Governing Financial Markets: Regulating Conflicts

• Publication year: 2021

GOVERNING FINANCIAL MARKETS: REGULATING CONFLICTS

Kristin N. Johnson(fn*)

Abstract: Payment, clearing, and settlement systems constitute a central component in the infrastructure of financial markets. These businesses provide channels for executing the largest and smallest commercial transactions in local, national, and international financial markets. Notwithstanding this significant role, there is a dearth of legal scholarship exploring central clearing counterparties (CCPs) and their contributions to the regulation of financial markets. To address this gap in the literature, this Article sketches the contours of the theory that frames regulation within financial institutions and across financial markets, examines the merits of implementing CCPs, and explores the role of CCPs as primary regulators within financial markets. Applying these theoretical constructs to a practical issue, this Article analyzes Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the statute's introduction of mandatory clearing requirements in the over-the-counter (OTC) derivatives market.

This Article advances several arguments that explore the merits of Title Vll's clearing mandate. First, this Article posits that introducing clearing requirements and authorizing only a handful of CCPs to execute clearing obligations concentrates systemic risk concerns. Title Vll's clearing mandate endows CCPs with the authority to serve as gatekeepers. As a result, these institutions become critical, first-line-of-defense regulators, managing risk within the OTC derivatives markets. Second, weak internal governance policies at CCPs raise noteworthy systemic risk concerns. CCP boards of directors face persistent and pernicious conflicts of interest that impede objective risk oversight, and thus may fail to adopt effective risk management oversight policies. Well-tailored corporate governance reforms are necessary to address these conflicts and to prevent CCP owners' self-interested commercial incentives or other institutional constraints from triggering systemic risk concerns.

Finally, this Article deconstructs the theory of self-regulation that characterizes financial markets regulation. After reviewing the benefits and weaknesses of the self-regulatory approach, this Article explores the emerging New Governance paradigm. Drawing from the New Governance literature and internal corporate governance reforms employed by venture capital and private equity firms, regulators, and federal prosecutors, this Article proposes that regulators appoint an independent, third party board observer or monitor to CCPs' board of directors. The appointed board observer or monitor will endeavor to ensure the safety and soundness of CCPs' risk-management decisions and that their risk-taking decisions are consistent with the public's interest in mitigating systemic risk concerns.

INTRODUCTION................................................................................187

I. ECONOMIC ORGANIZATION THEORY PROMOTES THE DEVELOPMENT OF SPECIALIZED FIRMS............................ 193

A. The Theory of the Firm Reveals the Contours of Allocational Efficiency........................................................194

B. Production Decisions Require Firms to Evaluate Transaction Costs and Agency Costs...................................196

C. Industries Endow Specialized Firms with Property Rights.. 198

D. Self-Regulating Organizations Illustrate the Development of Specialized Firms in Financial Markets........................... 199

1. Financial Markets Employ a Self-Regulatory Framework................................................................201

2. The Dynamic of Clearinghouse and Exchange Ownership Evolves from Cooperative to

Corporate..................................................................204

II. MITIGATING SYSTEMIC RISKS REQUIRES REGULATING OTC DERIVATIVES MARKETS.....................207

A. The Complexity of Financial Innovation and the Severity of the Crisis..........................................................................208

B. Dodd-Frank Introduces Mandatory Clearing.......................215

1. Anti-competitive Incentives Will Limit Access to Clearinghouse Membership ...................................... 222

2. Anti-competitive Incentives Will Limit Clearing Eligibility .................................................................. 224

3. Weak Clearinghouse Governance Creates Moral Hazard, Risk Management, and Systemic Risk Concerns ................................................................... 225

C. The Dodd Frank Act Imposes Federal Corporate Governance Reforms............................................................ 229

III. SELF-REGULATION ADDRESSES SOME CONFLICTS AND EXACERBATES OTHERS................................................233

A. Regulatory Theories Fall Along a Continuum..................... 233

B. New Governance Proposes a New Vision of Self-Regulation ............................................................................ 235

IV. PROSECUTORS AND PRIVATE MARKETS SUGGEST AN ALTERNATIVE TO TRADITIONAL SELF-GOVERNANCE ........................................................................... 238

A. Board Monitors or Board Observers Ensure Compliance with Federal Regulations.....................................................239

B. Evaluating Monitors and Observers' Performance Poses a Challenge...........................................................................241

CONCLUSION....................................................................................243

INTRODUCTION

Should bankers regulate bankers?(fn1) For more than two centuries, legislators, academics, and commentators have passionately debated the promise and the peril of permitting financial intermediaries(fn2) to regulate their own activities.(fn3) ln recent years, an escalating scandal involving a critical interest rate benchmark has revived the self-regulation debate.(fn4)

ln early 2008, investigative journalists released reports alleging that commercial banks manipulated the calculation of the London lnterbank Offered Rate (LlBOR)-one of the world's most significant interest rate benchmarks.(fn5) The British Bankers' Association (BBA), a prestigious international banking organization, developed LlBOR in the 1980s to offer member banks a comprehensive view of the rates at which banks borrow funds from other banks.(fn6) BBA member banks and market participants around the world now utilize LIBOR to decide the rates that they will apply to various domestic and international financial arrangements, including syndicated corporate loans and foreign exchange transactions.(fn7)

Financial markets have integrated LIBOR into more than $500 trillion of corporate and consumer loans-student loans, home mortgages, automobile financing arrangements-and sophisticated derivatives transactions.(fn8) For example, LIBOR influences the interest rates applied to more than half of variable rate private student loans.(fn9) Consequently, LIBOR impacts access to credit for millions of consumers and businesses.(fn10)

British and American investigations revealed that bank traders colluded to distort the international interest rate benchmark.(fn11) Evidence suggests that the securities, commodities, and foreign exchange traders who were employees of BBA member banks intentionally misreported information solicited by the BBA to determine LlBOR.(fn12) By manipulating borrowing and lending rates, these traders buttressed their firms' profits on structured derivatives products,(fn13) limited losses on their firms' trading positions,(fn14) and created the appearance that their firms had reduced their exposure to commercial risks.(fn15)

A pernicious and persistent tension plagues self-regulatory organizations (SROs) such as the BBA. SROs have unique expertise and sophistication. They frequently adopt and implement industry standards that enhance efficiency and organization within specific sectors of financial markets. Similar to other SROs, within the BBA internal committees establish and enforce rules governing member banks' activities. SROs are unencumbered by the bureaucratic processes that stymie government regulators' rule-making efforts and, when members violate community standards, SROs may act promptly to enforce their rules.

The BBA exemplifies the benefits and concerns that SROs create in financial markets. Prior to the rate-fixing scandal, commentators celebrated the BBA for developing an international interest rate benchmark.(fn16) LlBOR offers a critical tool that reduces transaction costs and mitigates information asymmetries in the calculation of lending rates.(fn17)

BBA member banks' manipulation of LlBOR, however, illustrates the intransigent conflicts of interest that plague self-governing financial institutions. Members' incentives frequently diverge from SROs' regulatory objectives. In an effort to increase profits or to avoid losses, members may disregard an SRO's regulatory policies and violate the trade organization's rules. In the absence of policies that effectively mitigate members' conflicts of interest, self-serving behavior may lead to regulatory failures, creating significant costs, triggering market disruptions, and leading to harmful spillover effects that impact the global economy.(fn18) Market participants' manipulation of LIBOR, for example, continued...