Regulating the invisible: the case of over-the-counter derivatives.

• Author: Baker, Colleen M.

In this Article, I focus on the regulation of the over-the-counter (OTC) derivative markets. I argue that current reform proposals and draft legislation fall short of constructing the linked domestic and international frameworks needed to successfully regulate the OTC derivative markets. The purpose of my Article is to propose and defend such a framework. Because of the inseparability of the domestic and international aspects of this issue, I argue that in addition to increased prudential supervision and regulation, the regulation of OTC derivative markets requires interwoven domestic and international systems for regulatory cooperation. This recommendation has two parts. First, Congress should create a framework of regulatory cooperation between the SEC and the CFTC through a regulatory joint venture. Second, I argue for an international framework of regulatory cooperation using a system of public-private partnerships to coordinate regulation of OTC derivatives in the global marketplace.

INTRODUCTION I. SKETCH OF THE OVER-THE-COUNTER DERIVATIVE MARKETS . A. Background B. An Overview of the Benefits and Costs of Using OTC Derivatives 1. Benefits 2. Costs II. CURRENT REGULATORY SCHEME AND CHALLENGES A. Current Regulatory Scheme 1. A Brief History 2. Description of the Current Regulatory Scheme B. Intractable Regulatory Challenges 1. Globalized Financial Markets 2. Financial Engineering and Innovation III. THE CONTENDERS: COMPETING REGULATORY PARADIGMS, PROPOSALS, AND INSTITUTIONS A. Contending Regulatory Paradigms B. Contending Regulatory Reforms C. Contending Regulatory Institutions IV. FRAMEWORKS OF COOPERATION: DOMESTIC AND INTERNATIONAL APPROACHES TO INCREASE REGULATION OF THE OTC DERIVATIVE MARKETS A. Domestic Frameworks of Cooperation: An SEC-CFFC Joint Regulatory Venture: The Derivatives Supervision Initiative 1. The DSI and Financial Regulatory Reform 2. The SEC and CFTC's Joint Report and Current Reform Proposals 3. The DSI: A Sketch 4. The DSI: Potential Objections B. International Frameworks of Cooperation 1. Background Descriptions 2. The Problem of Transaction Cost 3. Theoretical Background 4. Model of International Public-Private Governance Partnerships C. Linked Domestic and International Frameworks of Cooperation D. Extensions of Domestic and International Frameworks of Cooperation CONCLUSION INTRODUCTION

Mark Twain once said, "Everyone talks about the weather but nobody does anything about it." (1) The same can be said for one of the most famous--or infamous--of the financial products that were at the epicenter of the 2008-09 financial crisis: so-called "derivatives." In 1998, Robert Rubin, then U.S. Treasury Secretary, joined with Alan Greenspan, then Chairman of the Federal Reserve Board and Arthur Levitt, then Securities and Exchange Commission (SEC) Chairman, (2) to caution against a proposed "Concept Release" issued earlier that day (3) by Brooksley Born, then Chairperson of the Commodity Futures Trading Commission (CFTC), urging the regulation of the over-the-counter (OTC) derivative markets. (4) And even now, in the wake of a global financial disaster that many blame primarily on a host of exotic unregulated "invisible" financial instruments such as OTC credit default swaps (CDS), there is strong opposition to imposing restrictions on these markets. As one Congressman recently cautioned, "if Congress overreaches ... there could be very significant negative implications on how companies manage risk." (5) In addition, "[a]t least 42 nonfinancial companies and trade associations are lobbying Congress on derivatives" (6) and "[m]ore than 160 of Europe's largest companies have swung behind efforts to persuade regulators to exempt corporate users of over-the-counter derivatives from tough new regulations." (7) Several of the former companies argue that the ultimate stakes include the health of American businesses and the prices consumers pay for all types of products, presumably including even Post-It Notes. (8) And that does not even count the opposition of firms in the financial sector itself, most of which strongly oppose increased regulation. As some financial experts explain, OTC derivatives are the "last remaining source of supra-normal profits" (9) for the "world's largest banks." (10)

