Credit derivatives: Industry initiative supplants need for direct regulatory intervention - A model for the future of U.S. regulation?

Buffalo Law Review

Volumn 55, Issue 4, 2008, Pages 1371-1442

  Lynch, John T ^a  

^a UNIVERSITY AT BUFFALO   (United States)

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EID: 40749110277     PISSN: 00239356     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Note

References (389)

1. This Comment assumes some knowledge of derivative financial instruments, and therefore, some of the terminology in that market will not be defined. For a comprehensive introduction to derivatives, see MICHAEL DURBIN, ALL ABOUT DERIVATIVES (2006).
2. "A derivatives transaction is a contract whose value depends on (or 'derives' from) the value of an underlying asset, reference rate, or index." GROUP OF THIRTY, DERIVATIVES: PRACTICES & PRINCIPLES 2 (July 1993). "Underlyings can be anything that interests markets: cash instruments, like stocks and bonds; tangibles, like commodities; or intangibles, like interest rates, currency rates, stock market indices and credit quality."
3. Norman Menachem Feder, Deconstructing Over-The-Counter Derivatives, 2002 COLUM. BUS. L. REV. 677, 681.
4. DURBIN, supra note 1, at 1.
5. A User's Guide to Derivatives, FIN. TIMES (London), Nov. 18, 2006, at 19 (giving a quick snapshot of the various derivatives markets, including interest rate derivatives, foreign exchange derivatives, credit derivatives, equity derivatives, and commodity derivatives).
6. See Feder, supra note 2, at 681 ("Derivatives . . . are hard to define because they vary widely in content and application.");
7. cf. Saul S. Cohen, The Challenge of Derivatives, 63 FORDHAM L. REV. 1993, 1994 (1995) (stating that derivatives are constantly evolving).
8. For a history of derivatives, going back to 2000 B.C., and the development of derivatives in the U.S., see Jerry W. Markham, "Confederate Bonds," "General Custer," and the Regulation of Derivative Financial Instruments, 25 SETON HALL L. REV. 1 (1994).
9. It should be noted that not all financial professionals embrace derivatives. See, e.g., Letter from Warren Buffet, Chairman, Berkshire Hathaway, Inc., to Shareholders, at 15 (Feb. 21, 2003), available at http://www.berkshirehathaway.com/letters/2002pdf.pdf ("[Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.").
10. But see, recently, Letter from Warren Buffet, Chairman, Berkshire Hathaway, Inc., to Shareholders, at 17 (Feb. 28, 2007), available at http://www.berkshirehathaway.com/letters/2006ltr.pdf: I should mention that all of the direct currency profits we have realized have come from forward contracts, which are derivatives, and that we have entered into other types of derivatives contracts as well.... Why, you may wonder, are we fooling around with such potentially toxic material? The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts-few in number but sometimes for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are free of counterparty credit risk. So far, these derivative contracts have worked out well for us, producing pre-tax profits in the hundreds of millions of dollars (above and beyond the gains I've itemized from forward foreign-exchange contracts). Though we will experience losses from time to time, we are likely to continue to earn-overall-significant profits from mispriced derivatives.
11. It is important to remember that derivatives do not eliminate the risk of the initial investment, they just reposition it, i.e., lay it off onto another party, allowing the risk to be spread out and reducing each party's exposure to a level that they are comfortable undertaking. See Feder, supra note 2, at 683 ("[Derivatives do not eliminate underlying risk; they only reposition it.").
12. For example, if an investor believed that stock of company XYZ was going to go up in value over the next year, he could either (1) buy the stock and hold it for a year until it appreciated in value; (2) enter into a forward contract for that stock, whereby he agrees to buy some amount of the stock in one year at some designated price (presumably less than he thinks it is going be at that time); (3) if that stock is traded on a futures exchange, enter into a futures contract for that stock (the primary differences between a futures contract and a forward contract is that the futures contract is standardized and set up at established amounts and intervals, and the transaction takes place on an exchange rather than being negotiated bilaterally); or (4) enter into a long options contract, whereby in exchange for paying a premium, he has the option of buying some amount of that stock at some designated price at some specified time in the future (options are traded on exchanges and bilaterally). These methods are all speculating, but the latter three choices employ simple derivatives to achieve the same result as choice (1) without having to own the stock, thereby leveraging a smaller amount of outlay to achieve the same results.
13. DURBIN, supra note 1, at 5.
14. In this section, estimates for the notional amounts outstanding in the exchange-traded and over-the-counter markets are given. However, it should be noted that estimating notional amounts of the markets overstates the risk exposure of the markets since parties hedge positions by taking offsetting positions in other transactions, thereby increasing the notional value of the market, but reducing the market's true exposure to risk.
15. The latest report from the Bank for International Settlements (BIS) estimates that the total global outstanding notional principal amount of exchange-traded futures is almost $31.7 trillion. BANK FOR INT'L SETTLEMENT, QUARTERLY REVIEW, at A 108 (Sept. 2007), available at http://www.bis.org/publ/qtrpdf/r_qa0709.pdf.
16. The BIS estimates the total global outstanding notional principal amount of exchange-traded options is almost $65 trillion. Id.
17. The BIS estimates the total OTC notional amounts outstanding as almost $415 trillion. Id. at app. 103 (Table 19: Amounts outstanding of over-the-counter (OTC) derivatives).
18. Pub. L. No. 106-554, 114 Stat. 2763 (Dec. 21, 2000) (codified as amended in scattered sections of 7 U.S.C).
19. Commodity Exchange Act of 1936, ch. 545, 49 Stat. 1491 (codified as amended in scattered sections of 7 U.S.C).
20. See Securities Act of 1933, 15 U.S.C. § 77(a)-(aa) (2000); Securities Exchange Act of 1934, 15 U.S.C. § 78(a)-(o) (2000). The other laws governing the regulation of the securities markets grew out of these laws. See, e.g., Investment Company Act of 1940, 15 U.S.C. § 80(a)(1)-(64) (2000); Investment Advisors Act of 1940, 15 U.S.C. § 80(b)(1)-(21) (2000).
21. See Jerry W. Markham, Super Regulator: A Comparative Analysis of Securities and Derivatives Regulation in the United States, the United Kingdom and Japan, 28 BROOK. J. INT'L L. 319, 338-40 (2003).
22. Prices would skyrocket during the off-season, when the supply of crops was low, but then those prices would plummet after the crops were harvested when the market was flooded with that year's supply. See WILLIAM CRONON, NATURE'S METROPOLIS: CHICAGO AND THE GREAT WEST 123-25 (1991). Forwards and futures developed to stabilize these prices for commodities like crops.
23. See CHICAGO BD. OF TRADE, COMMODITY TRAINING MANUAL 3-4 (1982).
24. In fact, the enforceability of OTC derivative transactions and swaps was not even certain until the Futures Trading Practices Act (FTPA) of 1992, which amended the Commodity Exchange Act. Pub. L. No. 102-546, 106 Stat. 3590. In the FTPA, Congress provided that transactions by certain "appropriate persons" (e.g., institutional traders) could be exempt from the exchange trading requirement of the CEA. For a discussion of the exemptive provisions of the FTPA, see Markham, supra note 6, at 22.
25. See 7 U.S.C. §§ 6, 6h. For a discussion of the problems created by creating an exchange market monopoly
26. see Jerry W. Markham, The Commodity Exchange Monopoly-Reform is Needed, 48 WASH. & LEE L. REV. 977 (1991).
27. Pub. L. No. 93-463, 88 Stat. 1389 (1974).
28. Hybrid instruments contained elements of futures, options and securities, thus sparking jurisdictional confusion as to who should be able to regulate this market: the SEC or CFTC. For a discussion of these jurisdictional problems, see Jerry W. Markham, Regulation of Hybrid Instruments Under the Commodity Exchange Act: A Call for Alternatives, 1990 COLUM. BUS. L. REV. 1 (1990). Further compounding the problem of CFTC regulatory jurisdiction was the Treasury Amendment to the CEA, which stated that the CEA did not govern or apply to an agreement, contract, or transaction in foreign currency; security warrants, security rights, re-sales of installment loan contracts, re-purchase options, government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sales thereof for future delivery conducted on an organized exchange. 7 U.S.C. § 2(c) (2000). For a discussion of the jurisdictional and interpretative difficulties surrounding the Treasury amendment
29. see Markham, supra note 6, at 17-21.
30. The CFTC proposed regulations that were the prelude to the regulatory framework that Congress adopted in the CFMA, which included exempting swap transactions and creating a tiered regulatory framework. See A New Regulatory Framework for Multilateral Transaction Execution Facilities, Intermediaries and Clearing, 65 Fed. Reg. 77962 (Dec. 13, 2000) (to be codified at 17 C.F.R. pts. 1,5,15,36-38,100,170,180);
31. see also JERRY W. MARKHAM, 13A COMMODITIES REG. § 27:12:1 (2002).
32. A New Regulatory Framework for Multilateral Transaction Execution Facilities, Intermediaries and Clearing, 66 Fed. Reg. 42256 (Aug. 10, 2001) (to be codified at 17 C.F.R. pts. 1,5,15,36-38,40,41,100,170,180).
33. The 2000 CFMA established a set of "core principles" that contract markets would have to abide; it was meant to open up competition by eliminating prescriptive rules. CFTC Reauthorization to Dominate 200: Security Futures, Energy Likely Topics, 37 Sec. Reg. & L. Rep. (BNA) No. 2, at 72 (Jan. 10, 2005). "Other highlights of the act were the establishment of security futures products and a unique regulatory structure to oversee them, the assurance of legal certainty for derivatives products and a sliding scale of oversight for contract markets that depended on the level of sophistication of the participants."
34. Id.
35. CFMA § 2 (Purposes of CFMA).
36. Walt Lukken, CFTC Comm'r, Address at the ISDA Energy, Commodities and Developing Products Conference: The Derivatives World is Flat (June 14, 2006), available at http://www.cftc.gov/opa/speeches06/opalukken-20.htm.
37. See Dean Kloner, The Commodity Futures Modernization Act of 2000, 29 SEC. REG. L. J. 286, 286 (2001) (explaining the key provisions of the CFMA that apply to the derivatives markets).
38. Eligible Contract Participants broadly means that the party must be a large sophisticated institution or a wealthy individual. For a detailed explanation of Eligible Contract Participant, see CFMA, section 101 (Definitions). Excluded commodities are interest rates, exchange rates, currencies, securities, securities indices, credit risks and measures such as inflation and other indices based solely on commodities that have no cash market or on prices or values not within the control of any party to the transaction. Exempt commodities are all commodities that are not "excluded" and not agricultural commodities, such as metals and energy products. See Markham, supra note 23.
39. See CFMA, Title III.
40. Kloner, supra note 29, at 287.
41. Single stock futures had been prohibited under the Shad-Johnson Accords, an agreement between the SEC and CFTC made in 1982, and later codified by Congress, during the jurisdictional disputes between the two commissions. Pub. L. No. 97-303, 96 stat. 1409 (1982). For a discussion of the Shad-Johnson Accords, see Don L. Horwitz & Jerry W. Markham, Sunset on the Commodity Futures Trading Commission: Scene II, 39 BUS. LAW. 67, 72-76 (1983).
42. See Markham, supra note 24, at § 28:3.
43. Id. The Chicago Board of Trade and the Chicago Mercantile Exchange were once the predominant exchanges for futures, but the Eurex exchange and even newer exchanges like the Intercontinental Exchange (ICE) were able to undercut the American markets by adopting electronic trading while the CBOT and CME remained steadfastly tied to the trading floors. "Like the American car manufacturers in the 1970s, the exchanges and their members saw their volume being eroded by more nimble competitors, but refused to compete, preferring shelter in their dwindling market share to the risks of competition."
