macro-economic conditions.

Legislation that led to the deregulation of the financial services industry in the 1990s placed no limits on the use of highly speculative instruments even as it increased industry homogenization and strategic trade behavior (herding) in global markets; eventually all banks’ balance sheets looked more or less the same and so did their risk management and trading policies (Haldane 2009). In the absence of regulatory restrictions, shadow banking operations proliferated. As a result, even venerable institutions like AIG eventually adopted trade and investment policies that more resembled those of highly geared/highly speculative and unregulated hedge funds (Lo 2009), rather than the conservative investment policies normally associated with insurance firms.

Furthermore, low interest rate policies in the U.S., the U.K., and the rest of the EU not only led to the formation of gigantic asset bubbles, especially in the housing sector, but also fuelled irrational exuberance sentiments in the markets (Avgouleas 2009). Market participants acting on the belief that the good times would last forever started making investment decisions that involved the acquisition of disproportionately risky assets through the obvious channel of derivatives trading. Arguably, those decisions were much more the result of “animal spirits” and much less that of any rational risk calculation (Shiller and Akerlof 2009, FSA 2009).

At the same time, international trade liberalization and a bubble in global oil and commodity prices led to the accumulation of gigantic trade surpluses in developing countries which could not be invested in underdeveloped domestic financial systems (UN Experts Report 2009). Thus, they sought higher yields abroad and inevitably ended up, in part, as investments in derivatives markets either directly or indirectly through investment participations in hedge funds or shadow banking vehicles.

Finally, flawed regulations that fostered ratings arbitrage through the use of derivatives and wrongfully focused on capital adequacy without placing any restrictions on leverage increased the fragility of the system as a whole because of interconnectedness. For instance, Lehman Brothers’ CDS exposure was eight times bigger than its capital (Haldane 2009).

The biggest consequence of the proliferation of OTC derivatives trading in the past decade and especially of the use of credit derivatives was that it increased complexity while at the same time bringing – in very opaque ways – the different parts of the financial system closer together, thus strengthening ties of interconnectedness. According to the EU Commission, “the characteristics of OTC derivative markets – the private nature of contracting with limited public information, the complex web of mutual dependence, the difficulties of understanding the nature and level of risks – increases uncertainty in times of market stress and accordingly poses risks to financial stability” (EU Commission Communication 2009). Furthermore, risks from the use of CDSs was exacerbated by the fact that financial institutions are normally lenders and borrowers at the same time, a situation that prevented the taking of offsetting action to limit exposure “because of concerns about counterparty credit risk” (Brunnermeier 2008).

However, the systemic risks created by derivatives trading are not a “black swan,” i.e., an extremely rare and thus virtually unpredictable event (Taleb 2007). In fact, they have materialized with worrying regularity since derivatives trading became a mainstream market activity (for example, the troubles of Long Term Capital Management in 1998 and the systemic risks posed by its inability to unwind its derivatives positions). On the other hand, margin requirements tend to be insufficient to stem systemic instability. Margin calls will only necessitate further asset sales and thus further depreciation of traded assets’ value (Brunnermeier 2008), assuming that a liquid market exists with willing buyers of such assets.

None of the above findings exonerates the derivatives industry from its obvious responsibility for deliberately creating highly complex financial instruments whose value could not be calculated. Yet the increased interconnectedness created by complex derivatives such as credit default swaps was more the by-product of mindless conglomeration and resulting balance sheet homogenization that reduced the resilience of the financial system and increased interconnectedness and less because of the use of the specific instruments per se. Regulators and senior bank management did not heed the threats to systemic stability involved in the use of derivatives to lay off credit risk. And, while short-termism and limited understanding is responsible for the attitude of the latter, the former proved to be victims of their quasi-religious belief in the correcting powers of the invisible hand. How this would make systemic risk disappear remains a mystery. Equally puzzling is regulators’ lack of alertness to the risks posed by increasing interconnectedness created by derivatives trading. Given the total lack of transparency characterizing credit derivatives markets and the absence of a global register of claims against financial institutions, regulators should have been put at the highest state of alarm long before the second phase of the global financial crisis in September 2008, when these became evident even to lay observers.

Proposed Remedies
The central point of the preceding analysis was that the flawed use of complex derivatives was a by-product of other developments, such as unrestrained financial liberalization and conglomeration, and of global macro-economic conditions. Also, excessive maturity transformation and risk arbitrage was partly the industry’s fault (motivated by greed and focused on short-term profit) and partly the result of flawed and incomprehensive capital adequacy regulations. Assuming that the above reflect a broader consensus, it becomes much easier to devise appropriate reforms to protect systemic stability for financial innovation without unduly stifling the industry’s creativity. Arguably, three reforms of varying intensity would suffice to resolve the financial innovation versus systemic stability dilemma.

