The dynamics of OTC derivatives regulation: Bridging the public-private divide

European Business Organization Law Review

Volumn 11, Issue 2, 2010, Pages 155-193

  Awrey, Dan ^a  

^a LINACRE COLLEGE   (United Kingdom)

Author keywords

asymmetries of information and expertise; complexity within financial markets; financial market regulation; over the counter (OTC) derivatives regulation; private and social costs of regulation; public and private ordering

Indexed keywords

EID: 77955864470     PISSN: 15667529     EISSN: 17416205     Source Type: Journal    
DOI: 10.1017/S1566752910200010     Document Type: Article

References (248)

1. Norman Feder, 'Deconstructing Over-the-Counter Derivatives', Columbia Business Law Review (2002) p. 677, at pp. 681-682
2. Bernard Karol, 'An Overview of Derivatives As Risk Management Tools', 1 Stanford Journal of Law, Business & Finance (1995) p. 195, at p. 195
3. Adam Waldman, 'OTC Derivatives and Systemic Risk: Innovative Finance or Dance into the Abyss?', 43 American University Law Review (1994) p. 1023, at p. 1026.
4. While beyond the scope of this paper, developing a sufficiently robust definition of derivatives for regulatory purposes has proven problematic.
5. Karol, supra n. 1, at p. 195, and Waldman, supra n. 1, at pp. 1027-1028.
6. While a number of observers view swaps as representing a third building block (see Feder, supra n. 1, at p. 691) a swap is at its core simply a series of forwards.
7. Satyajit Das, Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives (London, Prentice Hall Financial Times 2006), at p. 23
8. Charles Pouncy, 'Contemporary Financial Innovation: Orthodoxy and Alternatives', 51 SMU Law Review (1998) p. 505, at p. 520
9. Roberta Romano, 'A Thumbnail Sketch of Derivatives Securities and Their Regulation', 55 Maryland Law Review (1996) p. 1, at p. 8.
10. Todd Petzel, 'Derivatives: Market and Regulatory Dynamics', 21 Journal of Corporation Law (1995) p. 95, at p. 96.
11. Significantly the development of the Black-Scholes option pricing model; see Fischer Black and Myron Scholes, 'The Pricing of Options and Corporate Liabilities', 81 Journal of Political Economy (1973) p. 637.
12. As the business activities of many firms became increasingly international during the 1960s and 1970s, these activities exposed firms to an increasing degree of foreign exchange risk, thus generating a demand for financial instruments capable of assisting firms to manage this risk.
13. The abandonment of the Bretton Woods system by the US in 1971 in favour of a floating exchange rate regime precipitated an increase in exchange rate volatility, thus further enhancing the demand for financial instruments capable of managing foreign exchange risk.
14. Specifically, the decision by many central banks during the 1970s and 1980s to abandon money supply targets led to an increase in interest rate volatility, thus generating a demand for financial instruments capable of managing interest rate risk.
15. Karol, supra n. 1, at pp. 197-198.
16. Waldman supra n. 1, at p. 1025.
17. For a more comprehensive overview of the taxonomy of OTC derivatives, see Satyajit Das, The Swaps and Financial Derivatives Library (New York, John Wiley & Sons 2005).
18. The Bank for International Settlements, BIS Quarterly Review (June 2009).
19. While illuminative of the size and growth of derivatives markets, notional value-effectively the benchmark against which cash flows are calculated in the context of derivatives transactions-does not provide an accurate picture of value actually at risk.
20. Feder, supra n. 1, at p. 717, and Waldman, supra n. 1, at pp. 1036-1037. In the case of many securitisations, dealers perform a role resembling that of an underwriter in a more securities offering.
21. See, for example, Feder, supra n. 1, at pp. 717-721; Frank Partnoy, 'Financial Derivatives and the Costs of Regulatory Arbitrage', 22 Journal of Corporation Law (1996-1997) p. 211, at pp. 223-227
22. Lynn Stout, 'Betting the Bank: How Derivatives Trading under Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets', 21 Journal of Corporation Law (1995) p. 53.
23. Jonathan Macey, 'Derivative Instruments: Lessons for the Regulatory State', 21 Journal of Corporation Law (1995) p. 69, at p. 72.
24. Feder, supra n. 1, at p. 682.
25. This example in particular (and that of the rancher) illustrates the conceptual difficulties associated with characterising hedging and speculation as mutually exclusive motivations. While the prevailing view would be that this transaction constituted a hedge, is the company not simultaneously taking a speculative position on the basis of its expectation that interest rates may increase (or at least not decrease)?