44. Id.
45. Markham, supra note 6, at 2 n. 6 (citing CONG. RESEARCH SERV., SUBCOMM. ON TELECOMM. & FINANCE OF THE HOUSE COMM. ON ENERGY & COMMERCE, 103D CONG., REP. ON DERIVATIVE FIN. MKTS. 13-17 (Comm. Print 1993)).
46. It is important to note that the OTC derivatives market is not unregulated, but rather, "[o]ne of the major reasons behind the exclusion of OTC derivatives from [the CFTC's] jurisdiction was the fact that other Federal regulators were already overseeing many of the entities trading these products." Lukken, supra note 28. The sophisticated institutions that deal in OTC derivatives are large banks and firms that are regulated by the Federal Reserve Bank, the SEC and other regulatory agencies; it is only the OTC derivative transactions themselves that do not have a separate regulatory agency.
47. U.S. GOV'T ACCOUNTABILITY OFFICE, CREDIT DERIVATIVES: CONFIRMATION BACKLOGS INCREASED DEALERS' OPERATIONAL RISK, BUT WERE SUCCESSFULLY ADDRESSED AFTER JOINT REGULATORY ACTION, 10-11 (June 2007), available at http://www.gao.gov/new.items/d07716.pdf [hereinafter GAO REPORT].
48. The GAO was asked by Congress to review the causes of the confirmation backlogs and the steps U.S. financial regulators were taking to address the issue. Id. at 2. The GAO analyzed credit derivatives market data, conducted interviews of industry groups, market participants and regulators in Charlotte, N. Carolina; Chicago; New York; and Washington, D.C from August 2006 to March 2007.
49. Id. at 2-3.
50. Jenny Anderson, Calm Before and During a Storm: Derivatives May Put the New York Fed Chief Through a Stress Test, N.Y. TIMES, Feb. 9, 2007, at C1 (discussing Federal Reserve Bank of New York president Timothy Geithner, and the success of the initiative in the credit derivatives market).
51. INT'L SWAPS & DERIVATIVE ASS'N, INC. 2006 YEAR-END MKT. SURVEY, http://isda.org (follow "Surveys & Market Statistics" hyperlink; then follow "Summaries of Market Survey Results" hyperlink). This survey monitors credit default swaps on single-name references, baskets, and portfolios of credit and index trades. Credit default swaps make up the overwhelming majority of credit derivative instrument, see infra note 52. Credit default swaps are discussed and explained, infra, in the text accompanying notes 52-58.
52. INT'L SWAPS & DERIVATIVE ASS'N, INC. 2002 YEAR-END MKT. SURVEY, available at http://isda.org (follow "Surveys & Market Statistics" hyperlink; then follow "Summaries of Market Survey Results" hyperlink).
53. DURBIN, supra note 1, at 62.
54. Credit derivatives are usually concerned with debt securities, specifically corporate or sovereign bonds. See id.;
55. Feder, supra note 2, at 707.
56. For a discussion of the other types of risk, including, market, liquidity, operational, legal and systemic risks, see Feder, supra note 2, at 721-31.
57. Anderson, supra note 39, at C1.
58. As Durbin points out, this begs the question of how you can be sure that the protection seller will not default. Thus, in reality you have just substituted one credit risk for another. DURBIN, supra note 1, at 63 n.1.
59. While the parties are free to determine what will constitute a credit event for their transaction, there are five standard credit events defined by the ISDA: bankruptcy, failure to pay, obligation default, obligation acceleration and restructuring. "Bankruptcy involves seeking court protection against creditors when a company can't pay its bills, failure to pay is essentially like missing a payment on a car loan, obligation default is when the lender declares the borrower in violation of payment terms and demands return of the principal, obligation acceleration is when the terms of a debt call for immediate payment of some or all of a debt 'ahead of schedule' as a result of some issue, and restructuring is a broad event that includes things like debt consolidation." Id. at 65.
60. CRMPG II REPORT, infra note 87, at app. A-3.
61. Feder, supra note 2, at 707.
62. DURBIN, supra note 1, at 62-63.
63. "The diversity of the range of credit derivatives products continues to expand and since the first BBA survey was published in 1996, the market has risen exponentially." Press Release, British Bankers' Ass'n, Credit Derivatives Market Expected to Reach $33 Trillion by End of 2008 (Sept. 21, 2006) (quoting Ian Mullen, Chief Executive of the BBA).
64. Some authorities estimate that credit default swaps make up ninety-five percent of the credit derivatives market. Credit Derivatives Market Swells to $26 Trillion in Year, Association Says, 38 Sec. Reg. & L. Rep. (BNA) No. 38, at 1590 (Sept. 25, 2006).
65. See supra note 47 for an explanation of common credit events.
66. DURBIN, supra note 1, at 64. Large financial institutions are often also holders of corporate and sovereign bonds.
67. th" (depending on the terms of the contract) reference entity in the portfolio experiences a credit event. This type of CDS is cheaper than buying a single-name CDS on each reference entity. See Donald A. Bendernagel, Common Derivatives and Their Uses: Credit Derivatives, 1559 PLI CORP. 85, 98-101 (2006).
68. In exchange for a premium, the "CDS option" or "Credit Default Swaption" creates the right to buy or sell a CDS on a reference entity in the future at a predetermined price. The buyer would enter into a CDS option if it believes that the cost of a CDS on a reference entity will increase, thereby enabling the buyer to buy protection at a lower price than the market is trading for in the future, allowing the buyer to simultaneously sell protection at the higher market price and pocket the difference (minus the premium paid for the option). A seller would take the view that the cost of protection for a reference entity will decrease, thereby locking in that higher price for the cost of the premium. See id. at 113.
69. An index linked CDS is an extremely liquid instrument that is like buying a CDS on each reference entity that composes the index all at once. An example is the Dow Jones CDX.IG, which is composed of 125 reference entities. The instrument is so liquid because of the diversity of the entities that compose the index, which enables the index-linked CDS to be an effective hedge for many positions. See id. at 112.
70. A "binary CDS" or "digital CDS" is where the protection buyer receives a specified fixed payment from the protection seller upon the occurrence of a credit event by the reference entity, rather than the seller compensating the buyer for the actual loss suffered, or having to pay the buyer par value for the reference obligation. See DURBIN, supra note 1, at 69; Bendernagel, supra note 55, at 114 (describing fixed recovery swaps).
71. This description of a total return swap is based on the explanation provided in DURBIN, supra note 1, at 66-68.
72. Id. at 68-69.
73. This description of CDOs is summary in nature, for a more comprehensive explanation, see Gary Barnett, Understanding CDOs, 891 PLI COMMODITIES 769 (2006);
74. Bendernagel, supra note 55, at 102-05.
75. While the TARN and CPPI investment strategies have been around for a while, they are becoming more prevalent and more widely applied as derivatives markets expand the base of positions to which they can be applied.
76. This description is based on the CRMPG II REPORT, infra note 87, at A-38.
77. This description is based on id. at A-39.
78. See also bfinance, Constant Proportion Portfolio Insurance (CPPI) 101, http://www.bfinance.co.uk/inst/article.do?serieId=1&docid=N12309 (last visited Feb. 20, 2007).
79. This is a type of structured credit product introduced in 2006; it is discussed briefly to show the constant innovation in the credit derivatives market. See Paul Davies, Questions lie behind CPDO hype: The new kid on the block has made a big impact, but investors should take a long look before they leap, FIN. TIMES, NOV. 14, 2006, at 43 (discussing the impact of CPDOs on the credit market). Such innovation is a constant attempt to more efficiently allocate risk, and may not be possible if the market was directly regulated, as discussed infra.
80. LIBOR refers to the London Inter Bank Offer Rate, an interest rate that is published daily and commonly used as a reference rate in derivatives and other financial instruments. And, "bp" refers to basis point, i.e., 1/100th of a percent.
81. This brief discussion of CPDOs in the preceding two paragraphs relied on information found at: CITIGROUP, CORPORATE AND INVESTMENT BANKING, CPDOs THE NEW BEST SELLER? (NOV. 10, 2006) available at http://www.nuclearphynance.com/User%20Files/464/Citi_cpdos%20%20tb. e%20new%20best%20seller.pdf (giving a comprehensive discussion of CPDOs);
82. Davies, supra note 65, at 43 (giving a brief description of CPDO mechanics). However, there has been some controversy regarding the AAA ratings that some CPDOs, especially early ones, received from ratings agencies.
83. See Paul J. Davies, Fitch Criticizes Ratings of CPDOs, FIN. TIMES, Apr. 18, 2007, at 39.
84. See text accompanying supra notes 39-41.
85. The FSA is the United Kingdom financial markets' regulatory body, it "is an independent non-governmental body, given statutory powers by the Financial Services and Markets Act of 2000 .... The FSA is accountable to the Treasury Ministers, and through them to Parliament. It is operationally independent of Government, and is funded entirely by the firms it regulates. See Fin. Servs. Auth., Who are we, http://www.fsa.gov.uk/Pages/About/Who/ index.shtml (last visited Feb. 1, 2007).
86. Letter from Gay Huey Evans, Dir., Mkt. Servs. Div., Fin. Servs. Auth., to CEOs (Feb. 2005), available at http://www.fsa.gov.uk/pubs/ceo/ derivatives_22feb05.pdf [hereinafter FSA Letter].
87. "A confirmation sets out the terms and conditions of a credit derivative transaction .... While the economic terms of the transactions can be agreed upon upfront, confirmation problems can be traced back to a number of non-economic, technical issues." N. Y. Fed Said Pleased With Banks' Plan To Address Key Credit Derivatives Issues, 37 Sec. Reg. & L. Rep. (BNA) No. 40, at 1682 (Oct. 10, 2005).
88. "Confirmations serve as an internal control to verify that both parties agree to the trade terms and have accurately recorded the trade in their systems. For this reason, trades should be confirmed as soon as possible." GAO REPORT, supra note 38, at 15.
89. "Though transactions become legally binding once agreed to over the telephone, regulators are concerned that the backlog of confirmations would become an operational nightmare if credit markets were rocked by, for example, a series of corporate defaults." N.Y. Fed Hails Banks' Progress In addressing Credit Derivatives Issues, 37 Sec. Reg. & L. Rep. No. 41, at 1713 (Oct. 17, 2005).
90. FSA Letter, supra note 70.
91. Id.;
92. see also Press Release, Fin. Servs. Auth., FSA Warns Firms on OTC Credit Derivatives Administration (Feb. 22, 2005), available at http://www.fsa.gov.uk/Pages/Library/Communication/PR/2005/022.shtml.
93. FSA Letter, supra note 70.
94. Confirmations take place in the "back office," where the trades were recorded, verified and confirmed through largely manual processes. In contrast, the "front office" is where the traders and sales staff execute the deal by interacting with the customer. GAO REPORT, supra note 38, at 8.
95. Id. at 11.
96. Id. at 3.
97. "The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (LAIS) to deal with issues common to the banking, securities and insurance sectors, including the regulation of financial conglomerates. The Joint Forum is comprised of an equal number of senior bank, insurance and securities supervisors representing each supervisory constituency." Bank for Int'l Settlements, Joint Forum, http://www.bis.org/bcbs/jointforum.htm (last visited Feb. 1, 2007).
