Helpful Hints for the New Derivatives Regulators

Disclaimer: The views expressed here are solely those of the author and do not necessarily reflect the views of the Linklaters LLP.  

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 (The Section 3(a)(2) Exemption for Equity Index-Linked Notes), 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 was 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 interim 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. These are 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 therefore 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, though 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.

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[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 http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom/