واگرایی مشتقات: قانون، حکومت داری و بازارهای مالی مدرن

This paper examines the institutional, political and regulatory history of U.S. derivatives markets from the 1980s until the financial crisis of 2008 to understand the divergence between exchange-traded derivatives and over-the-counter derivatives. Although exchanges like the Chicago Mercantile Exchange and Chicago Board of Trade were powerful market incumbents with strong political connections, they were eclipsed by the over-the-counter market. The latter remained unregulated, despite numerous attempts to do so, and grew to enormous size. With such growth, the political decision not to regulate became increasingly irreversible, even in the face of events like the failure of Long Term Capital Management. The implications for law and the politics of financial regulation are discussed.

The term “derivative” possesses a number of useful meanings. It is familiar to anyone who has taken an elementary calculus course because it refers to a mathematical function that is derived from another function. In differential calculus, for example, dx/dt, the first derivative of a continuous function x = f(t), can be used to calculate the slope of the tangent line at a particular point, and measure instantaneous change over time. In finance, a derivative is an “arrangement or instrument (such as a future, option, or warrant) whose value derives from and is dependent upon the value of an underlying variable asset, such as a commodity, currency, or security” (Oxford English Dictionary). Modern financial derivatives include futures, options, and swaps, as well as more complicated instruments. In this paper, I exploit this double-meaning of “derivative” to discuss how and why the markets for two types of financial derivatives diverged over time. Modern financial derivatives can be distinguished in a number of ways. Here I focus on where they are transacted. Generally they are traded in one of two venues: on an organized exchange (e.g., on the Chicago Mercantile Exchange [CME], EUREX, or HKEx) or over-the-counter (OTC). Exchange traded (ET) derivatives are standardized, fungible, and of limited variety. The host exchange provides clearing services and allows for price discovery and a high degree of both transparency and regulatory oversight. The OTC market, by contrast, involves private bilateral transactions that can be uniquely customized to the needs of a corporate client. There is little transparency, no price discovery (the terms of the transaction are not made public), no clearing, and no regulatory oversight. ET markets are publicly regulated, while OTC is subject to looser private ordering, chiefly through an industry group called the International Swaps and Derivatives Association (ISDA). Modern derivatives markets are part of a larger and recent pattern of “financialization” (Krippner, 2011), and have greatly expanded in activity, value, and significance. Financialization produced high earnings and growing employment in the financial industry (Philippon and Reshef, 2009), and increasingly attracted into financial careers the graduates of elite universities and business schools (Ho, 2009). However, evidence also suggests that financialization has its limits (Cecchetti and Kharroubi, 2012 and Lazonick, 2010), and that increased size of the financial industry does not necessarily mean more efficient financial intermediation (Philippon, 2011). Although they both grew substantially, ET and OTC derivatives markets have diverged over the past several decades. Older organized exchanges (like the CME, Chicago Board of Trade [CBOT] and Chicago Board Options Exchange [CBOE]) expanded into new kinds of contracts (shifting from commodity options and futures into currency, debt and index derivatives), and their volume of business has grown considerably. They also switched from open-outcry (face-to-face trading on an exchange floor) to electronic trading. But as fast as they grew, the exchanges enjoyed nothing like the explosive growth of OTC derivative markets, whose total annual notional values are now in the hundreds of trillions of dollars (far greater than total annual world GDP). The OTC market is much newer, and now much bigger, than the ET market. Whereas in 1986 the total value of outstanding ET derivatives contracts was larger than that for OTC, by 2008 OTC activity was worth roughly ten times as much as that for ET, despite the fact that value of ET had increased 100-fold over this period (Jorion, 2010, table 2). Some telling differences between the two kinds of derivatives markets became apparent during the financial crisis of 2008. Consider the failure of Lehman Brothers in September of that year. Like other major investment banks, Lehman was heavily involved in both the OTC and ET derivatives markets, right up until the bank collapse in September of 2008. As of May and August of that year, Lehman had over 900,000 derivatives positions worldwide (Valukas, 2010, vol. 2: 569). In part because it was one of the most active participants in the credit default swap (CDS) market, Lehman’s failure helped ignite a chaotic period in OTC markets in which, for example, financial institutions stopped dealing with each other because of worries over counter-party risk and their inability to value assets (Gorton, 2010: 51). Furthermore, many of Lehman’s creditors and counterparties were unable to extricate themselves from their positions once the bankruptcy court imposed a judicial stay (New York Times July 15, 2009, p. B7). Meanwhile, over at the CME, Lehman’s exchange-based derivatives positions were cleared and closed out without incident or turmoil. Another of the most prominent financial events also involved the OTC market: American International Group (AIG) was heavily involved in the CDS market. It had to be bailed out by the Federal Reserve in September of 2008 when a ratings downgrade required it to post additional collateral as required by the CDS contracts it had entered into. AIG was unable to meet its collateral obligations, and rather than let it fail the Fed made available $85 billion in credit (Johnson and Kwak, 2010: 163–170). Despite these sharp discrepancies in growth rates and performance during the crisis, the two markets have some important connections. Most directly, ET and OTC markets are linked because many of the same financial institutions trade in both at the same time. A large dealer-bank (e.g., Goldman Sachs, Deutsche Bank, or JPMorgan Chase) that takes on risk in a bespoke OTC derivative contract with a