A New Foundation for OTC Derivatives?

We must build a new foundation for financial regulation and supervision that is simpler and more effectively enforced, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial markets.
- Financial Regulatory Reform – A New Foundation: Rebuilding Financial Supervision and Regulation (a paper published by the United States Department of the Treasury)

Everything new must have its roots in what was before.
- Moses and Monotheism (Sigmund Freud) 

Introduction
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.

Conclusion
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?

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  [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, https://www.isdadocs.org/speeches/pdf/ISDA-Response-to-Turner-Review-and-DP092.pdf