Governing the World's Biggest Market: The Politics of Derivatives Regulation After the 2008 Crisis 9780190864576

In the wake of the 2008 global financial crisis, the regulation of the world's enormous derivatives markets assumed

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Governing the World's Biggest Market: The Politics of Derivatives Regulation After the 2008 Crisis
 9780190864576

Table of contents :
Cover
Half title
Governing the World’s Biggest Market
Copyright
Contents
List of Illustrations
List of Tables
Preface
Abbreviations
Contributors
Introduction—Governing the World’s Biggest Market: The Politics of Derivatives Regulation after the 2008 Crisis
1. Becoming the World’s Biggest Market: OTC Derivatives before the Global Financial Crisis of 2008
2. Financial Regulatory Cooperation: Coordination of Derivatives Markets
3. Global Markets, National Toolkits: Extraterritorial Derivatives Rule-​Making in Response to the Global Financial Crisis
4. Power Plays from the Fringe: East Asian Responses to Derivatives Regulatory Reform
5. The Second Half: Interest Group Conflicts and Coalitions in the Implementation of the Dodd-​Frank Act Derivatives Rules
6. The Politics and Practices of Central Clearing in OTC Derivatives Markets
7. Positioning for Stronger Limits? The Politics of Regulating Commodity Derivatives Markets
8. A Web without a Center: Fragmentation in the OTC Derivatives Trade Reporting System
Index

Citation preview



Governing the World’s Biggest Market





Governing the World’s Biggest Market The Politics of Derivatives Regulation after the 2008 Crisis EDITED BY ERIC HELLEINER S T E FA N O PA G L I A R I I R E N E   S PA G N A

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1 Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and certain other countries. Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America. © Oxford University Press 2018 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization. Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above. You must not circulate this work in any other form and you must impose this same condition on any acquirer. CIP data is on file at the Library of Congress ISBN 978–​0–​19–​086457–​6 1 3 5 7 9 8 6 4 2 Printed by Sheridan Books, Inc., United States of America



CONTENTS

List of Illustrations   vii List of Tables   ix Preface  xi Abbreviations  xiii Contributors  xvii

Introduction—Governing the World’s Biggest Market: The Politics of Derivatives Regulation after the 2008 Crisis   1 E r i c H e l l e i n e r , S t e fa n o Pa g l i a r i , a n d I r e n e   S pa g n a

1. Becoming the World’s Biggest Market: OTC Derivatives before the Global Financial Crisis of 2008   27 I r e n e   S pa g n a

2. Financial Regulatory Cooperation: Coordination of Derivatives Markets   54 Elliot Posner

3. Global Markets, National Toolkits: Extraterritorial Derivatives Rule-​Making in Response to the Global Financial Crisis   82 M at t h e w G r av e l l e a n d S t e fa n o Pa g l i a r i

4. Power Plays from the Fringe: East Asian Responses to Derivatives Regulatory Reform   107 Y u -​wa i   V i c   L i

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vi C o n t e n t s

5. The Second Half: Interest Group Conflicts and Coalitions in the Implementation of the Dodd-​Frank Act Derivatives Rules   137 S t e fa n o Pa g l i a r i

6. The Politics and Practices of Central Clearing in OTC Derivatives Markets   168 Erin Lockwood

7. Positioning for Stronger Limits? The Politics of Regulating Commodity Derivatives Markets   199 Eric Helleiner

8. A Web without a Center: Fragmentation in the OTC Derivatives Trade Reporting System   226 Peter Knaack

Index  257



I L L U S T R AT I O N S

1.1 1.2 1.3 1.4 5.1 5.2 5.3 5.4



6.1 6.2 8.1 8.2 8.3

8.4

The global OTC derivatives market  31 The markets for OTC and exchange-​traded derivatives  31 The global OTC derivatives market by counterparty type (% of notional amounts outstanding)  32 Gross market value of OTC derivatives in function of different types of derivative instruments (billion USD)  33 Firms lobbying CFTC and SEC over derivatives rules (2010–2014)  147 Groups most frequently lobbying (meetings + letters) the CFTC and SEC over implementation of derivatives rules (2010–2014)  148 Network of groups lobbying over SEC and CFTC derivatives rules  149 Numbers and links among groups lobbying the CFTC and SEC (meetings + letters) across different derivatives rule-​making (2010–2014)  151 Bilateral and centrally cleared networks  187 Links between banks and global CCPs  188 International financial network, portfolio assets  233 CDS network on EU sovereign reference entities  235 ISDA’s role in the agreement on a temporary stay on early termination rights  238 The current global TR network  248

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TA B L E S

I.1 I.2 2.1

Core aspects of the G20 agenda for derivatives regulatory reform  The political dynamics of post-​2008 derivatives regulation  22 What is to be explained? Patterns of cooperation in implementing G20 principles for derivatives regulation  61

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P R E FA C E

Since the 2008 global financial crisis, scholars have written extensively about various post-​crisis regulatory reforms designed to improve the stability and resilience of financial markets. Within this literature, however, the extensive efforts to reform the regulation of derivatives markets have received less attention than other dimensions of the post-​2008 reform agenda. This relative neglect is unusual given the significance of derivatives markets in the crisis and in the contemporary global economy more generally. We think it is also unfortunate given the fascinating nature of the politics surrounding post-​2008 derivatives regulatory reforms. As the momentum for reforming the regulation of these enormous markets weakens, we believe that it is more important than ever to improve understandings of the politics of derivatives regulation. This volume aims to contribute to that task. The book is a product of a very fruitful collaboration among the contributors to this volume that began with a workshop at the Balsillie School of International Affairs in September 2015. We are extremely grateful to all the authors in this volume for writing such interesting chapters. For their contributions to that initial workshop and very helpful comments, we also extend enormous thanks to Derek Hall, Dave Kempthorne, Jonathan Kirshner, Kate McNamara, Sylvia Maxfield, and Heather Whiteside. We also thank the Balsillie School of International Affairs for funding the workshop and the Social Sciences and Humanities Research Council of Canada for research support. Many thanks as well to Dave McBride at Oxford for his support of this project as well as to Claire Sibley for her help and the anonymous reviewers of the initial draft of this manuscript for their very useful suggestions and comments. Eric Helleiner, Stefano Pagliari, and Irene Spagna April 2017

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A B B R E V I AT I O N S

AFC AFL-​CIO AIG ANE ASIFMA ASX BCBS BIS BRICS CCP CDO CDS CEA CEO CFMA CFTC CGFS CMC CME CMOC COU CPMI CPSS CRMPG CVA DCO

Asian Financial Crisis American Federation of Labor and Congress of Industrial Organizations American International Group arranged, negotiated, or executed Asian Securities Industry and Financial Market Association Australian Securities Exchange Basel Committee on Banking Supervision Bank for International Settlements Brazil, Russia, India, China, and South Africa central counterparty collateralized debt obligation credit default swap Commodity Exchange Act Chief Executive Officer Commodity Futures Modernization Act Commodity Futures Trading Commission Committee on the Global Financial System Commodity Markets Council Chicago Mercantile Exchange Commodity Markets Oversight Coalition Central Operating Unit Committee on Payments and Market Infrastructures Committee on Payment and Settlement Systems Counterparty Risk Management Policy Group credit valuation adjustment derivatives clearing organization xiii



xiv A b b r

Dodd-​Frank DTCC EMIR ESMA ETP FBOT FRB FSB FX G14 G16 G20 G30 GDP G-​SIB HKEX HKMA IATP ICE IIF IMF IOSCO IPE IRS ISDA JFSA JSCC LCH LEI LTCM MAS MBS MiFID II MoU MTF NDF NGO NYMEX OCC ODRF

eviations

Dodd-​Frank Wall Street Reform and Consumer Protection Act Depository Trust & Clearing Corporation European Market Infrastructure Regulation European Securities and Markets Authority electronic trading platform Foreign Board of Trade Federal Reserve Board Financial Stability Board foreign exchange largest fourteen derivatives dealers largest sixteen derivatives dealers Group of Twenty Group of Thirty gross domestic product global systemically important bank Hong Kong Exchange Hong Kong Monetary Authority Institute for Agriculture and Trade Policy Intercontinental Exchange Institute of International Finance International Monetary Fund International Organization of Securities Commissions international political economy interest rate swap International Swaps and Derivatives Association Japanese Financial Service Authority Japan Securities Clearing Corporation London Clearinghouse legal entity identifier Long Term Capital Management Monetary Authority of Singapore mortgage-​backed security Revision of the Market in Financial Instruments Directive Memorandum of Understanding multilateral trading facility non-​deliverable forward nongovernmental organization New York Mercantile Exchange Office of the Comptroller of the Currency OTC Derivatives Regulators’ Forum



Abbreviations

ODRG ODWG OFR OTC PFMI RCAP SDMA SEC SEF SFC SGX SIFMA SOMO SPV SSB TARP TR UCC UTI VaR WDM WEED WMBAA

OTC Derivatives Regulators Group OTC Derivatives Working Group Office for Financial Research over-​the-​counter Principles for Financial Market Infrastructures Regulatory Consistency Assessment Program Swaps and Derivatives Market Association Securities and Exchange Commission swap execution facility Securities and Futures Commission Singapore Exchange Securities Industry and Financial Markets Association Stichting Onderzoek Multinationale Ondernemingen (Centre for Research on Multinational Corporations) special purpose vehicle standard-setting body Troubled Asset Relief Program trade repository Uniform Code Council unique trade identifier value-​at-​risk World Development Movement World Economy, Ecology and Development Wholesale Markets Brokers Association of America

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CO N T R I B U TO R S

Matthew Gravelle  recently completed his PhD in Political Science at the University of British Columbia in Vancouver, Canada. Eric Helleiner is a Professor in the Department of Political Science and Balsillie School of International Affairs, University of Waterloo, Ontario, Canada. Peter Knaack  is a postdoctoral research fellow at the Blavatnik School of Government, University of Oxford. Yu-​wai Vic Li is an Assistant Professor in the Department of Social Sciences at the Education University of Hong Kong. Erin Lockwood is an Assistant Professor in the Department of Political Science at the University of California, Irvine. Stefano Pagliari is a Senior Lecturer in the Department of International Politics at City University of London. Elliot Posner  is an Associate Professor of Political Science at Case Western Reserve University, Cleveland, Ohio. Irene Spagna  is a PhD candidate in Global Governance/​Global Political Economy at the University of Waterloo, Ontario, Canada.

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Governing the World’s Biggest Market





Introduction

Governing the World’s Biggest Market The Politics of Derivatives Regulation after the 2008 Crisis Eric Helleiner , Stefano Pagliari, and Irene Spagna

This book examines the politics of derivatives regulation after the 2008 global financial crisis. At the time of the crisis, derivatives had come to occupy a central position in the global economy. By the end of 2008, the notional value of outstanding over-​the-​counter (OTC) derivatives contracts totaled USD 684 trillion, a staggeringly large figure that was approximately ten times the global gross domestic product (GDP).1 Taken together, derivatives had in fact grown to be the world’s biggest market. This market involved participants from across the globe ranging from large banks and pension funds to farmers and manufacturers, from governments and municipalities to international financial institutions and sovereign wealth funds. The 2008 financial crisis revealed very starkly that derivatives mattered not just to these groups participating in this huge market. The trading of these financial products—​which include forwards, futures, options, or swaps—​was also enormously significant to everyone else in the world. Before the crisis, star investor Warren Buffett had warned in 2002 that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”2 This warning proved prescient when derivatives contributed in significant ways to the severity of the 2008 meltdown.

  OTC figures from Bank for International Settlements 2010:  6. OTC derivatives represented about 90% of all global derivatives at the time. 2   Buffett 2002: 15. 1

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In the wake of the crisis, policymakers in the G20 jurisdictions committed to reform the regulation of derivatives markets.3 The regulation of derivatives was a topic that had previously not attracted much sustained public attention, despite the extremely rapid growth of the markets since the early 1980s. A few corporate scandals (e.g., Enron, Orange County) and episodes of financial instability involving derivatives (e.g., Long Term Capital Management) in the 1990s had briefly brought derivatives onto the agenda of regulators and scholars, but these episodes proved to be short-​lived and failed to alter significantly the regulation of these markets.4 The situation changed with the financial crisis of 2008, as the regulation of derivatives markets now assumed center stage on the international public policy agenda and not just because of concerns about systemic financial instability. Critics argued that inadequate regulation of derivatives also contributed to commodity price volatility, sovereign and corporate debt problems, market abuse, and, more generally, the growing and unchecked influence of private financial interests. In short, derivatives markets were suddenly at the middle of core political debates about the distribution of power and wealth in the modern world economy. What have been the precise goals of the G20 reform agenda? What have been the results of efforts to implement this agenda to date? More generally, what does this episode teach us about the politics of derivatives regulation after the global financial crisis? Despite the global importance of derivatives markets, these questions have not received much attention to date from those interested in the politics of the global economy. Even among those who specialize in the study of the politics of global financial regulation, other topics such as banking rules receive much more attention than the governance of derivatives. For many scholars and students of global political economy, derivatives markets remain mysterious and complex. This volume is designed to begin to rectify this relative neglect. The first chapter by Irene Spagna provides some background for readers with less knowledge of derivatives by describing and analyzing the dramatic growth of pre-​crisis derivatives and their contribution to the 2008 crisis. The rest of the chapters then address the questions we have raised by analyzing various aspects of the politics of post-​2008 derivatives regulation. Some of these chapters focus on the dynamics of international regulatory coordination between leading powers, while others examine reforms in specific geographical contexts or with respect to specific issue areas. Despite these different foci, some common themes emerge   The G20 jurisdictions are:  Argentina, Australia, Brazil, Canada, China, European Union, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, and United States. 4   Tsingou 2006. 3



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in addressing the three core questions. The purpose of this introductory chapter is to summarize these themes.

What Have Been the Goals of the G20 Regulatory Agenda? The first theme concerns the content of the G20-​led reform objectives themselves. As Irene Spagna explains in ­chapter  1, policymakers in the United States and other leading financial powers such as the United Kingdom had allowed derivatives to grow largely unchecked in the years leading up to the crisis, particularly OTC derivatives that are traded bilaterally and privately away from organized exchanges. They had done this not just through various liberalizing and permissive rules but also through their support for self-​ regulatory initiatives of market actors and private industry bodies such as the International Swaps and Derivatives Association (ISDA). The 2008 crisis ushered in an important change in official attitudes whose dimensions this volume explores. The shift in attitudes was already apparent when the G20 leaders met for the first time in November 2008 to endorse a new international agenda for financial regulatory reform. In their final statement, the G20 leaders called for “a review of the scope of financial regulation, with a special emphasis on institutions, instruments, and markets that are currently unregulated” and OTC derivatives were specifically identified as a priority area.5 By the time of their third summit in September 2009 in Pittsburgh, the G20 leaders had settled on a new comprehensive set of regulatory goals for derivatives markets that they each agreed to implement.6 To begin with, the G20 leaders committed to force all standardized OTC derivatives contracts to be cleared by central counterparties (CCPs) by the end of 2012. CCPs are designed to act as an intermediary between sellers and buyers of derivatives, guaranteeing trades should either party default, and forcing both parties to post margin or collateral to cover potential losses. Officials argued that CCPs would reduce systemic risks by minimizing uncertainty in the markets and by enabling counterparty risks to be managed centrally and to be better supervised and regulated. CCPs were already used in some segments of the industry and the G20 leaders now committed to extend this practice for all standardized derivatives contracts on a mandatory basis.

  G20 2008.   G20 2009.

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The G20 leaders also declared that derivative contracts not centrally cleared should be subject to higher capital requirements, a move that both incentivized central clearing and mitigated the risks associated with non-​standardized contracts that continued to be cleared bilaterally. In addition, they decided in 2011 to create common global standards for initial and variation margins for non-​ centrally cleared contracts in order to ensure that collateral was available to cushion the impact of defaults and to help address “de-​stabilizing pro-​cyclicality” that resulted from the tendency of market actors to lower margins in boom times and raise them in crises.7 These standards were then announced in 2013.8 Equally important, they committed to ensure that CCPs be subject to effective regulation and supervision—​a particularly important aim given that derivatives​related counterparty risks would now become increasingly concentrated in CCPs. International financial standard-setting bodies subsequently developed standards for CCPs that addressed issues such as prudential requirements, market access rules, measures to protect customer positions and assets, governance arrangements, information disclosure, as well as resolution and recovery.9 Another goal outlined by the G20 leaders in September 2009 was that, by the end of 2012, “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate.”10 By bringing bilateral OTC trades onto these organized trading platforms, policymakers sought to make them more transparent not just to regulators but also to other market participants. Greater transparency would help reduce the asymmetric control of information by the dealer banks that dominated these markets through their unique knowledge of trading prices and volumes. The markets would, it was hoped, thus become less prone to what the G20 called “market abuse” and would function more smoothly, particularly in times of stress.11 Another major objective outlined by the G20 leaders in September 2009 was that all OTC contracts—​both cleared and non-​cleared—​should be reported to “trade repositories” (TRs). TRs serve as centralized registries collecting and maintaining records about who has traded what and with whom. One TR had already emerged before the crisis to reduce confirmation backlogs for credit default swaps (CDSs), a product whose purchasers pay a fee every quarter to the seller in return for a promise that the full value of an underlying bond will be repaid in the event of a default. Because CDSs ended up at the center of the 2008 crisis (for reasons explained in the next chapter), this TR was able to help calm   BCBS and IOSCO 2012: 2; see also G20 2011.   BCBS and IOSCO 2013. 9   CPSS and IOSCO 2012; IOSCO and CPMI 2014. 10   G20 2009. 11   Quote from G20 2009: 9. See also Financial Stability Board 2010: 10. 7 8



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fears during the Lehman crisis by publicizing how the size of net CDS exposure was smaller than many expected at the time. By forcing all OTC derivatives contracts to be reported to TRs, the G20 leaders hoped to give market actors greater information, and regulators and supervisors a more complete picture of risk exposures across all markets.12 International regulatory bodies subsequently also developed standards for TRs that cover similar issues as those for CCPs and seek to ensure that regulatory authorities gain access to TR data and that global aggregation mechanisms are established.13 Alongside those various goals, the G20 leaders also announced one final objective in late 2011 that applied more specifically to commodity derivatives markets. During the financial crisis of 2008, commodity prices spiked dramatically in ways that contributed further to the global economic instability at the time. As Eric Helleiner details in his chapter, this experience and another set of price spikes in 2010‒11 generated much concern about whether growing speculative trading in commodity derivatives markets was contributing to commodity price volatility. Responding to this concern, the G20 leaders declared in late 2011 that regulators of commodity derivatives markets “should have, and use formal position management powers, including the power to set ex-​ante position limits.”14 Many countries already had in place “position management powers”—​such as position limits that set ceilings on the number of contracts each trader could hold in specific markets—​but this statement signaled a new international endorsement and encouragement of their use. Taken together, these core goals outlined by the G20 leaders (and summarized in table I.1) were heralded as a historic departure from the pre-​crisis regulatory paradigm. They did indeed signal a new willingness to strengthen public regulation and supervision of global derivatives markets. At the same time, this volume argues that it is important not to overstate the degree of change from pre-​crisis norms that is embodied in the G20 reform agenda.

The Limits of Change One reason to be cautious is that the G20 leaders continued to assign profit-​ seeking private actors a prominent place in the governance of derivative markets. Many of the institutions placed at the center of the reforms—​CCPs, exchanges, and TRs—​were of this kind. In the important case of CCPs, the Bank of England initially warned against this strategy, arguing that a nonprofit, user-​owned governance structure would be optimal because these institutions were now being   Helleiner 2014b.   CPSS and IOSCO 2012, 2013. 14   G20 2011. 12 13



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Table I.1 Core aspects of the G20 agenda for derivatives regulatory reform Issue

Requirements

Central clearing

• All standardized OTC derivatives should be cleared via CCPs • Non-​cleared contracts subject to margin requirements and higher capital requirements • CCPs subject to effective regulation and supervision, including recovery and resolution plans

Trading

• All standardized OTC derivatives should be traded on exchanges or electronic trading platforms

Reporting

• All OTC derivatives controls should be reported to TRs • All TRs should meet international standards

Position limits

• Regulators of commodity derivatives markets should have, and use formal position management powers, including the power to set ex-​ante position limits

set up to play a key role in restraining risky behavior in the market. But this idea gained little political traction.15 As Erin Lockwood’s chapter in this volume shows, many CCPs replicate key practices and techniques of risk-​management that had failed in the OTC markets before the crisis.16 The dangers of poor risk management at CCPs were only compounded by the fact that the content of the G20 reform agenda had the effect of encouraging an intense competitive struggle among various private sector groups trying to capture the new mandatory clearing business. G20 policymakers also delegated key aspects of the post-​crisis rule-​making and implementation process to the same private groups that orchestrated self-​ regulation before the crisis. For example, public authorities worked closely with ISDA and the leading dealer banks (“the G14” and more recently the “G16”) in order to encourage greater transparency, central clearing, and contract standardization.17 ISDA also played the lead role in areas such as the design of contractual models for CDS eligible for CCP clearing, and the solicitation and adjudication of private sector proposals for the introduction of new TRs for commodity,   Bank of England 2010: 10.   See also Lockwood (2015) for the enduring role of banks’ value-​at-​risk models as an “authoritative practice” with “productive power” in the context of broader post-​2008 regulatory reforms. 17   Financial Stability Board 2011; Biggins and Scott 2012. The G14 included: Bank of America, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, Royal Bank of Scotland, Société Générale, UBS, and Wells Fargo. The following two were added to make up the G16: Crédit Agricole and Nomura. 15 16



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interest rate, and equity derivatives.18 In addition, as the chapter by Matthew Gravelle and Stefano Pagliari notes, ISDA has been at the center of industry-​led initiatives designed to assist the implementation of the G20 agenda by promoting mutual recognition of domestic regulatory frameworks. In instances such as these, ISDA’s role has shifted to complementing, rather than substituting for or preempting, public regulatory initiatives, but its central place within the governance of these markets persists.19 Indeed, some ISDA initiatives have even given it a more prominent role. For example, John Biggins and Colin Scott have made this case in the context of their 2013 analysis of ISDA’s creation of a set of new 15-​member ISDA Determinations Committees (composed of 10 CDS dealers and 5 non-​dealers). These Committees define the “credit events” that will trigger payment in a credit default swap and their decisions can be extremely important because the Committee’s decisions are legally binding under ISDA contracts. In March 2012, for example, the decision about whether a Greek quasi-​voluntary debt restructuring deal was to be considered a “credit event” impacted the evolution of debt crisis in the Eurozone.20 More generally, the G20 leaders have also refused to endorse many reforms that would have aimed more squarely at constraining the size and speculative features of the markets. For example, while the G20 endorsed position limits in commodity derivatives markets, they refrained from backing this kind of constraint on speculative trading vis-​à-​vis other asset classes that are vastly larger in size and volume. They also ignored calls for bans on derivatives products that were particularly associated with destabilizing speculative trading such as “unattached” (or “naked”) CDS contracts in which the purchaser does not hold the underlying bond to which the contact is linked. In the words of New York insurance superintendent Eric Dinallo, these products were the equivalent of “taking out insurance on your neighbor’s house and maybe hoping it blows up.”21 Yet the G20 backed no efforts to ban, or even license, these products. Only in the more limited European regional context did authorities—​provoked by speculation against Greek sovereign debt in 2010—​undertake a limited initiative to regulate unattached CDS on European sovereign bonds.22   Saguato 2013; CPSS and IOSCO 2012: 6.   McKeen-​Edwards and Porter 2013: 57–​58. 20   Biggins and Scott 2013. 21   Quoted in Helleiner 2011: 138. 22   Pagliari 2013b. The idea of licensing derivatives had been raised by the BIS (2009), which suggested that all new financial products be registered and evaluated on an ongoing basis by a consumer financial products regulator because of their respective potential to contribute to systemic risk. A precedent for banning derivatives products on public policy grounds in the United States came from Congress’s rejection of a Pentagon proposal for the introduction of terrorism futures in 2003 (as a market-​based predictor of likelihood of terrorist attacks) (Omarova 2013: 105n30). 18 19



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Similarly, at the height of the crisis, some reformers called for all OTC contracts to be centrally cleared and traded on exchanges, a move that would have significantly curtailed the size, complexity, and speculative features of these markets. But the G20 limited requirements for central clearing and exchange trading to “standardized” contracts, leaving out more complex “bespoke” transactions. With this provision, officials estimate that as much as one-​quarter of interest rate swaps, one-​third of CDS, and two-​thirds of other OTC derivatives will remain uncleared.23 Summing up, while the G20 leaders endorsed strengthened public regulation and supervision of the markets, their overall reform agenda did not seek to turn back the clock by radically reducing the size and importance of global derivatives markets or by reimposing the kind of tight public controls over financial markets that existed in many countries in the early postwar years. Instead of trying to constrain market growth and speculative activity in significant ways, the main goal was a more modest one of enhancing the transparency and resiliency of the markets. This more “market-​friendly” objective was reinforced by the fact that the G20 continued to rely on profit-​seeking private actors and private rule-​ making to play important roles in the governance of the markets, as had been done in the pre-​crisis period. As Duncan Wigan has suggested, post-​crisis regulatory initiatives appear much more as efforts to “improve the operations of the system” than ones designed to challenge it.24

What Have Been the Results of Efforts to Implement the G20 Agenda to Date? The forging of the G20 reform agenda was just the first phase in the process of regulatory change in the global derivatives sector after the crisis. Equally important have been the subsequent efforts to implement that agenda. Many of the chapters in this volume analyze the politics of the implementation phase. Taken together, they reveal how implementation has been associated with a number of unanticipated outcomes.

Delays and Inconsistencies The first of these has been the slow nature of implementation. The institution at the center of coordinating the implementation has been the Financial Stability   BCBS and IOSCO 2012: 2n4.   Wigan 2010: 122. See also Wigan 2009.

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Board (FSB), a body created in 2009 by the G20 with membership that includes all G20 countries and a few others.25 Its regular updates have highlighted the failure of its members to meet deadlines initially set by the G20 leaders. The G20 leaders set a very clear deadline at their September 2009 summit that “all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-​2012 at the latest.”26 In April 2013, however, the FSB acknowledged that “no jurisdiction had fully implemented requirements by end-​2012” and only “less than half of the FSB member jurisdictions currently have legislative and regulatory frameworks in place to implement the G20 commitments.”27 Since then, more countries have taken steps toward implementing the G20 agenda, but in 2016 the FSB continued to lament that progress in the implementation of OTC derivatives reforms “remains uneven.”28 Delays have even characterized the domestic reforms in the two major jurisdictions—​the United States and the European Union—​at the center of driving the international regulatory agenda.29 The G20 reform agenda was significantly influenced by regulatory goals outlined by the Obama administration in May 2009. The United States was also the first major jurisdiction to develop comprehensive legislation strengthening derivatives regulation with the passage of the Dodd-​Frank Wall Street Reform and Consumer Protection Act (Dodd-​ Frank) in July 2010. As a number of the chapters in this volume describe, however, since the passage of the Dodd-​Frank, the details of its implementation have been unexpectedly delayed and continue to be rolled out slowly by the two domestic regulators allocated strengthened authority to oversee and regulate derivatives:  the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). The election in November 2016 of President Donald Trump and his pledge to roll-​back many aspects of the Dodd-​Frank have further called into question the prospects for the implementation of these commitments. In Europe, the European Commission presented its first Communication outlining possible derivatives regulatory reforms in July 2009, shortly after the Obama administration announced its goals in May. Following approval by the European Parliament and the major European member countries, the European Market Infrastructure Regulation (EMIR) came into force in August 2012 as a new EU-​wide regulatory framework for OTC derivatives that followed many   For an overview, see Helleiner 2014c: ch. 5.   G20 2009. 27   Financial Stability Board 2013: 1. 28   Financial Stability Board 2016a: 1. 29   Knaack 2015. 25 26



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of the G20 goals. Other relevant initiatives of the European Commission have included:  a revision of its Capital Requirements Directive in order to introduce differentiated capital charges between CCP cleared and non-​CCP cleared contracts, and a revision of its Market Abuse Directive to increase the power of regulatory authorities to investigate market abuses in derivatives markets, and regulations of short-​selling that cover the use of credit default swaps. But as some chapters in this volume note, progress has been slow in areas such as the execution of OTC derivatives on electronic platforms, post-​trade transparency, and position limits for commodity derivatives that were included in the revision of the Market in Financial Instruments Directive (MiFID II), which was adopted by the European Parliament and European Council in 2014 but whose details then had to be developed by the European Securities and Markets Authority (ESMA). Other jurisdictions, such as Japan, have also undertaken legislative initiatives to implement G20 commitments, but others have delayed action in various areas. In particular, while the regulatory frameworks for central clearing and trade reporting have been implemented in most jurisdictions, the drafting of guidelines related to resolution frameworks for CCPs by international standard-​ setting bodies has been lagging behind. As a result, the FSB noted in 2016 that a number of CCPs still lacked the adequate safeguards to ensure that they maintained sufficient financial resources and procedures needed to facilitate their resolution in the case of a crisis.30 The FSB also noted in 2016 that “platform trading frameworks are relatively undeveloped in most jurisdictions”31, with only “less than half of FSB member jurisdictions” having in place comprehensive criteria to achieve this objective.32 Along the same lines, the FSB highlighted that only 3 of 24 member jurisdictions were on track to have variation and initial margin requirements for non-​centrally cleared derivatives in force from September 2016 in accordance with the schedule set by the International Organization of Securities Commissions (IOSCO) and Basel Committee on Banking Supervision (BCBS).33 Even where implementation was more widespread such as in the area of trade reporting that is analyzed in Peter Knaack’s chapter, the FSB highlighted inconsistencies. Although all but five FSB jurisdictions had trade reporting requirements in place covering over 90% of OTC derivatives transactions in their jurisdictions by mid-​2016,34 the FSB noted that different implementation issues   Financial Stability Board 2016b: 31.   Financial Stability Board 2016b: 1. 32   Financial Stability Board 2016b: 35. 33   Financial Stability Board 2016b: 13. 34   Financial Stability Board 2016b: 5. 30 31



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continued to influence the effectiveness of trade reporting requirements, including “difficulties with TR data quality, challenges in aggregating data across TRs, and legal barriers to reporting complete data to TRs and to authorities’ access to TR-​held data.”35 Differences have also emerged between major jurisdictions at the stage of implementation with respect to issues such as:  requirements for mandatory clearing, the scope of the exemptions offered to specific market players and types of derivatives from the clearing and trading requirements, segregation and portability requirements, CCP ownership and governance requirements, definitions of organized trading platforms, and details of position limits.36 In some cases, differences that existed in primary legislation have been reconciled during the implementation stage, but the latter has also been an occasion to introduce new divergences across jurisdictions. These divergences often reflected changes that dilute in various ways the goals of the initial G20 agenda.

Conflict and Fragmentation In addition to the delayed and inconsistent nature of implementation across jurisdictions, another unexpected outcome has been the degree of conflict and regulatory fragmentation that has emerged between jurisdictions. The negotiation of the initial G20 reform agenda was a remarkably cooperative process that held out the prospect of the emergence of common global rules governing globally integrated markets. In the end, however, the implementation of the same agenda has been characterized by much disagreement and regulatory fragmentation. Disagreements have been generated not just by the divergent pace and content of implementation across jurisdictions but also by issues relating to the jurisdictional scope of the rules being introduced—​an issue explored in a number of the chapters in this volume. For example, Dodd-​Frank contains explicit references to the extraterritorial application of many of its rules to foreign entities, which, according to one analyst, “have seldom, if ever, been seen before in U.S. financial regulation.”37 These provisions have been justified by US authorities on the grounds that American taxpayers were asked to bail out American International Group (AIG) whose troubles stemmed largely from swaps written by its UK subsidiary.38 But they have generated controversy abroad, particularly in East Asia, as Yu-​wai Vic Li’s chapter describes. EMIR also contains   Financial Stability Board 2016b: 9-​10.   CFTC and SEC 2012. 37   Coffee 2014: 29. 38   Coffee 2014; Helleiner 2014a; Greene and Potiha 2013. 35 36



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extraterritorial provisions regulating trades between non-​EU entities when these have a “direct, substantial and foreseeable effect” within the European Union or when this is necessary to guard against evasion of the rules.39 As Gravelle and Pagliari’s chapter explains, both the United States and European Union included legislative provisions enabling the extraterritorial application of their respective laws to be waived if a foreign jurisdiction introduced domestic laws that were equivalent to their own. But they also highlight how the determination of equivalency has generated substantial tension, first and foremost in the US‒EU relationship itself. Since 2008, US and European policymakers have devoted considerable time to the task of trying to resolve potential transatlantic conflicts in this area. As Elliot Posner’s chapter analyzes, the negotiations between US and European authorities to develop a collaborative framework to defer to each other’s rules have been fraught with difficulties. The FSB has identified the persistence of this disagreement between the United States and European Union as a stumbling block negatively affecting the consistent implementation of the G20 agenda in a number of smaller markets.40 Jurisdictional issues have equally arisen around the implementation of the G20 goals of promoting central clearing. For example, rather than rely on US-​ based CCPs, European authorities pressured the major derivative dealers in 2009 to clear CDSs on European reference entities through CCPs based in Europe.41 Location requirements for the clearing of derivatives, or jurisdiction-​specific authorization requirements for cross-​border access have also been introduced in many jurisdictions outside of the European Union, generating new challenges for international cooperation. As the FSB noted in 2014, “few CCPs are currently permitted to operate in more than one or two jurisdictions, which poses challenges to the wider global uptake of central clearing, in particular for participants engaged in cross-​border transactions.”42 In 2016, the FSB also expressed the concern that the absence of cross-​border availability of CCPs was potentially leading authorities to “delay consideration and adoption of specific central clearing determinations by an authority whose CCP is not yet authorised abroad.”43 The implementation of other G20 commitments has generated similar fragmentation trends. For example, in implementing the trading requirement, US regulators have required that every trading platform used by US market actors, regardless of its geographical location, should come under US regulatory oversight. As Gravelle and Pagliari’s chapter notes, this move has triggered a   Coffee 2014:9.   Financial Stability Board 2011. 41   Pagliari 2013a. 42   Financial Stability Board 2014: 3. 43   Financial Stability Board 2016b: 30. 39 40



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bifurcation in a number of markets, as European trading platforms have sought to escape the US rules. Similarly, Knaack’s chapter describes how, instead of relying on one single TR to collect information on trades globally for each asset class, a multitude of TRs with more restricted national or regional reach have emerged in a variety of jurisdictions across the world, The chapter shows how the cross-​ border sharing of information across these different TRs is plagued by obstacles that have proven difficult to overcome. The G20 leaders committed in June 2012 to develop a “global legal entity identifier (LEI) system for parties to financial transactions, with a global governance framework representing the public interest.”44 Although the LEI system has addressed initial technical inconsistencies, trade reporting faces legal obstacles that undermine cross-​border compatibility of OTC trade reporting and the capacity of regulators to obtain a global picture of the OTC derivatives markets. These kinds of jurisdictional issues—​in combination with differences in the timing and the content of the rules implemented across countries—​have generated a number of heated disputes. Given the highly international nature of derivatives, it is no surprise that the FSB has noted “that resolution of cross-​border issues continues to be the most significant implementation issue.”45 To address these issues, the G20 leaders agreed in September 2013 that “jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, in a non-​discriminatory way, paying due respect to home country regulation regimes.”46 Regulators from the largest jurisdictions such as the United States and European Union have signaled support for mechanisms such as “substituted compliance” and “equivalence and recognition” to solve cross-​border regulatory issues, but Gravelle and Pagliari show how in practice the application of these mutual recognition tools has frequently failed to rein in the extraterritorial application of US and EU rules. Two years after the G20 commitment to defer to each other’s rules, the FSB noted that “only a small number of jurisdictions” had made “deference determinations” to other jurisdictions’ regulatory regimes.47 Since then, several specific decisions have been made to defer in some way to foreign jurisdictions’ regulatory regimes for CCPs.48 But the difficulties in reconciling different and overlapping regulatory regimes continue to threaten to generate fragmentation along territorial lines not just in terms of the content of regulations   G20 2012: 8.   Financial Stability Board 2014: 26. 46   G20 2013:17. 47   Financial Stability Board 2015b: 20. 48   Financial Stability Board 2016b: 2, 23. 44 45



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but in global derivatives market activity itself.49 Already, regulators have noted that inconsistencies and cross-​border issues emerging in the implementation of the G20 agenda have triggered a “reorganisation of business activities along jurisdictional lines.”50 In a July 2015 report, the FSB also emphasized that “some authorities note that the absence of deference may contribute to market fragmentation.”51 In sum, this volume’s second core theme is to call attention to the fact that implementation of the modest G20 reform agenda has been associated with many unexpected outcomes: delays, inconsistencies, conflicts between jurisdictions, and growing regulatory fragmentation. The last outcome is particularly significant. Not only does it challenge the G20’s initial goals, but it threatens to undermine the globally integrated nature of derivatives markets. In this sense, this unintended consequence of the G20 agenda may have more radical consequences for derivatives markets than the aims of the initial agenda itself.