26. Partnoy, supra n. 15, at p. 211.
27. Ibid., at pp. 227-235.
28. Ibid., at pp. 225-226, and Macy, supra n. 16, at p. 82.
29. Partnoy, supra n. 15, at pp. 225-226.
30. Although, as discussed in greater detail in section 7, regulatory proposals currently being debated in both the US and Europe would, if enacted into law, dramatically alter this regulatory landscape.
31. Feder, supra n. 1, at pp. 731-732.
32. Ibid., at pp. 732-734. A clearing house is in effect a single, centralised counterparty. In order to manage the concentrated counterparty credit and settlement risk to which the clearing house is exposed, exchanges (or regulators) typically impose initial and maintenance (or variation) margin requirements which oblige end-users to post specified collateral.
33. In the US, for example, the SEC and CFTC possess the authority within their spheres of influence to require the registration of exchanges and contract markets, respectively, and establish and enforce rules of conduct, financial standards and disclosure of market positions, monitor individual transactions and, where necessary, intervene in the marketplace to ensure fair and orderly trading. Within the EU, derivatives exchanges typically constitute either authorised regulated markets or multilateral trading platforms under the Markets in Financial Instruments Directive (MiFID) and are thus subject to the provisions under Titles II or III thereof, as applicable, concerning, amongst other matters, the promulgation of regulations governing access to the exchange, fair and orderly trading, the efficient execution of orders, the approval of new instruments, compliance monitoring and reporting and post-trade transparency.
34. Although, as described in great detail in section 2.3, participants in OTC derivatives markets have, through the auspices of ISDA, developed bilateral mechanisms which perform a similar function.
35. The Bank for International Settlements, BIS Quarterly Review (June 2009).
36. The US in particular possesses a labyrinthian and often overlapping system of qualifications and exemptions, many of which reflect the historic turf war between the SEC and CFTC respecting the regulation of derivatives.
37. 'Prudential' banking requirements are regulatory mechanisms such as minimum capital requirements and maximum leverage ratios designed to constrain risk-taking by financial institutions and thus ensure the stability of the financial system.
38. 'Mark-to-market' or 'fair value' accounting refers to a widely employed accounting methodology pursuant to which financial assets such as OTC derivatives are ascribed a value based on the current market price of the asset (or similar assets).
39. See ISDA Mission Statement, available at: http://www.isda.org.
40. Feder, supra n. 1, at p. 736.
41. Ibid..
42. Ibid., at p. 737.
43. The value of a 'master' agreement resides primarily in its ability to incorporate multiple future transactions between end-users under the umbrella of a single legal relationship, contemplating only the preparation of a brief trade confirmation in respect of individual transactions. A master agreement thus reduces the transaction costs which would otherwise be incurred in connection with the negotiation and preparation of transaction documentation in respect of individual transactions.
44. For further details, see Commission of the European Communities, 'Ensuring Efficient, Safe and Sound Derivatives Markets', Commission Staff Working Paper accompanying the Commission Communication (3 July 2009), at s. 3.1.4.1.
45. Sean Flanagan, 'The Rise of a Trade Association: Group Interactions within the International Swaps and Derivatives Association', 6 Harvard Negotiation Law Review (2001) p. 211, at p. 229.
46. Ibid., at p. 228. Notably, the influence of ISDA has been considerably more muted within the securitisation markets residing at the epicentre of the current global financial crisis.
47. Ibid., at p. 233.
48. Andrew Parry, 'ISDA/FpML for Financial Institutions', 22 Journal of International Banking Law and Regulation (2007) p. 495.
49. John Lynch, 'Credit Derivatives: Industry Initiative Supplants Need for Direct Regulatory Intervention-A Model for the Future of U.S. Regulation?', 55 Buffalo Law Review (2008) p. 1371.
50. Creditex, TFS-ICAP, Tradeweb, BBG and Bloomberg, for example.
51. Markit Wire, Swift and CLS, for example.
52. ICE, SwapClear and LCH.Clearnet, for example.
53. Trade Information Warehouse, for example.
54. For a more thorough description of the nature and scope of the services provided by these private actors, see European Commission Working Paper, supra n. 37.
55. SwapClear, for example, has been praised for its successful unwinding of open interest rate swap positions following the default of Lehman Bros. in September 2008; European Commission Working Paper, supra n. 37, s. 4.2.
56. Timothy Besley, Principled Agents? The Political Economy of Good Government (Oxford, Oxford University Press 2006), at p. 21.
57. Per-Olov Johansson, An Introduction to Modern Welfare Economics (Cambridge, Cambridge University Press 1991), at p. 2.
