The inherent limits of 'legal devices': Lessons for the public sector's central counterparty prescription for the OTC derivatives markets

European Business Organization Law Review

Volumn 12, Issue 1, 2011, Pages 87-119

  Braithwaite, Joanne P ^a  

^a LONDON SCHOOL OF ECONOMICS   (United Kingdom)

Author keywords

CCPs; central counterparty clearing; clearing houses; collateral; contract; credit default swaps; Dodd Frank Act; netting; OTC derivatives; reform; regulatory

Indexed keywords

EID: 82655186541     PISSN: 15667529     EISSN: 17416205     Source Type: Journal    
DOI: 10.1017/S1566752911100038     Document Type: Article

References (103)

1. For example, 'Counter Insurgency; The Craze for Clearing Houses', The Economist, 27 June 2009 (where CCPs are described as 'part of the financial plumbing');
2. 'Making a Stink; Credit Derivatives', The Economist, 1 July 2006;
3. N. Aubry, 'Regulating the Plumbing of Europe', 23 Journal of International Banking Law and Regulation (2008) p. 578;
4. P. Wood, 'What Is a Central Counterparty in the Financial Markets?', Allen & Overy, 20 August 2009, noting the usual metaphors and expressing a preference for a comparison with cathedral columns, available at: . (All websites last visited 14 October 2010).
5. The regulatory framework is discussed in B. Penn, 'Recognised Investment Exchanges (RIEs) and Recognised Clearing Houses (RCHs)', in M. Blair and G. Walker, eds., Financial Markets and Exchanges Law (Oxford, OUP 2007).
6. The detail of the international consensus behind this reform and its progress into legislation is discussed in section 2 of the paper below.
7. Counterparty Risk Management Policy Group III, Containing Systemic Risk: The Road to Reform. The Report of the CRMPG III (6 August 2008), at p. 1.
8. 'CDS' are credit default swaps which are one type of OTC derivative. They have attracted particular attention during the debate about the CCP prescription and are discussed in more detail in section 2.1 of the paper below.
9. Letter from senior managements of sixteen major dealers, the International Swaps and Derivatives Association (ISDA), the Managed Funds Association and the Asset Management Group of the Securities Industry and Financial Markets Association to Timothy F. Geithner, President, Federal Reserve Bank of New York, 31 October 2008 (making reference to correspondence between the parties earlier in 2008), available at: .
10. ISDA, 'Major Firms Commit to EU Central Counterparty for CDS', News Release, 19 February 2009.
11. ISDA's role in reforming the derivatives industry, including in the context of clearing initiatives, is discussed in more detail in R. Pickel, 'Navigating the Financial Crisis: Choosing the Right Path for the Derivatives Industry', 4(S1) Capital Markets Law Journal (2009) p. S69.
12. European Central Bank/Eurosystem, Credit Default Swaps and Counterparty Risk, August 2009, at p. 77, available at: .
13. For example, academics from the disciplines of finance and economics were well-represented at the high-level conference organised by the European Commission on 25 September 2009 to conclude its public consultation on OTC derivatives markets. The agenda and materials from this conference are available at: . There has also been some input to the CCP debate from practising lawyers.
14. For example, a detailed discussion by an experienced securities lawyer, covering the history of regulatory interest in OTC derivatives, changes to documentation and market practice and addressing the limits on the kinds of OTC credit derivatives that can be cleared is set out in A. Glass, 'The Regulatory Drive towards Central Counterparty Clearing of OTC Credit Derivatives and the Necessary Limits on This', 4(S1) Capital Markets Law Journal (2009) p. S79.
15. Indeed, as I suggest in section 3 of the paper, a private law analysis is a valuable way in which to consider the function and capacity of a range of complex, market-generated legal devices. This mode of analysis therefore has the potential to contribute to the debates about regulatory reform in a number of areas beyond the OTC derivatives market.
16. A. Turner, The Turner Review: A Regulatory Response to the Global Banking Crisis (London, FSA, March 2009), at p. 27.