The Politics of Derivatives Regulation after  the Global Financial Crisis What explains both the emergence of the G20 regulatory agenda and the difficulties associated with its implementation? To address this question, we need to understand the politics that shape derivatives regulation. This subject has received less attention than the politics of regulation in other financial sectors such as international banking. Literature that does exist on the topic focuses mostly on the weak nature of public regulation before the 2008 crisis. Building on the analytical insights of some of that literature, this volume develops its third core theme: that post-​2008 trends in derivatives regulation are best explained as a product of a complex interplay of transnational, inter-​state, and domestic political dynamics.52

The Transnational Political Context In explaining the pre-​crisis pattern of regulation, many analysts have pointed to the power and influence of a transnational private community of financiers working through various transnational private bodies such as ISDA.53 As   Helleiner 2014a.   Financial Stability Board 2014: 26. 51   Financial Stability Board 2015a: 25. 52   This framework also builds on Helleiner and Pagliari 2011. 53   See, e.g., Biggins and Scott 2012, 2013; McKeen-​Edwards and Porter 2013; Morgan 2008, 2010; Porter 2005. See also Tsingou’s (2003, 2006, 2015)  important work on the G30. For a 49 50



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Spagna’s chapter notes, these private actors played a central role in constructing these markets, dominating policy debates, and preempting stronger official regulation. At the core of this community was the small group of well-​organized dealer banks with strong material interests in OTC derivatives trading (which accounted for up to 40% of their profits before the crisis).54 Their influence was strengthened by the lack of expertise and incentives among politicians to challenge their preferences, as well as by their ability to secure access to leading technocratic financial officials with whom they shared a common background, expertise, and worldview shaped by neoliberal ideology and modern finance theory.55 How influential have these transnational private groups been over the direction of regulatory reforms in the derivatives sector in the post-​crisis period? As noted earlier, ISDA and the leading dealer banks have worked closely with public authorities to assist in the implementation of core goals of the G20 reform agenda. But the dealer banks have also continued to lobby fiercely against reforms that might challenge their central role in the markets. As a number of chapters in this volume note, this lobbying has helped to fend off calls for more radical reform and to water down G20 goals at the implementation phase. As Lockwood’s chapter argues, existing transnational industry practices also created a certain path-​dependency in some areas, making it more difficult for public actors to impose dramatically new governance regimes. In general, the relationship between public authorities and ISDA has been less cooperative than before the crisis. For example, ISDA’s willingness to cooperate with public regulators broke down when public authorities endorsed more “anti-​market” forms of regulation such as the strengthening of position limits on commodity derivatives. As Helleiner’s chapter explains, ISDA launched an unprecedented legal challenge in late 2011 to block the initial detailed rules of the United States that were aimed at strengthening position limits, a challenge whose success forced a major delay in the US implementation. As noted by Knaack, as well as by Gravelle and Pagliari, transnational private financiers have equally been very critical of developments such as the proliferation of TRs and the resort to extra-​territorial rules. From the other side, public authorities have also shown a much greater willingness to assert their authority vis-​à-​vis transnational private groups such as ISDA and to pursue initiatives that diverged from their preferences. For example, in 2009, they successfully pressured ISDA to change its internal governance broader structural analysis of the political economy of derivatives before the crisis, see Bryan and Rafferty 2006.   Statistic is from McLean and Nocera 2010: 104. See also Biggins and Scott 2013.   Porter 2014; Tsingou 2003, 2006, 2015; McKeen-​Edwards and Porter 2013: 43–​46.

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to give greater representation to investor groups that were supportive of their goals to promote greater market transparency.56 More generally, while ISDA and other private transnational groups continue to remain important players in the post-​crisis derivatives markets, they are no longer the primary drivers of change in international rule-​making. In the wake of the crisis, it was the official sector—​ not ISDA and the dealer banks—​that took over this role in developing the new G20 regulatory reform agenda. The speed with which the G20 agenda was developed can be attributed at least in part to the density of transgovernmental networks of financial officials with expertise in this area.57 These networks have emerged not just through the G7/​G20 process but also through a large array of international standard-​setting bodies (SSBs) such as the FSB, the BCBS, IOSCO, the Committee on the Global Financial System (CGFS), and the Committee on Payment and Settlement Systems (renamed Committee on Payments and Market Infrastructures, CPMI). Also important have been more specialist bodies that have brought together financial officials from leading financial powers to focus exclusively on derivatives regulation. Some of these already existed before the crisis (such as the OTC Derivatives Supervisors Group created in 2005), but the majority emerged in its aftermath including the OTC Derivatives Coordination Group, the OTC Derivatives Working Group, the OTC Derivatives Regulators Forum, the OTC Derivatives Regulators Group, and OTC Derivatives Assessment Team. The commitment of officials in these expert networks to regulatory reform after the crisis was greatly strengthened by the new prominence of a “macroprudential” framework for thinking about regulation. This framework emphasized the need to tackle the build-​up of “systemic risk,” and it quickly became the new conventional wisdom in official expert circles after the crisis. Within this new ideational frame, poorly regulated OTC derivatives came to be seen as a key source of systemic risk because of their interconnectedness, opacity, excessive leverage, and contribution to pro-​cyclicality. Increasingly dense transgovernmental expert networks were centrally important in forging this new ideational consensus that, in turn, shaped and justified the G20 reform agenda.58 At the same time, it is important not to overstate the influence of these transgovernmental networks. The development of the standards drafted by these networks has been uneven and characterized by delays. One challenge has been the fragmented and weak nature of the transgovernmental institutional environment in this area. As Posner’s chapter notes, there is no established transnational institution with the same kind of experience, capacity, and legitimacy to act as a   McKeen-​Edwards and Porter 2013: 44.   Helleiner 2011, 2014a. 58   Ibid. 56 57



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focal point in the development of derivatives rules that the BCBS has in the area of international banking standards. Posner argues that this contrast explains the sequencing of rule-​making in the derivatives sphere, where the design of new derivatives regulatory frameworks in key jurisdictions such as the United States and the European Union often preceded rather than followed the transnational rule-​making process. It also accounts for the fact that European and US authorities have often preferred to resolve the jurisdictional issues bilaterally, rather than through transnational networks. The unexpected delays, inconsistencies, conflicts, and fragmentation that have arisen at the implementation stage also reflect weaknesses in the broader governance of international financial standards as a whole. Governance of these standards relies on soft-​law and network-​based institutions that lack power to effectively coordinate and constrain the actions of national authorities. As Knaack’s chapter highlights, the institution at the center of efforts to coordinate the implementation of the overall G20 financial regulatory agenda—​the FSB—​is a toothless body of this kind. Although it has consistently declared the implementation of derivatives regulatory reforms as one of its highest priority issues, the FSB has been forced to rely only on relatively ineffectual monitoring exercises and peer reviews to promote this outcome.59

The Inter-​State Context In addition to showing the influence of these transnational dynamics, this volume demonstrates how post-​crisis regulatory trends have also been shaped by competition and power among states. In explaining the weak nature of pre-​crisis regulation, analysts often pointed to the significance of competitive deregulation dynamics between leading states. As Spagna describes in her chapter, US and UK officials feared that tighter official regulation would push highly mobile OTC derivatives activity to the other’s territory.60 Before 2008, international competitive pressures also encouraged many governments to incorporate ISDA’s ideas into national legislation, as a way of attracting business to their markets.61 Several chapters in this volume illustrate how competitive pressures have continued to shape regulatory trends in the post-​crisis period. Interestingly, however, these pressures have not always generated deregulatory trends. For example, Helleiner’s chapter shows how competitive pressures help to explain why US authorities played the lead role in strengthening international standards. Once US authorities had decided to tighten domestic regulations, they   See also Knaack 2015.   Coleman 2003; Helleiner 2011, 2014a. 61   Biggins and Scott 2012. 59 60



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recognized the need to push other jurisdictions to follow suit via the G20 in order to ensure a level playing field for US businesses and trading infrastructures.62 Other jurisdictions seeking to tighten domestic regulations, such as the European Union, faced similar incentives to support and follow the G20 agenda. In this way, the rapid emergence of G20 reform agenda reflected not just the successful agency of transgovernmental networks but also national concerns about inter-​state competitive pressures undermining domestic reform objectives. Competition helped to generate cooperation. Inter-​state competition and concerns for inter-​state distributional consequences have also clearly influenced the politics of reform implementation. In some instances, competitive pressures helped to undermine implementation when individual jurisdictions chose not to fully comply with international standards as a means of attracting footloose business. A number of the contributors to this volume suggest that the uneven and inconsistent implementation of G20 goals in the United States, Europe, as well as Asia can be explained partly through this lens. In other cases, however, competitive dynamics may have accelerated the implementation of specific aspects of the G20 agenda. For example, one reason policymakers in Europe have promoted the establishment of local CCPs has been to capture rapidly expanding clearing business.63 Inter-​state power relationships have also helped to shape post-​crisis regulatory trends. As Posner’s chapter emphasizes, the high concentration of derivatives market activity within the United States and European Union has given those two jurisdictions major leverage to dictate the main dimensions of the G20 agenda in this sector.64 Posner notes that, for this reason, they have often simply resorted to bilateral negotiations to move the international reform agenda forward. Indeed, there is little evidence that the perspectives of other jurisdictions have influenced the development of the content of international reform agenda in significant ways.65 To prevent other jurisdictions from undercutting their efforts to tighten domestic regulatory standards, US and European authorities have relied not just on their diplomatic resources in the G20 and other international fora. The chapters by Gravelle and Pagliari, and Helleiner describe how they have also flexed their market power by threatening extraterritorial application of their rules and the exclusion of non-​complying firms from their markets in their domestic legislative frameworks. These threats have encouraged foreign jurisdictions to endorse the international reform agenda of the United States and the European   See also Helleiner 2011, 2014a.   Pagliari 2013b; Norman 2012. 64   For this case more generally in international financial regulation, see also Posner 2009. 65   Mügge 2014: 64–​65. 62 63



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Union, but they have also generated considerable conflict and fragmentation—​ including between the United States and the European Union themselves—​at the implementation stage as noted in the previous section. Li’s chapter highlights how US and EU market power has not, however, prevented some East Asian jurisdictions from implementing reforms in ways that deviate from the expectations of these leading powers and of international standard-​setting bodies. Rejecting a simple passive rule-​taking role, East Asian authorities have set their own autonomous pace of adapting to the post-​crisis international priorities and “cherry-​picking” among different parts of the G20 derivatives agenda in order to promote the development of local derivatives markets and to increase their share of the fast-​growing regional derivatives markets in the area. Li shows how emerging markets in East Asia have also skillfully resisted external pressures by leveraging the power of US and European private dealers based in their region and exploiting differences between EU and US rules. In these ways, these less powerful states have demonstrated not just their desire but also their considerable ability to carve out “power-​as-​autonomy” to develop a more independent regulatory path in ways that has contributed to the uneven implementation of G20 goals.66

The Domestic Political Context The chapters in this volume also point to the importance of domestic political dynamics in explaining post-​crisis trends in derivatives regulation. One such dynamic is the changing levels of domestic political salience of the issue of derivatives regulation. Literature on the pre-​crisis period highlighted how the subject of derivatives regulation rarely attracted much sustained attention among politicians or the wider public in the United States and Europe where most trading took place. This low domestic political salience of the issue allowed dealer banks and expert officials to dominate policymaking in those jurisdictions before 2008. There were occasional exceptions when crises or scandals generated brief public debate, but the latter did not last long enough to generate sufficient domestic support for tighter public regulation.67 The chapters in this volume show how this situation changed dramatically within both the United States and the European Union in 2008 because of the severity of the financial crisis and the use of taxpayer money to bail out institutions whose troubles were linked to derivatives. As Helleiner’s chapter notes, public attention was also drawn to derivatives markets by the 2008 and 2010‒11

  For the concept of “power as autonomy,” see Cohen 2006.   Pagliari 2012, 2013a; Tett 2009.

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spikes in politically sensitive energy and agricultural prices that were blamed in part on unchecked speculation in commodity derivatives markets. In the face of outrage from the general public, domestic politicians demanded tighter regulation and heads of state placed the issue on the agenda of the high-​profile G20 leaders’ meetings. If the higher domestic political salience of derivatives helped generate the G20 reform agenda, it also complicated the politics of implementation. Agreements reached at the international level were not always fully compatible with the legislative initiatives launched by elected politicians in US Congress or the European Parliament who were suddenly more interested in this issue but had a more parochial focus.68 Gravelle and Pagliari emphasize how greater domestic concerns about systemic risk and costs to be borne by taxpayers also encouraged rules about extraterritoriality that contributed to conflict and fragmentation at the international level.69 Knaack’s chapter shows how the difficulties in the TR reform agenda can be attributed in part to obstacles imposed on new kinds of international cooperation by domestic legislatures.70 At the same time, as distance from the crisis grew, the domestic political salience of derivatives began to decline somewhat in the United States and European Union. This development, however, did not always make the implementation of G20 goals easier. A number of chapters show how lower levels of issue salience and the shift toward the more technical phase of implementation often provided greater space for private sector opponents of stricter rules to exercise greater influence over outcomes. Post-​crisis regulatory trends have also been strongly shaped by patterns of interest-​group mobilization within countries. Analyses of the pre-​crisis period reveal how dealer banks were the interest group most involved within US and European domestic discussions about derivatives regulations before 2008. They remained very involved after the crisis, helping to shape domestic legislation as well as to block, water down, or delay the domestic implementation of initiatives that did not serve their interests.71 But contributors to this volume also highlight the active roles of a broader set of domestic interest groups. For example, Pagliari’s chapter shows how some US reforms opposed by the dealer banks were strongly supported by others in the financial industry such as organized exchanges and interests associated with the buy-​side of the market, such as institutional investors.72 Helleiner also notes how the initiative to   Knaack 2015.   See also Pagliari 2013b; Mügge 2014: 55, 65–​66; Helleiner 2014a. 70   See also Knaack 2015. 71   See, e.g., Litan 2010; Morgan 2010, 2012. 72   See also Helleiner 2011, 2014a; Morgan 2012. 68 69



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tighten position limits in commodity derivatives markets was strongly backed by broad-​based US domestic coalition of consumer advocacy groups, international development organizations, environmentalists, and many producers, distributors, retailers, and end-​users in the agricultural, food, and energy sectors.73 At the same time, in their efforts to dilute tough reforms, the dealer banks successfully mobilized new alliances with corporate “end-​users” outside the financial sector whose costs would rise as a result of regulatory initiatives.74 When business lobbies were more unified in this way, Pagliari shows that they were usually more successful. Li’s analysis of the implementation of the G20 agenda in East Asia also points to the importance of “new” financial interests associated with emerging local derivatives markets and established transnational dealers in generating complex dynamics that influence the distinct path taken by these jurisdictions. A final domestic political variable shaping the content and pace of implementation of post-​2008 reforms is the domestic institutional context within which rule-​making has taken place. For example, the implementation of Dodd-​Frank has been delayed and complicated by the need for coordination among multiple US regulatory agencies with diverging priorities and mandates and internal divisions, such as the SEC, CFTC, Federal Energy Regulatory Commission, Office of the Comptroller of the Currency, Federal Reserve, and Federal Deposit Insurance Corporation.75 Pagliari’s chapter highlights how implementation has been made even more difficult by the unwillingness of Congress to increase the resources available to regulators such as the CFTC. The analyses in this volume also bring out how the development of new European legislation for OTC derivatives has been slowed considerably by the institutional complexities of European cooperation. To explain both the emergence of the G20 regulatory agenda and the difficulties associated with its implementation, the chapters in this volume thus suggest the need for analysts to examine a complicated set of interacting transnational, inter-​state, and domestic political dynamics (see table I.2). Many of these are quite distinctive from the dynamics that shaped derivative regulation before the crisis. Others are familiar to those who have studied pre-​crisis regulatory politics, but some of these dynamics—​such as competitive pressures or the degree of power of transnational private elites—​have manifested themselves in new ways in the post-​crisis environment.

  See also Clapp and Helleiner 2012; Helleiner and Thistlethwaite 2013.   See also Pagliari and Young 2013, 2014. 75   See also Knaack 2015. 73 74



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Table I.2 The political dynamics of post-​2008 derivatives regulation Political Context

Key Drivers of Change

Transnational

• Transgovernmental networks and institutions (G20, FSB, SSBs) • Transnational private interests and institutions (ISDA, authoritative practices)

Inter-​State

• Competition for market share between jurisdictions • Market power and priorities of the United States and European Union • Power-​as-​autonomy of weaker states

Domestic

• Changing levels of political salience • Patterns of interest group mobilization • Domestic institutional context

Conclusion Alongside its analyses of various aspects of the politics of derivatives regulation after the 2008 crisis, this volume develops three core themes. First, while G20 leaders have endorsed greater public regulatory control over derivatives markets, it is important not to overstate the degree of change embodied in this agenda. The G20 goals have been primarily focused on enhancing the transparency and resilience of the markets rather than constraining their growth. The G20 leaders have also endorsed continued delegation of key governance functions to profit-​ seeking private actors and private rule-​making in ways that are reminiscent of the pre-​crisis world. Despite the severity of the crisis, the G20 leaders’ agenda was thus not a manifesto to change the prominent place of derivatives in the world economy in a radical manner. Second, many unexpected outcomes have arisen as policymakers set out to implement the G20 reform agenda. Implementation has been inconsistent across jurisdictions and has been subject to unanticipated delays. Considerable tensions have also emerged between jurisdictions as the timing and content of their respective rules have diverged and as governments have resorted to extraterritorial application of their new rules. These developments, in turn, have resulted in a growing fragmentation of the regulation of derivatives markets, a quite different result than G20 policymakers initially intended and one with potentially larger significance for the trajectory of global economic governance after the crisis. Finally, both the emergence of the G20 reform agenda and its implementation have been influenced by a complex combination of transnational, inter-​state,



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and domestic political dynamics. At the transnational level, outcomes have been shaped by transgovernmental networks and transnational private financial groups, each with their own institutions. Important political dynamics have also included intense inter-​state competition for market shares as well as inter-​ state power plays involving the projection of power by the United States and European Union and the protection of autonomy by less powerful countries. At the domestic level, post-​crisis regulatory trends have reflected changing levels of political salience of derivatives regulation, patterns of interest group mobilization, and distinctive institutional structures. These three core themes are developed through detailed analyses of a number of aspects of the politics of post-​2008 derivatives regulation. In ­chapter 2, Posner examines the dynamics of international regulatory coordination between the United States and European Union. In c­ hapter 3, Gravelle and Pagliari explore how these two jurisdictions have implemented the G20 agenda in an extraterritorial way. In c­ hapter 4, Li shifts the focus to the role of East Asian countries in the post-​2008 reform process. In c­ hapter 5, Pagliari zeros in on the US case to explore the role of domestic interest groups in the politics of implementing the Dodd-​Frank. The last three chapters explore in more depth three core issue areas in the post-​2008 reform process:  the push for greater use of central clearinghouses (Lockwood’s ­chapter 6), efforts to strengthen position limits over commodity derivatives (Helleiner’s ­chapter 7), and the new information reporting requirements (Knaack’s ­chapter  8). Before turning to these detailed analyses, however, Spagna’s ­chapter 1 provides an analysis of the growth of OTC derivatives and their regulation before 2008, as well as their contribution to the 2008 crisis.

Acknowledgments The authors would like to thank Matthew Gravelle, Kate McNamara, and two anonymous reviewers for their valuable comments on an earlier draft of the chapter, as well as to acknowledge the contribution by the Social Sciences and Humanities Research Council of Canada.

Works Cited Bank for International Settlements. 2009. 79th Annual Report. Basel: BIS. Bank for International Settlements. 2010. “OTC Derivatives Market Activity in the Second Half of 2009.” May. Basel: BIS. http://​www.bis.org/​publ/​otc_​hy1005.pdf. Bank of England. 2010. “Financial Stability Report No. 28.” December. http://​www.bankofengland.co.uk/​publications/​fsr/​2010/​fsrfull1012.pdf.