58. Within the framework of welfare economics, social welfare is commonly conceptualised as a function of the aggregate well-being (or utility) of the members of a society. In turn, the utility function of each member of a society is generally conceived of as comprising anything and everything to which the member ascribes value, whether rooted in material desires, aesthetic tastes, altruistic feelings or notions such as 'morality', 'fairness' or 'justice'
59. Steven Shavell, Foundations of Economic Analysis of Law (Cambridge, Harvard University Press 2004), at p. 2. Welfare economics is thus theoretically capable of incorporating an infinitely broad range of values into the social welfare calculus. Nevertheless, it has become commonplace for scholars employing welfare economics to confine their methodology to measures of net social welfare which bracket aside issues of distributive justice and amorphous notions such as morality, fairness and justice. As Steven Shavell observes, introducing such amorphous notions into the equation-other than in connection with their functionality as constituent elements of individual utility-risks rendering the calculus unduly subjective and, thus, unintelligible for the purposes of identifying socially (sub-)optimal modes of regulation;
60. Ibid., at p. 664.
61. Furthermore, given the prospect of ex post redistribution via taxation, incorporating issues of distributive justice may serve to complicate the evaluation without in the end yielding meaningful changes to the product of the social welfare calculus
62. Ibid., at p. 3.
63. More fundamentally, bracketing aside issues of distributive justice in pursuit of socially optimal modes of regulation does not ultimately prejudice redistributive objectives. Indeed, to the extent that it generates welfare gains capable of subsequent redistribution and forces us to identify the 'winners' and 'losers' in connection with potential modes of regulation, this pursuit is entirely consistent with these objectives. Accordingly, consistent with much of the previous scholarship within this field, this paper is not primarily concerned with issues of redistribution or notions of morality, fairness or justice.
64. Critics of welfare economics often suggest that the concept of social welfare is both logically incoherent and inherently contested; Besley, supra n. 49, at p. 21. Perhaps most notably, the assumption that the aggregation of individual utilities or preferences into a social welfare function is in fact possible has been challenged by Kenneth Arrow
65. Kenneth Arrow, 'A Difficulty in the Concept of Social Welfare', 58 The Journal of Political Economy (1950) p. 328.
66. Arrow argued that the task of aggregating individual utilities or preferences is 'plagued by the difficulties of interpersonal comparison.'
67. Ibid., at p. 329.
68. Under certain specified conditions, Arrow illustrated that a rational paradox could result from the aggregation of the preferences of as few as two individuals faced with as few as three potential states, thus precluding the construction of a social welfare function. This paper proceeds on the basis that it is possible to construct a social welfare function by relaxing two of Arrow's conditions: (1) that preferences are expressed by ranking discrete pairs of potential states without any knowledge of other potential states, and (2) non-dictatorship. Relaxing these assumptions reflects the realities that: (1) subject to bounded rationality, individuals (including academics and policymakers) will seek to identify as many potential states as possible prior to ordering their preferences, and (2) to the extent that neither academics nor policymakers typically seek to directly measure the preferences of impacted individuals, it must be acknowledged that their activities violate the condition of non-dictatorship.
69. Or, cloaked in the jargon of welfare economics, the tangency between the utility possibilities frontier and the highest attainable social welfare indifference curve (i.e., the 'constrained bliss' point); see Johansson, supra n. 41, at pp. 28-29
70. John Eatwell, Murray Milgate and Peter Newman, eds., The New Palgrave: Allocation, Information and Markets (New York, The Macmillan Press Limited 1989), at p. 1.
71. In this respect, the aim of this paper is not to engage broader normative questions respecting whether markets represent the socially optimal form of economic organisation, but rather to provide a framework for identifying the socially optimal mode of regulating OTC derivatives markets.
72. Christine Cuccia, 'Informational Asymmetry and OTC Transactions: Understanding the Need to Regulate Derivatives', 22 Delaware Journal of Corporate Law (1997) p. 197, at p. 215.
73. Ibid., and Peter Huang, 'A Normative Analysis of New Financially Engineered Derivatives', 73 Southern California Law Review (2000) p. 471.
74. Ronald Coase, 'The Problem of Social Cost', 3 Journal of Law and Economics (1960) p. 1, at p. 10.
75. Ibid., at p. 17.
76. See also Daniel Fischel and Sanford Grossman, 'Customer Protection in Futures and Securities Markets', 4 Journal of Futures Markets (1984) p. 273, at p. 284.
77. Coase, supra n. 57, at p. 23.
78. Avery Katz, 'Taking Private Ordering Seriously', 144 University of Pennsylvania Law Review (1997) p. 1745, at p. 1748.