17. George Soros has also written that 'the outbreak of the current financial crisis can be officially fixed at August 2007': G. Soros, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means (New York, PublicAffairs 2008), at p. xiii.
18. See the definition of derivatives generally in J. Benjamin, Financial Law (Oxford, OUP 2007), at p. 65.
19. To use the term which is central to Benjamin's thesis of financial law, Benjamin, ibid.
20. The obligations of the protection buyer and seller under a single name CDS are helpfully set out in diagrammatic form in D. Rule, 'The Credit Derivatives Market: Its Development and Possible Implications for Financial Stability', in The Bank of England Financial Stability Review (June 2001) p. 117, at p. 118.
21. For example, the European Central Bank/Eurosystem notes that the CDS market rose by 900% in the three years to the end of 2007 by which point it had a gross nominal value of $58 trillion (European Central Bank/Eurosystem, 'OTC Derivatives and Post-Trading Infrastructures' (September 2009), at p. 13).
22. The European Commissioner for Internal Market and Services has commented of CDS that 'the opaqueness of these products leads to nasty surprises when things go wrong', European Commissioner for Internal Markets and Services Charlie McCreevy, 'Time for Regulators to Get a Better View of Derivatives: Statement on Reviewing Derivatives Markets before the End of the Year' (Brussels, 17 October 2008), Speech/08/538.
23. US Department of the Treasury, 'Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation' (undated), at p. 47.
24. The playwright David Hare concluded in a recent play (through which he 'seeks to understand the financial crisis') that '[n]obody understood them. Even Alan Greenspan ⋯ he didn't understand them⋯ He said he had hundreds of people with PhDs working for him and they didn't understand them either', D. Hare, The Power of Yes (London, Faber and Faber 2009), at p. 34.
25. H. Davies, 'With the Benefit of Hindsight: Lessons from the Credit Crisis for Banks, Regulators and Central Banks', speech, 10 November 2008, at p. 3, transcript available at: .
26. C. Morris, The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash (London, PublicAffairs Ltd 2008), at p. xvi.
27. The meaning of financial collateral is discussed further in section 3 of the paper.
28. In 2000, US$200 billion was posted to support OTC derivatives exposures and there were 12,000 collateral agreements. By the end of 2005, US$1.3 trillion was posted and there were 110,000 collateral agreements: Committee on Payment and Settlement Systems, New Developments in Clearing and Settlement Arrangements for OTC Derivatives (Bank for International Settlements, March 2007), at p. 21.
29. G20, 'Declaration on Strengthening the Financial System' (London, 2 April 2009), under heading 'The Scope of Regulation', available at: .
30. G20, 'Leaders' Statement: The Pittsburgh Summit' (Pittsburgh, 24-25 September 2009), at paragraph 13, available at: .
31. For example, see European Commission, 'Ensuring Efficient, Safe and Sound Derivatives Markets: Future Policy Actions' (October 2009), COM(2009) 563, at p. 3 ('a comprehensive policy on derivatives is necessary in order to avoid market participants exploiting differences in rules, i.e. regulatory arbitrage').
32. For the European Commission alone, the legislative agenda includes the regulation of alternative investment funds and credit rating agencies, addressing risk management in financial institutions, new rules on financial conglomerates and so on.
33. FSA and HM Treasury, Reforming OTC Derivative Markets: A UK Perspective (December 2009), at p. 11, available at: .
34. Included in a list of areas where the 'Bank believes change is needed', Bank of England, Financial Stability Report (June 2009), at p. 36, available at: .
35. See, for example, Bank of England, Financial Stability Report (April 2007), at p. 54, stating that 'there are several challenges associated with CCP in OTC, as compared with exchange-traded, derivatives markets', available at: .
36. Proposal for a Regulation (EC) on OTC derivatives, central counterparties and trade repositories (Proposed Derivatives Regulation), COM(2010) 484/5; 2010/0250 (COD).
37. Proposed Derivatives Regulation, Title II, Art. 3(1).