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BCBS and IOSCO. 2012. “Margin Requirements for Non-​ Centrally-​ Cleared Derivatives: Consultative Document.” July. Basel: BIS. http://​www.bis.org/​publ/​bcbs226.htm. BCBS and IOSCO. 2013. “Margin Requirements for Non-​ Centrally Cleared Derivatives.” Basel: BIS. http://​www.bis.org/​publ/​bcbs261.pdf. Biggins, John, and Colin Scott. 2012. “Public‒Private Relations in a Transnational Private Regulatory Regime:  ISDA, the State and OTC Derivatives Market Reform.” European Business Organization Law Review 13(3): 309–​346. Biggins, John, and Colin Scott. 2013. “Private Governance, Public Implications and the Tightrope of Regulatory Reform: The ISDA Credit Derivatives Determinations Committees.” Osgoode Comparative Research in Law and Political Economy. Research Paper No. 57/​2013. http://​ digitalcommons.osgoode.yorku.ca/​clpe/​299. Bryan, Dick, and Michael Rafferty. 2006. Capitalism with Derivatives. Basingstoke, UK: Macmillan. Buffett, Warren E. 2002. “Chairman’s Letter. Berkshire Hathaway Inc. 2002 Annual Report.” http://​www.berkshirehathaway.com/​2002ar/​2002ar.pdf. CFTC and SEC. 2012. “Joint Report on International Swap Regulation.” Washington, DC:  Commodity Futures Trading Commissions, Securities and Exchange Commission. http://​www.cftc.gov/​idc/​groups/​public/​@swaps/​documents/​file/​dfstudy_​isr_​013112.pdf. Clapp, Jennifer, and Eric Helleiner. 2012. “Troubled Futures? The Global Food Crisis and the Politics of Agricultural Derivatives Regulation.” Review of International Political Economy 19(2): 181–​207. Coffee, J. C. 2014. “Extraterritorial Financial Regulation: Why E.T. Can’t Come Home.” European Corporate Governance Institute (ECGI)—​Law Working Paper, 236/​2014. http://​www. ecgi.org/​wp/​wp_​id.php?id=641. Cohen, Benjamin. 2006. “The Macrofoundations of Monetary Power.” In International Monetary Power, edited by D. Andrews, 31–​50. Ithaca, NY: Cornell University Press. Coleman, William. 2003. “Governing Global Finance: Financial Derivatives, Liberal States and Transformative Capacity.” In States in the Global Economy, edited by Linda Weiss, 271-​92. Cambridge: Cambridge University Press. CPSS and IOSCO. 2012. “Principles for Financial Market Infrastructure.” April. Basel and Madrid: BIS and IOSCO. http://​www.bis.org/​cpmi/​publ/​d101a.pdf. CPSS and IOSCO. 2013. “Authorities’ Access to Trade Repository Data.” August. Basel and Madrid: BIS and IOSCO. http://​www.bis.org/​cpmi/​publ/​d110.htm. Financial Stability Board. 2010. “Implementing OTC Derivatives Market Reforms.” October 25. Basel:  FSB. http://​www.fsb.org/​2010/​10/​fsb-​report-​on-​implementing-​otc-​derivatives-​ market-​reforms/​. Financial Stability Board. 2011. “OTC Derivatives Market Reforms:  Progress Report on Implementation.” October 11. Basel:  FSB. http://​www.fsb.org/​wp-​content/​uploads/​r_​ 111011b.pdf. Financial Stability Board. 2013. “OTC Derivatives Market Reforms:  Fifth Progress Report on Implementation.” April 15. Basel:  FSB. http://​www.fsb.org/​wp-​content/​uploads/​r_​ 130415.pdf?page_​moved=1. Financial Stability Board. 2014. “OTC Derivatives Market Reforms:  Seventh Progress Report on Implementation.” April 8. Basel: FSB. http://​www.fsb.org/​wp-​content/​uploads/​r_​140408.pdf. Financial Stability Board. 2015a. “OTC Derivatives Market Reforms:  Ninth Progress Report on Implementation.” July 24. Basel: FSB. http://​www.fsb.org/​wp-​content/​uploads/​OTC-​ Derivatives-​Ninth-​July-​2015-​Progress-​Report.pdf. Financial Stability Board. 2015b. “Implementation and Effects of the G20 Financial Regulatory Reforms: Report of the Financial Stability Board to G20 Leaders.” November 9. Basel: FSB. http://​www.fsb.org/​2015/​11/​implementation-​and-​effects-​of-​the-​g20-​financial-​regulatory-​ reforms/​. Financial Stability Board. 2016a. “Implementation and Effects of the G20 Financial Regulatory Reforms:  2nd Annual Report.” August 31. Basel:  FSB. http://​www.fsb.org/​wp-​content/​ uploads/​Report-​on-​implementation-​and-​effects-​of-​reforms.pdf.



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Financial Stability Board. 2016b. “OTC Derivatives Market Reforms: Eleventh Progress Report on Implementation.” August 26. Basel:  FSB. http://​www.fsb.org/​wp-​content/​uploads/​ OTC-​Derivatives-​Market-​Reforms-​Eleventh-​Progress-​Report.pdf. Greene, E. F., and I. Potiha. 2013. “Issues in the Extraterritorial Application of Dodd-​Frank’s Derivatives and Clearing Rules:  The Impact on Global Markets and the Inevitability of Cross-​ Border and U.S. Domestic Coordination.” Capital Market Law Journal 8(4): 338–​394. G20. 2008. “Declaration of the Summit on Financial Markets and the World Economy.” Washington, DC, November 15. http://​www.g20.org/​Documents/​g20_​summit_​declaration.pdf. G20. 2009. “Leaders’ Statement: The Pittsburgh Summit.” September 24‒25. https://​www.treasury.gov/​resource-​center/​international/​g7-​g20/​Documents/​pittsburgh_​summit_​leaders_​ statement_​250909.pdf. G20. 2011. “Communiqué—​G20 Leaders Summit—​Cannes.” November 3‒4. https://​www. oecd.org/​g20/​summits/​cannes/​Cannes%20Leaders%20Communiqué%204%20%20 November%202011.pdf. G20. 2012. “G20 Leaders Declaration—​Los Cabos.” June 18‒19. http://​www.g20.utoronto.ca/​ 2012/​2012-​0619-​loscabos.html. G20. 2013. “G20 Leaders’ Declaration—​St Petersburg Summit.” September 5–​6. http://​www. g20.utoronto.ca/​2013/​2013-​0906-​declaration.html. Helleiner, Eric. 2011. “Reining in the Market.” In Governing the Global Economy, edited by D. H. Claes and C. H. Knutsen, 131‒150. London: Routledge. Helleiner, Eric. 2014a. “Towards Cooperative Decentralization: The Post-​Crisis Governance of Global OTC Derivatives.” In Transnational Financial Regulation after the Crisis, edited by T. Porter, 132‒153. London: Routledge. Helleiner, Eric. 2014b. “Out from the Shadows: Governing OTC Derivatives after the 2007‒08 Financial Crisis.” In Public as Practice, edited by Jacquie Best and Alexandra Gheciu, 70‒94. Cambridge: Cambridge University Press. Helleiner, Eric. 2014c. The Status Quo Crisis: Global Financial Governance after the 2008 Meltdown. Oxford: Oxford University Press. Helleiner, Eric, and Stefano Pagliari. 2011. “The End of an Era in International Financial Regulation? A Post-​Crisis Research Agenda.” International Organization 65:169–​200. Helleiner, Eric, and Jason Thistlethwaite. 2013. “Subprime Catalyst: Financial Regulatory Reform and the Strengthening of US Carbon Market Governance.” Regulation and Governance 7(4): 496–​511. IOSCO and CPMI. 2014. “Recovery of Financial Market Infrastructures.” October. Basel and Madrid: BIS and IOSCO. http://​www.bis.org/​cpmi/​publ/​d121.pdf. Knaack, Peter. 2015. “Innovation and Deadlock in Global Financial Governance:  Transatlantic Coordination Failure in OTC Derivatives Regulation.” Review of International Political Economy 22(6): 1217–​1248. Litan, Robert. 2010. “The Derivatives Dealers’ Club and Derivatives Market Reform.” Initiative on Business and Public Policy at Brookings, April 7. Washington, DC: Brookings. Lockwood, Erin. 2015. “Predicting the Unpredictable:  Value-​at-​Risk, Performativity, and the Politics of Uncertainty.” Review of International Political Economy 22(4): 719–​756. McKeen-​Edwards, Heather, and Tony Porter. 2013. Transnational Financial Associations and the Governance of Global Finance. London: Routledge. McLean, Bethany, and Joe Nocera. 2010. All the Devils Are Here: The Hidden History of the Financial Crisis. New York: Portfolio/​Penguin. Morgan, Glenn. 2008. “Market Formation and Governance in International Financial Markets: The Case of OTC Derivatives.” Human Relations 61(5): 637–​660. Morgan, Glenn. 2010. “Legitimacy in Financial Markets:  Credit Default Swaps in the Current Crisis.” Socio-​Economic Review 8:17–​45. Morgan, Glenn. 2012. “Reforming OTC Markets: The Politics and Economics of Technical Fixes.” European Business Organization Law Review 13(3): 391–​412.



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Mügge, Daniel. 2014. “Securities and Derivatives Markets.” In Europe and the Governance of Global Finance, edited by D. Mügge, 53‒66. Oxford: Oxford University Press. Norman, Peter. 2012. The Risk Controllers. Chichester, UK: John Wiley. Omarova, Saule. 2013. From Reaction to Prevention: Product Approval as a Model of Derivatives Regulation. Harvard Business Law Review Online. 3:  98–​107. http://​www.hblr.org/​wp-​ content/​uploads/​2013/​03/​Omarova_​From-​Reaction-​to-​Prevention.pdf Pagliari, Stefano. 2012. “Who Governs Finance? The Shifting Public‒Private Divide in the Regulation of Derivatives, Rating Agencies and Hedge Funds.” European Law Journal 18(1): 44–​61. Pagliari, Stefano. 2013a. “Public Salience and International Financial Regulation: Explaining the International Regulation of OTC Derivatives, Rating Agencies, and Hedge Funds.” PhD diss., University of Waterloo. Pagliari, Stefano. 2013b. “A Wall around Europe? The European Regulatory Response to the Global Financial Crisis and the Turn in Transatlantic Relations.” Journal of European Integration 35(4): 391–​408. Pagliari, Stefano, and Kevin Young. 2013. “The Wall Street‒Main-​Street Nexus in Financial Regulation: Business Coalitions Inside and Outside the Financial Sector in the Regulation of OTC Derivatives.” In Great Expectations, Slow Transformations: Incremental Change in Post-​ Crisis Regulation, edited by Manuella Moschella and Eleni Tsingou, 125‒148. Colchester, UK: ECPR Press. Pagliari, Stefano, and Kevin Young. 2014. “Leveraged Interests: Financial Industry Power and the Role of Private Sector Coalitions.” Review of International Political Economy 21(3): 575–​610. Porter, Tony. 2005. Globalization and Finance. Cambridge, MA: Polity. Porter, Tony. 2014. “Technical Systems and the Architecture of Transnational Business Governance Interactions.” Regulation and Governance 8:110–​125. Posner, Elliot. 2009. “Making Rules for Global Finance: Transatlantic Regulatory Cooperation at the Turn of the Millennium.” International Organization 63:665–​699. Saguato, P. 2013. “Private Regulation in the Credit Default Swaps Market: The Role of ISDA in the New Regulatory Scenario of CDSs.” In The Governance and Regulation of International Finance, by G. P. Miller and M. Cafaggi, 32‒72. Cheltenham, UK: Edward Elgar. Tett, Gillian. 2009. Fool’s Gold. New York: Free Press. Tsingou, Eleni. 2003. “Transnational Policy Communities and Financial Governance: The Role of Private Actors in Derivatives Regulation.” CSGR Working Paper No. 111/​03, January. Warwick, UK:  Centre for the Study of Globalisation and Regionalisation, Warwick University. http://​wrap.warwick.ac.uk/​2009/​. Tsingou, Eleni. 2006. “The Governance of OTC Derivatives Markets.” In The Political Economy of Financial Market Regulation, edited by Peter Mooslechner, Helene Schuberth, and Beat Weber, 168‒190. Cheltenham, UK: Elgar. Tsingou, Eleni. 2015. “Club Governance and the Making of Global Financial Rules.” Review of International Political Economy 22(2): 225–​256. Wigan, Duncan. 2009. “Financialisation and Derivatives: Constructing an Artifice of Indifference.” Competition and Change 13(2): 157–​172. Wigan, Duncan. 2010. “Credit Risk Transfer and Crunches:  Global Finance Victorious or Vanquished?” New Political Economy 15(1): 109–​125.



1

Becoming the World’s Biggest Market OTC Derivatives before the Global Financial Crisis of 2008 Irene Spagna

This chapter sets the scene for the analysis of the politics of derivatives regulation after the global financial crisis by examining the growth of OTC derivatives from the 1980s to 2008. The focus is on the role of the United States because of the dominance of US financial institutions in the OTC derivatives business and the importance of a series of permissive US regulatory choices and transnational private policy outputs largely inspired by US actors. As Eleni Tsingou puts it, the policy debate surrounding the growth of derivatives during this period before the crisis was “predominantly US-​centred.”1 The United Kingdom, which together with the United States dominates the global market, had deregulated OTC derivatives in one single step in the context of the large-​scale financial liberalization embodied in the Financial Services Act of 1986 (the “big bang”).2 From 1986 until 2008, British officials then refrained from interfering in the OTC markets, as did the European Union.3 The chapter shows that the three political contexts identified in this volume as sources of post-​crisis regulatory developments (inter-​state, domestic, and transnational) already shaped pre-​crisis trends. It also illuminates the importance of transnational private interests and institutions that, albeit at a lower level, persist in the post-​crisis world. Both factors point to an important element of continuity characterizing the political dynamics of both the deregulation of derivatives before the crisis and the creation and implementation of the post-​2008 G20 regulatory agenda. At the same time, the discussion reveals a significant factor of change. While the introductory chapter identified a high degree of conflict

  Tsingou 2015: 243.   Biggins and Scott 2012: 318–​319. 3   Mügge 2014; Awrey 2010. 1 2

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and regulatory fragmentation as a dominant feature of the post-​crisis regulatory environment, the pre-​crisis period was characterized by a broad-​based, though not unanimous, consensus favoring deregulated markets and globally designed private rules. The chapter begins with an overview of the nature of derivatives and their basic functions as well as a brief description of the growth of the OTC derivatives market. The subsequent two sections explore the political sources of the market’s expansion, analyzing relevant public and private regulatory decisions that promoted the market’s growth. The first of these sections shows how US authorities—​encouraged through heavy interest group lobbying by leading private actors—​implemented a series of deregulatory measures intended to remove uncertainty about the regulatory status of OTC derivatives and to prevent the migration of the business to less regulated markets. The chapter then discusses some prominent cases of private transnational rule-​making and explores how public decision makers actively supported this kind of self-​regulation by the private derivatives industry that promised to keep market risks at bay. These two sections highlight how both groups of actors—​public and private—​were united by their belief in the superiority of market-​based regulation before the crisis. To set up for the analyses of the subsequent chapters, the final section of the chapter engages in a brief analysis of derivatives’ contribution to the 2008 crisis, with a particular focus on the role of credit default swaps (CDSs).

Understanding Derivatives Markets Derivatives include a variety of financial products whose value depends on the value of an underlying asset or a market variable, such as an equity instrument, a bond, a commodity, an interest rate or exchange rate.4 They allow market actors to hedge against price volatility and risk but also provide them with the opportunity for speculation. While speculating implies trying to anticipate market movements through directional bets in an attempt to exploit price differentials and volatility, hedging involves the idea of using a derivative contract in order to offset a change in the value of the underlying asset or market variable.5 The most common derivatives instruments include forwards, futures, options, and swaps. Forward contracts oblige two parties to, respectively, buy or sell a specific asset at a future date for a price defined when the contract was concluded. Futures are standardized forwards traded on formal exchanges. Unlike   For the definitions in this paragraph, see Valiante 2010:  1; Coleman 2004:  274; Culp and Mackay 1994: 39. 5   Chui 2012: 4. 4





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forwards, option contracts do not involve a contractual commitment. Rather, they grant the user the right to buy (call option) or sell (put option) the underlying asset. Finally, swaps allow counterparties to exchange cash flows associated with financial instruments they respectively own at pre-​defined future dates. It is also possible to create more complex instruments by combining these derivatives with each other or with securities and loans. Take a beer brewery. The firm could negotiate a forward contract with a supplier to lock in the price of wheat and barley. With the help of two futures contracts, the brewery might also manage its exposure to changes in the market price of aluminum and natural gas used to produce the cans and to heat the production site. If the firm exports its beer and wants to hedge against exchange rate fluctuations, it could buy a foreign currency option to sell the currency in which it is paid at a pre-​defined price. The brewery would exercise this option depending on the movement of the underlying exchange rate, that is, it would sell the foreign currency on the pre-​defined terms if the option provides it with a better price than the prevailing market exchange rate. Assuming the firm has outstanding debt set at a floating interest rate and wants to protect itself against a rise in interest rates, it could also enter in an interest rate swap with another party holding a fixed-​rate loan. As a result, the brewery would make fixed-​rate payments to its counterparty and receive payments at a floating rate, which would improve its interest structure. Derivatives can be traded on an exchange or bilaterally over-​the-​counter. The main determinants differentiating the two forms of trading include the design of the terms of contract, its liquidity, maturity, and credit risk (i.e., risk of default).6 Exchange-​traded contracts consist of standardized terms whose details are publicly recorded, whereas OTC deals are tailored and kept private by the counterparties. Exchange-​traded derivatives’ high degree of standardization is also one of the main reasons why they are more liquid than OTC derivatives. In addition, exchange-​traded contracts tend to have short maturities, often less than a few months, whereas OTC derivatives typically have longer maturities that can span many years. Differences in credit risk are among the most significant factors separating exchange-​traded derivatives from OTC derivatives. The credit risk in the exchange market is born by CCPs that are often attached to the exchange houses. The CCP acts as an intermediary institution located between the two counterparties. A  party to every deal, it guarantees contract performance and assumes the risk of counterparty default. By contrast, before the 2008 crisis, many OTC deals were not cleared through CCPs, meaning the counterparties were immediately exposed to each other’s risk of default.   For this paragraph, see Gregory 2014: 6.

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There are three ways to measure the global market volume of OTC derivatives:  by notional size, by gross market value, and by gross credit exposure. Measured in terms of notional value, by June 20087 the market had grown to a size of USD 684 trillion, a figure equaling approximately ten times global GDP. The notional size of the market measures the total asset value of the underlying positions. Notional value provides a good estimate of turnover and market expansion. As a measure, it is particularly relevant during times of crisis when market actors are affected by high degrees of uncertainty about overall credit exposure and counterparty risk.8 On the other hand, the notional size often tends to overestimate actual exposure, as the underlying asset is not always exchanged. For example, while cross-​currency swaps include an exchange of the underlying currency, there is no such exchange of an underlying asset in the case of interest rate swaps.9 Gross market size addresses this concern by calculating the actual market value defined as the total cost that would occur, if all existing contracts were to be replaced with new, equivalent ones. Using this measure, the OTC derivatives market reached a peak of USD 32 trillion in 2008. However, gross market size is still a multiple of exposure, as it does not consider legally enforceable bilateral netting agreements that reduce exposure. As the name suggests, netting agreements allow counterparties to net their respective claims and liabilities to each other. Gross credit exposure is the sum of the absolute values resulting from this process across all counterparties deducted from gross credit exposure. Figure 1.1 illustrates the development of the OTC derivatives market from the beginning of the twenty-​first century until the 2008 crisis. The market for exchange-​traded derivatives also grew very rapidly before the crisis. Between the mid-​1980s and 2008, its size increased by a factor of 100. This expansion, however, pales in comparison to the OTC market which grew even more quickly. As shown in figure 1.2, at the height of the crisis the market for exchange-​traded derivatives represented not more than 10% of the market for OTC derivatives. In terms of global market share, the OTC business is dominated by the United Kingdom and the United States, which together account for the bulk of the market. Next in terms of market share are France, Japan, and Germany.10 The most active participants in the derivatives markets are dealers, a relatively small number of large banks and brokers which act as market makers by quoting bids and offers and which often also trade for their own account. US banks   BIS 2010: 6.   Persaud 2013: 234. 9   Gregory 2014: 18. 10   Bourse Consult and City of London 2007:12. 7 8





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Figure 1.2  The markets for OTC and exchange-​traded derivatives (Source: BIS derivatives statistics)

heavily dominate the dealer market. At the end of 2008, US commercial banks had closed deals worth USD 200 trillion of notional value, with the top four institutions, JP Morgan Chase, Bank of America, Citibank, and Goldman Sachs accounting for 90% of this amount.11 OTC derivatives trades represent a major

  OCC 2008: 6 and table 1.