79. Ronald Coase, 'The Lighthouse in Economics', 17 Journal of Law and Economics (1974) p. 357.
80. See Robert Ellickson, Order Without Law: How Neighbors Settle Disputes (Cambridge, Harvard University Press 1991);
81. Bruce Benson, 'The Spontaneous Evolution of Commercial Law', 55 Southern Economic Journal (1989) p. 644
82. Avner Greif, Paul Milgrom and Barry Weingast, 'Co-ordination, Commitment and Enforcement: The Case of the Merchant Guild', 102 Journal of Political Economy (1994) p. 745
83. Paul Milgrom, Douglas North and Barry Weingast, 'The Role of Institutions in the Revival of Trade: The Medieval Law Merchant, Private Judges and the Champagne Fairs', 2 Economics & Politics (1990) p. 1
84. Lisa Bernstein, 'Opting out of the Legal System: Extralegal Contractual Relations in the Diamond Industry', 21 Journal of Legal Studies (1992) p. 115
85. Lisa Bernstein, Private Commercial Law in the Cotton Industry: Creating Cooperation through Rules, Norms and Institutions, John. M. Olin Law &Economics Working Paper No. 133 (2001)
86. Paul Mahoney, 'The Exchange As Regulator', 83 Virginia Law Review (1997) p. 1543
87. Jonathan Macey and Maureen O'Hara, 'Regulating Exchanges and Alternative Trading Systems: A Law and Economics Perspective', 28 Journal of Legal Studies (1999) p. 17
88. David Snyder, 'Private Lawmaking', 64 Ohio State Law Journal (2003) p. 371
89. Alan Schwartz and Robert Scott, 'The Political Economy of Private Legislatures', 143 University of Pennsylvania Law Review (1995) p. 595
90. Marcel Kahan and Michael Klausner, 'Standardization and Innovation in Corporate Contracting (or "The Economics of Boilerplate")', 83 Virginia Law Review (1997) p. 713.
91. Furthermore, while private ordering may in certain circumstances enhance the welfare of group members, this outcome must be distinguished from the welfare maximising (i.e., optimally efficient) outcome
92. Eric Posner, 'Law, Economics and Inefficient Norms', 14 University of Pennsylvania Law Review (1996) p. 1697.
93. While private ordering may evolve to become more efficient over time, factors such as imperfect information, bounded rationality, transaction costs and path dependence may steer groups off the welfare-maximising course
94. Jody Kraus, 'Legal Design and the Evolution of Commercial Norms', 26 Journal of Legal Studies (1997) p. 377
95. Randal Picker, 'Simple Games in a Complex World: A Generative Approach to the Adoption of Norms', 64 University of Chicago Law Review (1997) p. 1225.
96. The findings of both Kraus and Picker also underscore the utility and importance of adopting a dynamic perspective respecting the generation, evolution and replacement of regulation.
97. Katz, supra n. 60, at p. 1754.
98. See, for example, Arrow, supra n. 52.
99. Robert Hahn and John Hird, 'The Costs and Benefits of Regulation: Review and Synthesis', 8 Yale Journal on Regulation (1990) p. 233, at p. 233.
100. Posner, supra n. 63, at p. 1743.
101. Feder, supra n. 1, at pp. 717-721
102. Macey, supra n. 16, at pp. 72-81
103. Partnoy, supra n. 15, at pp. 223-227
104. Henry Hu, 'Misunderstood Derivatives: The Causes of Information Failure and the Promise of Regulatory Incrementalism', 102 Yale Law Journal (1993) p. 1457, at pp. 1465-1467.
105. Assuming perfect pricing, these increases would flow from the optimal allocation of risk. However, any increases in net social welfare would likely be diminished or, as Lynn Stout suggests, perhaps even negated, by the existence of pricing imperfections; see Stout, supra n. 15.
106. Huang, supra n. 56, at p. 473.
107. For example, where they were legally prohibited.
108. Hu, supra n. 68, at p. 1465.
109. Waldman, supra n. 1, at p. 1038.
110. Kenneth Arrow and Gerard Debreu, 'Existence of an Equilibrium for a Competitive Economy', 22 Econometrica (1954) p. 265
111. Eatwell, Milgate and Newman, supra n. 44, at p. 185.
112. A frequently cited example of this is the use of CDS by commercial lenders. CDS enable lenders to isolate borrower credit risk from the economic benefits attached to ownership of the underlying debt and, thereafter, shift this credit risk to other parties. CDS thus enable lenders to extend more credit without experiencing a corresponding increase in their aggregate credit risk exposure. Furthermore, the use of CDS to hedge credit risk often provides relief from prudential capital requirements which would otherwise require lenders to maintain a prescribed amount of risk capital on their balance sheets. CDS thus serve to free up capital which can then be re-deployed by lenders toward more productive ends, such as underwriting additional debt.