98. JOINT FORUM, CREDIT RISK TRANSFER (Mar. 2005), available at http://www.bis.org/publ/ joint13.pdf
99. [hereinafter JOINT FORUM REPORT]. It should be noted here, that while the JOINT FORUM REPORT was published in March 2005, it was circulated for comment in October 2004, and was cited as a motivating force behind the FSA Letter urging the credit derivatives market to take action to improve its infrastructure.
100. Id. at 1;
101. FSA Letter, supra note 70.
102. JOINT FORUM REPORT, supra note 79, at 1.
103. Id. at 16 (pointing out issues where the market has taken upon itself to address perceived vulnerabilities: creating a database for CDS reference entity names, developing services to support matching and confirmation, development of standardized documents, and development of voluntary standards for appropriate use of non-public information).
104. Id. at 2-3.
105. Id. at 25-29 (stressing the importance of parties conducting their own assessment of parties credit worthiness and not simply relying on external rating services, emphasizing that ratings across different types of investments do not necessarily correspond, i.e., a AAA rating for a bond differs in risk profile from a AAA rating for a credit default swap).
106. Firms should dynamically (i.e., constantly) reassess the amount of collateral required for a transaction, and not simply rely on a one-time calculation. Also, parties need to assess the correlative effects across their aggregate transactions, the possible correlations between the protection seller and reference entity, and the possible change in liquidity of contracts, especially complex products, in the face of a default buy a major market participant. Id. at 29-30.
107. Id. at 31-34. The report highlighted problems associated with corporate and debt restructuring, and the effect on corresponding credit derivative reference obligations. It also pointed out the need for greater standardization in documentation to eliminate uncertainty and misunderstandings, especially as products become more complex. The report applauded ISDA for its part in creating many of the current standardized documents in the market, and encouraged the ISDA to continue its efforts in this area.
108. Id. at 35-36. Other general recommendations included ensuring that market participants employ sufficient personnel to deal with the increasing complexity of the credit markets, and the need for supervisors and management to take an active role in ensuring the adequacy of their entity's risk management program.
109. COUNTERPARTY RISK MANAGEMENT POLICY GROUP II, TOWARD GREATER FINANCIAL STABILITY: A PRIVATE SECTOR PERSPECTIVE (July 27, 2005), available at http://www.crmpolicygroup.org/
110. [hereinafter CRMPG II REPORT]. On January 15, 2005, the organizational meeting of the Counterparty Risk Management Policy Group II (CRMPG II) was held in New York. CRMPG II is comprised of senior officials from major financial institutions and is chaired by E. Gerald Corrigan, Managing Director, Goldman Sachs [and former NY Fed president] .... The primary purpose of CRMPG II - building on the 1999 report of CRMPG I - is to examine what additional steps should be taken by the private sector to promote the efficiency, effectiveness and stability of the global financial system.
111. Id. at 1. The CRMPG I report issued in 1999 had similar objectives: improving on "(i) counterparty credit assessment, (ii) risk management, measurement and reporting, (iii) market practices, and (iv) conventions and regulatory reporting."
112. Zdenka Seiner Griswold, Counterparty Risk Management Policy Group II: OTC Documentation Practices in a Changing Risk Environment, in BROKER-DEALER REG. 177, 179 (ALI-ABA ed., 2006) (offering a comprehensive discussion of the CRMPG II REPORT, particularly as it relates to the OTC derivatives markets).
113. CRMPG II REPORT, supra note 87, at 13-40 (listing the 47 Guiding Principles and Recommendations).
114. Id. at 74-76.
115. Id. at 75.
116. See id. at 77-84, which discusses some of the automated trade matching and processing platforms available in the market, including DTCC (discussed infra notes 111-13 and accompanying text), eConfirm, SwapClear, and Swapswire, and the benefits of these developing market innovations. The ultimate goal for the market should be straight through processing, which would "reduce[ ]the number and frequency of trade disputes and maximizes market efficiency, opportunity and access. STP therefore fosters legal, credit, market and operational certainty."
117. Id. at 84. Straight through processing has been the goal for many markets seeking to eliminate the need for human intervention in processing orders and confirmations, thereby expediting and reducing the possibility of mistakes in the process.
118. The CRMPG II cited approvingly the available netting possibilities in the DTCC and SwapClear, as well as the netting approach available in the IFXCO Master Agreement, the close out valuation methods in the ISDA Master Agreements of 1992 and 2002, the ISDA Bridge Agreement, Bond Market Association's Cross-Product Master Agreements, and the legal opinions gathered by the ISDA in many jurisdictions, confirming the enforceability of its Bridge Agreement. See id. at 85-95.
119. The IFXCO Master Agreement governs foreign exchange and currency derivatives. Id. The close out valuation methods in the 1992 ISDA Master Agreement (Market Quotation and Loss) and the method in the ISDA 2002 Master Agreement (Close-out Amount) provide for netting obligations under a single master agreement.
120. Id. The ISDA Bridge and Bond Market Association Cross-Product Master Agreements provide for netting of obligations across more than master agreement.
121. Id. The CRMPG II also applauded the efforts of many jurisdictions, including in the U.S. Bankruptcy Code and U.S. bank insolvency laws, for their efforts to adopt legislation consistent with netting enforcement.
122. Id. at 93-94.
123. Id. at 101-05 (focusing especially on harmonization of documents for cross-agreement application).
124. Id. at 115-16.
125. Id. at 110-12.
126. Id.
127. Id.
128. Id. at 10.
129. Id. at § V.
130. See supra note 92 and accompanying text.
131. N.Y. Fed Invites Wall Street Firms to Discuss Use of Credit Derivatives, 37 Sec. Reg. & L. Rep. (BNA) No. 35, at 1450 (Aug. 29, 2005) (quoting N.Y. Fed. Reserve Bank President, Timothy Geithner);
132. see Riva D. Atlas, Fed Officials Summon Wall Street Firms to Discuss Derivatives, N.Y. TIMES, Aug. 25, 2005, at C5;
133. Henny Sender, Michael Mackenzie & Ramez Mikdashi, Fed, Banks Will Meet Over Derivatives, WALL ST. J., Aug. 25, 2005, at C3.
134. Press Release, Fed. Reserve Bank of N.Y., Statement Regarding Meeting on Credit Derivatives, (Sept. 15, 2005), available at http://www.newyorkfed. org/newsevents/news/markets/2005/an050915.html;
135. see also Riva D. Atlas, Trying to Put Some Reins on Derivatives, N.Y. TIMES, Sept. 16, 2005, at C7 (quoting one banker who attended the meeting but wished to remain anonymous as saying "[rjegulators wanted to get everyone together to make sure the industry knew they were concerned. It was left to the industry to come back with solutions.");
136. Henry Sender, Credit Derivatives and Their Risks are on the Table, WALL ST. J., Sept. 15, 2005, at C1 (quoting Thomas Russo, Vice Chairman of Lehman Brothers Holdings, Inc., as referring to the issues of market infrastructure discussed at the meeting as the "plumbing of the market");
137. N.Y. Fed, Wall Street Firms Mull Thorny Credit Derivatives Issues, 37 Sec. Reg. & L. Rep. (BNA) No. 37, at 1527 (Sept. 19, 2005).
138. For a list of the industry participants and regulatory entities in attendance, see Fed. Reserve Bank of N.Y., List of Attendees, http://www.newyorkfed.org/newsevents/news/markets/2005/DerivativesParticipants. doc (last visited Feb. 2, 2007). Many of these participants were also involved in CRMPGII.
139. Statement Regarding Meeting on Credit Derivatives, supra note 102;
140. see also Wall Street Firms to Submit Plan to Shrink Confirmation Backlog, 37 Sec. Reg. & L. Rep. (BNA) No. 39, at 1632 (Oct. 3, 2005) (stating that the next step in the process would be a plan in the form of a letter from the market participants which would be released in early Oct. 2005).
141. Also known as the "Fed 14." See, e.g., New York Fed's Geithner Urges Care in Use of Credit Derivatives, 38 Sec. Reg. & L. Rep. No. 21, at 882 (May 22, 2006).
142. Letter from Senior Mgmt. of the Fourteen Indus. Participants, to Timothy Geithner, Pres, of Fed. Reserve Bank of N.Y. (Oct. 4, 2005), available at http://www.newyorkfed.org/newsevents/news/markets/2005/industryletter.pdf [hereinafter First Industry Letter];
143. see also N.Y. Fed Said Pleased with Banks' Plan to Address Key Credit Derivatives Issues, supra note 71, at 1682 (summarizing the issues discussed in the letter);
144. N.Y. Fed Hails Banks' Progress in Addressing Credit Derivatives Issues, 37 Sec. Reg. & L. Rep. (BNA) No. 41, at 1713 (Oct. 17, 2005) (further discussing the content of the letter).
145. First Industry Letter, supra note 106. To enable the regulators to monitor the dealers' progress as part of the joint regulatory initiative, the 14 dealers agreed to collect data on their credit derivatives activities, including trading volume, unconfirmed trades, and trades confirmed using automated systems. Under the agreement, the dealers provide their individual data to Markit Group, a provider of independent data, portfolio valuations, and OTC derivatives trade processing. In turn, Markit Group aggregates the data across the dealers to protect the confidentiality of each dealer's data and then provides the regulators with aggregate data in a monthly report.
146. GAO REPORT, supra note 38, at 20.
147. The ISDA 2005 Novation Protocol amends the ISDA Master Agreements to allow for the transfer of an obligation or interest under the requires Agreement without written consent of the Remaining Party (i.e., email and fax consent is satisfactory). INT'L SWAPS & DERIVATIVES ASS'N, 2005 NOVATION PROTOCOL, (published Sept. 12 2005), available at http://isda.org (follow "ISDA Protocols" hyperlink; then follow "2005 Novation Protocol" hyperlink; then follow "2005 Novation Protocol Text and Form of Adherence Letter" hyperlink; then follow "here" hyperlink for text). All adhering parties, when in the position of Transferor, are required to obtain consent from the Remaining Party on the day of proposed novation, and provide detail sufficient to identify the transaction being transferred, and upon consent of the Remaining Party, provide notice of that consent to the Transferee.
148. Id. at Annex 1. When in the position of the Remaining Party, adhering parties may withhold consent to a novation for any reason, but must provide notice of whether it consents to the Transferor by 6:00 p.m. on the day of the novation.
149. Id. When in the position of Transferee, upon notice of consent by the Remaining Party it must confirm all relevant details of the transaction being transferred.
150. Id. If consent is not provided by the Remaining Party, the rights and obligations vis a vis the Transferor and Transferee are still in effect, but the Transferor effectively becomes a "pass-through" and acts as a conduit whereby the obligations of the Transferee and Remaining Party flow through the Transferor, but Transferor remains as counterparty to both, rather than stepping out of the transaction and allowing the Remaining Party and Transferee to become counterparties.
151. Id. All novations will be documented by all parties entering into a Novation Confirmation as soon as practicable after the novation.
152. Id.;
153. see also Guide to Implementation of the 2005 ISDA Novation Protocol, available at http://isda.org (follow "ISDA Protocols" hyperlink; then follow "2005 Novation Protocol" hyperlink; then follow "Guide to the Implementation of the 2005 Novation Protocol" hyperlink) (offering a comprehensive explanation of the novation terms in the Protocol).
154. First Industry Letter, supra note 106. The Major Dealers committed to setting an effective date for the ISDA 2005 Novation Protocol of October 24, 2005, and finalizing a Guide to support implementation of that Protocol.
155. Id. The highlights of the Guide include: (1) obligation of the transferor to obtain written consent from the remaining Party on the novation trade date; and (2) a process for notification and method for communication.