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100.0% 90.0% 80.0% 70.0%

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Figure 1.3  The global OTC derivatives market by counterparty type (% of notional amounts outstanding) (Source: BIS data)

share of the dealers’ total revenue. Goldman Sachs, for example, reported an estimated 25%‒35% share of revenue for the years 2006‒2009.12 The other side of the OTC market is composed of derivatives “end-​users.” This category comprises market actors from the financial sector, including institutional investors, insurance firms, pension funds, and hedge funds, but also non-​financial firms such as manufacturers and farmers. In recent years, the range of actors relying on derivatives markets has broadened to incorporate a number of public actors such as national governments, municipalities, sovereign wealth funds, and international financial institutions, such as the World Bank and other multilateral development assistance agencies. As illustrated by figure 1.3, dealers and other financial institutions account for more than 90% of global OTC market activity. The market share of “other financial institutions” has risen since 2008, given the deleveraging efforts undertaken by reporting dealers in the wake of the crisis.13 With roughly 10% of the market, non-​financial entities, also called commercial end-​users, represent a rather small fraction of the market. The dramatic growth in the size of the OTC derivatives markets began in the 1970s, promoted by at least two important factors. The first was the end of the Bretton Woods exchange rate system, following which market actors increasingly sought new financial products to hedge against the rising volatility of currency values, commodity prices, and interest rates, or to exploit them through speculative investments. The second was related to advances in financial theory

  Data reported to the Federal Deposit Insurance Corporation, quoted in Financial Crisis Inquiry Commission 2011: 50. 13   Amariei and Valiante 2014: 3. 12





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through which investors felt better equipped to manage the risk incurred by the use of these products. For instance, Fisher Black and Myron Scholes developed a formula (known as the Black-​Scholes equation) that enabled its user to derive the development of the price of an option over time. It mathematically showed that using certain financial derivatives made it possible to perfectly hedge an option and thus to control financial risk.14 In a mutually self-​reinforcing process, the formula became highly popular among market actors, given that it predicted observed prices fairly well.15 It was subsequently further developed and has become part of several derivative pricing and risk management models. A related innovation, “Value-​at-​Risk” (VaR) developed by JP Morgan in the late 1980s, also promised more sophisticated risk management. Through VaR, an investor can estimate the maximum loss on a portfolio that would not be exceeded with a given probability. Despite some limitations (such as short periods of observation often not exceeding 12 months, the assumption that price movements followed a normal distribution, and an overall approach that considered financial markets to be characterized by risk, i.e., quantifiable randomness, rather than also by uncertainty, where events lack measurable probabilities16), the model was soon applied industry-​wide. Both factors encouraged market growth. Figure 1.4 plots the volume of OTC derivatives by asset class. The largest market share is for interest rate derivatives. Next in size are foreign exchange derivatives. Growing rapidly in the years   Black and Scholes 1973.   MacKenzie 2006. 16   FSA 2009: 44; Taleb 2007; Nelson and Katzenstein 2014: 378; Schmid 2002: 5. 14 15



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immediately preceding the 2008 crisis were CDSs. CDS, a product that will be further explained, provides protection against counterparty default through the transfer of credit exposure.17 Another product type is equity-​linked derivatives whose value fluctuates based on changes in the share price of the underlying equity securities. Commodity-​based derivatives, which used to dominate before the 1970s, represent a relatively small portion of the present-​day market.

Permissive Public Regulatory Choices Beyond the development of new products and innovations in financial risk management, a series of public deregulatory choices also played a key role in promoting the growth of the market for OTC derivatives. These choices were motivated partly by a desire to remove regulatory uncertainty regarding the treatment of OTC derivatives as well as by fears that tight regulation would lead to the migration of the OTC derivatives markets to less intrusive jurisdictions. The deregulatory path was periodically questioned by large-​scale derivative-​ related losses in the markets, but the course was not reversed, largely because of intense interest group pressure. Financial institutions also lobbied on their own or through other trade associations, such as the American Bankers’ Association or the Securities Industry and Financial Markets Association (SIFMA). The bulk of private (financial) sector activism, however, was channeled by the ISDA, the trade association representing the derivatives industry, which some consider the “primary source of governance” in the OTC market.18 While ISDA was also open to end-​users, its most important members were the large dealer banks.19 The discussion of regulatory uncertainty was rooted in a requirement under the Commodity Exchange Act (CEA) of 1936 stipulating that all commodity futures and options contracts be traded on authorized exchanges by authorized dealers. A  “commodity” was defined as “all  .  .  .  goods and articles  .  .  .  and all services, rights and interest in which contracts for future delivery are presently or in the future dealt in.”20 When the volume of OTC derivatives began to grow in the 1980s, this wording caused uncertainty among counterparties to tailored transactions regarding the enforceability of swaps and other hybrid contracts. The chief concern was that the CFTC, which under the CEA had full jurisdiction over all commodity futures and options contracts, would consider OTC   Reid 2005.   McKeen-​Edwards and Porter 2013: 43. 19   Partnoy 2002: 217. 20   See section 2(a)(1)(A) as quoted in Horwitz 1994: 522. 17 18





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derivatives a form of futures and thus subject them to the exchange-​trading requirement.21 The CFTC responded in 1989 by publishing a Swap Policy Statement clarifying that it would not consider eligible swaps as futures under the CEA.22 Investors, however, were not reassured, since the CFTC effectively lacked the legal authority for this decision.23 Their skepticism was nurtured by a court ruling in 1990, which stated that OTC energy contracts traded on the Brent market were in fact futures and thus instruments to be regulated by the CFTC.24 Market actors threatened that unless the situation was clarified, they would transfer their business abroad to London where this concern was absent.25 Two years later, the US Congress passed the 1992 Futures Trading Practices Act that granted the CFTC the necessary authority to exclude bespoke OTC derivatives traded between sophisticated parties from regulation under the CEA.26 The CFTC immediately used its newly granted authority and exempted a series of hybrid instruments meeting certain requirements, such as lack of standardization as to material economic terms (e.g., notional amount, maturity, payment formulas), lack of a central clearing arrangement, and lack of trading on or through a futures exchange or multilateral execution facility.27 In the early 1990s, the CFTC also made another regulatory choice that further fueled the growth of the OTC market. It began to offer exemptions to swap dealers from position limits that had long been imposed on commodity derivatives exchange trading. This move provided a significant boost for the market, as it allowed the dealers to hedge the risks involved in OTC commodity swaps with offsetting futures contracts.28 The CFTC was not the only regulatory authority actively promoting the growth of the derivatives market. Another US government agency, the US Office of the Comptroller of the Currency (OCC) that regulates the large national banks, also played an enabling role. From the mid-​1980s onward, it published a series of administrative interpretations of the existing legal framework that relaxed statutory constraints and clarified that derivatives transactions were considered permissible activities in the “business of banking.”29 These interpretations facilitated the move of commercial banks into OTC derivatives trading,   Markham 2015: 265.   CFTC 1989. 23    Greene et al. 2015: 12-​53–​12-​54. 24   Markham 2015: 265. 25   Carruthers 2013. 26   Funk and Hirschman 2014: 21. 27   Stroock et al. 2000: 3. 28   Clapp and Helleiner 2012. 29   McGinity 1996; Omarova 2009. 21 22



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which led to the creation of an “investment-​banking-​like market,” even before the formal separation between commercial and investment banking was officially abandoned by the Financial Services Modernization Act of 1999.30 In the mid-​1990s, the OCC, in cooperation with the Federal Reserve, also approved banks’ use of CDSs to reduce their required capital reserves under Basel I.31 During this period, several warnings of the risks involved in derivatives transactions were voiced and a series of large-​scale derivatives-​related losses raised public attention, which again increased the potential of stronger public regulatory intervention. For example, in 1992, the Bank for International Settlements (BIS) warned “that the risks involved in OTC derivative operations may not always be properly understood by all participants.”32 The accuracy of this warning was proven two years later, when the Federal Reserve unexpectedly raised interest rates in several steps, following which large-​scale losses related to mortgage-​backed securities and interest rate swaps spiraled through the economy.33 With the interest rate increase lengthening the maturity of fixed-​rate mortgages, banks sold large quantities of US Treasury securities to adjust their hedges, which caused shocks to the US bond market.34 The interest rate hike also caused bets on interest rate derivatives to backfire. For example, Gibson Greeting and Procter & Gamble lost more than USD 20 million and 150 million, respectively, due to interest swap transactions through which they had hoped to improve their financing cost structure.35 The main problem for these firms consisted of their decision in having chosen a structure for their interest rate swaps that was profitable for them only as long as interest rates were stable or decreasing. In California, the treasurer of Orange County who had experimented with the county’s investment fund suffered a loss of USD 2 billion as a direct consequence of such a decision.36 The repercussions were also felt abroad, with the German firm Metallgesellschaft losing more than USD 1 billion.37 Several investors who had experienced severe losses filed lawsuits against their banks claiming that they had not been fully informed of the risks inherent in these trades. In light of these debacles, several prominent official bodies, such as the IMF (International Monetary Fund) and the US General Accounting Office, rang   Funk and Hirschman 2014: 18.   Tett 2009: 63. Published in 1988, Basel I represents a set of global banking rules decided by the Basel Committee on Banking Supervision, an international group of central bank governors. Basel I has since been updated several times. 32   BIS 1992: 184. 33   Tett 2011. 34   Ibid. 35   Tett 2009: 36. 36   Hull et al. 2014: 91, 521. 37   Kuprianov 1995: 5. 30 31





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the alarm bell, though neither of them questioned the use of derivatives as risk management tools per se. The IMF warned that it had “identified the exponential expansion of these markets and the growing involvement of banks in over-​ the-​counter activities as potential sources of systemic risk.”38 The US General Accounting Office also issued a warning that is worth quoting at greater length, given its accuracy in anticipating the great crash of 2008: If one of these large OTC dealers failed, the failure could pose risks to other firms—​including federally insured depository institutions—​and the financial system as a whole. Financial linkages among firms and markets could heighten this risk. . . . The concentration of OTC derivatives activities among a relatively few dealers could also heighten the risk of liquidity problems in the OTC derivatives markets, which in turn could pose risks to the financial system. Because the same relatively few major OTC derivatives dealers now account for a large portion of trading in a number of markets, the abrupt failure or withdrawal from trading of one of these dealers could undermine stability in several markets simultaneously, which could lead to a chain of market withdrawals, possible firm failures, and a systemic crisis. The federal government would not necessarily intervene just to keep a major OTC derivatives dealer from failing, but to avert a crisis, the Federal Reserve may be required to serve as lender of last resort to any major US OTC derivatives dealer.39 Several members of the US Congress decided to take action and introduced bills that would curb the OTC derivatives markets at this time. The “Derivatives Safety and Soundness Supervision Act of 1994” and the “Derivatives Supervision Act of 1994” were both intended to strengthen rules over OTC markets by imposing strict capital standards, accounting and disclosure principles, as well as internal oversight mechanisms.40 Proposing to go one step further, the “Derivatives Limitations Act of 1994” intended to prohibit proprietary trading by federally insured depository institutions. In response to the legislative threat, ISDA mounted a highly successful lobbying campaign, considered “one of the most startling triumphs for a Wall Street lobbying campaign in the twentieth century.”41 The Association worked on all fronts, trying to convince journalists to stop portraying derivatives in a negative way and persuading Congress to step back from legislative intervention.42 From ISDA’s perspective, tightened   IMF 1994: 25.   GAO 1994: 11–​12. 40   Culp and Mackay 1994: 42. 41   Tett 2009: 40. 42   Ibid., 38. 38 39



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regulation “would interfere with the management of banks and their affiliates in a rapidly evolving and competitive activity.” In his words, “industry participants should be allowed to continue their voluntary cooperation with regulators.”43 In the end, the Association’s efforts prevailed and no legislative action was taken. The failure of Long Term Capital Management (LTCM) in 1998 once again cast the spotlight on derivatives. LTCM, the flagship of the US hedge fund industry, had made large-​scale, highly leveraged investments in a ruble-​denominated security issued by the Russian government that promised a 40% return. To hedge its exposure, LTCM relied on forwards on the ruble that were supposed to absorb any losses in case the value of the bonds declined.44 But the Russian government suddenly stopped its debt payments and prohibited domestic banks from meeting their contractual obligations emanating from foreign exchange contracts.45 As a direct consequence, LTCM experienced serious difficulties, ultimately losing 90% of its assets. Fearing the repercussions for LTCM’s counterparties from a potential default, the New York Federal Reserve orchestrated a USD 3.6 billion bailout financed by a consortium of fourteen Wall Street banks.46 LTCM’s debacle rekindled the discussion about regulatory intervention to reign in the OTC derivatives market. Already in the months preceding the hedge funds’ failure, the CFTC’s chairman, Brooksley Born had begun to raise the issue of tightening the regulation of OTC derivatives. The clearest example of the CFTC’s consideration of increasing public oversight of the market was its 1998 concept release in which it argued that OTC derivatives “can present significant risks if misused or misunderstood by market participants.” The concept release therefore requested “comment on the extent to which certain matters are being or can be adequately addressed through self-​regulation, either alone or in conjunction with some level of government oversight, or through the regulatory efforts of other government agencies.”47 Following LTCM’s failure, Born stepped up the language, pointing to the “lack of transparency, excessive leverage, and insufficient prudential controls in this market” and warning that “the size and nature of the OTC market create a potential for systemic risk.”48 Her initiative, however, was not well received by her regulator colleagues and the US Treasury. Tim Geithner, who at the time worked at the Treasury, later recalled that “all the other U.S.  regulators and my Treasury colleagues

  ISDA 1994: no page.   Blyth 2003: 250. 45   Dunbar 2000: 199–​201. 46   Siconolfi et al. 1998. 47   CFTC 1998. 48   Born 1999. 43 44





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were deeply concerned that her plan could create dangerous legal uncertainties about trillions of dollars of existing derivatives contracts. The air was thick with warnings that Born’s ideas would create financial chaos.”49 One such warning was voiced by ISDA, which argued that investors had “a fundamental need for certainty that their contracts will be legally enforceable”50 and that, as a direct consequence of the threat of regulatory intervention, “large segments of U.S. swap activity moved offshore, and some US firms ceased development of swaps entirely, reducing the ability of US firms to manage risk and inhibiting the growth of these activities at US institutions.”51 Before long, Born’s initiative was derailed by US Treasury Secretary Robert Rubin, Fed Chairman Alan Greenspan, and SEC Chairman Arthur Levitt, who in a joint statement declared the following: “We seriously question the scope of the CFTC’s jurisdiction in this area, and we are very concerned about reports that the CFTC’s action may increase the legal uncertainty concerning certain types of OTC derivatives.”52 The defeat of Born’s initiative was then followed by a crucial US deregulatory decision designed to lock in the exception of OTC derivatives from public regulation. The inspiration for this decision was outlined by the President’s Working Group on Financial Markets that had been instructed with developing responses to the collapse of LTCM. In its 1999 report, the group argued that “the trading of financial derivatives by eligible swap participants should be excluded from the CEA” and that “[t]‌he sophisticated counterparties that use OTC derivatives simply do not require the same protections under the CEA as those required by retail investors.”53 It concluded that anything but an exemption of OTC derivatives from the CEA “would perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States.”54 Similar arguments were voiced at the time by important members of the US Congress, such as the chairman of the Senate Banking Committee, Phil Gramm. He insisted that “[w]e want legal certainty for swaps” and emphasized that “[w]e have competition from all over the world that would very much like to see this goose that lays the golden egg, these financial markets, roosting in their coop. They are trying to do things to attract it. They are unifying markets. They are reducing regulatory burden.”55 In a similar vein, the Clinton

  Geithner 2014: 86.   ISDA 1998: 4. 51   ISDA 1999: 5. 52   US Treasury 1998. 53   President’s Working Group on Financial Markets 1999: 1, 16. 54   Ibid., 1. 55   Gramm 2000: 4, 4–​5. 49 50



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government warned that a failure to pass a bill confirming this exemption “could result in the movement of these markets to overseas with more updated [i.e., less stringent] regulatory regimes.”56 Following the recommendations of the President’s Working Group on Financial Markets and these other voices, the US Congress in 2000 passed the Commodity Futures Modernization Act (CFMA). It removed OTC derivative transactions between “sophisticated counterparties” owning assets worth more than USD 5 million from public oversight,57 thus banning the regulatory specter that had haunted the market since the early 1980s.58 A Congressional report discussing the CFMA emphasized that “[w]‌hile the 1992 amendments provided a few years’ of relief, rapid development of markets here and abroad began to put competitive pressures on all markets.”59 It was therefore considered necessary “to reduce systemic risk by enhancing legal certainty in the markets” and “to enhance the competitive position of United States financial institutions and financial markets.”60

A Global Web of Private Rules As a consequence of public deregulation, the OTC derivatives market became “the most private of markets.”61 Yet this market was not a space void of rules. Rather, it was governed by a global set of private rules designed by the industry acting as part of a transnational policy community.62 The free market paradigm widely endorsed at the time (though not unanimously shared as already explained) provided the intellectual foundation for the design of these rules. Setting the tone was Fed Chairman Greenspan, one of the most ardent supporters of self-​regulation who believed that the industry was best capable of protecting itself. In his opinion, “[t]‌here [was] nothing involved in federal regulation per se which makes it superior to market regulation.”63 Embracing this perspective, many public officials championed self-​regulation by the industry both at the national and transnational level and limited the creation of public rules to areas necessary to support the viability of private rules.   Quoted in Chander and Costa 2010: 22.   This did not apply to the application of some of the anti-​fraud and anti-​manipulation clauses of the CEA. 58   Tett 2009: 75; Carruthers 2013. 59   US Congress 2000: 31. 60   US Congress 2000: 2. 61   Riles 2008: 608. 62   Tsingou 2006, 2015. 63   Greenspan, quoted in Goodman 2008. 56 57





