The Dynamics of OTC Derivatives Regulation: Bridging the Public-Private Divide

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The Dynamics of OTC Derivatives Regulation
Bridging the Public-Private Divide

• Dan Awrey
• Presentation to the Oxford Extra-Legal Governance
  Institute
• November 5th, 2009

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The Dynamics of OTC Derivatives Regulation
Background

• The size, complexity and systemic importance of
  OTC derivatives markets have increased
  exponentially in recent years.
• Notional value (June 1987) USD 225 Billion.
• Notional value (December 2008) USD 592
  Trillion.
• Identified by many as conduits for the avarice,
  hubris and miscalculation which triggered the
  current global financial crisis.
• Financial regulators have thus found themselves
  under considerable pressure to enhance their
  regulation of OTC derivatives markets.
• The U.S., for example, recently proposed
  restricting derivatives trading to regulated
  exchanges.
• Source ISDA/BIS

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The Dynamics of OTC Derivatives Regulation
Project Overview

• The Research Question whom to entrust with the
  responsibility for OTC derivatives regulation?
• Examining the respective roles of public and
  private ordering in achieving the optimal mode of
  regulating OTC derivatives markets.
• The Contribution illustrating the importance of
  bridging the public-private divide.
• The alignment of incentives.
• Facilitating the long term transfer of
  information and expertise.
• The Evaluative Framework welfare economics.
• All potential modes of regulation should be
  evaluated on the basis of their expected costs
  and benefits with a view to maximizing net social
  welfare.
• Emphasis on constrained efficiency reflective of
  real world limitations facing policymakers.

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The Dynamics of OTC Derivatives Regulation The
Costs and Benefits of OTC Derivatives

• Benefits
• Risk management
• Completion of asset markets
• Enhanced price discovery
• Absorbing systemic risk
• All these benefits rely on assumptions
  respecting the extent to which Efficient Markets
  Theory (EMT) reflects the reality of financial
  markets.

• Costs
• Private risks
• Asymmetries of information
• Dealers v. end-users
• F/S disclosure
• Overinvestment
• Excess leverage
• Systemic risks
• Regulatory arbitrage

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The Dynamics of OTC Derivatives Regulation The
Pre-Crisis Regulatory Environment

• Important distinction between exchange-traded and
  OTC derivatives.
• OTC derivatives subject to minimal public
  regulatory intervention beyond prescribed
  regulatory capital treatment.
• U.S. experience turf war.
• U.K. experience light touch.
• Private actors have stepped in to fill the
  regulatory void.
• ISDA.
• Ad hoc industry groups (ie. The Group of
  Fourteen).
• Private providers of trade execution,
  confirmation, clearing, settlement and data
  repository services.

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The Dynamics of OTC Derivatives Regulation The
Strengths and Weaknesses of Private Ordering

• Weaknesses
• Conflicts of interest
• Divergence of private and social welfare
• Absence of legitimacy
• Bureaucratic failure
• Toothless enforcement

• Strengths
• Competitive equilibrium
• Nimble, flexible, responsive
• Incentives to acquire information and expertise
• Ability to transcend jurisdictional boundaries

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The Dynamics of OTC Derivatives Regulation The
Strengths and Weaknesses of Public Ordering

• Weaknesses
• Conflicts of interest
• Lack of information and expertise
• Inherent jurisdictional constraints

• Strengths
• Unparalleled coercive powers of the state
• (Democratic) Legitimacy
• Expert generators of regulation
• Already overcome collective action and
  coordination problems

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The Dynamics of OTC Derivatives Regulation
Bridging the Public-Private Divide

• The current global financial crisis has spurred a
  series of reform proposals aimed at
• Minimizing systemic risks.
• Reducing asymmetries of information.
• Curbing opportunistic behavior.
• Each of these proposals must evaluated on the
  basis of their costs (including lost benefits)
  relative to the reduction in harmful effects.
• Yet few proposals appear to be motivated by the
  desire to achieve the socially optimal mode of
  regulating OTC derivatives markets or addressing
  key challenges in terms of
• Conflicts of interest and the corresponding need
  to align the incentives of both public and
  private actors.
• Lack of sufficient information and expertise.

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The Dynamics of OTC Derivatives Regulation
Bridging the Public-Private Divide

• How do we move forward?
• Abandon the largely artificial distinction
  between public and private ordering.
• Craft a tailored mode of regulation which draws
  upon the respective strengths of, and works
  constructively with the interplay between, public
  and private systems of ordering.
• A tentative proposal coerced self-regulation.
• Public governance and oversight of
  self-regulatory infrastructure.
• Regulatory objectives established by public
  actors.
• Technical regulation designed within the context
  of a dialogic process between public and private
  actors.
• Regulation can promulgated, monitored and
  enforced at either the public or private level,
  depending on perceived needs.

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The Dynamics of OTC Derivatives Regulation
Bridging the Public-Private Divide

• Aligning the incentives of public and private
  actors.
• Ex ante role in promulgation engenders higher ex
  post commitment to compliance.
• Omnipresent threat of more burdensome public
  regulation would incentivize private actors to
  design technical regulation consistent with
  public regulatory objectives and then comply with
  it.
• Parallels to vertical regulatory competition
  theory (Roe 2004).
• Facilitating the long term transfer of
  information and expertise.
• Cultivating a dialogic relationship will lead to
  technical knowledge transfer.
• Pays dividends in terms of enhanced cooperation
  and information sharing from private actors.
• Assists private actors to better understand
  regulatory objectives.

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The Dynamics of OTC Derivatives Regulation
Bridging the Public-Private Divide

• Encouraging signs The Over-the-Counter
  Derivatives Markets Act (U.S.).
• Registration of centralized counterparties,
  repositories and alternative execution
  facilities.
• Registrants must comply with a set of core
  principles.
• Primary responsibility for generating technical
  regulation in compliance with core principles
  arguably falls to registrants.
• HOWEVER, its still too early to tell
• Outstanding questions.
• To what extent will reputational enforcement
  mechanisms work in the context of diffuse,
  heterogeneous and constantly changing OTC
  derivatives markets?
• How do we constrain private actors who perceive
  coerced self-regulation (or any other mode of
  regulation) as being too burdensome from engaging
  in regulatory arbitrage?

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The Dynamics of OTC Derivatives Regulation
Bridging the Public-Private Divide

• Discussion.