This Article will argue that it is time to prove Mark Twain wrong and actually do something about derivative markets--specifically those traded OTC. A flurry of reform proposals and draft legislation in Congress has arisen in response to the financial crisis. Individually and in common, they advocate many important changes in both prudential supervision (11) and regulation such as increases in transparency, disclosure, capital, and margin requirements (altogether, regulatory reforms) for OTC derivatives that are not cleared by a central counterparty (CCP) clearinghouse, in addition to CCP clearing of standardized OTC derivatives. But they generally share at least three major shortcomings. First, they advocate splitting regulation of OTC derivatives between the SEC and CFTC on a product basis. This solution has already been proven to be highly problematic. Second, they advocate mandated CCP clearing for "standardized" OTC derivatives. (12) This division between standardized and nonstandardized derivative products has not only failed in the past, but also arguably incentivized the creation of the OTC derivative products that have caused some of the biggest problems. (13) Third, they do not seriously address the international aspects of domestic regulations addressing these global markets. As one commentator has noted, "all of these efforts [at regulatory reform] leave unresolved a critical problem--that is, the regulatory arbitrage that will be created by a U.S. regulatory regime that is different from that continuing or established in other jurisdictions." (14) And as Professor Joseph Norton notes, there are "enormous opportunities for regulatory arbitrage and regulatory jurisdictional ambiguities existing at the international level." (15)

In sum, current reform proposals and draft legislation fall short of constructing the linked domestic and international framework needed to successfully regulate the OTC derivative markets. The purpose of this Article is to propose and defend such a framework. (16) Because of the inseparability of the domestic and international aspects of this issue, I argue that in addition to commonly proposed regulatory reforms, the regulation of OTC derivative markets requires interwoven domestic and international systems for regulatory cooperation. This recommendation has two parts. First, Congress should create a framework of regulatory cooperation between the SEC and the CFTC through a regulatory joint venture. Second, I argue for an international framework of regulatory cooperation using a system of public-private partnerships to coordinate regulation of OTC derivatives in the global market.

The time is right for thoughtful action in this long-deferred regulatory field. Many leaders who counseled caution in the 1990s have changed their tunes. For example, Robert Rubin now predicts that "'[i]n some form it [OTC derivatives regulation] will happen.'" (17) And Alan Greenspan has famously acknowledged that he "'made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.'" (18) While this Article does not claim, as do some proponents of increased regulation of OTC derivative markets, that the stability of the entire global financial system hinges on blanket regulation of these instruments, it does argue that additional regulatory measures will add much-needed transparency and an important degree of protection from systemic risk that is currently lacking in the OTC derivatives area.

Legal scholarship concerning the regulation of the OTC derivative markets has been almost as sparse as the regulation itself. (19) This is unfortunate since much scholarship in financial economics focuses on this area, but as legal scholars and a host of others--including Queen Elizabeth (20)--note, this financial crisis took most economists by surprise. (21) Perhaps the economists can be forgiven as legal scholars such as Lynn Stout argue that "the roots of the catastrophe lay not in changes in the markets, but changes in the law.... It was the deregulation of financial derivatives that brought the banking system to its knees." (22) Professor of finance Darrell Duffle notes that derivative markets "exacerbated" the financial crisis. (23) In recent congressional testimony, Stout argued that derivatives "may provide some economic benefit," but cautioned that "no empirical evidence" supports claims of the "substantial" social benefit of these instruments. (24) In another congressional hearing, however, Professor Christian Johnson cautioned Congress to focus on the "practicalities and complexities" of regulating the OTC derivative markets and to understand "the need to proceed carefully in order to preserve U.S. leadership in the world's capital markets." (25) As Congress and major financial regulators such as the SEC, CFTC, and Federal Reserve Board begin to revisit the question of regulating the OTC derivative markets, legal scholarship can also contribute to this conversation. This Article seeks to do that.

In Part I, I provide necessary background for my thesis by discussing the myriad of participants, instruments, and transacting practices in the OTC derivative markets. Part II explains the current regulatory framework surrounding OTC derivatives. I also explain a bit of the history behind this minimal and inadequate regulatory structure. I end this Part by addressing whether any justification for government regulation of these markets even exists. Part III treats what I term the "regulatory contenders," the regulatory paradigms, reform...