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A cornerstone of this web of private rules was the “ISDA Master Agreement,” a boilerplate contract designed by ISDA in 1987 and later updated in 2002. The Master Agreement, which continues to be used after the crisis,64 represented a hallmark of market-​based solutions designed to address and minimize market risk.65 It provided industry-​wide accepted definitions of key terms, such as “counterparty default,” which could be used across a wide variety of transactions. This reduced transactions costs in the negotiation of contracts, allowing counterparties to focus on the customized elements of the deals, such as details concerning payments.66 This streamlined negotiation process further enabled market growth.67 In developing the terms of the Master Agreement, ISDA pursued several objectives, two of which had particularly far-​reaching consequences. The first was to ensure that creditors on OTC derivatives were allowed to take top position in the creditor queuing arrangement, meaning the solvent counterparty would always be the first creditor to be repaid, before everyone else. ISDA’s second aim was to firmly anchor the process of close-​out netting within the Master Agreement and to guarantee its legal enforceability. Close-​out netting involves terminating payments in case of counterparty default and calculating a net balance by offsetting the amounts the counterparties owe each other across all deals.68 The benefit of this strategy lies in a reduction of exposure of up to 50%, and sometimes even more, which goes hand in hand with decreased capital requirements. The 1994 amendments to the Basel I Accord of 1988 allowed the use of close-​out netting in the calculation of capital requirements, conditional, among other requirements, upon the availability of legal opinions clearly demonstrating its enforceability under the respective national law.69 In order to meet this requirement, ISDA provided national legislators with tailored templates containing the exact language required to bring national legal frameworks in line with the Master Agreement. Public actors across a wide variety of countries swiftly implemented the reforms deemed necessary by the industry.70 Privileged creditor status and the opportunity to decrease overall capital requirements through the use of derivatives further added to the attractiveness of OTC deals. In the early 1990s, when the danger of public regulation of OTC derivatives in the United States loomed large, the G30, a private transnational “club” organization, developed guidelines in order to prevent official regulation.71 As ISDA   See Knaack, in this volume.   Partnoy 2002: 217. 66   Riles 2008: 610; Partnoy 2002: 220. 67   Flanagan 2001: 243f. 68   Gregory 2014: 61. 69   ISDA 1998: 8–​9. 70   McKeen-​Edwards and Porter 2013: 43–​46; Morgan 2010. 71   For this paragraph, see Tsingou 2006, 2015. 64 65



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emphasized, “[w]‌e set out to design a business guided by market discipline because we believed that it should be an even better guide to good behaviour than regulatory proscription.”72 The G30 combined private sector representatives, academics, and (former) regulators, who developed harmonized global recommendations in a collegial, consensus-​based context. In 1993, led by former Fed Chairman Paul Volcker, the G30 published a highly influential report, “Derivatives Practices and Principles,” in which the industry endorsed 24 recommendations designed to ensure smooth interactions between dealers and end users.73 The industry thus promised to promote detailed knowledge about derivative products among counterparties, to foster effective risk management techniques, to ensure the efficient processing of deals, and to provide for adequate disclosure mechanisms. The G30 report quickly developed the status of a global guidebook and served as the basis for the development of further public recommendations and private rules. The BCBS, for example, explicitly stated that its “Risk Management Guidelines for Derivatives” brought together “practices currently used by major international banks.”74 The report also inspired the establishment of the Derivatives Policy Group formed upon suggestion by the US SEC’s chairman Arthur Levitt, which designed a Framework for Voluntary Oversight. Firms promised to apply prudent risk management practices, to implement measures evaluating credit risk exposure and its impact on capital levels, and to share information with regulators.75 Goldman Sachs’s E.  Gerald Corrigan, who co-​ chaired the Derivatives Policy Group, emphasized that these measures were “not recommendations, or proposals,—​they [were] commitments.”76 Further private initiatives were undertaken after the collapse of LTCM. In 1999, 12 major international banks formed the Counterparty Risk Management Policy Group (CRMPG) to reflect on lessons of the collapse for the industry. They committed themselves to the development of measures enhancing counterparty credit risk management.77 In particular, they promised to strengthen firm-​level efforts to improve the internal documentation of transactions.78 In the early 2000s, it also became clear that the financial infrastructure supporting OTC derivatives transactions needed to be reformed because trades were frequently “novated” (i.e., reassigned) to a new counterparty without notification of the original counterparty. In addition, the confirmation of transactions had   Davies et al. 2008.   G30 1993. 74   BCBS 1994: 1. 75   Faerman et al. 2001: 374–​375. 76   Corrigan, quoted in Faerman et al. 2001: 375. 77   Counterparty Risk Management Policy Group 1999: 2. 78   Ibid., 2, 37. 72 73





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created backlogs of up to several months because banks relied on manual procedures and faxes.79 To address these issues, the New York Fed under Tim Geithner brought together the 14 largest dealers accounting for 95% of the market who implemented ambitious operational reforms that significantly reduced the backlog and increased the use of electronic confirmation processes. Reflecting on this effort, Geithner later stated: I don’t want to overstate the importance of these reforms. The Wild West with better plumbing was still the Wild West. Large banks and nonbanks had a mutual interest in upgrading their derivatives infrastructure, so we managed to persuade them to upgrade it. But we couldn’t persuade enough of them to reduce their leverage or manage their risks more carefully, because they didn’t think that was in their interest. That was the real danger to the system.80

Financial Derivatives’ Contribution to  the Global Financial Crisis The high levels of leverage and risk in the OTC derivatives sector described by Geithner ultimately contributed to the financial crisis.81 While OTC derivatives and in particular CDSs did not “cause” the crisis by themselves, they were a key enabling factor that—​in combination with securitized mortgage debt, the financial innovations it triggered, and other weaknesses of the financial system—​led to the near collapse of the global economy.82 In the lead-​up to the crisis, CDSs played a critical role in at least two ways. First, they facilitated the accumulation of excessive risk by investors. Second, they created a false sense of security encouraging market actors to believe that this risk could be sufficiently diversified. Once the crisis broke out, the high degree of interconnectedness created by CDSs fueled contagion that was further intensified by the opacity of the market and the lack of transparency regarding counterparty exposure. Securitization can be understood as “a method of financing whereby loan receivables or other cash flows are bundled into securities and sold to investors.”83 From the seller’s perspective, the principal aim is to convert future streams of income (e.g., mortgage payments by homeowners) into immediately   Tett 2009: 158.   Geithner 2014: 103–​104. 81   Helleiner and Pagliari 2009. 82   Moran 2009: 32. 83   Simkovic 2013: 214. 79 80



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available funds. Securitized mortgage debt had existed since the 1970s, but at a rather small scale, limited to “conforming” loans extended to homeowners able to meet high credit standards. The introduction of relaxed lending standards by the Clinton and Bush administrations—​intended to boost private income by increasing homeownership—​encouraged the emergence of a new group of lenders and brokers who focused on “non-​conforming” mortgages granted to subprime debtors without solid background checks that were quickly passed on to other investors.84 Between 1994 and 2005, the share of subprime mortgages increased by a factor of nearly 18 from USD 35 billion to USD 625 billion.85 Banks bought these mortgages and parked them in special purpose vehicles that functioned as legally separate entities whose main purpose was to protect the core business from the risks associated with the securitization business.86 Not covered by the Basel capital requirements, these vehicles were free to operate with high levels of leverage (i.e., they drew on large amounts of borrowed capital for their investments).87 The special purpose vehicles funded themselves through the sale of mortgage-​backed securities (MBSs) that were bundled together into collateralized debt obligations (CDOs) that, in turn, were combined into CDO squared, also known as “CDOs of CDOs.” At each stage of the process, these products were sliced up in tranches with different risk profiles reflected by different credit ratings.88 Each transaction generated fees for the selling party, which further increased the attractiveness of the business.89 According to a Bear Stearns estimate, in 2006 alone, securities firms in New York earned a staggering USD 540 billion from packaging subprime loans into securities.90 The degree of riskiness of these products was supposed to decrease significantly across tranches, from the “equity” tranche bearing the greatest risk to the “mezzanine” and the “senior” tranches, respectively, considered to be safer and very safe. Indeed, while income was distributed sequentially from the “senior” to the “mezzanine” and “equity” tranche, losses had to eat their way through the opposite direction.91 In practice, however, the constant slicing and dicing meant that the “senior” tranche of a CDO square, for example, could actually contain mortgages of the “equity”

  Financial Crisis Inquiry Commission 2011: 41; Moran 2009: 48.   Blinder 2013: 70. 86   Gregory 2014: 21. 87   Helleiner 2011: 72. 88   Strictly speaking, credit ratings do not reflect the “riskiness” of an asset, but rather the ability of a debtor to pay back her debt. 89   Blinder 2013: 75; FSA 2009: 16. 90   Bear Stearns estimate quoted in Richard 2007. 91   McLean 2007. 84 85





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tranche of an MBS. This fact was often unbeknownst to investors who thought they had purchased a “safe” product. There were several background factors that sustained the demand for MBSs and CDOs. The most important ones among them included the availability of cheap capital in light of low interest rates following the end of the dot-​com boom and the 9/​11 terrorist attacks,92 the ratings awarded by credit rating agencies that did not accurately reflect the riskiness of these products,93 as well as VaR models that indicated extremely small probabilities of default.94 In the two years preceding the crisis, more than USD 200 billion of CDOs were generated out of subprime mortgages.95 Investors believed that rising prices of real estate would keep the market afloat, allowing subprime debtors to refinance their mortgages with little to no problem. Housing prices nearly doubled in the early 2000s, indicating the emergence of a bubble.96 CDSs contributed to the bubble in allowing excessive risk-​taking by market actors. The decision by the OCC and the Fed to approve reduced capital requirements conditional on the use of CDSs encouraged banks to reallocate the freed up capital to the securitized mortgage debt business.97 In addition, CDSs created a (false) sense of safety as they were considered a hedge against the default of the reference mortgage. Among the most important sellers of CDSs were monoline insurers and, above all, the international insurance giant AIG. CDSs helped create the false impression that risk could be sufficiently diversified. Losses would be shouldered by a large number of parties, which would keep the risk of contagious large-​scale losses at bay and therefore increase the overall safety of the financial system.98 As Fed chairman Greenspan put it, “[c]‌oncentrations of risk are more readily identified, and when such concentrations exceed the risk appetites of intermediaries, derivatives and other credit and interest rate risk instruments can be employed to transfer the underlying risk to other entities. As a result, not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”99 The system’s safety became increasingly fragile, however, as diversification in fact led to the homogenization of balance sheets and rising levels of   Rosenberg 2010: 132–​133; Moran 2009: 13–​14.   Helleiner 2011: 70. 94   Tett 2009: 136. 95   Lowenstein 2008. 96   Byun 2010: 6–​7. 97   Levine 2010: 5. 98   Gai and Kapadia 2010: 4. 99   Greenspan 2004. 92 93



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interconnectedness.100 Banks sold MBSs and CDOs to other financial institutions that in turn resold them or used them as collateral to secure short-​term liquidity, with each of the counterparties relying on CDSs to protect itself against the risk of default. The fact that CDSs could be bought “naked” (i.e., without immediate exposure to the underlying asset101) only facilitated speculation in the markets, as positions could be quickly bought and sold. A group of critics later also emphasized the contribution of these products to the “financialization” of the wider economy and society writ large (i.e., a trend reflecting the growing influence of financial markets and institutions on economic and societal life) in terms of allowing protection buyers to outsource responsibility and thus to dissolve the “link between property and stewardship.”102 Securitization and CDSs tied together a wide range of market actors, both domestically and internationally, with half of the overall share of MBSs and a significant portion of CDSs being sold outside the United States, predominantly in Europe.103 The bubble burst following a significant increase in the number of defaults on mortgage payments in 2007. CDS contracts were associated with key developments in the unfolding crisis. The first was the rushed sale of troubled investment bank Bear Stearns to JP Morgan Chase with support from the New York Fed in March 2008.104 Public officials backed the sale, given Bear Stearns’s role as a major player in the market for CDSs. The consequences of the collapse of a major counterparty in the OTC derivatives market then became evident when US authorities did not bailout Lehman Brothers in September 2008. Lehman Brothers was not only an important player in derivatives trading but also an actively traded reference entity. Because of its centrality in the market, Lehman Brothers’ collapse sent shockwaves through the global financial system. Soon afterwards, the US government decided to bailout AIG, which had sold CDSs worth USD 440 billion against an inadequate capital base.105 While representing a towering figure, AIG’s exposure accounted for less than 1% of the faltering market for CDSs, which underlined the extent of the problem. CDSs fueled the contagion, given the opacity of the market and the lack of information on exposure and interconnectedness. This uncertainty created panic among market actors and caused the inter-​bank markets to freeze.106 Desperate to   Haldane and May 2011.   This is one of the main differences between CDSs and classical insurance products that are only available to protection seekers holding the asset. 102   Wigan 2009: 157; Wigan 2010. This criticism was often not just limited to CDSs, but also applied to other derivative risk categories, such as commodity derivatives (for a discussion, see Clapp and Helleiner 2012; for a rejection of the skeptics’ view, see, e.g., Pirrong 2010). 103   Roubini and Mihm 2010: 119. 104   Moran 2009: 57. 105   Cox 2008. 106   Persaud 2013: 235. 100 101





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keep reputational risk at bay, banks reintegrated the securitized products parked in special purpose vehicle into their books, a move which in turn forced them to deleverage by quickly selling off assets.107 This fire sale of securitized products sparked fears of an immediate re-​pricing of similar products, both within and outside the market for derivatives, which further reinforced the downward spiral. US and European banks’ decision to recall their international loans to meet their funding difficulties added a new twist to the crisis which soon reached global dimensions.108 In this situation, the system’s high degree of interconnectedness led to the multiplication of losses. In the words of Haldane: “[i]‌nterconnections serve as shock amplifiers, not dampeners, as losses cascade. The system acts not as a mutual insurance device but as a mutual incendiary device.”109 Confronted with a crisis that risked spiraling out of control, the US government put together the Troubled Asset Relief Program (TARP) that provided a capital infusion of USD 700 billion to the economy, and the Federal Reserve designed a series of large-​scale lending facilities to support the banking sector.110 With the dimensions of the crisis becoming clear, prominent analysts quickly began to criticize the lack of public regulation and supervision of OTC derivatives. Key regulatory choices, such as the passage of the CFMA were re-​evaluated. Prominent economists, such as Alan Blinder, argued that the act “was probably the most egregious policy error leading up to the financial crisis.”111 Former SEC chairman Levitt recanted: “All tragedies in life are preceded by warnings. We had a warning. It was Brooksley Born. We didn’t listen.”112 Even Alan Greenspan who had been an ardent believer in a hands-​off regulatory philosophy conceded having made “a mistake” in his analysis before the crisis.113 Official views about the regulation of OTC derivatives began to change, both at the national and the global level. Discussions on the lack of transparency of OTC derivatives and their role in the creation of systemic risk served as catalysts for broader derivatives-​related issues that had not directly been related to the

  Davies 2010: 48.   Helleiner 2011: 69. 109   Haldane 2009: 5. 110   Other countries also began to implement expansionary measures in an attempt to absorb the shocks to their economies. In addition to the US-​centered financial crisis, CDSs have also become associated with other episodes of financial stress. For example, investors’ decisions to call CDSs on Icelandic bank debt essentially cut domestic banks off the wholesale capital markets, which precipitated the domestic economy into collapse (OECD 2011: 46). In addition, some observers have linked CDSs to the deepening of the European sovereign debt crisis through their influence on governments’ borrowing costs (e.g., Delatte et al. 2012). 111   Blinder 2014. 112   Quoted in Hirsh 2008. 113   Greenspan, quoted in Beattie and Politi 2008. 107 108



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crisis, but now gained prominence, such as the potential contribution of commodity derivatives to commodity price volatility.114

Conclusion This chapter has analyzed the growth of OTC derivatives before the global financial crisis. It provided an overview of derivatives used as risk management instruments by investors to hedge against or exploit the volatility of asset prices. The popularity of derivatives began to increase significantly with the rise of global economic instability after the end of the Bretton Woods exchange rate system and with advances in financial theory. But the growth of OTC derivatives was also encouraged by public regulatory choices and private self-​regulation. On the public side, after the British deregulation of 1986, US public regulatory decisions were particularly important in fostering the expansion of OTC derivatives trading. These choices were driven by interest group lobbying (often organized transnationally through ISDA), the market-​friendly views of many domestic authorities, and concerns about regulatory uncertainty and international competitiveness (the latter had also encouraged the 1986 British deregulation). Public officials also championed private transnational self-​regulatory initiatives, such as ISDA’s Master Agreement and the recommendations and initiatives of bodies such as the G30, the Derivatives Policy Group, and the CRMPG. Taken together, these pre-​crisis regulatory trends were shaped by political dynamics in each of the three contexts identified in the introductory chapter to this volume: inter-​state (e.g., competitive pressures), domestic (e.g., domestic policymakers’ worldviews), and transnational (e.g., private lobbying and self-​regulation). Subsequent chapters in this volume show how political dynamics within each of these three contexts have continued to influence regulatory trends after the crisis. Some of the post-​crisis dynamics have echoed those of the pre-​crisis period, such as the influence—​less pronounced but still important—​of powerful transnational private interests and institutions such as ISDA. But, in many instances, the political dynamics in inter-​state, domestic, and transnational contexts were changed in important ways by the crisis experience. Perhaps the most significant change has been the erosion of the widely shared pre-​crisis consensus in favor of public deregulation and globally unified markets governed by private rules, which was shaken by the devastating crisis of 2008. From the experience of high degrees of global interconnectedness created by the extensive use

  See Helleiner’s chapter, in this volume.

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of financial derivatives, particularly CDSs, we have witnessed the emergence of efforts by G20 policymakers to forge a new consensus about the governance of derivatives. Yet this search for a new approach has been marked by growing conflict and an unprecedented degree of fragmentation in the politics of global derivatives regulation. The rest of the volume explores these post-​crisis trends and their political sources across various issue areas.

Works Cited Amariei, Cosmina, and Diego Valiante. 2014. “The OTC Derivatives Markets after Financial Reforms.” ECMI Commentary No. 36, May. https://​www.files.ethz.ch/​isn/​180606/​ OTC%20derivatives_​%2021_​05%20(2).pdf. Awrey, Dan. 2010. “The FSA, Integrated Regulation, and the Curious Case of OTC Derivatives.” University of Pennsylvania Journal of Business Law 13(1): 1–​58. BCBS. 1994. “Risk Management Guidelines for Derivatives.” July. http://​www.bis.org/​publ/​ bcbsc211.pdf. Beattie, Alan, and James Politi. 2008. “‘I Made a Mistake’, Admits Greenspan.” Financial Times, October 23. http://​www.ft.com/​intl/​cms/​s/​0/​aee9e3a2-​a11f-​11dd-​82fd-​000077b07658.html. Biggins, John, and Colin Scott. 2012. “Public‒Private Relations in a Transnational Private Regulatory Regime:  ISDA, the State and OTC Derivatives Market Reform.” European Business Organization Law Review 13:309–​346. BIS. 1992. “62nd Annual Report.” June 15. Basel: BIS. https://​www.bis.org/​publ/​arpdf/​archive/​ ar1992_​en.pdf. BIS. 2010. “OTC Derivatives Market Activity in the Second Half of 2009.” May. Basel: BIS. http://​ www.bis.org/​publ/​otc_​hy1005.pdf. Black, Fischer, and Myron Scholes. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy 81(3): 637–​654. Blinder, Alan S. 2013. After the Music Stopped. London: Penguin Press. Blinder, Alan S. 2014. “What’s the Matter with Economics?” New York Review of Books, December 18. Blyth, Mark. 2003. “The Political Power of Financial Ideas—​Transparency, Risk, and Distribution in Global Finance.” In Monetary Orders—​Ambiguous Economics, Ubiquitous Politics, edited by Jonathan Kirshner, 239–​259. Ithaca, NY: Cornell University Press. Born, Brooksley. 1999. “Remarks of Brooksley Born Chairperson Commodity Futures Trading Commission before the Futures Industry Association’s 24th Annual International Futures Industry Conference.” Boca Raton, Florida, March 18. http://​www.cftc.gov/​opa/​speeches/​ opaborn-​49.htm. Bourse Consult and City of London. 2007. “The Competitive Impact of London’s Financial Market Infrastructure”. April. http://bourse-consult.com/wp-content/uploads/2014/03/ The-Competitive-Impact-of-Londons-Financial-Market-Infrastructure1.pdf. Byun, Kathryn J. 2010. “The U.S. Housing Bubble and Bust: Impacts on Employment.” Monthly Labor Review, December, 3–​17. https://​www.bls.gov/​opub/​mlr/​2010/​12/​art1full.pdf. Carruthers, Bruce G. 2013. “Diverging Derivatives:  Law, Governance and Modern Financial Markets.” Journal of Comparative Economics 41:386–​400. CFTC. 1989. “Policy Statement Concerning Swap Transactions.” July 21. Washington, DC: CFTC. CFTC. 1998. “Over-​the-​Counter Derivatives.” May 6. Washington, DC: CFTC. http://​www.cftc. gov/​opa/​press98/​opamntn.htm. Chander, Anupam, and Randall Costa. 2010. “Clearing Credit Default Swaps: A Case Study in Global Legal Convergence.” Chicago Journal of International Law 10(2): 1–​46. Chui, Michael. 2012. “Derivatives Markets, Products and Participants: an Overview.” Irving Fisher Committee on Central Bank Statistics Bulletin 35:3–​11.



