In a more perfect world, policy questions regarding over-the-counter derivatives would be taken up in the context of legislation modernizing and harmonizing the U.S. regulatory infrastructure for all financial activity, and not in the context of the periodic tribal ritual we have come to know as "CEA reauthorization."
Dutifully, we play the hand we have been dealt. In the context of CEA reauthorization, the OTC derivatives industry has two important objectives: eliminate legal uncertainty and barriers to innovation.
Sources of uncertainty that cloud the status of various transactions, such as individually negotiated swaps, hybrid instruments and over-the-counter transactions involving foreign currencies, government securities and other financial instruments and interests, must be eliminated. Clear and objective exemptions and exclusions for these products must be codified in order to clarify the status of existing products and minimize the risk of uncertainty as new products are developed. No other category of financial products confronts a comparable degree of uncertainty as to their legal status.
Amendments must also eliminate the anomalous treatment of swap transactions and hybrid instruments that involve non-exempt securities. It defies logic that, under federal commodities regulation, swaps and hybrids involving securities are subject to greater constraints than those involving commodities.
In the aftermath of last year's market turmoil and the near-collapse of Long Term Capital Management, observers (some perceiving themselves as having peered into the abyss) have labored to discern the lessons of these events. One point seems clear, however. Had any of the major sources of legal uncertainty come home to roost in that environment, as might have happened, we would have confronted significantly greater turmoil and instability. Whatever views one has about substantive regulatory policy, we cannot indulge ourselves by ignoring or tolerating the risks presented by continuing legal uncertainty under the CEA.
The CEA must be amended so as to eliminate obstacles to pending and future innovations: clearing and electronic trading today, perhaps "virtual trading" tomorrow. Important markets in foreign currencies, government securities and other financial instruments already use electronic trading facilities and use, or are exploring the use of, clearance and settlement mechanisms. These innovations lower the cost and enhance the efficiency of risk management and mitigate systemic risk. The CEA stands as a significant obstacle to these developments because it incorporates a regulatory framework and philosophy ill-equipped to deal with (or get out of the way of) these developments. The CEA must not be permitted to prevent American businesses from taking advantage of these developments or to obstruct the process of innovation.
Statutory amendments will be necessary to accomplish both of these objectives.
Other considerations, including globalization of the financial markets, are relevant to these issues. Globalization has led to global competition in the financial services industry as well as the internationalization of the client base of multinational U.S. financial institutions.
U.S. customers are a minority (and in some cases already a relatively small minority) of the overall client base of many U.S. financial institutions. U.S. institutions must compete with foreign institutions to win foreign customers. To the extent that transacting with U.S. financial institutions introduces legal risk into the transaction that does not arise when doing business with European or Japanese dealers, U.S. dealers face a competitive disadvantage imposed by uncertainty under the CEA.
Ready access to electronic trading systems and clearing mechanisms also enhances the competitive position of foreign financial institutions.
For business as well as regulatory reasons, the major OTC derivatives dealers are obliged to implement internal controls to manage and mitigate risks arising from their activities. The one risk that these firms cannot manage through internal systems and policies is legal risk. Legal risk can be addressed in two ways: by discontinuing risk-generating activity in the U.S. and by conducting as much of the activity as possible outside the U.S.
A number of factors-such as time zones, geographic proximity and regulatory infrastructure-already bestow a competitive advantage upon foreign financial centers. As concerns about legal risk and constraints on innovation grow, multinational financial institutions also confront a choice between centering operations in London, subjecting only a small percentage (the U.S. percentage) of their affected activities to legal uncertainty, or, on the other hand, centering operations in New York and subjecting 100 percent of their affected activities to legal uncertainty. This is not complex math.
There are those, however, who believe it is in their interest to preserve the legal uncertainty affecting OTC derivatives and the barriers to technological and risk-mitigating innovations. They advance a familiar litany of arguments in favor of the status quo:
"OTC derivatives are dangerous! You can lose money... Lots of money!"--Well, that's kind of the point. OTC derivatives are used by sophisticated institutions specifically to transfer risk. Risk exists in the financial marketplace; derivatives merely transfer that risk. The most notorious trading losses and failures, such as Barings, Metallgesellschaft and Orange County, simply did not involve OTC derivatives.
"OTC derivatives are unregulated!"--So are corporate loans. But the fact is, the vast majority (well over 90 percent) of activity is conducted by regulated banks, regulated broker-dealers and affiliates whose activities are subject to risk assessment oversight or oversight under the voluntary Derivatives Policy Group Framework. In the past, sensational losses and failures have been cited as cause for concern-witness LTCM, Barings, Orange County, Metallgesellschaft and Procter & Gamble. These events, however, were not attributable to an absence of regulation. There may be gaps in regulation, but the losses that have occurred, to the extent they are relevant to the debate at all, are attributable to management failures, aggressive trading strategies that failed and internal control regime failures, not because the parties losing money conducted business with unregulated knaves and scoundrels.
"OTC derivatives growth is outpacing listed derivatives growth because OTC derivatives are unregulated. It's not fair."--Many of the most successful and innovative OTC derivatives dealers are banks, whose supervision is so extensive that exchange regulation pales in comparison. It is clear for all to see (who wish to see) that the success of OTC derivatives is attributable to the economic characteristics of the products--in particular, their nearly infinite flexibility and ease of administration and execution--and has little to do with perceived regulatory disparities.
"OTC derivatives are just like listed derivatives-they are standardized and fungible."--We may conceivably get to a point in the future where the distinctions between these products blur, but today this observation is more sophistry than substance. Much of the appeal of these products is that they are not standardized. The focus on mechanisms to reduce counterparty credit risk arises precisely because these products are not fungible. Congress first regulated futures contracts because their standardized terms and delivery requirements were perceived as rendering them particularly susceptible to manipulation and because the contracts performed a vital national price discovery function. Privately negotiated swap activity simply does not raise the same policy concerns that the CEA was designed to address.
"The CEA stands for 'functional' regulation--so the CFTC must regulate all risk management products, including swaps and futures on securities."--The CEA regulates futures contracts and commodity options. Functional regulation should not be confused with product regulation. Moreover, because derivative products are combinations of contract types and underlying interests, it is not obvious that it is more appropriate to base the regulatory status of a product on the contract type rather than by reference to the underlying interest. Is it obvious that a contract to buy wheat in a month and a contract to buy a security in a month are more closely related to each other than a contract to buy IBM stock tomorrow and a contract to buy IBM stock in a month? This is the logic that brought us the jurisdictional accord in the first place.
Reauthorization of the CEA involves many complex problems without clear answers. Whatever measures are warranted going forward, we can be confident of one thing: the solution is not to preserve a cloud of legal uncertainty over these products under the CEA or to inhibit useful technological innovation in this country.
Edward J. Rosen is a partner and Karl J. Wachter is an associate in the New York office of Cleary, Gottlieb, Steen & Hamilton.