By Gary Gensler
In 2008, the financial system failed. The financial regulatory system failed. Though there were many causes of the 2008 financial crisis, derivatives played a central role.IFor example, to what extent did macroeconomic factors and monetary policy play a role in the crisis? What impact did the housing bubble and lax mortgage origination and underwriting practices have in the lead-up to the crisis?

Over-the-Counter derivatives (OTCs) and OTC swaps have a net notional value of approximately $300 trillion in the United States. That is roughly 20 times the size of the American economy.

History of non-regulation
Over-the-counter derivatives, which started to be transacted in the 1980s, have not been regulated in Europe, Asia or North America. Until the reforms being debated this year, I am not aware of any major country that had directly regulated these markets over a nearly 30-year period. I will touch upon five reasons that some have articulated in the past for such a lack of regulation in the over-the-counter derivatives marketplace.

First, it was claimed that the derivatives market was an institutional marketplace, with “sophisticated” traders who did not need the same types of protections that the broader public needs when investing in the securities or futures markets. This was included in a President’s Working Group report in 1999. European regulators held a similar view that sophisticated traders needed less regulation that the broader investing public. For example, the UK’s regulatory approach was different for investment services offered to “sophisticated” investment professionals than the approach for investment services offered to other investors. Derivatives, however, are complex financial instruments. Even the most “sophisticated” parties would benefit from protections in the marketplace. Markets, even amongst institutions, work better when transparency and market integrity are promoted, protecting against fraud, manipulation and other abuses.

Second, it was claimed that over-the-counter derivatives did not need regulation because the institutions dealing them were already regulated. That, however, proved to be a faulty assumption. The banks that deal derivatives have not been expressly regulated for their derivatives business. Furthermore, there were derivatives dealers that emerged that were affiliates of nonbanks, such as insurance companies or investment banks. These affiliates were at best lightly regulated. For example, though AIG was a regulated insurance company, its derivatives affiliate, called AIG Financial Products, was not subject to any meaningful regulation by prudential regulators or market regulators. Just because a bank, an insurance company or an oil company may be regulated for one line of business does not mean that it also was regulated for all of its risky endeavors.

Third, it was claimed that large, sophisticated financial institutions dealing over-the-counter derivatives, as well as their counterparties, were so expert and self-interested that the markets would discipline themselves. This assumption proved to be false. These “sophisticated” participants had countervailing incentives to assume risks in order to boost revenues. They also were often unable to adequately judge the risks they were assuming due to the complexity and lack of transparency of the instruments they were trading and the counterparty credit risk they were assuming.

Further, as a perverse consequence of the financial bailouts of 2008, many in the markets may assume that dealers – so big, concentrated and interconnected – could be bailed out again if another crisis strikes. This creates a significant moral hazard – a system where “heads” Wall Street wins and “tails” the taxpayers lose once again.

Fourth, some claimed that over-the-counter derivatives were customized and not susceptible to centralized trading or clearing. Whereas a share of a company’s stock is identical to any other share of that company’s stock, derivatives can be much more tailored to meet the particular needs of a particular business. But derivatives have become much more standardized over the last decade and thus more susceptible to central market structures. One Wall Street CEO testified before this Commission in January that as much as 75 to 80 percent of the over-the-counter derivatives marketplace is standard enough to be centrally cleared.

Fifth, it was claimed at least here in the United States that we should not regulate over-the-counter derivatives because they are not regulated in Europe or Asia. If we did, we would somehow push our markets overseas. But after the 2008 financial crisis, there is now broad consensus across borders that we must bring transparency and lower risk through regulation of the global derivatives marketplace. In fact, Japan passed regulatory reform legislation last month. The European Commission will provide legislative language to the European Parliament in the next few months. Just last week in Toronto, the G20 mandated acceleration of swaps transparency and standardization and reaffirmed its commitment to require all standardized over-the-counter derivatives contracts to be cleared and traded on transparent platforms.