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Clapp, Jennifer, and Eric Helleiner. 2012. “Troubled Futures? The Global Food Crisis and the Politics of Agricultural Derivatives Regulation.” Review of International Political Economy 19(2): 181–​207. Coleman, William D. 2004. “Governing Global Finance: Financial Derivatives, Liberal States, and Transformative Capacity.” In States in the Global Economy, edited by Linda Weiss, 271‒292. Cambridge: Cambridge University Press. Counterparty Risk Management Policy Group. 1999. “Improving Counterparty Risk Management Practices.” June. http://​www.isda.org/​educat/​pdf/​CRMPG-​Report6-​99.pdf. Cox, Christopher. 2008. “Swapping Secrecy for Transparency.” New  York Times, October 18. http://​www.nytimes.com/​2008/​10/​19/​opinion/​19cox.html?_​r=0. Culp, Christopher L., and Robert J. Mackay. 1994. “Derivatives—​The Current System and Proposed Changes.” Regulation 4:38–​51. Davies, Howard. 2010. The Financial Crisis—​Who Is to Blame? Cambridge, UK: Polity Press. Davies, Paul J., Tett, Gillian, and Aline van Duyn. 2008. “A New Formula?” Financial Times, October 11. http://​www.ft.com/​cms/​s/​0/​ceabcdb2-​8f50-​11dd-​946c-​0000779fd18c.html?ft_​ site=falcon&desktop=true#axzz4fNkmZMNc. Delatte, Anne-​Laure, Mathieu Gex, and Antonia López-​Villavicencio. 2012. “Has the CDS Market Influenced the Borrowing Cost of European Countries during the Sovereign Crisis?” Journal of International Money and Finance 31(3): 481–​497. Dunbar, Nicholas. 2000. Inventing Money:  The Story of Long-​Term Capital Management and the Legends Behind It. Chichester, UK: John Wiley. Faerman, Sue R, David P. McCaffrey, and David M. Van Slyke. 2001. “Understanding Interorganizational Cooperation:  Public-​ Private Collaboration in Regulating Financial Market Innovation.” Organization Science 12(3): 372–​388. Financial Crisis Inquiry Commission. 2011. “The Financial Crisis Inquiry Report.” January. Washington, DC: US Government Printing Office. https://​www.gpo.gov/​fdsys/​pkg/​GPO-​ FCIC/​pdf/​GPO-​FCIC.pdf. Flanagan, Sean M. 2001. “The Rise of a Trade Association:  Group Interactions within the International Swaps and Derivatives Association.” Harvard Negotiation Law Review 6:211–​264. FSA (Financial Services Authority). 2009. “The Turner Review—​A Regulatory Response to the Global Banking Crisis.” March. London: Financial Services Authority. http://​www.fsa.gov. uk/​pubs/​other/​turner_​review.pdf. Funk, Russell J., and Daniel Hirschman. 2014. “Derivatives and Deregulation: Financial Innovation and the Demise of Glass-​Steagall.” Administrative Science Quarterly 20(10): 1–​36. G30. 1993. “Derivatives:  Practices and Principles.” Washington, DC:  Group of Thirty. http://​ group30.org/​publications/​detail/​183. Gai, Prasanna, and Sujit Kapadia. 2010. “Contagion in Financial Networks.” Bank of England Working Paper 383. London: Bank of England. http://​www.bankofengland.co.uk/​research/​ Documents/​workingpapers/​2010/​w p383.pdf. GAO (General Accounting Office). 1994. “Actions Needed to Protect the Financial System.” May 18. Washington, DC:  US General Accounting Office. http://​www.gao.gov/​assets/​160/​ 154342.pdf. Geithner, Timothy. 2014. Stress Test: Reflections on Financial Crises. New York: Crown Publishing. Goodman, Peter S. 2008. “Taking Hard New Look at a Greenspan Legacy.” New York Times, October 8.  http://​w ww.nytimes.com/​2008/​10/​09/​business/​economy/​09greenspan. html?pagewanted=all. Gramm, Phil. 2000. Opening Statement of Hon. Phil Gramm, a US Senator from Texas, Chairman, Committee on Banking, Housing, and Urban Affairs, Joint Hearing before the Committee on Agriculture, Nutrition, and Forestry United States Senate and the Committee on Banking, Housing, and Urban Affairs, 106th Congress, Second Session, on S.2697—​The Commodity Futures Modernization Act of 2000, June 21. https://​www.gpo.gov/​fdsys/​pkg/​CHRG-​ 106shrg70514/​pdf/​CHRG-​106shrg70514.pdf.





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Greene, Edward F., Alan L. Beller, Edward J. Rosen, Leslie N. Silverman, Daniel A. Braverman, Sebastian R. Sperber, and Nicolas Grabar. 2015. US Regulation of the International Securities and Derivatives Markets. 11th ed. New York: Wolters Kluwer. Greenspan, Alan. 2004. “Remarks by Chairman Alan Greenspan, at the American Bankers Association Annual Convention.” New York, New York, October 5. https://​www.federalreserve.gov/​boarddocs/​speeches/​2004/​20041005/​default.htm. Gregory, Jon. 2014. Central Counterparties—​Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives. Chichester, West Sussex: John Wiley. Haldane, Andrew G. 2009. “Rethinking the Financial Network.” Speech by Mr. Andrew G. Haldane, Executive Director, Financial Stability, Bank of England, at the Financial Student Association, Amsterdam, April 28. http://​www.bis.org/​review/​r090505e.pdf. Haldane, Andrew G., and May, Robert M. 2011. “Systemic Risk in Banking Ecosystems.” Nature 469:351–​355. Helleiner, Eric. 2011. “Understanding the 2007‒2008 Global Financial Crisis: Lessons for Scholars of International Political Economy.” Annual Review of Political Science 14:67–​87. Helleiner, Eric, and Stefano Pagliari. 2009. “The End of Self-​Regulation? Hedge Funds and Derivatives in Global Financial Governance.” In Global Finance in Crisis:  The Politics of International Regulatory Change, edited by Eric Helleiner, Stefano Pagliari, and Hubert Zimmerman, 74‒90. London: Routledge. Hirsh, Michael. 2008. “Hirsh: The Coming Fight over Re-​Regulation.” Newsweek, December, 23. http://​www.newsweek.com/​hirsh-​coming-​fight-​over-​re-​regulation-​83439. Horwitz, Marc A. 1994. “Swaps Ahoy! Should Regulators Voyage into Unknown Waters?” Indiana Journal of Global Legal Studies 1(2): 515–​550. Hull, John C., Sirimon Treepongkaruna, Richard Heaney, David Pitt, and David Colwell. 2014. Fundamentals of Futures and Options Markets. Frenchs Forest, NSW, Australia: Pearson. IMF. 1994. “Annual Report of the Executive Board for the Financial Year Ended April 30.” Washington, DC: IMF. ISDA. 1994. Testimony of Mark C.  Brickell, International Swaps and Derivatives Association before the Subcommittee on Financial Institutions Supervision, Regulation and Deposit Insurance of the Committee on Banking, Finance and Urban Affairs United States House of Representatives, Hearing on the Derivatives Safety and Soundness Supervision Act of 1994, H.R. 4503, July 12. https://​archive.org/​stream/​hr4503derivative1994unit/​hr4503derivative1994unit_​djvu.txt. ISDA. 1998. Letter to Jean A.  Webb, Secretary Commodities Futures Trading Commission, October 13. http://​www.isda.org/​press/​pdf/​cftc1098.pdf. ISDA. 1999. Statement Submitted on Behalf of the International Swaps and Derivatives Association, Inc. to the Subcommittee on Risk Management and Specialty Crops Committee on Agriculture, May 17. http://​www.isdadocs.org/​press/​pdf/​bauman599.pdf. Kuprianov, Anatoli. 1995. “Derivatives Debacles.” Federal Reserve Bank of Richmond Economic Quarterly 81(4): 1–​39. Levine, Ross. 2010. “The Governance of Financial Regulation: Reform Lessons from the Recent Crisis.” BIS Working Papers No. 329, November. Basel:  BIS. http://​www.bis.org/​publ/​ work329.pdf. Lowenstein, Roger. 2008. “Triple-​A Failure.” New York Times, April 27. http://​www.nytimes.com/​ 2008/​04/​27/​magazine/​27Credit-​t.html?pagewanted=all&_​r=0. MacKenzie, Donald. 2006. An Engine, Not a Camera:  How Financial Models Shape Markets. Cambridge, MA: MIT Press. Markham, Jerry W. 2015. Law Enforcement and the History of Financial Market Manipulation. London: Routledge. McGinity, Steven. 1996. “Derivatives-​Related Bank Activities as Authorized by the, Comptroller of the Currency and the Federal Reserve Board.” Chicago-​Kent Law Review 71(4): 1195–​1246. McKeen-​Edwards, Heather, and Tony Porter. 2013. Transnational Financial Associations and the Governance of Global Finance. London: Routledge.



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McLean, Bethany. 2007. “The Dangers of Investing in Subprime Debt.” Fortune, March 19. http://​ archive.fortune.com/​magazines/​fortune/​fortune_​archive/​2007/​04/​02/​8403416/​index. htm?postversion=2007031909. Moran, Eamonn K. 2009. “Wall Street Meets Main Street: Understanding the Financial Crisis.” North Carolina Banking Institute 13:5–​101. Morgan, Glenn. 2010. “Legitimacy in Financial Markets:  Credit Default Swaps in the Current Crisis.” Socio-​Economic Review 8:17–​45. Mügge, Daniel. 2014. “Securities and Derivatives Markets.” In Europe and the Governance of Global Finance, edited by Daniel Mügge, 53‒66. Oxford: Oxford University Press. Nelson, Stephen C., and Peter Katzenstein. 2014. “Uncertainty, Risk, and the Financial Crisis of 2008.” International Organization 68(2): 361–​392. OCC. 2008. “OCC’s Quarterly Report on Trading and Derivatives Activities, Fourth Quarter 2008.” Washington, DC:  Comptroller of the Currency Administrator of National Banks. https://​www.occ.gov/​topics/​capital-​markets/​financial-​markets/​derivatives/​dq408.pdf. OECD (Organisation for Economic Co-​operation and Development). 2011. OECD Economic Surveys ICELAND.” June. Paris: OECD. Omarova, Saule T. 2009. “The Quiet Metamorphosis: How Derivatives Changed the ‘Business of Banking’.” University of Miami Law Review 63:1041–​1110. Partnoy, Frank. 2002. “ISDA, CFMA, and SDNY: The Four Horsemen of Derivatives Regulation?” Brookings-​W harton Papers on Financial Services, 213–​252. https://​muse.jhu.edu/​article/​ 26660. Persaud, Avinash D. 2013. “Will the New Regulatory Regime for OTC Markets Impede Financial Innovation?” Banque de France Financial Stability Review 17 (April): 233–​238. Pirrong, Charles. 2010. “No Theory? No Evidence? No Problem!” Regulation 33(2): 38–​44. President’s Working Group on Financial Markets. 1999. “Over-​ the-​ Counter Derivatives Markets and the Commodity Exchange Act.” Report by the President’s Working Group on Financial Markets, Department of the Treasury, Board of Governors of the Federal Reserve System, Securities and Exchange Commission, Commodity Futures Trading Commission, November. https://​www.treasury.gov/​resource-​center/​fin-​mkts/​Documents/​otcact.pdf. Reid, Christopher. 2005. “Credit Default Swaps and the Canadian Context.” Financial System Review, 45–​51. http://​www.bankofcanada.ca/​w p-​content/​uploads/​2012/​01/​fsr-​0605-​ reid.pdf. Richard, Christine. 2007. “Subprime Losers Blame Bear, Credit Suisse, JPM, Morgan Stanley.” Bloomberg, April 11. http://​www.bloomberg.com/​apps/​news?pid=newsarchive&sid=avI 34G5JBAjQ. Riles, Annelise. 2008. “The Anti-​Network: Private Global Governance, Legal Knowledge, and the Legitimacy of the State.” American Journal of Comparative Law 56:605–​630. Rosenberg, Jeffrey. 2010. “No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets.” In Lessons from the Financial Crisis, edited by Arthur M. Berd, 129‒166. London: Risk Books. Roubini, Nouriel, and Stephen Mihm. 2010. Crisis Economics. New York: Penguin. Schmid, Frank A. 2002. “The Stock Market: Beyond Risk Lies Uncertainty.” Regional Economist, July, 4–​9. https://​www.stlouisfed.org/​~/​media/​Files/​PDFs/​publications/​pub_​assets/​ pdf/​re/​2002/​434.pdf. Siconolfi, Michael, Anita Raghavan, and Mitchell Pacelle. 1998. “How Salesmanship and Brainpower Failed to Save Long-​Term Capital.” Wall Street Journal, October 16. http://​www. wsj.com/​articles/​SB911168945488412500. Simkovic, Michael. 2013. “Competition and Crisis in Mortgage Securitization.” Indiana Law Journal 88:212–​271. Stroock & Stroock & Lavan LLP. 2000. “Swaps and Hybrid Instruments: Fitting the Square Peg of OTC Derivatives into the Round Hole of the CEA?” Stroock Capital Markets 2(1): 1–​8. Taleb, Nassim Nicholas. 2007. The Black Swan:  The Impact of the Highly Improbable. New York: Random House.





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Tett, Gillian. 2009. Fool’s Gold. London: Little Brown. Tett, Gillian. 2011. “Investors Should Learn from 1994’s Rate Spikes.” Financial Times, March 10. http://​w ww.ft.com/​intl/​cms/​s/​0/​fcf0267e-​4b4a-​11e0-​b2c2-​00144feab49a. html#axzz3KKWbe8Bo. Tsingou, Eleni. 2006. “The Governance of OTC Derivatives Markets.” In The Political Economy of Financial Market Regulation—​ The Dynamics of Inclusion and Exclusion, edited by Peter Mooslechner, Helene Schuberth, and Beat Weber, 168‒190. Northampton, UK: Edward Elgar. Tsingou, Eleni. 2015. “Club Governance and the Making of Global Financial Rules.” Review of International Political Economy 22(2): 225–​256. US Congress. 2000. “Commodity Futures Modernization Act of 2000.” Report by Mr. Combest from the Committee on Agriculture, 106th Congress, 2nd Session. https://​www.congress. gov/​106/​crpt/​hrpt711/​CRPT-​106hrpt711-​pt1.pdf. US Treasury. 1998. Joint Statement by Treasury Secretary Robert E.  Rubin, Federal Reserve Board Chairman Alan Greenspan and Securities and Exchange Commission Chairman Arthur Levitt, May 7. https://​web.archive.org/​web/​20090311235937/​http:/​www.treas. gov/​press/​releases/​rr2426.htm. Valiante, Diego. 2010. “Shaping Reforms and Business Models for the OTC Derivatives Market. Quo Vadis?” European Capital Markets Institute Research No. 5, April. http://​aei.pitt.edu/​ 14437/​1/​ECMI_​RR5_​Valiante_​on_​Derivatives.pdf. Wigan, Duncan. 2009. “Financialisation and Derivatives: Constructing an Artifice of Indifference.” Competition and Change 13(2): 157–​172. Wigan, Duncan. 2010. Credit Risk Transfer and Crunches:  Global Finance Victorious or Vanquished? New Political Economy 15(1): 109–​125.



2

Financial Regulatory Cooperation Coordination of Derivatives Markets Elliot Posner

This chapter explores the cross-​border politics of derivatives regulation, giving special attention to conflicts over the implementation of G20 principles. As in other areas of financial regulation, public officials post 2008 found cooperation with foreign counterparts necessary to balance new imperatives for greater stability with the continued goals of facilitating financial globalization and keeping the playing fields level. By contrast with other cases, however, negotiations over implementing the agreed principles for derivatives stand out in three main ways. First, the leading negotiating jurisdictions, the European Union and the United States, made more frequent use of bilateral, as opposed to transnational, forums to manage high-​profile disputes than they had in other regulatory areas. The reliance on bilateral discussions is puzzling because it undermines the legitimacy of their joint initiative to prevent regulatory arbitrage through the enhancement of the FSB and other transnational arenas.1 Second, in comparison to other areas of negotiation, those over derivatives regulation took longer and included a broader list of outstanding issues to be managed. Before the crisis, derivatives market participants operated relatively seamlessly across borders regardless of their home jurisdiction. In attempting to recreate a similar market in a period of more stringent official regulation, authorities took on an enormous feat. Yet the nature and scope of EU and US reforms do not distinguish derivatives from other areas such as banking. Why were negotiations in derivatives so prolonged? Lastly, the gap between early expectations and actual possibilities for finding common ground was particularly wide. As a result, the tenor of negotiations deteriorated from harmonious to conflictual and acrimonious, and contributed to an atmosphere of misperception and distrust. What made negotiations over   Helleiner 2014a; Posner 2015.

1

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derivatives rules so vulnerable to miscalculation, tit-​for-​tat dynamics and suspicion of others’ motivations? Answering these questions is important. As the editors’ introductory chapter points out, derivatives markets are the world’s largest markets and, like others, can be understood as social and political institutions comprised of rules about participants, assets, and terms of exchange. If there are lessons from the great financial crisis, surely among them are that market rules affect market outcomes, have uneven effects on market participants, and have broad societal and economic consequences that extend well beyond the financial system and a single set of political borders. Thus, financial markets are political, like other important social institutions. Their rules can be highly contested, need to be interpreted, and can be manipulated. A better grasp of how rules are made and who is making them goes a long way toward understanding likely distributive effects of post-​crisis finance and is essential for addressing central themes of this collaborative project, such as the degree to which regulatory trends are creating more fragmented financial markets along political frontiers.2 Finding answers to these questions is also important to the extent that the enterprise contributes to a better understanding of the role of international regulatory cooperation in national and regional rule-​making. The processes by which financial rules are made have become increasingly complex and multilevel.3 Even in the United States, which has sometimes been depicted in the academic literature as hegemonic, rule-​making has become interdependent (i.e., the United States cannot achieve its policy goals without considering the actions of other jurisdictions)4 and cannot be properly understood without reference to transnational processes and soft law.5 International cooperation (or the lack thereof) is a central element of contemporary rule-​making. Large and small polities frequently transpose transnational soft law; but transnational networks, processes, and standards can also have indirect effects on the politics of financial regulation. The point is that cross-​border negotiations and other collaborative interactions concerning the implementation of transnational standards contribute to the content of domestic and regional legislation and help establish the terms by which national and regional markets are linked. It is through negotiated processes that we get answers to whose laws apply to which actors, assets, and transactions. 2   Helleiner, Pagliari, and Spagna, in this volume. Also see Helleiner 2014a; Helleiner and Pagliari 2011; Germain 2010. 3   Porter 2014a, b; Farrell and Newman 2014. 4   Drezner 2007; Posner 2009. 5   Porter 2005; Brummer 2012; Newman and Posner, forthcoming.