client may lay off some or all of that risk on one of the exchanges (Remolona, 1992: 38).1 Hence, financial institutions use one market to balance their positions in the other. These connections are deepened because some quite similar instruments trade in the two markets (which among other things create arbitrage opportunities). For example, a linked series of foreign exchange futures contracts, traded on an organized exchange, can be used to construct something very close to a currency swap contract, traded over-the-counter. Economically, the two are almost identical. In similar fashion, a futures contract, traded on an exchange, is simply a standardized version of a forward contract that is traded over the counter. The financial crisis of 2008 produced substantially different effects in the two derivatives markets, despite the connections between them. Worrisome instability in OTC contrasted with robust activity on the exchanges. In the political aftermath, this striking disparity motivated a number of policy proposals in both the United States and Europe to reform OTC markets in such a way as to make them more like organized exchanges, by adding more transparency, regulatory oversight, and clearing arrangements to reduce counter-party risk (Duffie, 2010, Litan, 2010 and Skeel, 2011).2 Since the exchanges were more stable that OTC, why not make OTC more like an exchange? The magnitude of the financial catastrophe notwithstanding, there has been strong resistance to reform from various financial institutions, particularly when regulation threatened to undercut the profitability of OTC activities for core market participants. Dealer-bankers made a lot of money in the pre-crisis OTC market, and consequently were reluctant to change the status quo. In this paper I am going to consider a number of issues raised by the intriguing contrast between OTC and ET: how and why did OTC grow so fast, as compared to ET? After all, derivatives exchanges like the CME, CBOT and CBOE were powerful market incumbents with strong political ties to Washington, DC and they enjoyed enduring relationships with their regulatory overseers in the Commodity Futures Trading Commission (CFTC). They had considerable political and economic resources to wield, and yet OTC markets provided competition that the exchanges were somehow unable to suppress, circumvent or mitigate. One reason had to do with the fact that, repeatedly throughout the late 1980s and 1990s, U.S. politicians and regulators decided not to regulate OTC markets, and that decision was emphatically underscored by the Commodity Futures Modernization Act [CFMA] of 2000. Given that public regulatory oversight may be one reason why ET markets performed so much less problematically during 2008, it is useful to recall the episode of 1998, when under Commissioner Brooksley Born the CFTC issued a concept release stating that the Commission might consider the issue of regulation for OTC. This “trial balloon”, which explicitly stated that the CFTC had no “preconceived result in mind”, nevertheless created a firestorm of controversy and revealed how formidable the opposition to regulation had become. Why did regulators not apply to OTC the kind of oversight and intervention that they historically applied to the exchanges? Why did the public interest in market stability not extend to the OTC market? The more general issue concerns the locus of market governance: in what venue are the “rules of the game” articulated and enforced? Is the locus primarily a public regulatory agency, or a private organization, or some kind of hybrid combination? And what are the implications for the relationship between law and markets? Public agencies use legal regulations to govern markets, but private regulators can also use contract law that ultimately relies on the coercive capacities of the state for enforcement. Consideration of the diverging trajectories of OTC and ET derivatives, both before and during the crisis of 2008, sheds light on the relationship between law, politics and markets. In particular, the two markets occupied quite distinct positions: one was publicly regulated, the other was not. Of course, OTC was not anarchic. But its rules and governance were largely private and did not directly involve statutory law or public administrative regulation. Law is not the only basis for market governance, although extra-legal modes of governance have important limitations. The divergence also underscores that these distinctive legal dispositions were endogenous, and that the unregulated status of OTC was a recurrent political accomplishment, not simply an ex ante state of nature. Well-functioning markets may depend on rule-of-law (secure property rights, enforceable contracts, non-predatory sovereigns, etc.), but market power begets political power and so indirectly shapes the legal framework under which a particular market operates. The central insight of “capture theory” ( Stigler, 1975), that regulated industries have a strong incentive to influence the regulatory agency that oversees them, can be extended from the administrative to the legislative arena. As the OTC market grew and acquired powerful constituents and vested interests, the initial decision not to regulate it became increasingly irreversible, despite prescient concerns that reliance on private interests alone might not serve the public interest in a well-ordered derivatives market. 3 Market actors used their influence over political institutions to enact laws that helped set the conditions for their own profit-seeking activities, sometimes through existing regulatory institutions, but sometimes by creating regulatory voids. The trade association that represented big OTC market participants, ISDA, proved to be a very able political actor. And its clout has been amplified by the recurrent threat of regulatory arbitrage, mostly between New York and London. OTC derivatives are traded in both places, and so market participants who face the prospect of unwelcome regulation can and do threaten to move their financial activities across the Atlantic. In the absence of global coordination among national regulators, this threat of “exit” will continue to empower key OTC market players. Furthermore, ISDA and its supporters made effective rhetorical use of “legal uncertainty” arguments in their opposition to regulation: any whiff of uncertainty about the decision not to regulate OTC would be enough, they contended, to undermine the market. These uncertainties had to be resolved decisively, they insisted.