113. Huang, supra n. 56.
114. 1 represents the price at the end of the specified period (and thus capital appreciation) and r represents the market capitalisation or discount rate (and thus the opportunity cost of capital).
115. Desmond Eppel, 'Risky Business: Responding to OTC Derivatives Crises', 40 Columbia Journal of Transnational Law (2002) p. 677, at p. 684.
116. Ibid., Columbia Journal of Transnational Law
117. Lynn Stout, 'Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives', 48 Duke Law Journal (1999) p. 701, at p. 738.
118. Ibid..
119. Alan Greenspan, 'Risk Transfer and Financial Stability', 5 May 2005, Remarks to the Federal Reserve Bank of Chicago's 41st Annual Conference on Bank Structure, available at: http://www.federalreserve.gov/Boarddocs/Speeches/2005/ 20050505/default.htm. It has been widely observed, for example, that the utilisation of CDS by commercial banks to hedge billions of dollars in ultimately worthless debt issued by Enron, Worldcom and Global Crossing enabled these institutions to avoid massive losses which might have otherwise jeopardised their solvency; Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (New York, Times Books 2003), at p. 376. Similarly, a joint study prepared by the US Federal Reserve System, Federal Deposit Insurance Corporation (FDIC) and Comptroller of the Currency acknowledged that it was unlikely that underlying markets would have performed as well during the September 1992 European currency crisis without the existence of derivatives markets enabling end-users to manage their foreign exchange risk; FDIC, Derivative Product Activities of Commercial Banks, 27 January 1993, joint study conducted in response to questions posed by Senator Riegle on derivative products, at p. 4.
120. Bounded rationality is a semi-strong form of rationality in which economic actors are assumed to be 'intendedly rational, but only limitedly so'; Oliver Williamson, The Economic Institutions of Capitalism (New York, The Free Press 1985), at p. 45
121. citing Herbert A. Simon, Administrative Behavior, 2nd edn. (New York, Macmillan 1961), at p. xxiv.
122. The concept of bounded rationality is grounded in the notion that, if the mind is a scarce resource, there will exist temporal and cognitive constraints on our ability to process information. exist temporal and cognitive constraints on our ability to process information.
123. In the context of a principal-agent (or other cooperative) relationship between two or more parties, the term 'agency costs' refers to costs incurred by the parties in connection with the monitoring and bonding of the other parties, along with any residual (hidden) losses, stemming from the divergence of incentives as between the parties.
124. For a broad and informative overview of behaviour finance, see Peter Bernstein, Capital Ideas Evolving (New York, John Wiley & Sons, Inc. 2007)
125. Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance (Oxford, Oxford University Press 2000)
126. and Eliezer Yudkowsky, 'Cognitive Biases Potentially Affecting Judgment of Global Risks', in Nick Bostrom and Milan Cirkovic, eds., Global Catastrophic Risks (Oxford, Oxford University Press 2008).
127. Feder, supra n. 1, at pp. 721-731, and Waldman, supra n. 1, at pp. 1039-1049.
128. Macey, supra n. 16, at pp. 85 and 89. That said, these costs are still relevant to the extent that they represent constituent elements of net social welfare.
129. Partnoy, supra n. 15, at p. 244.
130. For an illustration of how even the most sophisticated dealers and end-users can fail to appreciate the complexities of OTC derivatives, see Joshua Coval, Jakub Jurek and Erik Stafford, 'The Economics of Structured Finance' 23 Journal of Economic Perspectives (2009) p. 3.
131. The authors illustrate how small miscalculations respecting the probability of default and default correlations across underlying assets ultimately generated significant pricing errors within CDO markets.
132. The historical absence of organised OTC derivatives markets has meant, inter alia, that there existed nothing resembling a transparent 'bid-ask' mechanism for transmitting pricing information. Accordingly, the dealer creating the OTC derivative was often the only party with sufficient information and expertise to accurately price it; Cuccia, supra n. 55, at pp. 201-202.
133. Ibid., at p. 205.
134. Huang, supra n. 56, at p. 509.
135. Henry Hu, 'Hedging Expectations: "Derivative Reality" and the Law and Finance of the Corporate Objective', 21 Journal of Corporation Law (1995) p. 3, at pp. 38-39.
136. Where no market for an asset exists-such as occurred in many OTC derivatives markets at various points during the current global financial crisis-mark-to-market methods contemplate the use of financial models-commonly referred to as 'mark-to-model' accounting methods-to determine the value of the asset. One of the shortcomings of mark-to-model accounting methods derives from the fact that financial models inherently assume market liquidity. As a result, where market liquidity does not exist, mark-to-model accounting methods will distort balance sheet positions by giving the false impression of liquidity.
