Derivatives as a Financial Crisis Accelerator

Following links a few days ago led me to a fascinating journal article by Professor Mark Roe of Harvard Law School.  He suggests that the preferential treatment of OTC derivatives and repo collateral transfers in advance of bankruptcy skews incentives to make the financial system much more leveraged and more risky than it would be otherwise.  The top dealers - who have the best overall view of asset portfolios, trading positions and debt structures - can secure cash and assets to themselves through collateralisation, and even fraudulent over-collateralisation, without any risk of challenge in the ensuing bankruptcy.  As a result, they finance much higher levels of systemic leverage and write many more OTC derivatives than they would if they had to actually worry about counterparty failure.  And the failed companies themselves are left with much less of value to satisfy other claimants (employees, pensioners, trade creditors and the government) or to attract investors that might resuccitate the failed firm.  Because repos and OTC derivatives are bilateral and not reported, it is impossible for other creditors of a firm to monitor the exposure of the firm or the pre-insovlency transfers of assets through margin calls to the preferred secured creditors.  The result is that the market economy becomes progressively less transparent, less resilient and less equitable.

Professor Roe's observation is worth seriously evaluating as it accords very nearly with what we have observed in the five years of financial crisis.  It also helps explain why the crisis stubbornly persists in the face of extraordinary fiscal and monetary policies.  Assets are transferred pre-insolvency to preferred repo and OTC derivatives creditors.  (In the case of Lehman Brothers International, the global market liquidations started in March 2008 as available assets - including customer assets - were liquidated globally to make progressively more demanding margin calls to a handful of preferred creditors.)  Losses are socialised to investors, trade creditors, pensioners and taxpayers, while the dominant global banks continue to record healthy profits.  Investors shy from taking on failed firms as they have in previous downturns, because too little is left worth salvaging.

It may be the situation is still getting worse, rather than better.  In the recent failures of Bear Stearns, AIG, Lehman and MF Global, the failures actually reinforced the dominance of the top incumbents and further concentrate dealing, custody and collateral to these same firms.  They have more market power today than ever, and better vantage should they choose to game the system.

Besides indicting the preferences of the Bankruptcy Code reforms, Professor Roe also suggests that the move toward central counterparty clearing will not improve the situation as hoped.  His objections include:

• Poor incentives in exchanges and clearing houses to manage risk as they are competitive and owned by the dominant incumbents;
• Clearing house margining of many OTC derivatives will not fully address credit risk as past experience indicates that many transactions look just fine right up until default is recognised - "jump to default" risk;
• The risks netted in a clearing house are only netted among direct clearing members, resulting in reallocation of the risks to those outside the circle of direct clearing members while concentrating assets in the hands of fewer and fewer dominant players;
• Clearing houses "up the ante" on Too Big To Fail by themselves being too big to fail, and concentrating liquidity and assets in the hands of clearing members and settlement banks.

I'd like to believe the work we are undertaking as an industry to implement CCPs will prove risk reducing, making the financial system stronger and more resilient.  But I also believed the same thing when I helped repeal Glass-Steagall and promoted OTC derivatives in my early career as a regulator.  I believed the same thing when I was involved in driving forward the harmonisation of laws on securities ownership, transfer and pledging globally.  I sincerely believed that deregulation and harmonisation would make the world a safer place for capitalism. Legal certainty of transaction enforceability grows markets, and our success in gaining legal recognition of repo, derivatives and their collateral arrangements underpinned the massive global growth in repo and OTC derivatives dealing that defines today's markets.

But capitalism requires risk if capital is to be allocated efficiently.  If the dominant players in the game never lose, because they can always allocate losses to others at the table, then that isn't really capitalism anymore.  The result will be consistent misallocation of capital and inequitable returns to firms that do not contribute to the overall social welfare and economic prosperity.  In a nutshell, this is what the Occupation movement objects to about the current system.

At its core, an economy requires wages be paid for there to be sustainable wealth creation.  As wages grow, so does broader prosperity.  Industries that create jobs and pay more and higher wages to more people contribute more to the greater social good.  Industries that are insensitive to the destruction of jobs, stagnation of wages and deflation of private wealth are bad for society.

Professor Roe suggests that reforms to bankruptcy laws that removed the risk of loss for repo and OTC derivatives counterparties went too far.  The small cohort of repo creditors and OTC derivatives counterparties that dominate global markets became insensitive to the business rationale or commercial prospects of their counterparties so long as they gained possession of enough quality assets as collateral to comfortably cover any credit risk.  Something is clearly wrong in a system where the dominant incumbents never lose while most of us become progressively more exposed to unemployment, pension devaluation, higher taxes and economic insecurity.

Bankruptcy law usually tells the end of a story.  If Professor Roe is right, we might consider whether the bankruptcy preferences created by a generation of visionary capital markets lawyers are somewhere near the beginning of the story of today's global financial crisis.

Extra-Territorial Implications of Dodd-Frank - Part 2

Another excellent podcast on the extra-territoriality of Dodd-Frank as it applies jurisdiction and scope, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and David Lucking of Allen & Overy.