The broad deregulatory trends that affected so many countries in the 1980s and 1990s also reshaped finance (Krippner, 2011: 58–85). Much of the regulatory apparatus constructed in the US during the 1930s to oversee banks and financial activities was weakened or simply abolished (witness the 1999 repeal of Glass-Steagal). And while previously regulated areas of finance saw their regulations weakened, entirely new areas of financial activity saw their publicly-unregulated status maintained and even strengthened. A regulatory apparatus designed to stabilize a bank-centric financial system, to protect retail investors, and to maintain order in financial markets dominated by equity and debt instruments simply did not evolve in response to disintermediation, globalization, financial innovation, the rise of institutional investors and the growth of new financial markets (Cartwright, 2009 and Davis, 2009). If anything, it devolved. These trends certainly encompassed OTC derivatives. Despite the historical stigma attached to speculation, and notwithstanding a number of highly publicized scandals and disasters that appeared to implicate OTC derivatives in one way or another, a powerful market-based financial constituency successfully fended off all regulatory attempts until the events of 2007–2008. With the growth in size and profitability of the OTC market, the initial decision not to regulate became increasingly irreversible. A process of political “lock-in” changed the terms of the decision by creating a new constituency strongly opposed to regulation, whose power only grew over time. And even today, various provisions in the Dodd–Frank Act aimed at adding transparency and oversight to OTC derivatives have been met with stern resistance when it came to writing rules and implementing the new law (witness, for example, attempts to explain the financial crisis as resulting from too much, as opposed to too little, regulation). Regulatory forbearance stemmed from a combination of political clout and economic ideology. The U.S. polity is notorious porous, and provides multiple veto points at which organized interest groups can apply political leverage. They can be particularly effective in maintaining the status quo. Furthermore, the limited authorization given to the CFTC meant that its regulatory mandate, and the rules promulgated to govern derivatives, returned repeatedly to the political agenda. Derivatives market players spread money around, built political alliances, and took full advantage of reigning neo-liberal economic doctrine. They also credibly raised the specter of regulatory arbitrage: globally mobile financial markets might shift from New York and Chicago to London or Frankfurt if regulation overseas was significantly less onerous. As the prevailing economic doctrine, neo-liberalism enjoyed well-placed advocates like Alan Greenspan, who sincerely believed that private self-interest would combine with effective private risk management in financial markets to remove the need for public risk management or even public oversight. At key moments, he was joined by most other high-level officials and regulators (with the notable exception of Brooksley Born), and bolstered by the mainstream consensus within the economics profession ( Tett, 2010). Those who publicly raised doubts about the adequacy of private risk management were subject to heavy criticism, even if they were eventually proved right by events (e.g., Rajan, 2005). 15 The diverging fates of exchange-traded and OTC derivatives stemmed in part from historical contingency: OTC was established outside the existing national regulatory framework that encapsulated the organized exchanges, and benefitted from the inadvertent precedent set by the 1974 Treasury Amendment. The OTC market was highly concentrated among a small set of large financial organizations, which facilitated both formal and informal coordination in pursuit of collective private goals (like remaining unregulated) or in response to crises (e.g., LTCM). At the same time, the OTC market was chiefly domiciled in either London or New York, which always raised the prospect of flight to the other jurisdiction should regulation become onerous in either place.16 Core OTC participants also had a significant presence on the derivatives exchanges, which severely undercut the ability of the CME or CBOT to push for regulation of OTC as a way to level the playing field between themselves and OTC. It proved too tough to lobby against one’s own customers. Instead, a political alliance among the derivatives markets helped lead to the CFMA of 2000, which emphatically preserved the unregulated status of OTC and granted a measure of regulatory relief to the exchanges. But the divergence did not stop there, because OTC markets were more adversely affected by the financial crisis of 2007–2008 than were ET derivatives. Lack of public regulation has not meant an absence of regulation. Like other markets, OTC market participants follow a set of rules. But rather than having publicly-determined rules (which might take into account