156. Id. A novation is "[t]he act of substituting for an old obligation a new one that either replaces an existing obligation with a new obligation or replaces an original party with a new party." BLACK'S LAW DICTIONARY 1094 (8th ed. 2004). In this context, it deals with one counterparty assigning its obligation to a contract to another party, often without informing or getting the consent from its original counterparty.
157. The Major Dealers committed to make significant progress on the reduction of their backlogs. First Industry Letter, supra note 106. ("The Major Dealers commit that by January 31, 2006, we will each reduce our number of confirmations outstanding more than 30 days by 30% from our number of confirmations outstanding more than 30 days as of September 30, 2005 .... The Major Dealers commit to set a further aggressive target for March 31, 2006. We will finalize this target by December 15, 2005, when we expect to have substantial knowledge of the impacts of automation advances, lock-ins, and the Novation Protocol.")
158. The ultimate goal will be moving the industry to a standard of all vanilla (plain or simple) confirmations taking place within five days after the trade or transaction and to "dramatically increase utilization of automated matching through DTCC and to change the current market practices on novations [which] will lay the foundation for moving to that standard, which will be met through high levels of automated processing." Id.
159. The Depository Trust & Clearing Corporation (DTCC) provides electronic clearance, settlement and information services for a wide range of derivative products, including OTC derivatives. DTCC, About DTCC: An Overview, http://www.dtcc.com/about/business/index.php (last visited Oct. 5, 2007). DTCC Deriv/Serv is a matching and settlement service that provides for payment netting and settlement, and can accommodate virtually all standard credit default swap transactions; it has gained wide industry acceptance globally and is partnered with the Reference Entity Data (RED) service.
160. DTCC, DTCC Deriv/Serv, http://www.dtcc.com/ProductsAndServices/ derivserv/index.htm (last visited Feb. 3, 2007).
161. The Major Dealers committed to fully using DTCC existing functionality by October 31, 2005. It will also requires all active clients to subscribe to DTCC or alternative industry accepted electronic matching platforms, by January 15, 2006, and require all clients who trade on average one time per week over the prior three months to subscribe to subscribe and use DTCC by March 31, 2006. First Industry Letter, supra note 106.
162. Id.
163. The Major Dealers worked with the ISDA to complete the Delta & Northwest CDS Index Protocol to deal with the settlement of contracts to which Delta and Northwest were reference entities after the two airlines filed for bankruptcy. Thanks in large part to the efforts of the ISDA and industry participants, the obligations of Delta and Northwest were settled without the chaos predicted by some in the face of a large reference entity default. See e.g. Geithner Says Credit Derivatives Bolster Financial System Stability, 38 Sec. Reg. & L. Rep. (BNA) No. 12, at 479 (Mar. 20, 2006) (stating "[a] critical issue going forward for the dealers involves establishing policies, procedures, and documentation for settlement of credit default swaps in the aftermath of a default by a reference entity."). The Major Dealers pledge to keep working with the ISDA to refine the ad hoc protocol process for settlement of defaulting entity obligations. The ISDA has subsequently developed protocols to deal with the defaults of Delphi, Dura, Dana, and Calpine. See ISDA, ISDA Protocols, http://isda.org (follow "ISDA Protocols" hyperlink) (last visited Oct. 18, 2007). The Major Dealers also formed a working group to further integrate cash settlement processes for North American index contracts by March 2006, the next index roll (a process in which indices change the composition of their members to ensure that the index remains representative of the most liquid entities; usually takes place every six months).
164. First Industry Letter, supra note 106.
165. The Major Dealers scheduled an industry tear-up on October 7, 2005. First Industry Letter, supra note 106.
166. For a description of a "tear-up," see infra note 138.
167. Letter from Senior Mgmt. of the Fourteen Indus. Participants, to Timothy Geithner, Pres, of Fed. Reserve Bank of N.Y. (Dec. 16, 2005), available at http://newyorkfed.org/newsevents/news/markets/2006/industryletter.pdf [hereinafter Second Industry Letter]. The Major Dealers committed to reducing outstanding confirmations of more than thirty days by 50% from the September 30, 2005 number of confirmations outstanding more than thirty days by April 30, 2006.
168. Id.
169. Press Release, Fed. Reserve Bank of N.Y., February 16 Meeting on Credit Derivatives (Jan. 12, 2006), available at http://newyorkfed.org/ newsevents/news/markets/2006/an060112.html.
170. Press Release, Fed. Reserve Bank of N.Y., Statement Regarding Progress in Credit Derivatives Markets (Feb. 16, 2006), available at http://newyorkfed.org/newsevents/news/markets/2006/an060216.html.
171. Id.
172. Id.
173. N.Y. Fed Pleased by Banks' Progress in Addressing Credit Derivatives Targets, 38 Sec. Reg. & L. Rep. (BNA) No. 9, at 322 (Feb. 27, 2006);
174. see also Henry Sender, Concerns Dog Credit Derivatives-Industry Group Symposium Explores Market Imbalances Bankruptcies May Trigger, WALL ST. J., Mar. 1, 2006, at C3 (discussing the progress made in the credit derivatives market since the first Major Dealer meeting, but recognizing that there is still work to be done, especially with regard to issues such as stress testing and scenario analysis which need to take into account the possible strain caused by the exit of a major player in the credit derivatives market which has a concentrated dealer base).
175. Letter from Senior Mgmt. of the Fourteen Indus. Participants, to Timothy Geithner, Pres, of Fed. Reserve Bank of N.Y. (Mar. 10, 2006), available at http://newyorkfed.org/newsevents/news/markets/2006/industryletter2.pdf [hereinafter Third Industry Letter].
176. The Major Dealers committed to implementing industry wide best practice guidelines, which include processing electronically all trades that are so capable of being processed (called Eligible Trades), with straight through processing as the ultimate industry goal. Id.;
177. see also Credit Derivatives Dealers Issue New Set Of Commitments For Industry improvement, 38 Sec. Reg. & L. Rep. (BNA) No. 12, at 479 (Mar. 20, 2006) (quoting Corrigan, former NY Fed chairman and organizer of CRMPG II, as saying that "fully automated, or 'straight through,' trade processing that would require virtually no human intervention is a key long term industry goal.").
178. "Details of Eligible Trades should be submitted to the relevant Electronic Platform no later than T + 1 business day and matched/affirmed (and any rejections/exceptions/discrepancies resolved) no later than T + 5 business days. Confirmation for non-Eligible Trades should be issued no later than T + 10 calendar days." Third Industry Letter, supra note 123. All trades should be confirmed (or resolved) no later than T + 30 calendar days.
179. Id.
180. The Major Dealers were working with DTCC to create "a central trade information warehouse for credit derivatives - essentially a comprehensive database containing the 'golden copy' of each contract - and a central support infrastructure that standardizes and automates downstream processes throughout the life of each contract." Id. The DTCC Deriv/Serv Trade Information Warehouse was launched in September 2006.
181. See DTCC Deriv/Serv, Trade Information Warehouse: A Practical Guide for the Buy Side, http://derivserv.dtcc.com/binary/ 31182A%20Practical%20Guide-%20Release10-06.pdf (last visited Feb. 3, 2007) (a comprehensive description of the services provided by Deriv/Serv and the Trade Information Warehouse). "The initial Warehouse Eligible Transactions will be single name CDS (both corporate and Sovereign using master confirmation agreements, default master confirmation agreements or the ISDA physical settlement matrix), CDS Index products, and Tranched index products, all being confirmable through Deriv/SERV confirmation services as of June 1, 2006."
182. BOND MKT. ASS'N, THE ASSET MANAGERS FORUM WEEKLY REP., AMD Speaks on CDS Automation, Sept. 22, 2006, available at http://www. theassetmanager.com/WeeklyReport/092206.html (discussing the DTCC Trade Information Warehouse);
183. see also Clearing the Derivatives Backlog, DIALOUGUE, THE VOICE OF THE SWIFT CMTY. (Q2 2006), at 22.
184. The Major Dealers were working with the "ISDA, the members of CDS IndexCo LLC and International Index Company, and various service providers to develop a new framework for the settlement of credit derivatives contracts following a credit event. The settlement solution will provide for net physical settlement at a single auction-based price." Third Industry Letter, supra note 123.
185. "Each Major Dealer commits to a 70% reduction in its number of confirmations outstanding for more than 30 days on June 30, 2006 from those outstanding more than 30 days on September 30, 2005." Id.
186. Id.
187. Press Release, Fed. Reserve Bank of N.Y., New York Fed Welcomes New Industry Commitments on Credit Derivatives (Mar. 13, 2006), available at http://newyorkfed.org/newsevents/news/markets/2006/an060313.html [hereinafter NY Fed Press Release].
188. Susan Schmidt Bies, Governor, Fed. Reserve Bd., Address at the Financial Women's Association Washington Briefing: A Supervisor's Perspective on Enterprise Risk Management (June 12, 2006) (speaking on enterprise risk management issues facing the markets).
189. Letter from Senior Mgmt. of the Fourteen Indus. Participants, to Fellow Credit Derivatives Mkt. Participants & Clients (July 19, 2006), available at http://isda.org [hereinafter Letter to Market Participants];
190. see also Credit Derivatives Dealers Cut Backlog of Confirmations by 80 Percent, 38 Sec. Reg. & L. Rep. (BNA) No. 30, at 1270 (July 24, 2006) (summarizing the Letter to Market Participants).
191. Letter to Market Participants, supra note 132;
192. see 38 Sec. Reg. & L. Rep. No. 30, supra note 132, at 1270 (discussing the progress made by the Major Dealers to date, and fully automated processing as the long-term industry goal).
193. Press Release, Fed. Reserve Bank of N.Y., Statement Regarding Progress in Credit Derivatives Markets (Sept. 27, 2006), available at http://newyorkfed.org/newsevents/news/markets/2006/an060927.html.
194. Id.
195. Id.;
196. see Credit Derivatives Market Swells to $26 Trillion in Year, Association Says, 38 Sec. Reg. & L. Rep. (BNA) No. 38, at 1590 (Sept. 25, 2006) (discussing the new statistics announced by the ISDA on Sept. 19 and quoting Geithner as being happy with the progress made in the credit derivatives market, but also mindful of the need to remain vigilant).
197. NY Fed Press Release, supra note 130;
198. see Letter from Senior Mgmt. of the Seventeen Industry Participants, to Timothy Geithner, Pres, of Fed. Reserve Bank of N.Y. (Nov. 21, 2006), available at http://newyorkfed.org/newsevents/news/markets/2006/ an061121c.pdf (committing to take similar initiatives in the equity derivatives markets, as had been made over the course of the last fourteen months in the credit derivatives markets, including increased automation and reduction of unconfirmed transactions).
199. This commitment was welcomed by the NY Fed, which hoped to see similar progress made in the equity derivatives markets. Press Release, Fed. Reserve Bank of N.Y., New York Fed Welcomes Industry Commitments on Equity Derivatives (Nov. 21, 2006), available at http://newyorkfed.org/newsevents/news/ markets/2006/an061121.html;
200. see also Firms Meet at N.Y. Fed to Ponder Questions on Credit, Equity Derivatives, 38 Sec. Reg. & L. Rep. (BNA) No. 39, at 1636 (Oct. 2, 2006) (discussing the meeting on Sept. 27 at the NY Fed);
201. Equity Dealers' Plan Focuses On Market Efficiency, Standardization, 38 Sec. Reg. & L. Rep. (BNA) No. 47, at 1994 (Dec. 4, 2006) (discussing the equity dealers' letter to NY Fed, and commitments).