The discussion of cross-border perfection of interests in securities has a particular resonance for me.  I was on the International Bar Association Ad Hoc Working Group on Modernising Ownership, Transfer and Pledging Laws which developed the modern legal standards for transfer and perfection of interests in securities.  After almost 20 years, it still isn't clear that US regulators and US judges would recognise international principles.

• Section 772 provides territorial scope of Dodd-Frank jurisdiction for CFTC and SEC, and they are different.  CFTC jurisdiction will not apply unless there is a “direct and significant connection” or attempted evasion of US law.  SEC jurisdiction shall not apply to business outside the USA unless there is evasion.  Both have evasion, but CFTC has “direct and significant connection” test.  Little guidance has been provided from either on how they will interpret these provisions, although CFTC has indicated it will address jurisdiction in Spring 2012.
•  “US Person” definition has not been provided for Title VII of Dodd-Frank.  Scope focuses on types of activities and where they take place and the connection with the US, rather than limiting scope by the nationality of entities entering into transactions.  There is no definition of “US Person” in the Commodities Exchange Act although CFTC rule says a “non-US person” is one organised under the laws of a foreign jurisdiction or that has a principal place of business in a foreign jurisdiction.  For the SEC, Regulation S has a whole body of law as to who is a US person for Regulation S.  Dodd-Frank seems to focus on impact of a transaction on the US for a connection to the US.
• If two persons are clearly outside the US, but the underlying basis of a transaction is in the US, then the status is unclear.
•  There are now final rules on registration provisions and registration can be found on the National Futures Association website.  Market participants are still confused on whether their activities and products bring them within the registration provisions.  Some will have to make a judgement call to start the registration process without being certain which entities or activities may be subject to registration on extra-territorial activity.
•  Likely there will be some structuring and activity which increases the cost of doing business as a consequence of uncertainty as to the application of registration requirements.  This may be particularly a constraint on a large international bank which is uncertain of whether the whole entity must register or just a US branch of the bank.  Requirements for registration include the principles of the organisation and the fingerprints of senior executives.  This will be difficult for some entities where management is likely to resent such intrusive US demands.
•   Both CFTC and SEC have made initial proposals on the definition of a “Swap Execution Facility”.  This is a new concept, though derives from exchanges or contract markets.  The regulators need to explain how SEFs will work.  The SEC and CFTC proposals are very different from each other – so equity derivatives and credit derivatives may be treated differently.  Similar products will have divergent regulation and execution requirements.  This may encourage some geographic migration as platforms are set up near underlying markets.
• Platforms in Europe may be considered to be SEFs by SEC or CFTC, but the authorisation principles and coordination on mutual recognition and supervision are unclear. 
• There was no international consensus that SEFs are “a good idea”.  The G20 did not embrace this idea, although Europe may be moving toward the concept.
• There is broad global consensus that mandatory, central clearing of some derivatives should be required.  The issue for market participants will work in practice.  Section 725(h) provides for exemption of a clearing entity if the CFTC determines it is subject to comparable regulation elsewhere.  The CFTC has not devoted resources to comparability analysis for foreign clearing organisations, so as a practical matter you have different CCPs in different geographies complying with different legal  regimes.
• The US Uniform Commercial Code creates a “security interest” in margin and collateral, but in Europe there are security interests using title transfer.  The two different legal models may create a conflict for anyone taking margin or collateral from a US entity because of the different implications for customer protection in a default.
• Some clearing houses might have gone for mutual recognition – choosing not to register in the US as a Designated Clearing Organisation (DCO).  If this is so, any US customer would have to use a US Futures Commission Merchant.  LCH-Clearnet and ICE, which are already registered as DCOs, have changed their rules to allow FCMs access to clearing members on behalf of their customers to meet US requirements.
• The CFTC has finalised rules on reporting (1) reporting of information to swap data repositiories, (2) public dissemination of information for post-trade price transparency.  Reporting is also a feature under EMIR.  There needs to be further clarity on mutual recognition of reporting or dual reporting requirements.  Confidentiality of information also raises issues in some jurisdictions and with some counterparties, which will have to be reflected in documentation so that reporting can comply with regulatory requirements.  It still isn’t clear that the US will recognise the sufficiency of overseas data repositories, or whether some form of global data repository would be preferable.
• The US political context will be influenced by US political priorities in an election year, including unemployment.  US extra-territoriality may be extended more strictly in order to preserve business in the US, and prevent firms from moving jobs, operations or transactions to overseas markets.  While it would be optimal to address these issues globally through Financial Stability Board or G20, the reality is that this remains impractical given competing domestic priorities.
• Dodd-Frank was enacted in 2010 but implementation is still lagging.  Actual requirements are now rolling out, and 2012 will be a big year to monitor developments and ensure businesses are compliant as rules become effective.  The rules will be evolving over several years as international understandings and clarifications address gaps and inconsistencies, so the compliance challenge will be ongoing.