137. Again, as explored in greater detail in section 7, this may be on the verge of changing. Indeed, significant progress has already been made in this regard within CDS markets, where Markit now publishes two price indices (iTraxx and CDS) and last quotes on the most liquid CDS contracts.
138. Milton Friedman, Capitalism and Freedom (Chicago, University of Chicago Press 1962), at p. 13.
139. Or the securities of end-users.
140. Eatwell, Milgate and Newman, supra n. 53, at p. 36.
141. Indeed, there exists some preliminary empirical evidence to support the proposition that insider trading takes place within some OTC derivatives markets; see Viral V. Acharya and Timothy C. Johnson, Insider Trading in Credit Derivatives (2005), available at: http://papers.ssrn.com/sol3/papers.cfm? abstract-id=767864#PaperDownload.
142. Prominent examples of alleged abuse by dealers include claims brought by Proctor &Gamble, Gibson Greeting Cards and Orange County, California. More recently, Deutsche Bank was named as plaintiff in German lawsuits alleging that the financial institution sold its clients complicated and opaque derivatives products without due regard to suitability or whether the client understood what they were buying; see 'Snakes and Ladders', The Economist, 21 February 2008, available at: http://www.economist.com/finance.
143. To the extent that they facilitate the separation of ownership from voting power in respect of corporate equity, OTC derivatives also generate a second-and potentially perverse-investment incentive in the form of so-called 'empty voting'; Henry Hu and Bernard Black, 'The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership', 79 Southern California Law Review (2006) p. 811.
144. Macy, supra n. 16, at p. 82, and Brian Booth, 'Prudence or Paranoia: Considering Stricter Regulation of the International Over-the-Counter Derivatives Market', 5 Duke Journal of Comparative and International Law (1995) p. 499, at p. 513.
145. Partnoy, supra n. 15, at pp. 225-226. Indeed, OTC derivatives are often employed exclusively for the purposes of obtaining leverage, and many OTC derivatives can be viewed as the economic equivalent of leveraged transactions in non-derivative markets; Macy, supra n. 16, at p. 82.
146. Partnoy, supra n. 15, at pp. 225-226.
147. Macey, supra n. 16, at p. 84.
148. See Das, supra n. 3.
149. Feder, supra n. 1, at p. 729
150. Waldman, supra n. 1, at pp. 1053-1054
151. Booth, supra n. 102, at p. 515.
152. See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York, Random House 2000).
153. See 'The $2 Bailout', The Economist, 19 March 2008, 'What Went Wrong?', The Economist, 19 March 2008, 'Domoclean Days', The Economist, 7 August 2008, all available at: http://www.economist.com/finance.
154. This susceptibility was, rather presciently, described in The Economist in 1992: 'It is difficult to liquidate a derivative that cannot be valued and it is difficult to value a derivative that cannot be liquidated'; 'Taming the Derivatives Beast', The Economist, 23 May 1992.
155. Hu, supra n. 68, at p. 1482.
156. Palgrave, supra n. 53, at p. 185.
157. Hu, supra n. 93, at p. 11.
158. Besley, supra n. 49, at pp. 3 and 45.
159. Ibid..
160. Johansson, supra n. 50, at p. 60.
161. Gillian Hadfield and Eric Talley, 'On Public versus Private Provision of Corporate Law', 22 Journal of Law, Economics, and Organization (2006) p. 414
162. Snyder, supra n. 62, at p. 437, and Mahoney, supra n. 62.
163. Cally Jordan and Pamela Hughes, 'Which Way for Market Institutions: The Fundamental Question of Self-Regulation', 4 Berkeley Business Law Journal (2007) p. 205
164. Robert Baldwin and Martin Cave, Understanding Regulation: Theory, Strategy and Practice (Oxford, Oxford University Press 1999), at p. 65
165. Snyder, supra n. 62, at pp. 422-424, and Benson, supra n. 62, at p. 650. For a counter-argument that the problem of information lag also afflicts systems of private ordering, see Posner, supra n. 63.
166. Barak Richman, 'Firms, Courts, and Reputation Mechanisms: Towards a Positive Theory of Private Ordering', 104 Columbia Law Review (2004) p. 2328, at p. 2341.