38. Clearing will be required for contracts between a financial and non-financial counterparty unless the latter's transactions relate to its commercial activities or fall below a certain threshold, which is to be defined separately: Proposed Derivatives Regulation, Title II, Art. 7(2) and (4).
39. This term is defined as derivatives that 'share common, essential characteristics'. In a complex and innovative market, this may not prove to be a very practical definition. Proposed Derivatives Regulation, Title I, Art. 2(4).
40. House of Lords European Union Committee, The Future Regulation of Derivatives Markets; Is the EU on the Right Track? Report with Evidence, HL Paper 93 (10th Report of Session 2009- 10, 31 March 2010), at p. 2 (hereafter, the 'HL EU Committee Report').
41. This report saw the Committee scrutinise two Communications published by the European Commission: European Commission, 'Ensuring Efficient, Safe and Sound Derivatives Markets' (July 2009), COM(2009) 332
42. European Commission, 'Ensuring Efficient, Safe and Sound Derivatives Markets: Future Policy Actions' (October 2009), COM(2009) 563.
43. European Commission, 'Commission Proposal on OTC Derivatives and Market Infrastructures - Frequently Asked Questions' (15 September 2010) MEMO/10/410.
44. H.R. 4173, signed into law by President Obama on 21 July 2010 (hereafter the 'Dodd-Frank Act'). The scope of the Act is captured by its long title: 'An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.'
45. For example, the new limits on banks' proprietary activities in the Dodd-Frank Act, Title VI ('Improvements to Regulation of Bank and Saving Association Holding Companies and Depository Institutions').
46. Though these terms are defined in existing legislation, the Act provides that the Authorities 'further define' certain key terms used in Title VII, including swap and security-based swap: Dodd- Frank Act, s 712(d).
47. Dodd-Frank Act, s 712(a)(1) and (2).
48. As regards swaps: Dodd-Frank Act, s 723(a), inserting a new Commodity Exchange Act (7 U.S.C. 2), s 2(h)(1)(A). As regards security-based swaps: Dodd-Frank Act, s 763, inserting a new Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), s 3C(a)(1).
49. As regards swaps: Dodd-Frank Act, s 727, inserting a new Commodity Exchange Act (7 U.S.C. 2(a)), s 2(a)(13). As regards security-based swaps: Dodd-Frank Act, s 763, inserting a new Securities Exchange Act of 1934 (15 U.S.C. 78m), s 13(m).
50. The meaning of which is explained in section 3 of the paper. As regards swaps: Dodd-Frank Act, s 731, inserting new Commodity Exchange Act (7 U.S.C. 1 et seq.), s 4s(e)(2)(A) and (B). As regards security-based swaps: Dodd-Frank Act, s 764, inserting new Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), s 15F(e)(2)(A) and (B).
51. As regards swaps: Dodd-Frank Act, s 723. As regards security-based swaps: Dodd-Frank Act, s 763.
52. As regards swaps: Dodd-Frank Act, s 723, inserting a new Commodity Exchange Act (7 U.S.C. 2), s 2(h)(7). As regards security-based swaps: Dodd-Frank Act, s 763, inserting a new Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), s 3C(g).
53. See definition of 'Major Swap Participant', referencing 'substantial position' at Dodd-Frank Act, s 721, referenced in the definition of 'financial entity' at Dodd-Frank Act, s 723, inserting a new Commodity Exchange Act (7 U.S.C. 2), s 2(h)(7).
54. DLA Piper, 'Dodd-Frank Alert: Regulators Take Centre Stage' (2010), at p. 1, available at: .
55. While the rest of this paper concentrates on the private law dimensions of the CCP prescription and discusses how this analysis might inform the regulatory debate, there are separate questions to be explored about the extent to which institutions responsible for reform are equipped to tackle questions of private law.
56. The issue of institutional competence in respect of the private law aspects of the financial markets merits further research in light of current regulatory reform projects, but is beyond the scope of this paper.
57. In particular, as regards the importance of a coordinated approach to standard setting for CCPs. International coordination is facilitated in this respect by the work of the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organisation of Securities Commissions (IOSCO), which are currently engaged in an ongoing review (at the G20's request) of their recommendations for CCPs in light of the proposed extension of CCP clearing.