202. The Dealers made a second commitment to the Fed in May 2007, after meeting their target reduction of equity derivative confirmation backlogs by 25% by the end of January, improving automated processing and increasing the use of electronic trading platforms. Letter from Senior Mgmt. of the Eighteen Indus. Participants, to Timothy Geithner, Pres, of Fed. Reserve Bank of N.Y. (May 15, 2007), available at http://newyorkfed.org/newsevents/news/markets/2007/ FedLetter0507.pdf; Dealers' Pledge Added Infrastructure, Improvements in Second Commitment to Fed, 39 Sec. Reg. & L. Rep. (BNA) No. 20, at 799 (May 21, 2007).
203. GAO REPORT, supra note 38, at 23: To achieve these reductions in their unconfirmed trade backlogs, dealers took various steps. For example, dealers engaged in events called "lock ins" with other dealers and, to a lesser extent, end-users. Under a lock in, operations staff from either two dealers or staff from one dealer and one of their key end-user customers convened in a room and compared the trades they had conducted together until all or almost all were reconciled and confirmed. Dealers and end-users also used "tear-up services" to reduce the total number of open trades and thus eliminate the number of trades that needed to be confirmed. In a tear-up process, an automated system matches up offsetting positions across many market participants, allowing those trades to be, in effect, terminated and thereby removing the need to confirm such trades.... To prevent new trades from adding to the backlog, the dealers also increased their use of automated confirmation systems and set deadlines for confirming trades.
204. There have been some minor events that have shaken the credit derivatives markets, but these have been dealt with, notably (1) the bankruptcy filings of Northwest, Delta, Dephi, and others; and (2) in May 2005, the unanticipated correlative effects of General Motors rating falling to junk status and the sharp fall in their bond prices had effects on credit derivative portfolios and indices which contradicted the models upon which traders had relied. See Riva D. Atlas, A Relief: Some Gains for Hedges, N.Y. TIMES, June 8, 2005, at C1;
205. Jonathan Fuerbringer & Danny Hakim, Fitch Cuts G.M. to Junk, Citing Poor S.U.V Sales, N.Y. TIMES, May 25, 2005, at C3;
206. Mark Whitehouse et. al, The Sky Darkens for Bondholders-Backfiring Bets on Derivatives, Corporate Executives' Allegiances Are Among Worries Raising Risk, WALL ST. J., May 12, 2005, at C1. Only seven reference entities have defaulted since 2005, and the market was able to effectively settle trades referencing those entities.
207. GAO REPORT, supra note 38, at 15-16.
208. ISDA, About ISDA, http://isda.org (follow "About ISDA" hyperlink) (last visited Oct. 18, 2007): ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has over 815 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities. Since its inception, ISDA has pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business. Among its most notable accomplishments are: developing the ISDA Master Agreement; publishing a wide range of related documentation materials and instruments covering a variety of transaction types; producing legal opinions on the enforceability of netting and collateral arrangements (available only to ISDA members); securing recognition of the risk-reducing effects of netting in determining capital requirements; promoting sound risk management practices, and advancing the understanding and treatment of derivatives and risk management from public policy and regulatory capital perspectives.
209. MFA, headquartered in Washington, D.C., is the primary trade association representing professionals who specialize in alternative investment strategies including hedge funds, funds of funds, and managed futures funds. MFA's over 1,200 members are affiliated with the majority of the 100 largest hedge funds, which manage a significant portion of the over $1.2 trillion invested in hedge funds. Since its inception in 1991, MFA has provided industry leadership in government relations, communications, media relations, and education to MFA members and investors. Press Release, Managed Funds Ass'n, MFA Applauds Recommendations by Senator Schumer and Mayor Bloomberg (Jan. 29, 2007), available at http://www.mfainfo.org/images/PDF/Schumer_Bloomberg.pdf.
210. The Bond Market Association merged with the Securities Industry Association to form the Securities Industry and Financial Markets Association (SIFMA) as of November 1, 2006. See, e.g., Out of the Alphabet Soup: SIFMA, WASH. WIRE, NOV. 1, 2006, http://blogs.wsj.com/washwire/2006/11/01/out-of-the-alphabet-soup-sifma/;
211. see also Press Release, SIFMA, SLA/BMA Merger Approved by Members, SIFMA Transition Begins: Joint Statement (July 27, 2006), available at http://www.bondmarkets.com/story.asp?id=2536 (discussing the shareholder approval of the merger). [SIFMA is an] organization [that] is passionately dedicated to representing more than 650 member firms of all sizes, in all financial markets in the U.S. and around the world. We are committed to enhancing the public's trust and confidence in the markets, delivering an efficient, enhanced member network of access and forward-looking services, as well as premiere educational resources for the professionals in our industry and the investors whom they serve. SIFMA, Welcome to SIFMA.org, http://www.sifma.org/section.cfm/about (last visited Feb. 4, 2007).
212. See Third Industry Letter, supra note 123 (acknowledging the contributions made by these associations);
213. see also MANAGED FUNDS ASS'N, STATEMENT OF SUPPORT IN RESPONSE TO THE MAJOR DEALERS' STEADY STATE PROPOSAL (Mar. 13, 2006), available at http://www.managedfunds. org/downloads/3-13-06MFA_Fed14_Stmt_3_13_06.pdf (discussing the Major Dealers initiative and the MFA's continuing support in that undertaking).
214. When two parties negotiate and sign an ISDA Master Agreement, they agree upon the ongoing legal and credit relationship between them. While they can, of course, agree to amend the terms of their agreement at any time, there is no need to negotiate a whole host of issues each time they enter into a new transaction. Also, unlike many other financial master agreements, the ISDA Master Agreement can be used to document a range of different types of transactions (it is "multi-product"). ALLEN & OVERY, LLP, AN INTRODUCTION TO THE DOCUMENTATION OF OTC DERIVATIVES 'TEN THEMES" 2 (May 2002), available at http://isda.org/educat/pdf/ten-themes.pdf (providing a comprehensive explanation of the structure and format of the standardized documents created by the ISDA for the OTC derivatives markets). Each individual transaction between two parties to a Master Agreement becomes a supplement to the Master Agreement, and therefore incorporates all of the terms agreed to by the parties in that agreement, allowing parties to negotiate only the economic terms for each transaction, rather than entire separate comprehensive agreements.
215. Id. at 2-3.
216. Credit support (a.k.a collateral or margin) are the assets that parties reserve and designate to ensure that an obligation will be fulfilled, thereby reducing counterparty credit risk. The ISDA published four Credit Support Annexes and Deeds in the mid-1990s, but [t]he 2001 ISDA Credit Support Protocol offers market participants the ability to amend the 1994 ISDA Credit Support Annex (New York law) and/or the 1995 ISDA Credit Support Annex (English law). Specifically, market participants may elect to amend provisions relating to transfer timing, dispute resolution, substitutions or exchanges of credit support and certain definitions. ISDA, 2001 ISDA Credit Support Protocol, http://isda.org (follow "ISDA Protocols" hyperlink; then follow "2001 ISDA Credit Support Protocol" hyperlink);
217. see also ALLEN & OVERY, supra note 144, at 5.
218. See supra note 105, for a discussion of the 2005 ISDA Novation Protocol. Also, the ISDA issued the Novation Protocol II in February 2006. "NPII is a free-standing protocol intended for parties that did not adhere to the 2005 Novations Protocol and those that wish to do novations business with these parties. The 2005 Novations Protocol continues to operate without amendment." News Release, ISDA, ISDA Opens 'Evergreen' Novation Protocol: Enables New Entities to Expedite Assignment Process (Feb. 1, 2006), available at http://isda.org (follow "Press" hyperlink; then follow "Press Releases (2006) hyperlink;
219. then follow "Press Release" hyperlink for February 1, 2006);
220. see also ISDA, DETAILS RELATING TO THE ISDA NOVATION PROTOCOL II, available at http://isda.org (follow "ISDA Novation Protocol" hyperlink; then follow "here" hyperlink for a brief explanation of the differences between the ISDA Novation Protocol and the 2005 Novation Protocol) (stating that there are no changes to the novation terms from the 2005 Novation Protocol to the Novation Protocol II).
221. ALLEN & OVERY, supra note 144, at 3: When used in the ISDA sense, "Definitions" are the various booklets of standard definitions and other terms and provisions published by ISDA for use in documenting different types of derivatives transactions. Generally, and broadly, each set of Definitions provides relevant terms for documenting a particular type of derivatives transaction.... [S]hort-form Confirmations rely on Definitions. They do this by stating that they incorporate a particular set (or sets) of Definitions. However, while they do a lot of the work for the parties, ISDA Definitions do not take care of everything. The Definitions themselves only provide a framework for documenting a transaction. It is still up to the parties to make various choices and to document the economic terms of the transaction itself in the short-form Confirmation. The parties are also free, of course, to amend the terms of the relevant Definitions or include additional provisions in the short-form Confirmation itself. While the terms of the Definitions represent the result of an extensive industry consultation process, they will not be appropriate for documenting all transactions without amendment or additional provisions.
222. The ISDA gathered legal opinions in many jurisdictions relating to collateral arrangements, netting, and novation. These opinions are available to members to ensure that the ISDA documentation in these areas are enforceable. See ALLEN & OVERY, supra note 144, at 5.
223. The ISDA created ad hoc protocols to deal with settlement of obligations that became due when a reference entity experienced a credit event. These protocols typically involve an auction methodology that facilitates settlement through bidding on acceptable terms of physical and cash settlement. See ISDA, http://isda.org (follow "ISDA Protocols" hyperlink) (last visited Oct. 18, 2007), for a list of protocols that have been developed to deal with the settlements due to the credit events of Dura Operating Corporation (filed for bankruptcy on October 30, 2006), Dana Corporation (filed for bankruptcy on March 3, 2006), Calpine Corporation (filed for bankruptcy on December 20, 2005), Delphi Corporation (filed for bankruptcy on October 8, 2005), Delta Airlines, Inc. and Northwest Airlines, Inc. (filed for bankruptcy on September 14, 2005) and Collins & Aikman Products Co. (filed for bankruptcy on May 17, 2005).
224. FpML, What is FpML?, http://www.fpml.org/factsheet.html (last visited Feb. 12, 2007) (explaining the development of this standardized "language" for communicating details of financial transactions which is a necessary step in increasing automation, as well as the benefits of such standardization and automation as opposed to the manual process of derivative trading): FpML® (Financial products Markup Language) is the business information exchange standard for electronic dealing and processing of financial derivatives instruments. It establishes a new protocol for sharing information on, and dealing in swaps, derivatives and structured products. It is based on XML (Extensible Markup Language), the standard meta-language for describing data shared between applications. All categories of over-the-counter (OTC) derivatives will eventually be incorporated into the standard.
225. See supra notes 111-13 and accompanying text for a description of DTCC Deriv/Serv.
226. See supra note 126 (discussing the Trade Information Warehouse).
227. Particularly, the NY Fed call for a meeting of the fourteen major market participants. See supra note 101 and accompanying text;
228. see also FSA Letter, supra note 70.
229. Annette L. Nazareth, Comm'r, Sec. & Exch. Comm'n, Remarks Before the Brooklyn Law School Symposium on the Structure of Securities Markets (Nov. 10, 2006), available at http://sec.gov/news/speech/2006/spch111006aln.htm. While this author agrees with the proposition that regulatory agencies were the "impetus" for the Major Dealers collective efforts, I do not agree with the characterization of this speech that the success in the credit derivatives should be attributed to regulatory intervention.
230. See id. As will be discussed infra, the role that the regulatory agencies played was vital, but limited, which was in itself a major factor in the success of the initiative.
231. GAO REPORT, supra note 38, at 27-28. "Given that individual efforts could not fully resolve the backlog problem, U.S. and foreign regulators we interviewed said that the joint regulatory initiative proved instrumental in ensuring that the problem was addressed."