the public interest in financial stability or reflect a broader set of stakeholders), OTC is guided proximately by private regulations that reflect private interests. Furthermore, these private institutions lack the coercive enforcement mechanisms that public regulators possess, and so they cannot always impose rules on their own members, either in relation to each other or between members and non-members (Awrey, 2010: 184). The organizational locus for private governance is in this case ISDA. The rhetoric of legal certainty espoused by ISDA and others seemed to be motivated mostly by a desire on the part of OTC market participants to be certain that their market would not be subject to public regulatory law, that there would be “regulatory voids”. The point of legal certainty was to tie the hands of regulators and not necessarily to produce calculable law per se. Indeed, this kind of certainty set the stage for what might be called “evasive innovation”: innovation intended to circumvent static regulations. Otherwise, OTC participants were happy to be able to make things up as they went along, promulgating successive Master Agreements that reflected emerging market practices, supported new financial products, and addressed whatever problems they felt compelled to deal with. When it is to their advantage, OTC market participants have been eager to utilize statutory law, as when ISDA successfully lobbied countries to incorporate its “model netting legislation” into their national bankruptcy codes and privilege swaps participants over all other creditors involved in a corporate bankruptcy proceeding. The events of 2007–2008 underscored some of the limits of private regulation. Gorton (2010) characterizes that period as akin to a bank run, with banks rather than depositors acting in panic mode. One of the factors setting off the panic was counter-party risk, supposedly mitigated in OTC markets by a combination of rating agencies and collateral (Kroszner, 1999), but in fact magnified by a sense that opaque institutions backed by opaque assets of uncertain value and dubious liquidity were much too risky to deal with (Gorton, 2010: 47). Banks stopped transacting with each other and previously liquid markets became illiquid. AIG’s inability to meet the requirements of its swap agreements and post more collateral in response to a ratings downgrade seemed to threaten systemic instability, mostly because it had become so important an issuer of unhedged CDSs. But rather than suffer the consequences of hard budget constraints, AIG was bailed out by the direct provision of liquidity from the Federal Reserve Bank (Mehrling, 2011: 132–33). Much of the money then went to AIG’s various counter-parties, including large financial institutions like Goldman Sachs, Société Général, Deutsche Bank, Barclays, and Merrill Lynch. In the depths of the crisis, privileged institutions gained access to precious liquidity, both directly and indirectly. Counter-party risk was not a problem for exchange-traded derivatives transactions because of the clearing arrangements that made the exchange itself the effective counterparty for each half of a transaction (Duffie, 2012: 8). Private regulation also suffered from its own lack of transparency and accountability. ISDA does not represent all stakeholders, and has no reason to concern itself with market failures, externalities, or systemic risk. Its activities are only partly visible, and there may be even less visible forms of informal private coordination that restrain competition and raise prices.17 Public adversity that follows from the failure of private governance threatened the legitimacy of the latter as the externalities produced by systemic insolvency underscored the fact that a broader set of interests were at stake. However, powerful financial institutions were not easily tamed. The final lesson offered by diverging derivatives reminds us that law is endogenous. Law may shape markets, but politics shapes law, and powerful market actors can use their political resources to shape law. As the economic landscape shifts, new economic interests arise and gain strength, and can even eclipse older incumbents. In this case, market actors shaped law so as to leave OTC derivatives as unregulated by public agencies as possible, subject only to private rules devised and imposed and revised by the private actors themselves. Although they deployed familiar arguments in favor of “legal certainty”, this mostly amounted to certainty in the protection of OTC derivatives from public regulation, even as the OTC market made use of contract law. Any discussion of the relationship between law and markets must necessarily include politics, and therefore recognize dynamic asymmetries of power between politicians, regulators, and market actors. Such power differences, which can change over time, ensure that law is not equally endogenous for all. For some, law really is a given constraint to which they are subject. But for the powerful, law is a malleable instrument to which they can subject their own, and others, actions.