167. Snyder, supra n. 62, at pp. 419-420.
168. Steven Schwarcz, 'Private Ordering', 97 Northwestern University Law Review (2002) p. 319, at p. 325
169. Julia Black and David Rouch, 'The Development of the Global Markets As Rule-makers: Engagement and Legitimacy', 2 Law and Financial Markets Review (2008) p. 218, at pp. 218 and 224
170. Jordan and Hughes, supra n. 118, at p. 220.
171. Jonathan Macey, 'Public and Private Ordering and the Production of Legitimate and Illegitimate Legal Rules', 82 Cornell Law Review (1997) p. 1123, at p. 1124
172. Robert McCormick and Robert Tollison, Politicians, Legislation and the Economy: An Inquiry into the Interest-Group Theory of Government (London, Martin Nijhoff Publishing 1981)
173. Robert Tollison, 'Public Choice and Legislation', 74 Virginia Law Review (1988) p. 339
174. Posner, supra n. 63, at p. 1718
175. Snyder, supra n. 62, at pp. 435-436, and Mahoney, supra n. 62, at p. 1463.
176. Snyder, supra n. 62, at p. 436.
177. Robert Cooter and Thomas Ulen, Law and Economics, 3rd edn. (Reading, Mass., Addison Wesley Longman 2000), at pp. 41-43
178. Stephen Pirrong, 'The Efficient Scope of Private Transactions-Cost Reducing Institutions: The Successes and Failures of Commodity Exchanges', 24 Journal of Legal Studies (1995) p. 229
179. Baldwin and Cave, supra n. 118, at pp. 9-16
180. Fischel and Grossman, supra n. 58, at p. 280 and 284-285
181. Ellickson, supra n. 62, at pp. 283-284
182. Posner, supra n. 63, at p. 1698; Kahan and Klausner, supra n. 62, at p. 730
183. Macey and O'Hara, supra n. 62, at pp. 26-27
184. Schwarcz, supra n. 121, at pp. 330-331.
185. Ian Ayres and John Braithwaite, Responsive Regulation: Transcending the Deregulation Debate (Oxford, Oxford University Press 1992), at p. 106.
186. A phenomenon of particular concern where the use of OTC derivatives generates negative externalities.
187. Gillian Hadfield, 'Privatizing Commercial Law', 40 Regulation (2001) p. 40
188. Snyder, supra n. 62, at p. 434, and Black and Rouch, supra n. 121, at p. 223.
189. Steven Bernstein and Benjamin Cashore, 'Can Non-State Global Governance Be Legitimate?', 1 Regulation and Governance (2007) p. 347
190. Hadfield, supra n. 127, at p. 44, and Schwarcz, supra n. 121, at pp. 337-338.
191. Baldwin and Cave, supra n. 118, at p. 128. This is, of course, not an attribute which is exclusive to private actors. The activities of many public actors are funded, either in whole or in part, via taxes, levies or other fees collected from regulated actors.
192. As Hadfield and Talley, supra n. 117, observe, subject to transaction costs, innovation and increased (if not necessarily optimal) efficiency are costless by-products of the differentiation which one would expect to observe within a competitive market for regulation.
193. These bureaucratic failures stem from, inter alia, the propensity to: (1) manage complexity; (2) forgive internal errors; (3) engage in log rolling; and (4) treat organisational procedures as ends in themselves; Williamson, supra n. 83, at p. 148.
194. Ellickson, supra n. 62
195. Greif et. al., supra n. 62
196. Milgrom et. al., supra n. 62
197. Bernstein, supra n. 62;
198. Mahoney, supra n. 62
199. Macey and O'Hara, supra n. 62
200. Snyder, supra n. 62.
201. Effectively by constraining the inherent conflicts of interest.
202. Posner, supra n. 63.
203. Macey, supra n. 122, at p. 1124; McCormick and Tollison, supra n. 122, and Tollison supra n. 122.
204. Adam Pritchard, 'Self-Regulation and Securities Markets', Regulation (Spring 2003) p. 32, at pp. 33-34.
205. Besley, supra n. 49, at pp. 36-43, and Johansson, supra n. 50, at pp. 82-83.
206. As observed by Timothy Besley, the term 'government failure' is often used, but rarely defined; Besley, supra n. 49, at p. 45. In Besley's words: '[t]he basic and highly intuitive idea is that there are systemic reasons why governments fail to deliver the kind of service to its citizens that would be ideal.'; Ibid.
207. Johansson, supra n. 50, at p. 84.
208. Besley, supra n. 49, at pp. 28 and 59.
209. Julia Black, Critical Reflections on Regulation, Discussion Paper No. 4 (The London School of Economics and Political Science Centre for Analysis of Risk and Regulation, January 2002), at p. 3
210. Baldwin and Cave, supra n. 118, at p. 126, and Mahoney, supra n. 62, at p. 1462.
211. Robert Cooter, 'Structural Adjudication and the New Law Merchant: A Model of Decentralized Law', 14 International Review of Law and Economics (1994) p. 215, at p. 216.
212. Ray Rees and John Vickers, 'RPIX Price Cap Regulation', in Matthew Bishop, John Kay and Colin Mayer, eds., The Regulatory Challenge (Oxford, Oxford University Press 1995) p. 358, at p. 362.