The first reform relates to the regulators’ establishment of central counterparty facilities for the clearing and settlement of OTC derivatives transactions (establishment much prized by the EU and U.S. regulators) (EU Commission Communication 2009, U.S. Treasury 2009a, b). Centralized clearing for OTC derivatives trading would enhance the transparency of these markets and greatly increase the resilience of the global financial system/network (Haldane 2009, EU Commission 2009, U.S. Treasury 2009a).

The second remedy would be to reconsider network robustness and especially the impact of conglomeration, namely to consider whether a change to the structure of the financial network is feasible, beneficial, and desirable (Haldane 2009). As a first step, regulators could place limits to what kind of exposures mainstream savings and loans institutions could have to derivatives markets or to institutions whose main source of revenue is derived from speculation in derivatives markets, such as hedge funds. This approach would incrementally lead to deconglomeration. This would also be the direct outcome of the G20 resolution to bring the shadow banking activities of regulated institutions under regulatory oversight. Also, this complex and expensive exercise is, in fact, no more arbitrary than assigning risk ratios to trading book assets for capital adequacy purposes and it would benefit the financial services industry and its customers in more than one way. First, it would enhance competition, as banking markets would inevitably become more contestable and less oligopolistic in the absence of today’s mega-banks. Second, it would safeguard systemic stability through the forced decoupling/dehomogenization of big banks’ balance sheets, increasing the system’s resilience. It is, thus, unfortunate that only Mervyn King, the governor of the Bank of England, seems to seriously discuss the benefits of deconglomeration in the financial services industry. [1]

The third remedy should be to require the relevant committees of the International Swaps and Derivatives Association (ISDA) to devise special rules for the orderly winding up of outstanding derivatives exposures in times of financial distress. These would reduce the amount of open positions and thus systemic risk stemming from the possibility of multiple institutional defaults (Hellwig 2008).

International Public Interest Oversight of ISDA Rulemaking Functions?
The urgent need for ISDA to devise special close-out netting and set-off rules, which would have to override national property and insolvency laws, for the winding up of outstanding derivatives positions in the event of institutional default or financial distress, means that ISDA’s rule-making function must be brought under some form of international public interest oversight. Already most rules promulgated by ISDA, although of a private law nature, almost always become de facto and very often de jure (as they are followed by implementing national legislation) binding in most major market jurisdictions. Thus, bringing ISDA’s rule-making function under some kind of global public interest oversight should be seen as a desirable inevitability.

This has already happened in the case of the International Accounting Standards Board (IASB) which promulgates International Financial Reporting Standards (formerly International Accounting Standards). In the aftermath of the Enron crisis, the standard setting committees of the International Federation of Accountants, including the IASB, came under the oversight of the Public Interest Oversight Board whose ten members are nominated by the International Organization of Securities Commissions, the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors, the World Bank, and the European Commission.

Arguably, instead of establishing yet another bureaucracy, international public oversight of ISDA’s rule-making function could be provided by the new Financial Stability Board (FSB) (formerly the Financial Stability Forum), although such a move would go much further than what was agreed in April’s G20 summit as to the remit of the revamped FSB. This solution would also mean that the body with the greatest involvement in maintaining global financial stability would have direct involvement, information, and knowledge about new financial instruments allowing it to assess the ramifications of their use in terms of systemic stability. Moreover, given that the FSB is supposed to be less subservient to the interests of domestic financial services industries than many of the mighty national regulators comprising its membership, FSB’s involvement could ensure a certain level of impartiality and avoidance of regulatory capture.

Concluding Remarks
Giving serious consideration to the concurrent implementation of all of the three remedies suggested above would also mean no further intervention in the process of financial innovation. Ideally, following this, the derivatives industry, arguably, the most creative segment of global financial markets would turn its considerable brainpower to finding solutions to pressing global welfare issues, such as the matter of perfecting a variety of derivatives insuring against bad harvests, unemployment, sudden financial hardship, and so forth. Innovative financial instruments and structured finance can indeed provide welfare enhancing solutions in these areas that could make a dramatic difference.

Naturally, most of the above sounds like a pipedream, but as Johan Wolfgang Goethe is famously quoted to have said, “[we should] dream no small dreams for they have no power to move the hearts of men.” While the financial rewards are not as promising, the pursuit of big goals that look like “dreams” is exactly what the global financial services industry needs right now to help it reclaim its legitimacy. And there is no worthier goal than assisting in economic development and poverty eradication through the use of human creativity and talent, both of which the financial sector can supply in abundance.


[1] The Governor of the BoE said in his Mansion House Speech: “It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure.” See “Mervyn King Presses His Case to Limit Size of Banks,” The Times, June 18, 2009, available at