Regulatory History of Derivatives
Derivatives have been around since the Civil War, when grain merchants came together to hedge the risk of changes in the price of corn, wheat and other grains on a central exchange. These derivatives are called futures. Nearly 60 years after they first traded, Congress brought Federal regulation to these markets. In the 1930s, the Commodity Exchange Act (CEA), which created the CFTC’s predecessor, became law.

From the 1930s until 1980, derivatives and publicly listed securities were subject to comprehensive oversight by federal regulators. This meant that derivatives were traded on regulated exchanges and policed to ensure fair and orderly trading. We refer to these on-exchange derivatives as futures.

Things began to change in 1981 with the first over-the-counter derivative transaction. Instead of trading through exchanges and being cleared through clearinghouses, over-the-counter derivatives are generally transacted bilaterally and are not subject to regulation.

The absence of a regulatory framework for over-the-counter derivatives in the United States was reflected in a combination of the statutory language of the CEA, Congressional action, CFTC interpretations and policy statements, case law and regulatory practice. For instance, in 1974, Congress introduced the “Treasury Amendment,” which exempted transactions in foreign currencies, government securities, mortgage securities and certain other debt instruments from CFTC regulation.

By the mid to late 1980s, the question of whether or not swaps should be regulated as futures started getting asked. They were initially unregulated as the marketplace was bilateral and highly customized. In 1989, the CFTC issued the Policy Statement Concerning Swap Transactions, in which the agency took the position that most swap transactions “were not appropriately regulated” as futures contracts under the CEA.

Congress subsequently addressed the issue of regulating swaps in the Futures Trading Practices Act of 1992 (FTPA). In that legislation, Congress afforded the CFTC broad exemptive authority over swap agreements and certain hybrid bank products. The FTPA Conference Committee noted that it granted the Commission this authority to specifically address the legal status of swaps and the possible exemption of swaps from the CEA. This authority was utilized starting in January 1993, when the CFTC concurrently published separate final rules that generally exempted swap agreements and hybrid instruments from provisions of the CEA. In particular, the January 1993 “Exemption for Certain Swaps Agreements” was relied upon by the market to exempt swap transactions as long as they were between eligible swap participants, were not standardized, had credit as a material term and were individually negotiated.

Later, in April 1993, the Commission issued an “Exemption for Certain Contracts Involving Energy Products,” which exempted various energy swaps from regulation, provided they were between covered commercial participants, individually negotiated and imposed binding delivery obligations upon the parties.

In the 1990s, the over-the-counter derivatives marketplace continued to grow significantly. Swaps started to become more standardized, though – it may be hard to remember now – we still lived in a world where the vast majority of these transactions happened over telephones, on a bilateral basis and had many components of individual negotiation, particularly on credit terms.

By 1998, the Bank for International Settlements estimated the total notional value of outstanding swaps to be approximately $80 trillion. The notional value of outstanding exchange-traded futures and options at that time was approximately $13.5 trillion. That year, the CFTC, under the leadership of Brooksley Born, issued a Concept Release on Over-the-Counter Derivatives that stated the agency’s intention to “reexamin[e] its approach to the over-the-counter derivatives market.”

In the Concept Release, the CFTC solicited industry and public input on whether the “regulatory structure applicable to OTC derivatives under the Commission’s regulations should be modified in any way in light of recent developments in the marketplace and to generate information and data to assist the Commission in assessing this issue.” As a result of the Concept Release being published, regulators, Congress and market participants engaged in a significant policy debate with regard to the swaps market. Some market participants also raised concerns that had been debated in earlier years with regard to legal certainty in the existing swaps market. Congress passed the Commodity Futures Modernization Act (CFMA) in 2000 to, among other things, confirm the then-existing regulatory practice of exempting swaps from regulation.

Post your comment  (1)

Connect:

Post to Twitter

Post to Facebook