213. Schwarcz, supra n. 121, at p. 324.
214. See US Department of the Treasury Press Release TG-261, 'Administration's
215. See also discussion and recommendations in European Commission Working Paper, supra n. 37
216. Adair Turner, The Turner Review: A Regulatory Response to the Global Banking Crisis, FSA (March 2009)
217. Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash Persaud and Hyun Shin, The Fundamental Principles of Financial Regulation, Geneva Reports on the World Economy 11 (International Center for Monetary and Bank Studies (ICMBS) 2009)
218. The High-Level Group on Financial Supervision in the EU, Report of the High-Level Group on Financial Supervision in the EU (2009), and International Monetary Fund, IMF Monetary and Capital Markets Department, Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management (2009).
219. See Lynn Stout, 'How Deregulating Derivatives Led to Disaster, and Why Regulating Them Can Prevent Another', available at: http://www.finreg21.com (6 July 2009)
220. Partnoy, supra n. 15; Huang, supra n. 56, and Cuccia, supra n. 55.
221. Black, supra n. 141, at p. 6.
222. Ayres and Braithwaite, supra n. 125, at pp. 3-4.
223. Ibid., at p. 158.
224. As explained by Frank Partnoy: 'derivatives self-regulation is likely to be inefficient, because financial industry participants will find it more profitable to avoid regulatory costs, ignore market failure, maximize fee income, and, to the extent they support any regulation, support those designed to extract economic rent or other benefits.'; Partnoy, supra n. 15, at p. 247.
225. Ayres and Braithwaite, supra n. 125, at p. 19. As Ayres and Braithwaite observe, private actors are bundles of contradictory commitments to values of economic rationality, law-abidingness and business responsibility which manifest themselves at different moments and in different contexts.
226. Baldwin and Cave, supra n. 118, at p. 39.
227. John Armour and David Skeel, 'Who Writes the Rules for Hostile Takeovers, and Why?-The Peculiar Divergence of U.S. and U.K. Takeover Regulation', 95 Georgetown Law Journal (2007) p. 1727, at p. 1764.
228. Ibid..
229. Ibid., at pp. 1759, 1761 and 1763-1764.
230. On the assumption that the expected benefits of defection did not exceed those of future 'unregulated' interactions.
231. This incentive could be further strengthened through the imposition of criminal penalties for individuals who fail to report potential violations; Ayres and Braithwaite, supra n. 125, at p. 106.
232. Mark Roe, 'Delaware's Competition', 117 Harvard Law Review (2004) p. 588.
233. Ibid..
234. See Daniel Esty and Damien Geradin, 'Regulatory Co-Opetition', in Daniel Esty and Damien Geradin, eds., Regulatory Competition and Economic Integration: Comparative Perspectives (Oxford, Oxford University Press 2000).
235. Roe, supra n. 158, at pp. 635-636.
236. This position is consistent with the view that legitimacy, especially within the context of inter-systemic governance, need not necessarily flow directly from democratic sources
237. Robert Schapiro, 'Federalism As Intersystemic Governance: Legitimacy in a Post-Westphalian World', 57 Emory Law Journal (2008) p. 115, at p. 123.
238. Baldwin and Cave, supra n. 118, at p. 40.
239. While the proximity of the relationship between public and private actors would precipitate concerns respecting regulatory capture, these concerns could be addressed through the implementation of transparency and due process mechanisms.
240. The Over-the-Counter Derivatives Market Act of 2009, supra n. 145, subsection 713(b). The EU has stated that it broadly approves the approach contemplated by the US proposal
241. European Commission Working Paper, supra n. 37.
242. Ibid., subsections 715(a) and 753(a).
243. Ibid., section 719 and subsection 753(a).
244. The proposal contemplates somewhat different requirements for swaps repositories, stipulating that they will be subject to standards prescribed by either the CFTC or SEC, as appropriate.
245. The Over-the-Counter Derivatives Market Act of 2009, supra n. 145, subsections 713(a) and 753(a). Although the proposal does contemplate that the CFTC and SEC will provide further joint guidance respecting this pivotal concept.
246. Effectively via the tacit threat of more burdensome public regulation or, in the case of individual actors, revocation of registration.
247. More specifically, the effectiveness of reputational enforcement mechanisms would be undermined by: (1) the constant movement of key personnel between market participants; (2) the fact that end-users often do not wish to report violations for competitive, reputational or legal reasons; and (3) the realistic prospect that the entire OTC derivatives industry would be painted with the same brush as a result of high-profile violations by a small number of market participants.
248. Niall Ferguson, The Ascent of Money: A Financial History of the World (London, Penguin Books 2008), at p. 47.