232. Id. at 37.
233. Thomas Huertas, Dir., Wholesale Firms Div. & Banking Sector Leader, Fin. Servs. Auth., Credit Derivatives: Boon to Mankind or Accident Waiting to Happen?, Remarks Before Rhombus Research Annual Conference (Apr. 26, 2006), available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/ 2006/0426_th.shtml.
234. The Major Dealers also cut the number of total confirmations outstanding more than 30 days by 94% by October 2006. GAO REPORT, supra note 38, at 4.
235. See Richard Beales, Continuing Rapid Growth in Deals Stretches Technological Resources, FIN. TIMES, May 28, 2007, at 18 (warning of the problems that could creep back into the credit derivatives markets as the volume of trading continues to increase, and stressing the need for even greater degree of automation). As proof of the continuing need to increase automation, many firms experienced a significant amount of backlogs during August 2007 as
236. volumes surged even though more than 90% of trades were being processed electronically. See Stacy-Marie Ishmael, Back Offices Feeling the Strain of Credit Crisis Trading Boom, FIN. TIMES, Aug. 14, 2007, at 37.
237. Serena Ng, -Trading Groups Are Agitating Over Apparent Leaks on Street-, WALL ST. J., Dec. 14, 2006, at C3;
238. Non-Tolerance of Misuse of Insider Info Reaffirmed by Industry Groups, 38 Sec. Reg. & L. Rep. (BNA) No. 49, at 2096 (Dec. 18, 2006).
239. Ng, supra note 159, at C3. These pledges also came in the face of recognition that the regulatory agencies, i.e., the SEC and CFTC, had no authority to regulate CDSs.
240. See Kara Scannell, Serena Ng & Alistair MacDonald, Can Anyone Police the Swaps?, WALL ST. J., Aug. 31, 2006, at C1 (stating that the ISDA says that the SEC, which has not brought any actions in relation to the CDSs, has no jurisdiction because the swaps are private contracts, and that the CFTC itself says it has no oversight).
241. The Chicago Mercantile Exchange and the Chicago Board of Trade (two futures exchanges) have launched futures trading of credit derivatives contracts, most likely expanding the market even further. See Anuj Gangahar et al., Banks' Unease Helped Drive the Rival Offer, FIN. TIMES, Mar. 16, 2007, at 28;
242. Ellen J. Silverman, CME, CBOT Differ on Credit Derivatives, GLOBAL ASS'N OF RISK PROFESSIONALS, Nov. 9, 2006, http://garp.com/risknews/newsfeed.asp?Category=6&MyFile=2006-11-09- 13811.html.
243. See Michael Mackenzie & Saskia Scholtes, Default Fear Lifts Demand for Credit Insurance, FIN. TIMES, Aug. 7, 2007, at 35 (describing the important role of credit derivative index contracts, especially the US CDX, in the current financial landscape).
244. The risk that your pricing models are not correct, i.e., do not provide adequate compensation for the risk that you incur in a position. See DURBIN, supra note 1, at 191.
245. Borrowing a phrase from the CRMPG II REPORT. CRMPG II REPORT, supra note 87, at 1;
246. see Treasury Official Warns Hedge Funds: Don't Be 'Lulled' on Possible Systemic Risk, 39 Sec. Reg. & L. Rep. (BNA) No. 24, at 942 (June 18,
247. See Banks Chart Significant Progress Toward Key Management Goals, 38 Sec. Reg. & L. Rep. (BNA) No. 10, at 366 (Mar. 6, 2006) (quoting E. Gerald Corrigan, chairman of CRMPG II: "As complex as it is today, its going to get more complex - there's no question about that"). Corrigan also said that this will require market participants to strengthen valuation practices, use more sophisticated tools to evaluate the relationship between risk and capital, liquidity and margin, and increase focus on comprehensive forms of stress testing and scenario analysis.
248. Id.;
249. Paul J. Davies, Banks and Brokers Pay a Higher Price for Volatility, FIN. TIMES, July 13, 2007, at 37 (describing the worries over complex products, counterparty risk, and correlations between various markets).
250. See CRMPG II REPORT, supra note 87, § V (discussing correlation and modeling risk);
251. JOINT FORUM REPORT, supra note 79, at 35-38 (discussing potential problems with correlation);
252. Anderson, supra note 39, at C1 (discussing NY Fed president Geithner's commitment to improve stress testing);
253. Greg Ip & Carrick Mollenkamp, U.S. & Britain Team Up to Test Financial Risk, WALL ST. J., Mar. 2, 2006, at C1 (discussing model risk and stress testing in the credit derivatives market); Emil Henry, Treasury Asst. Sec'y for Fin. Insts., Remarks at Federal Reserve Bank of Atlanta (Apr. 18, 2006) (discussing the nexus between hedge funds and credit derivatives and the need for more comprehensive stress testing);
254. see also Treasury's Henry Urges Attention to Link Between Hedge Funds, Credit Derivatives, 38 Sec. Reg. & L. Rep. (BNA) No. 17, at 706 (Apr. 24, 2006) (discussing Henry's speech, supra);
255. supra note 139 (discussing the unexpected correlation effects of G.M. bonds being downgraded to junk status).
256. Much of the recent worries about such systemic risk arises from the volatility in the credit derivatives market resulting from possible correlations between the subprime mortgage problems and credit derivatives; "[t]he market is convinced that somebody out there is holding a big bag of subprime." Scott Patterson, Default Swaps Could Magnify Credit Crisis, WALL ST. J., Aug. 13, 2007, at C1 (quoting a credit strategist at Deutsche Bank).
257. See Thomas Huertas, Dir., Wholesale Firms Div., and Banking Sector Leader, Fin. Servs. Auth., Remarks at the ISDA Regional Conference: One Down, Two to Go? Challenges Facing the Global Derivatives Industry (Sept. 19, 2006), available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/ 2006/0919_th.shtml (discussing how the industry values derivatives, and whether that valuation is based on adequate stress testing).
258. See Greg Ip et al., In Call to Deregulate Business, a Global Twist, WALL ST. J., Jan. 25, 2007, at Al; Henry M. Paulson, Sec'y, U.S. Treasury Dep't, Address at the Competitiveness of U.S. Markets Economic Club of New York (Nov. 20, 2006), available at http://www.ustreas.gov/press/releases/hp174.htm.
259. See, e.g., Michael R. Bloomberg & Charles E. Schumer, To Save New York, Learn from London, WALL ST. J., NOV. 1, 2006, at A18 (calling for reevaluation of U.S. regulatory, accounting, and legal systems to maintain U.S. financial preeminence).
260. Banks are regulated by the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision.
261. Securities are regulated by the SEC as well as those self-regulatory organizations to which the SEC has delegated authority, and is subject to state regulation from Blue-Sky Laws.
262. The futures and commodities industries are regulated by the Commodity Futures Trading Commission and the SROs to which it has delegated rulemaking authority.
263. The insurance industry is regulated by the states, with each state having its own set of regulations. The regulation of the insurance industry is the epitome of the redundant and inefficient form of regulation that this Comment is arguing must be changed. In the insurance industry, each state maintains its own rules and regulations making every decision made by insurance companies dependent upon maintaining compliance with, and seeking approval from, dozens of regulatory agencies; each with its own standards.
264. See, e.g., McKINSEY REPORT, infra note 194, at 81 ("Exhibit 21: The U.S. Regulatory Regime is Complex and Fragmented," illustrating the numerous regulators assigned to oversee each component of the financial services markets); "We have the SEC, CFTC, NASD, MSRB, 50 state insurance regulators, multiple banking authorities - all looking at specific products within their own jurisdiction, but rarely working in concert." Mary L. Schapiro, Chairman & C.E.O. of the NASD, Remarks at the Investment Company Institute General Membership Meeting (May 11, 2007), available at http://www.finra.org/PressRoom/SpeechesTestimony/MaryL. Schapiro/P019144.
265. See Judith Burns & Randall Smith, SEC Chairman Backs Creation of One Regulator for Brokerages, WALL ST. J., Nov. 11, 2006, at B3.
266. CCMR REPORT, infra note 179, at 67;
267. see Markham, supra note 18, at 319-74 (discussing U.S. specifically focusing on securities and commodities, futures markets, and modern problems facing the regulation of these markets, as well as the conflicts between the SEC and CFTC over jurisdiction).
268. See SEC INDUS. & FIN. MKTS. ASS'N, REINVENTING SELF- REGULATION, WHITE PAPER FOR THE SEC. INDUS. ASS'N (2000, updated Oct. 14, 2003) http://www.sia.com/market_structure/html/siawhitepaperfinal.htm (discussing securities regulation and offering six options for alternative regulatory models, ranging from maintaining the status quo to forming a single governmental regulatory organization);
269. Jake Keaveny, Note, In Defense of Market Self-Regulation, An Analysis of the History of Futures Regulation and the Trend Toward Demutualization, 70 BROOK. L. REV. 1419, 1420 (2005) (arguing "that the self-regulatory model, while in need of some type of reform, will survive the latest round of scrutiny because time has shown that it is the most efficient and practical alternative").
270. COMM. ON CAPITAL MARKETS REGULATION INTERIM REPORT (NOV. 30, 2006), available at http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf [hereinafter CCMR REPORT]. The Committee on Capital Markets Regulation is an independent, bipartisan committee composed of 22 corporate and financial leaders from the investor community, business, finance, law, accounting, and academia. Announced on September 12, 2006, its purpose is to explore a range of issues related to maintaining and improving the competitiveness of the U.S. capital markets. Our objective is to recommend policy changes that should be made, or areas of research that should be pursued, to preserve and enhance the balance between efficient and competitive capital markets and shareholder protection. This interim report focuses on equity capital markets. During the next two years, our Committee will continue to explore issues affecting other aspects of the competitiveness of U.S. capital markets.
271. Id. at vii.
272. Id. at 1.
273. Id. at 4-5.
274. But see Paul S. Atkins, Comm'r, Sec. & Exch. Comm'n, Is Excessive Regulation and Litigation Eroding U.S. Financial Competitiveness? (Apr. 20, 2007), available at http://sec.gov/news/speech/2007/ spch042007psa.htm ("The United States emerged from the end of World War II with its capital, industrial and scientific structures intact. The rest of the industrialized world lay in ruins. Communism and socialist ideas then suppressed the formation of financial markets in many parts of the world. So for many decades, these external factors made the United States the dominant financial marketplace in the world. Regardless of our regulatory costs, there were no other financial marketplaces with the size, liquidity, and depth of the United States - a position that we have continued to maintain to this day. . . . With burgeoning foreign capital centers and easy direct access of Americans to those markets, foreign companies no longer have to come here.").
275. Other recommendations discussed in the CCMR REPORT deal with (1) reforming public and private sector enforcement by allowing companies to adopt limits to their exposure to class actions, reserving criminal prosecutions for truly exceptional cases, reducing the present level of auditor liability, recognizing the practical difficulties in the present requirements facing outside directors acting in good faith reliance on prepared information, and allowing greater indemnification of those outside directors acting in good faith; (2) improving shareholder rights, especially in the areas of their right to vote on takeover defenses and the adoption of alternative dispute resolution procedures; and (3) revising implementation of section 404 of the Sarbanes-Oxley Act through greater clarity in defining "material weakness," better regulatory guidance, and revised requirements for small companies and foreign companies. See CCMR REPORT, supra note 179, at 12-21 (citing to executive summary, and also discussing at greater length in sections III, IV, and V). It should also be noted that the regulatory reforms of the CCMR REPORT are directed specifically at securities regulation, but many of the recommendations could be applied to the much broader issue of financial services market regulation as a whole (that being the focus of this Comment).