58. The European Commission has recently emphasised the need for global coordination in terms of these reforms, referencing the awaited review by CPSS/IOSCO.
59. As explained in European Commission, 'Explanatory Memorandum to the Proposal for a Regulation on OTC derivatives, central counterparties and trade repositories', COM(2010) 484/5, 2010/0250(COD), at pp. 3-4.
60. S. Waddams, Dimensions of Private Law: Categories and Concepts in Anglo-American Legal Reasoning (Cambridge, Cambridge University Press 2003), at p. 1.
61. Black's description of legal norms: J. Black, 'Mapping the Contours of Contemporary Financial Services Regulation', 2 Journal of Corporate Law Studies (2002) p. 253, at p. 256.
62. F. Partnoy, 'The Shifting Contours of Global Derivatives Regulation', 22 University of Pennsylvania Journal of International Economic Law (2001) p. 421, at p. 479.
63. For example, A. Gelpern and M. Gulati, 'Public Symbol in Private Contract: A Case Study', 84 Washington University Law Review (2006) p. 1627;
64. C. Bradley, 'Private International Law- Making for the Financial Markets', 29 Fordham International Law Journal (2005) p. 127, at pp. 160-164;
65. The first case study in S. Choi and G. Mitu Gulati, 'Contract as Statute', 104 Michigan Law Review (2005-6) p. 1129, at pp. 1133-1139.
66. A. Riles, 'The Anti-Network: Private Global Governance, Legal Knowledge, and the Legitimacy of the State', 56 American Journal of Comparative Law (2008) p. 605;
67. J. Golden, 'The Future of Financial Regulation: The Role of the Courts', in I. MacNeil and J. O'Brien, eds., The Future of Financial Regulation (Oxford and Portland, Oregon, Hart 2010) (discussing the implications of post-crisis litigation for markets which use standardised contracts, making particular reference to the ISDA documentation);
68. European Central Bank/Eurosystem, Glossary of Terms Related to Payment, Clearing and Settlement Systems (December 2009), at p. 4.
69. For example, as provided for in the Dodd-Frank Act, s 725(c), inserting a new Commodity Exchange Act (7 U.S.C. 7a-1(c)), s 5b(c)(2)(K) and (L), addressing the record-keeping and disclosure obligations of clearing houses. This provides that certain information is to be made public and disclosed to the CFTC, including the terms and conditions of each contract cleared, margin-setting methodology and daily settlement prices and volume.
70. See also the work of Riles, who explores in some detail how standard contracts are used in practice, for example, contrasting the socio-legal view that they represent 'the production of new legal regimes through the routinization of work and professional roles' with the law and economics perspective that they represent 'costs savings'.
71. H. Collins, Regulating Contracts (Oxford, Oxford University Press 1999), at pp. 209-222.
72. H. Collins, 'Regulating Contract Law', in C. Parker, et al., eds., Regulating Law (Oxford, Oxford University Press 2004), at p. 25.
73. For example, in the Memorandum by Ashurst LLP.
74. 'Non-financial firms, in particular, have a legitimate need to transfer their risks using bespoke products.
75. Airlines, for example, use derivatives to address the risk associated with fluctuating aviation fuel prices.
76. See the Memorandum by British Airways, providing evidence to the House of Lords European Union Committee, reproduced at HL EU Committee Report.
77. (LCH.Clearnet's witnesses stated that it is 'easier' to clear contracts if they are standardised but non-standardised contracts could be accepted for clearing too, as LCH.Clearnet does with its swap portfolio which was described by Mr Liddell as 'simple and vanilla in its risk but not standardised in terms of transactions').
78. LCH.Clearnet has stated that 'the fundamental requirement for eligibility is that the CCP can manage the default of a participant through the implementation of both its risk management and default management policies in a way that controls systemic risk'.
79. It has stated that there are four main considerations for the clearing house in this regard, which can be summarised as: the assurance of market liquidity; availability and reliability of market prices; CCP default management procedures; and cost of providing clearing service and maintaining risk management structures.
