Regulating the Invisible: The Case of Over-the-Counter Derivatives

Article excerpt

In this Article, I focus on the regulation of the over-the-counter (OTC) derivative markets. I argue that current reform proposals and draft legislation fall short of constructing the linked domestic and international frameworks needed to successfully regulate the OTC derivative markets. The purpose of my Article is to propose and defend such a framework. Because of the inseparability of the domestic and international aspects of this issue, I argue that in addition to increased prudential supervision and regulation, the regulation of OTC derivative markets requires interwoven domestic and international systems for regulatory cooperation. This recommendation has two parts. First, Congress should create a framework of regulatory cooperation between the SEC and the CFTC through a regulatory joint venture. Second, I argue for an international framework of regulatory cooperation using a system of public-private partnerships to coordinate regulation of OTC derivatives in the global marketplace.

INTRODUCTION
I.   SKETCH OF THE OVER-THE-COUNTER DERIVATIVE MARKETS .
     A. Background
     B. An Overview of the Benefits and Costs of Using OTC
        Derivatives
        1. Benefits
        2. Costs
II.  CURRENT REGULATORY SCHEME AND CHALLENGES
     A. Current Regulatory Scheme
        1. A Brief History
        2. Description of the Current Regulatory Scheme
     B. Intractable Regulatory Challenges
        1. Globalized Financial Markets
        2. Financial Engineering and Innovation
III. THE CONTENDERS: COMPETING REGULATORY PARADIGMS,
     PROPOSALS, AND INSTITUTIONS
     A. Contending Regulatory Paradigms
     B. Contending Regulatory Reforms
     C. Contending Regulatory Institutions
IV.  FRAMEWORKS OF COOPERATION: DOMESTIC AND
     INTERNATIONAL APPROACHES TO INCREASE REGULATION OF
     THE OTC DERIVATIVE MARKETS
     A. Domestic Frameworks of Cooperation: An SEC-CFFC Joint
        Regulatory Venture: The Derivatives Supervision Initiative
        1. The DSI and Financial Regulatory Reform
        2. The SEC and CFTC's Joint Report and Current
           Reform Proposals
        3. The DSI: A Sketch
        4. The DSI: Potential Objections
     B. International Frameworks of Cooperation
        1. Background Descriptions
        2. The Problem of Transaction Cost
        3. Theoretical Background
        4. Model of International Public-Private Governance
           Partnerships
     C. Linked Domestic and International Frameworks of
        Cooperation
     D. Extensions of Domestic and International Frameworks of
        Cooperation
CONCLUSION

INTRODUCTION

Mark Twain once said, "Everyone talks about the weather but nobody does anything about it." (1) The same can be said for one of the most famous--or infamous--of the financial products that were at the epicenter of the 2008-09 financial crisis: so-called "derivatives." In 1998, Robert Rubin, then U.S. Treasury Secretary, joined with Alan Greenspan, then Chairman of the Federal Reserve Board and Arthur Levitt, then Securities and Exchange Commission (SEC) Chairman, (2) to caution against a proposed "Concept Release" issued earlier that day (3) by Brooksley Born, then Chairperson of the Commodity Futures Trading Commission (CFTC), urging the regulation of the over-the-counter (OTC) derivative markets. (4) And even now, in the wake of a global financial disaster that many blame primarily on a host of exotic unregulated "invisible" financial instruments such as OTC credit default swaps (CDS), there is strong opposition to imposing restrictions on these markets. As one Congressman recently cautioned, "if Congress overreaches ... there could be very significant negative implications on how companies manage risk." (5) In addition, "[a]t least 42 nonfinancial companies and trade associations are lobbying Congress on derivatives" (6) and "[m]ore than 160 of Europe's largest companies have swung behind efforts to persuade regulators to exempt corporate users of over-the-counter derivatives from tough new regulations. …