276. Id. at 59.
277. Id. at 60-63.
278. Id. First, regulators, specifically the SEC, could submit proposed rules and regulations to the Office of Management and Budget's Office of Information and Regulatory Affairs for an assessment of potential costs and benefits, and this could become another input in the rule-writing process. The Office of Management and Budget is an office in the executive branch, which performs similar assessments for all significant executive agency actions (the SEC is an "independent" agency not currently subject to such a review). Second, is the creation of a separate agency to perform such cost/benefit analysis for SEC proposals. Third, such analysis could be performed internally by creating a new division within the SEC. Fourth, the SEC could incorporate such analysis into its existing rule-writing processes.
279. Id. at 65.
280. Id. at 66.
281. Id.
282. Id.
283. Id.
284. Id. at 67.
285. Id. at 68.
286. Id. at 68-70.
287. MCKINSEY & CO., SUSTAINING N.Y.'S AND THE U.S.' GLOBAL FIN. SERVS. LEADERSHIP (Jan. 2007), available at http://www.senate.gov/ ~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf [hereinafter MCKINSEY REPORT] ("Mayor Bloomberg and Senator Schumer asked McKinsey & Company to work with the New York City Economic Development Corporation (NYCEDC) to develop a better understanding of the contribution that strong, innovative financial markets can make to a vibrant economy. . . . To bring a fresh perspective to this topic, a McKinsey team personally interviewed more than 50 financial services industry CEOs and business leaders. The team also captured the views of more than 30 other leading financial services CEOs through a survey and those of more than 275 additional global financial services senior executives through a separate on-line survey.");
288. see also Aaron Lucchetti, Identity Crisis for New York?, WALL ST. J., Jan. 22, 2007, at C3 (discussing the release of the McKINSEY REPORT).
289. MCKINSEY REPORT, supra note 194, at 97-118. The MCKINSEY REPORT also has a thorough discussion of U.S. competitiveness in today's markets (Section II), and some specific suggestions for increasing New York's competitiveness (Section IV (B)).
290. Id. at 95-118. These eight recommendations are divided into three categories: critically important, near term national priorities ((1)-(3)); initiatives to level the playing field ((4)-(6)); and important longer-term national issues ((7)-(8)).
291. Id.
292. The efforts of the Basel Committee on Banking Supervision to revise the standards governing the capital adequacy of internationally active banks achieved a critical milestone in the publication of an agreed text in June 2004. The Basel II Framework describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rule-making and adoption procedures. It seeks to improve on the existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the Basel II Framework is intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a result, it is intended to be more flexible and better able to evolve with advances in markets and risk management practices. BANK FOR INT'L SETTLEMENTS, BASEL II, http://www.bis.org/publ/bcbsca.htm (last visited Feb. 11, 2007).
293. Specifically "Section II (C) Competition intensifying in two key markets: derivatives and debt and Section III (D) Recent US regulatory trends damaging competitiveness" and the corresponding recommendations of the MCKINSEY REPORT, supra note 194.
294. Id. at 54.
295. Id. at 78.
296. Id. at 80.
297. Id. at 81.
298. CCMR REPORT, supra note 179, at 67.
299. See MCKINSEY REPORT, supra note 194, at 81-82.
300. Id. at 83-84.
301. Id. at 84.
302. Id.
303. Id. at 113-15.
304. Id. at 114.
305. Id. at 84.
306. Id. at 22.
307. Id. at 115.
308. For a similar view on the benefits of private sector influence in regulation, see William H. Donaldson & Harvey L. Pitt, Outdated and Inefficient, WALL ST. J., Jan. 6-7, 2007, at A7 ("With the SROs and the industry taking the lead, the need for a governmental solution is eliminated, and that's always a preferable course.").
309. COMM. ON THE REG. OF U.S. CAPITAL MKTS. IN THE 21ST CENTURY, RPT. AND RECOMMENDATIONS (Mar. 2007), available at http://www.capitalmarketscommission.com/portal/ capmarkets/default.htm (follow "Download the full report" hyperlink)
310. [hereinafter COMMERCE REPORT];
311. see also Kara Scannell, Panel Urges Steps to Boost Allure of U.S. Markets, WALL ST. J., Mar. 12, 2007, at A1 (discussing the Commerce Report and the panels hosted by Treasury Secretary Paulson to discuss and debate U.S. competitiveness);
312. Panel Commissioned by U.S. Chamber Urges Ways to Advance U.S. Capital Markets, 39 Sec. Reg. & L. Rep. (BNA) No. 11, at 413 (Mar. 19, 2007) (discussing the COMMERCE REPORT and the conferences held by the Treasury department).
313. COMMERCE REPORT, supra note 213, at 1.
314. Id.
315. Id. at 12.
316. Id. at 11.
317. Id. at 146.
318. Id. at 11.
319. Whenever . . . the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation. National Securities Markets Improvement Act of 1996 (NSMIA) Pub. L. No. 104-290, 110 Stat. 3416, 3424-25 (codified as amended in scattered sections of 15 U.S.C). This language has been added to each of the three principal securities statutes-the Securities Act of 1933, Securities Exchange Act of 1934, and the Investment Company Act of 1940-demonstrating that the broader objectives of efficiency, competition, and promotion of capital formation have equal standing with the protection of investors. COMMERCE REPORT, supra note 213, at 120.
320. COMMERCE REPORT, supra note 213, at 17.
321. Id. at 6.
322. Id. at 6-10. The Commission recognized the important work and findings by other groups, i.e., the CCMR REPORT and the MCKINSEY REPORT, concerned with the challenges facing U.S. capital markets and specifically limited its recommendations to reduce duplication in examination in some areas.
323. Id. at 12. However, it echoed the efforts to "reform America's litigation system to reduce frivolous lawsuits."
324. Id.
325. Id. at 21. However, the Commission also recognized that the lessened competitiveness of U.S. capital markets was a combination of the fact that European and Asian markets were developing as sound and secure markets, which increasingly will attract more companies, and should be viewed as a positive development; along with the regulatory requirements that have increased the cost of raising capital in the U.S., a lack of convergence in accounting systems between the U.S. and foreign markets, and the level of U.S. civil litigation.
326. Id. at 16-17.
327. Id. at 117.
328. Id. at 121.
329. Id. at 128.
330. Id. at 129-30.
331. Id. at 131.
332. Id. at 131-33.
333. Id. at 139.
334. Id. at 139-40. The Commission also is mindful of the historical underpinnings of the
335. bifurcated system in this country. And the Commission is cognizant of the criticisms against simply merging the functions of the SEC and the CFTC into a single agency. For example, agricultural groups, including farmers and ranchers, which often use the commodities markets to hedge their risk, fear that their interests will become secondary to the interests of securities firms in a combined agency dominated by securities issues. Id. at 139.
336. Id. at 139-40 ("Commission recommends that Congress enact legislation that transfers from the CFTC to the SEC sole regulatory and supervisory authority over trading of futures on securities, including single securities and securities indexes."). Currently, these products are subject to a mix of SEC and CFTC regulation. Consolidating regulatory responsibility for these products will result in more streamlined regulatory oversight and will reduce the cost of complying with multiple schemes. Under this recommendation, the CFTC would retain jurisdiction over commodity futures. The Commission cautions that the interests of the commodities market participants must be preserved in order for this recommendation to be successfully implemented.
337. Id. at 140.
338. COMMERCE REPORT, supra note 213, at 137-38.
339. Id. at 36-40. "Substituted compliance" would allow for foreign institutions to be exempt from U.S. regulation if there was comparable home-country regulation and bilateral information sharing between the U.S. and foreign regulator, as well as reciprocal treatment for U.S. institutions in the foreign country.
340. Id. at 38.
341. Id. at 7. The Commission praises the SEC initiatives already in place that attempt to give such guidance through no-action letters, frequently-asked-questions (FAQs), and conferences.
342. Id. at 131.
343. Id. at 7, 122-23.
344. Id. at 117-19.
345. Henry M. Paulson, Jr., Sec'y, U.S. Dep't of the Treasury, Opening Remarks at Treasury's Capital Markets Competitiveness Conference (Mar. 13, 2007), available at http://www.treas.gov/press/releases/hp306.htm. Mr. Paulson stated: Throughout the day, the fundamental question we must ask is: Have we struck the right balance between investor protection and market competitiveness - a balance that assures investors the system is sound and trustworthy, and also gives companies the flexibility to compete, innovate, and respond to changes in the global economy? Id.
346. Deborah Solomon, A Summit on U.S. Rules: 'Too Gosh-Darn Complex,' WALL ST. J., Mar. 14, 2007, at C4 (discussing the Capital Markets Competitiveness Conference).
347. Id.
348. Press Release, U.S. Dep't of the Treasury, Paulson Announces Next Steps to Bolster U.S. Markets' Global Competitiveness (June 27, 2007), available at http://www.ustreas.gov/press/releases/hp476.htm (other initiatives announced include Encouraging Development and Adoption of Industry Best Practices for Asset Managers and Investors in Hedge Funds; Modernize Treasury's Cash Management and Debt Management; Complete Basel II Rulemaking; Empower All Investors through Financial Education; and Encourage International Investment Opportunities with Recognition of Comparable Regulatory Regimes). Paulson had released an earlier set of initiatives all "focused on strengthened financial reporting and a more sustainable and transparent auditing profession." Press Release, Henry M.
349. Paulson, Jr., Sec'y, U.S. Dep't of the Treasury, Paulson Announces First Stage of Capital Markets Action Plan (May 17, 2007), available at http://www.ustreas.gov/press/releases/hp408.htm.
350. See CCMR REPORT, supra note 179, at 59-65;
351. COMMERCE REPORT, supra note 213, at 121;
352. Robert K. Steel, Under Sec'y for Domestic Fin., U.S. Dep't of the Treasury, Strengthening Our Capital Markets Competitiveness, Remarks Before the Council on Competitiveness (May 17, 2007), available at http://www.treas.gov/press/releases/hp409.htm (discussing the Treasury Department initiatives, with special emphasis on the regulatory reforms, including "Benefit-Burden Analysis").
353. While the OTC derivatives market is not itself subject to regulation, the Major Dealers initiative is a poignant example of how market regulation could be achieved as an efficient and flexible collaborative undertaking by the actual market participants. There may be some resistance to efforts to make these "unregulated markets" subject to the same sort of oversight and cooperative action, but if this were part of an extensive revamp of the regulatory approach to all markets, this author believes that it would be successful; because, by giving up some modicum of freedom in OTC markets, there would be a much greater overall benefit of increased participation in and flexibility of rulemaking across all financial markets.
354. Timothy Geithner, Pres. & C.E.O. of Fed. Reserve Bank of N.Y., Economic Dynamics of Global Integration, Remarks at the Forum on Global Leadership: U.S. Competitiveness in a Globally Integrated Economy (July 25, 2007), available at http://www.newyorkfed.org/newsevents/speeches/2007/ gei070725.html.
355. Steel, supra note 242.
356. Corrigan Says Probability of Systemic Train Wreck Lower, 38 Sec. Reg. & L. Rep. (BNA) No. 47, at 2005 (Dec. 4, 2006) (quoting SEC Comm'r Annette Nazareth);
357. see also David Wessel, How Would Hedge Funds Behave in a Crisis?, WALL ST. J., July 20, 2006, at A2 (discussing the success of the Major Dealers initiative in "cleaning up the back-office derivatives mess" as a model of how government can play a role in regulation, "even without new rules"); Nazareth, supra note 154 (approving of the Major Dealers initiative in speech).