80. The Future and Options Association (FOA) gave the following as example of factors affecting clearing eligibility: 'pricing transparency, liquidity, volatility, risk complexity, valuation capability and the risk management capacity of the CCP'.
81. For a further discussion of 'initial margin' and 'variation margins', see P. Wood, English and International Set-Off (London, Sweet & Maxwell 1989), at p. 171 (noting that variation margins may be calculated daily or with greater frequency).
82. The Turner Review found that the obligation in AIG's derivative contracts to post more variation collateral as its credit worthiness fell contributed to the group's 'downward spiral' in September 2008.
83. The implications of this point in the context of global custody are discussed in J. Benjamin and M. Yates, The Law of Global Custody (London, Butterworths LexisNexis 2002), at p. 25.
84. See the detailed discussion of the law of property in the context of the financial markets in Benjamin.
85. The distinction between a prime broker's legal interest in clients' securities and cash was the backdrop to a dispute about what happened to securities which had 'leaked' into cash at the time of the prime broker's insolvency in In the Matter of Lehman Brothers International Europe (in administration), Anthony Victor Lomas and ors. v. RAB Market Cycles (Master Fund Limited) and anr. [2009] EWHC 2545 (Ch).
86. As noted in a recent Court of Appeal decision, the administrators of Lehman Brothers International Europe have written to 1,707 account holders who 'are thought to have potential claims against LBIE for the return of trust property', In the Matter of Lehman Brothers International (Europe) (in administration) [2009] EWCA (Civ) 1161 [8] (Patten LJ).
87. As described at In the Matter of Lehman Brothers International (Europe) (in administration) [2008] EWHC 2869 (Ch) [13], citing the (anonymised) applicants' evidence that 'if the present situation continues for very much longer the funds are virtually certain to lose the confidence of their investors so that they will suffer revenue impairment⋯ In summary, the funds will suffer economic loss, and so will their investors unless their positions are transferred soon.
88. [1975] 2 All ER 390.
89. British Eagle International Airlines Ltd [1975], at 404 (Lord Cross).
90. At the time, Companies Act 1948, s 302.
91. British Eagle International Airlines Ltd [1975], at 411 (Lord Cross).
92. International Air Transport Association v. Ansett Australia Holdings Ltd [2008] HCA 3.
93. International Air Transport Association [2008] HCA 3 [60] and [94] (Gummow, Hayne, Heydon, Crennan and Kiefel JJ).
94. M. Bridge, 'Clearing Houses and Insolvency', 2 Law and Financial Markets Review (September 2008) p. 418, at p. 420.
95. Supplementary memorandum by the International Swaps and Derivatives Association (ISDA), HL EU Committee Report.
96. As the FSA and HM Treasury note in their recent joint publication about CCPs in the OTC derivatives markets, extending their use 'will further significantly increase the systemic importance of CCPs' thereby heightening the importance of rules imposed on CCPs about their 'capital, risk management, margining and operational standards'.
97. R. Goode, Commercial Law, 3rd edn. (London, Penguin 2004), at p. 158.
98. citing, inter alia, Robinson v. Mollett (1875) LR 7 HL 802.
99. See, for example, the conflicting decisions reached by the Court of Appeal in Perpetual Trustee Company Limited v. BNY Corporate Trustee Services Limited and ors [2009] EWCA Civ 1160 and by Judge Peck of the US Bankruptcy Court for the Southern District of New York in Ch 11 Case No. 08-13555.
100. Adv. No. 09-01242 (25 January 2010), anticipated in Perpetual Trustee Company Limited v. BNY Corporate Trustee Services Limited [2009] EWHC 2953 (Ch).
101. discussed further in C. Brown and T. Cleary, 'Impact of the Global Financial Crisis on OTC Derivatives in Structured Debt Transactions', 5 Capital Markets Law Journal (2010) p. 218.
102. The conflict of laws complexities arising in connection with global securities holdings and the use of financial collateral were pointed out presciently in Benjamin and Yates, supra n. 120, at chapter 5.
103. There are currently divergent views about the location of CCPs. For example, the Turner Review argues that the European Commission's proposal that there needs to be a CCP in the euro zone is 'unnecessary for financial stability reasons'.