358. Emil E. Henry, Jr., Asst. Sec'y of the Treasury, Hedge Funds and Derivatives Markets: History, Issues and Current Initiatives, Remarks Before the Fixed Income Forum (Mar. 9, 2006), available at http://www.tres.gov/ press/releases/js4111.htm (speaking about the multi-faceted progress made in the credit derivatives market over the last year).
359. Banks Chart Significant Progress Toward Key Risk Managemet Goals, 38 Sec. Reg. & L. Rep (BNA) No. 10, at 366 (Mar. 6, 2006) (quoting Corrigan, and discussing the progress made in the credit derivatives markets, as well as continuing challenges).
360. Corrigan Says Probability of Systemic Train Wreck Lower, supra note 246 (quoting Geithner).
361. Press Release, Fed. Reserve Bank of N.Y., Statement Regarding New York Fed Meeting with Primary Dealers (Nov. 6, 2006), available at http://www.ny.frb.org/newsevents/news/markets/2006/an061105.html;
362. see also New York Fed Meets with Dealers, Treasury Seeking Ways to Improve Integrity of Market, 38 Sec. Reg. & L. Rep. (BNA) No. 45, at 1899 (Nov. 13, 2006).
363. See supra note 137 (discussing the initiative in the equity derivatives market).
364. See Corrigan Says Probability of Systemic Train Wreck Lower, supra note 246, and text accompanying note 249. Also, if Mr. Geithner's remarks were contemplating the fact that the Major Dealers had an increased motivation for self-correcting the problems in the industry in order to remain free of external regulation, such motivation would be inherent in all markets if they were given the opportunity to self-regulate as in the model proposed in this Comment. In fact, Mr. Geithner was also quoted as saying, "[w]e need to be able to move more quickly than we have in the past; we need to be prepared to work with the market and use the market to find sensible solutions-and we have to move to a more integrated framework . . . ."
365. Corrigan Says Probability of Systemic Train Wreck Lower, supra note 246. These remarks coincide perfectly with the model of regulation advocated in this Comment and lend even more support for using the Major Dealers initiative as a model for future regulation.
366. This author is not naive enough to believe that such dramatic changes to the U.S. regulatory structure will overcome the practical hurdles to become reality; but the principles of consolidation of oversight and delegation of rulemaking to market participants are ideals that should be furthered at every given chance to increase the efficiency of regulation and thereby enhance U.S. competitiveness. However, there has been recent discussion of merging regulators with overlapping responsibilities. See Deborah Solomon, Paulson to Launch Review of U.S. Regulatory System, WALL ST. J., June 27, 2007, at A6 (discussing possibility of merging two banking regulators: the Office of the Comptroller of the Currency and the Office of Thrift Supervision). At some point Congress will need to address these fundamental jurisdictional and policy issues [between the CFTC and SEC]. And dare I note that the issues of potential SEC-CFTC consolidation pale in comparison to the challenges, but also the potential cost savings and efficiencies, that could result from consolidation of even a few of the many federal banking regulators? Annette L. Nazareth, Comm'r, Sec. & Exch. Comm'n, Remarks Before the Council of Institutional Investors (Mar. 20, 2007), available at http://sec.gov/news/speech/2007/spch032007aln.htm.
367. For a discussion of the development of the SRO regulatory model in the securities and commodities and futures markets, see Markham, supra note 18, at 325-56
368. and Keaveny, supra note 178, at 1423-38.
369. The market participants would have the most powerful motivation to ensure efficient regulation: they would all benefit from eliminating redundancy; they have the firsthand knowledge to formulate regulations that ensure competitiveness; and their daily experience in the markets will allow them to constantly assess and evaluate the current regulations, and make any necessary changes.
370. It should be noted that there is potential for abuse by a single market regulator, as recognized by Markham, supra note 18, at 405: A single regulator may also seek to expand its powers after a scandal. A single regulator will also undoubtedly use bad judgment in times of crisis. A single regulator could also stifle competition, over-regulate, and cause a loss of competitive position in international markets. It could even try to . . . manage the economy by bureaucratic fiat (footnote omitted).
371. Professor Markham's point is well taken, and correct. Without competing regulatory bodies, there is less of a check on the ability of a regulator to overreach its authority. However, many of these concerns would be offset by the use of the extended SRO model advocated in this Comment, which would dilute the control of the government regulator to a role of guidance and enforcement. Also, the government regulator would answer to Congress, and through lobbying efforts, the financial services industries would be able to exercise a modicum of control over abuse of power by the government regulator. It should further be noted that Professor Markham did not come to the conclusion that a single regulator would be not be the best approach, but rather stated that "a unified regulator seems to be a sound idea," while recognizing both the strengths and weaknesses inherent in such an approach. Id. at 410.
372. No regulatory structure can exist on principles alone. Markets need and want a certain degree of rules to guide and give them assurance that they are acting properly. For a discussion of the need for regulatory rules and the "overblown" dichotomy between the U.S. rules-based approach and the U.K. principles-based approach to regulation, see Roel C Campos, Comm'r, Sec. & Exch. Comm'n, Principles v. Rules, Address Before Luxembourg Fund Industry Association & American Chamber of Commerce (June 14, 2007) (showing the need for rules in a regulatory structure, and pointing out that the FSA has an 8,000 page rulebook along with their eleven guiding principles); Robert C. Pozen, Bernanke's False Dichotomy, WALL ST. J., May 19-20, 2007, at A8 (describing the false dichotomy between rules-based and principles-based regulation). This Comment does not advocate market regulation based on principles alone, but merely that oversight by the government regulatory body be so based. Then, leave it to the market to develop the rules and practices based on its fundamental desire for efficient and flexible requirements.
373. Annette L. Nazareth, Comm'r, Sec. & Exch. Comm'n, Remarks Before the SIFMA Compliance and Legal Conference (Mar. 26, 2007), available at http://sec.gov/news/speech/20070/spch032607aln.htm.
374. Id. Commissioner Nazareth also recognizes that the SEC has made steps in this direction through its Consolidated Supervised Entity (CSE) Program, and that such an approach to regulation has limitations, i.e., it may not be the best approach for regulating retail sales practices.
375. Recommendations by the President's Working Group on Financial Markets: Hearing Before the Commission on Banking and Financial Services, 106th Cong. 84 (Apr. 11, 2000) (statement by Hon. James A. Leach, Chairman, Comm. on Banking and Fin. Services).
376. See News Release, NASD, NASD Member Firms Embrace Streamlined, More Efficient Regulation (Jan. 21, 2007), available at http://www.nasd.com/PressRoom/NewsReleases/2007NewsReleases/NASDW_018334 (discussing the merger between the two regulatory organizations into a single SRO which "create[d] a single regulator for the country's nearly 5,100 broker-dealers, eliminating overlapping regulation and reducing costs to the industry").
377. By placing the responsibility for regulating each market in the hands of the market participants through working groups organized by the governmental regulator or through non-profit membership organizations adaptation of the current SRO model, another controversy would be settled, i.e., the unrest caused by the demutualization of many exchanges. Many feel that by making exchanges a for profit enterprise, there will be increased incentive for those exchanges to become lax in their regulatory capacity and even inherent conflict between the pursuit of profit and the "separate" regulatory function of ensuring compliance by its members. For a discussion of the demutualization concerns, see Caroline Bradley, Demutualization of Financial Exchanges: Business as Usual?, 21 NW. J. INT'L L. & Bus. 657 (2001);
378. Keaveny, supra note 178, at 1438-50;
379. see also Aaron Lucchetti, Alistair MacDonald & Kara Scannell, NYSE, Euronext Set Plan to Form a Markets Giant - Landmark $20 Billion Deal by U.S., Europe Exchanges Face Oversight Questions, WALL ST. J., June 2, 2006, at A1.
380. See Randall Smith, NASD Approves Tie-up With NYSE on Oversight, WALL ST. J., Jan. 22, 2007, at C5; News Release, FINRA, NASD and NYSE Member Regulation Combine to Form Financial Industry Regulatory Authority - FINRA (July 30, 2007), available at http://www.finra.org/PressRoom/NewsReleases/2007NewsReleases/P036329.
381. Donaldson & Pitt, supra note 212, at A7 (both authors are former chairmen of the SEC) (criticizing the current state of securities regulation as "redundant and inefficient and in that context doesn't benefit either investors or the industry," and calling the merger "the first significant change in the self-regulatory regime in this country in more than 70 years");
382. see Christopher Cox, Chairman, Sec. & Exch. Comm'n, More Efficient and Effective Regulation in the Era of Global Consolidation of Markets, Remarks to the Securities Industry & Financial Markets Association (Nov. 10, 2006), available at http://sec.gov/news/speech/2006/ spch111006cc.htm ("As Chairman of the Securities and Exchange Commission, I strongly support these efforts, which are currently well underway, to fold the member regulation functions of both the NASD and the NYSE into one regulatory body. I'm firmly convinced that, done properly, this can make our self regulatory system more efficient and more robust from an investor protection standpoint."), it should be noted that not all of the comments regarding the merger have been positive. Most of the criticism focused on the perceived decrease in investor protection, subjugation of smaller market participant interests and increased industry influence as opposed to investor protection.
383. See William F. Galvin, Sec'y of the Commonwealth, of Mass. (Boston), Letter to the Editor, Multiple Regulators Vital to U.S. Securities Markets, WALL ST. J., Dec. 11, 2006, at A19 ("If NYSE regulation is merged into the NASD, there will be one less decision maker evaluating the conduct of market participants.");
384. see also Randall Smith, NASD's Chief Fights for United Regulators, WALL ST. J., Dec. 15, 2006, at C1 (presenting a brief balanced review of the issues that faced the merger).
385. The market participants would have somewhat of a voice in the rules and practice promulgated by the single regulator, with ten of the twenty-three seats on the board of directors reserved for industry representation. Smith, supra note 264, at C1. Having a minority representation on the board of directors is a far cry from the direct industry initiative of designing the rules for the markets in which they operate, as advocated by this Comment and exemplified in the Major Dealers initiative in the credit derivatives market.
386. However, with the recent budgetary concerns within the CFTC, and the fact that the CFTC has not been reauthorized - the CEA expired in 2005 - as well as the recent discussions of merging of certain banking regulators and of the SEC and CFTC (discussed supra note 253)
387. it would seem that the time may be ripe for serious contemplation of moving toward a unified regulatory system. See Hatfield Laments Budget, Staffing, But Sees Hope in SEC Ties as Realms Converge, 38 Sec. Reg. & L. Rep. (BNA) No. 47, at 2011 (Dec. 4, 2006) (discussing the CFTC Comm'r Hatfield's concerns over the underfunding of the CFTC and his optimism that the "CFTC and SEC can forge a closer alliance as the worlds of equity and derivatives trading become more closely aligned," and his proposed "formal structure to link the regulators");
388. CFTC Reauthorization Back, but Issue Faces Crowded Calendar for Attention, 39 Sec. Reg. & L. Rep. (BNA) No. 3, at 99 (Jan. 22, 2007) (discussing the CFTCs concerns, primarily its underfunding and Congress's failure to reauthorize the CEA since 2005).
389. See Smith, supra note 264, at C1 (describing a similar approach used by the NASD as one reason for opposition to the NASD-NYSE merger: "[NASD] dissidents are worried they will lose their voice because it will end the NASD's current 'one firm, one vote' policy, which favors small firms"). Such a policy carries with it the reciprocal concern of excluding the interests of the larger firms by diluting their influence in the collaborative process with copious representation of smaller firms.