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What explains the pattern of cooperation in implementing G20 principles for derivatives regulation—​the reliance on bilateral discussions, the duration of and difficulty in managing conflicts, and the pervasiveness of misperception? This chapter’s answers combine scholarly research on the temporal effects of transnational institutions with insights from inter-​state approaches. It takes seriously the potential for international institutions, over time, to condition and structure politics—​beyond the creators’ original intentions.6 The chapter thus asks to what extent and how the transnational institutional context mediates inter-​ state relations, and, specifically, how the pre-​crisis evolution of transnational networks, forums, and soft law affected post-​crisis regulatory cooperation in the area of derivatives markets. To find out, the analytical sections compare management of cross-​border conflicts over derivatives markets and banking regulation, beginning with the observation that finding mutually acceptable accommodation in some regulatory areas has been more challenging and drawn out than in others. Two prominent arguments—​featuring relative inter-​state power and complexity—​cannot satisfactorily explain the observed differences, as negotiations in both derivatives and banking are characterized by bipolar rule-​making and remarkable complexity. A third argument—​which expects the intensity of conflicts to stem from the degree of interest (in)compatibility—​overestimates the extent to which adopted regulatory approaches reflect fixed and enduring interests. This study instead attributes the contrasting outcomes in regulatory cooperation in large part to variance in the pre-​crisis development of transnational institutions. Compared to banking in which public officials found themselves in 2008 working within a transgovernmental focal forum7 with set procedures for improving mutual understandings and extensive experience in generating soft law, the relatively underdeveloped, pre-​crisis transgovernmental institutions for derivatives markets left public officials in 2009 with a fragmented rule-​making field, less adept forums, a paucity of established standards and thus fewer resources to manage coordination at a moment of rapid internal regulatory reforms. The differences in transnational institutional context shaped the outcomes in three specific ways:  derivatives markets officials were relatively ill-​equipped to prevent unwanted sequences wherein detailed national (and regional) implementation of G20 principles precedes transnational coordination; to foster accurate mutual appraisals of motivations, political constraints, and actions; and to forge aligned regulatory approaches in areas without previous public supervision.   Moschella and Tsingou 2013; Fioretos 2011; Meunier and McNamara 2007; Farrell and Newman 2010. 7   On transnational focal institutions, see Büthe and Mattli 2011: 18–​41. 6





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This chapter thus engages with the volume’s main themes. It examines the contours of G20 principles (especially for regulations on CCPs and uncleared derivatives), the implementation of these principles, and the role of transnational institutions in complex causal processes. First, it describes the politics of regulatory cooperation across issues and second it develops the argument featuring variance in transnational institutional context. Third and fourth, it presents the analysis by evaluating the chapter’s argument against the empirical record and then considering the complex interactions of alternative and competing explanations. It concludes by returning to the volume’s themes and discussing implications.

Regulatory Cooperation in the Implementation of G20 Principles: Descriptions and Puzzles A More Frequent Use of Bilateral Forums EU-​US domination of transnational standard-setting does not distinguish derivatives from other areas of financial regulation. Despite an expanded membership across transnational organizations (which more or less match the G20), US and European officials have remained the primary rule-​makers in the post-​crisis years. In his introduction to a volume containing chapters on the regulation of banking, capital markets, insurance, accounting and auditing standards, hedge funds, credit-​rating agencies, money laundering, offshore financial centers, for instance, Daniel Mügge concludes: One of the most remarkable patterns to emerge from this book is the centrality of transatlantic relations in the EU’s dealings with the “rest of the world.” Both conflict and cooperation in international regulatory organizations such as IOSCO can mostly be understood as a function of EU‒US relations. Japan, China, India, Russia, and Brazil have all, to date, played only modest roles in the evolution of global financial governance.8 Scholarship on the sources of regulatory power would not find the continued bilateralism surprising.9 Negotiating leverage, according to this literature, stems from a combination of a heavy reliance on domestic markets by foreign firms and internal institutional arrangements that enable officials to extend their

  Mügge 2014: 14.   Bach and Newman 2007; Posner 2009; Newman and Posner 2011; Quaglia 2014.

8 9



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agendas and wield credible threats to limit foreign access. Thus, by this logic, just as Chinese officials would not be expected to be rule-​makers, Brussels officials (to the extent that they maintain the ability to affect substantial revenues of foreign firms) would be expected to maintain rule-​making status. What is striking, however, is that compared to other regulatory areas, efforts to coordinate the implementation of G20 principles for derivatives regulation relied more heavily on transatlantic negotiations, outside the transnational architecture. In other regulatory areas, the transatlantic bilateralism was largely embedded in transnational standard-​setting bodies, the FSB and other plurilateral organizations. For sure, there is a lot of variance, even within single issue areas. In banking, for example, observers and market participants were impressed by the speed, alacrity, and competence by which the BCBS managed the early Basel III process that created new prudential standards for banks, especially when compared to Basel II. Yet even in the regulation of banking, with the perception that Basel III is the “gold standard” of transnational coordination, there are examples of the European Union and United States managing difficult issues in bilateral discussions, notably in the FSB’s development of higher (“additional loss absorbency”) standards for global systemically important banks (G-​SIBs).10 These exceptions notwithstanding, EU and US banking coordination took place primarily in transnational forums. In derivatives, by contrast, EU and US coordination efforts were dominated by a series of spats (largely over rules of access, and recognition and extraterritoriality of the other’s regulations11) that the parties took up in bilateral discussions, euphemistically labeled in July 2013 the Common Path Forward. The two most prominent issues involved the CFTC’s extraterritorial reach resulting from an expansive definition of “US-​persons” rooted in the Dodd-​Frank12 and the European Union’s reluctance to recognize US CCPs as equivalent because of a difference in the required number of days of margin.13 Transatlantic officials do interact extensively in a fragmented field of transnational bodies; nevertheless, bilateral discussions over access, recognition, and extraterritoriality were central to managing coordination through 2016 and continue to be as this chapter goes to press. As others have pointed out, for US and European officials, rule-​making within transnational forums has become a way to imbue agreed standards and practices with legitimacy and a deliberate tool to ensure similar regulatory rigor outside 10   See the series of FSB reports and documents on Total Loss-​Absorbing Capacity at http://​ www.financialstabilityboard.org. 11   See Gravelle and Pagliari, in this volume. 12   Braithwaite, Mackenzie, Barker, Stafford, and Chon 2013. 13   Stafford 2014.





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the North Atlantic corridor (i.e., a level playing field that does not penalize transatlantic firms or encourage risk to flow to Asia and the Middle East).14 Why, in their efforts to coordinate the implementation of G20 principles for derivatives regulation, did EU and US officials choose to negotiate outside transnational arenas?

Prolonged and Trying Negotiations There are many outstanding issues across regulatory areas. In banking, for instance, the United States and the European Union remain at odds over Basel III’s credit valuation adjustments for banks’ derivatives portfolios. Another is the uncoordinated reforms of national banking structures, such as in the ring-​fencing of deposit-​taking institutions by the United Kingdom and Switzerland. Because of the implications for home-​host arrangements, the conflict between the European Union and the United States over the US Federal Reserve Board (FRB)’s new regime for foreign banking regimes is very much alive and could still result in retaliation, as proposed EU legislation advances.15 Nevertheless, several acrimonious conflicts over derivatives regulation stretched out over many years, and officials fear that there is no shortage of new ones to emerge.16 The low point may have been the summer of 2014 when the European Union announced its intention to grant equivalence to clearinghouses in five countries but not the United States and a CFTC official suggested European clearing of US-​listed futures contracts should move to the United States to comply with US law.17 It took another two years for those issues to be managed to the satisfaction of both sides.18 Moreover, officials worry about similar types of conflicts arising from EU reforms of financial indices and about new unsettled issues related to the regulation and supervision of CCPs. As an indicator of potential difficulties, a 2014 FSB report points to the relatively few instances of jurisdictional deference, despite G20 support for such arrangements.19 Finally, during discussions with this author during the summer of 2015, officials from IOSCO, BCBS, BIS, CPMI, the FSB, and US and European regulatory bodies, without fail, mentioned coordination of derivatives regulation

  Helleiner 2014a; Posner 2015.   Barker, Brunsden, and Arnold 2016. 16   For a similar assessment of how coordination in the area of derivatives regulation stands out compared to that in other financial regulatory sectors, see Knaack 2015. 17   Massad 2015a. 18   Brunsden and Stafford 2016. 19   FSB 2014b. 14 15



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as among the most challenging and contentious areas. Why have EU and US officials found this area of coordination especially hard?

A Wide Expectations Gap Derivatives also stand out for the gap between early expectations, manifested in extensive transatlantic collaboration that gave rise to the agreement on G20 principles, on the one hand, and the actual potential for tight regulatory coordination in implementing them, on the other. Through 2012, finance observers portrayed EU‒US coordination as a smooth process that led to fairly easy establishment of G20 principles. Mügge, for instance, highlights a general comity in the area of derivatives regulation during the immediate aftermath of crisis and notes the particularly intensive efforts to prevent market fragmentation.20 Knaack similarly points to the close working relationship between the top EU and US negotiators, European Commissioner Michel Barnier and CFTC Chairman Gary Gensler.21 One leaves these observations of early consultation with the impression that derivatives markets promised to be a relatively easy area of coordination. By contrast, as already described, they proved to be among the most difficult. The expectations gap goes a long way in accounting for the bitter tone of negotiations. By fostering a lack of trust, suspicion of protectionism, and misperceptions about the other’s motives, the gulf in expectations has contributed to the tit-​for-​tat interactions and has arguably diminished the ability of both sides to achieve their stated goals of preventing the fragmentation of markets.22 What accounts for the expectations gap?23

Transnational Institutions as Explanatory Variable This section develops the theoretical framework for answering the questions posed in the previous section and explaining variance in patterns of financial regulatory cooperation (see table 2.1). It begins with general empirical observations   Mügge 2014.   Knaack 2015: 1224–​1229. 22   Good examples can be found in testimony given before the US House Committee on Agriculture Hearing, “Dodd-​Frank Turns Five:  Assessing the Progress of Global Derivatives Reforms,” July 29, 2015. 23   The gap is all the more surprising because the US authority at the center of the conflict, the CFTC, was historically more relaxed about mutual recognition than the SEC. For example, in contrast to the SEC’s intransigence over letting European stock exchanges place monitors in the United States, the CFTC allowed it. See Posner 2009. 20 21





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Table 2.1 What is to be explained? Patterns of cooperation in implementing G20 principles for derivatives regulation Description of Cross-​Border Politics of Derivatives Regulation

Compared to Other Areas

Rule-​makers and main rule-​making forum?

European Union and United States used transatlantic negotiations to deal with most challenging issues.

Bilateral rule-​making is typical. Yet less reliance on transnational forums to manage most intense conflicts.

Length of time to find accommodation?

Six years and counting (in some areas).

Longer than most.

Character of negotiations?

Gap between early expectations and potential for finding accommodations; from harmonious efforts in creating G20 principles to conflictual and acrimonious tit-​for-​tat negotiations during implementation stages.

Stands out for having large expectations gap, for being the most acrimonious and for raising so many challenging issues.

of the inter-​state context, taken largely from the secondary literature; and then, in a deductive exercise, puts forth two propositions for how the politics of cooperation might vary under different transnational institutional contexts. In terms of the inter-​state configurations of post-​2008 financial regulation, there has been important continuity. As mentioned, the European Union and the United States remain the two primary transnational rule-​makers because of the size of international participation in their markets, and their respective internal capacities that, among other things, enable them to use access to home markets as bargaining leverage and thus create incentives for harmonization. Both the European Union and the United States have been in the process of rapid and far-​reaching financial regulatory reforms that, while not living up to all expectations,24 put in place more stringent official regulations that have increased costs for financial services industries and generated innumerable challenges for officials who, to a large extent, still desire interoperability of markets and market   Helleiner 2014b.

24



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participants across borders. Moreover, the two rule-​makers jointly forged and support the G20 agenda (including the coordinating role of the FSB and other elements of the post-​crisis international architecture)—​as a general mechanism to achieve the interoperability goal but also as a tool to limit less stringent regulation in third countries (and the deleterious competitive effects on financial entities based in the high regulation European Union and United States).25 Indeed, a key feature of the post-​crisis inter-​state context is that bipolar rule-​making coexists in a world of increasingly important financial markets governed by third-​ country regulation,26 and there is an ever-​present uncertainty over the extent to which transatlantic coordination can be expected to become global best practice as it had in the pre-​crisis period. This post-​crisis inter-​state context makes the two rule-​makers vulnerable to unintended and perverse dynamics. First, the complexity and unpredictability of relatively rapid but separate crisis-​induced internal political processes means that rules implemented in the two polities will inevitably have differences, regardless of the degree of prior coordination. Second, such processes also render the synchronization of reforms unlikely.27 One of the two will inevitably implement G20 principles first. Third, because of the internationalization of financial markets, the competitiveness issues surrounding domestic financial services industries and markets are central preoccupations of negotiators. As was the case before 2008, politicians, officials and market participants in the European Union and the United States are deeply concerned that actions taken on the other side of the Atlantic are aimed to establish competitive advantage. In the post-​crisis period, these concerns have been exacerbated by the possibility that such a “defection” would amount to a bid to create lax global standards attractive to recalcitrant jurisdictions. The heightened fears can easily lead to a retaliatory dynamic as the result of an atmosphere of unrealistic suspicion, where officials interpret actions as defections when in fact they are reflections of domestic political and institutional constraints. The latter point is worth emphasizing. The inter-​state configuration creates an environment prone to fear and suspicion, regardless of the motivations for implementing first. It is true that in some cases policy entrepreneurs believe—​ probably falsely28—​in the likelihood of winning benefits from implementing

  Helleiner 2014a; Posner 2015.   For development of this point, see Li’s chapter, in this volume. 27   Lannoo 2013. 28   Network effects tend to be weak in bipolar regulatory arenas where the second mover has relatively equal capacities and thus the wherewithal to pressure the first mover to choose between mutual recognition or two sets of rival rules (Drezner 2007; Newman and Posner 2015b). 25 26





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early and thus are tempted to make a bid for first-​mover advantages by using equivalency requirements and extraterritorial provisions to generate network effects and lock in its rules. It is also true, however, that the timing of implementing transnational principles frequently has to do with idiosyncratic internal factors such as the desire to complete legislation before elections. Moreover, as Gravelle and Pagliari point out in this volume, some market participants see early implementation as a disadvantage.29 There is thus a range of reasons for why the European Union or the United States might implement reforms before the other. Irrespective of the reason, the second mover is still likely to harbor suspicion and act defensively. Lastly, under the post-​crisis inter-​state configuration, EU and US market participants, politicians, and authorities are prone to unrealistic expectations about what kind of market integration is possible. In the North Atlantic corridor, financial markets have been open to one another’s firms for decades. The question has been about the terms: whether cross-​border interoperability would be based on a variant of either national treatment/​non-​discrimination or mutual recognition/​substituted compliance, with the latter typically requiring legislative provisions giving officials discretion within boundary conditions (such as harmonization or equivalence). In the post-​crisis years, internal reforms (involving shifts away from self-​regulation, heightened and new prudential concerns, reversals of previous arrangements that largely entrusted the home supervisors with oversight of foreign firms, and stiffer requirements for extending equivalence designations) have diminished possibilities for more permissive terms of access.30 Instead of a return to near “seamless” operability or fairly liberal formal and informal recognition arrangements, greater fragmentation along jurisdictional frontiers is the more likely outcome.31 The mismatch between these realities and expectations is likely to foster suspicion of protectionism and complicate negotiations. Given this bipolar inter-​state environment and its likely effects, how might variance in the evolution of pre-​crisis transnational institutions condition EU-​US efforts to cooperate? One way to begin answering this question is to locate institutional settings for transnational cooperation along two dimensions.32 The first dimension measures the extent to which standard-setting, monitoring, and other efforts to coordinate and integrate national markets take place in private authorities,33 such as the ISDA as opposed to official   Gravelle and Pagliari, in this volume.   On the trend toward more permissive pre-​crisis arrangements, see Posner 2009. 31   Helleiner and Pagliari 2011; Helleiner 2014a. 32   Büthe and Mattli 2011: 18–​41. 33   Green 2013; McKeen-​Edwards and Porter 2013. 29 30



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transgovernmental bodies, such as BCBS, IOSCO, and the FSB.34 The second dimension captures the development, capacities, and perceived legitimacy of the forums in which transnational cooperation occurs. On one extreme are relatively undeveloped forums that lack experience and accepted procedures and exist in fields of poorly defined networks and lots of competitors. On the other extreme are single “focal” forums, widely perceived (because of their experience, procedures, and capacities) as the legitimate locus of coordination for the sector.35 This exercise allows us to think about likely differential effects on regulatory cooperation of a wide range of transnational institutional contexts. For the purposes of this chapter, however, it is possible to narrow the enquiry to reflect the post-​2008 turn, embodied in G20 principles, toward direct official regulation36—​a turn that heightened the need for coordination of national (and regional) regulation in transgovernmental bodies as heavy reliance on private authorities became unsuitable for the task. How, then, is regulatory cooperation likely to differ when the relative role of private authority is waning and the transnational institutional contexts are located in different places along the second dimension? Compared to underdeveloped transgovernmental organizations in fragmented fields historically reliant on coordination in private authorities, transgovernmental focal forums (with strong capacities, organizational experience, established procedures, and existing relationships among member authorities) are expected to quicken the pace of producing new standards for national (and regional) legislation, increase their precision, and expand the likelihood that officials will accurately appraise their counterparts’ motivations, positions, and actions. Because creating legitimacy involves perceptions of experiences and because building capacities and finding acceptable procedures takes time, it is also expected that—​regardless of mutually recognized urgency—​developing the institutional setting cannot easily be done from scratch. There is thus an expectation that the institutional landscape of the pre-​crisis world would have an important bearing on patterns of post-​ crisis regulatory cooperation. Thus, the core argument is that different institutional settings can be expected to have differential effects on bipolar regulatory coordination efforts. Specifically, one should expect differential capacities to manage two central problems that

  Slaughter 2004; Zaring 1998.   Büthe and Mattli 2011: 18–​41. 36   Pagliari 2013a. 34 35





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plague negotiations in the contemporary inter-​state context: the sequence problem and the information problem. The sequence problem’s central issue is whether coordination comes before or after the European Union and United States implement the principles of the G20 agenda. Regulatory differences tend to be easier to manage when officials from the two leading jurisdictions can achieve fairly detailed coordination of regulations and establish market access frameworks before their respective legislators and agencies devise detailed rules. Coordinating first limits unwanted dynamics that arise from (1) inward-​looking and unconstrained policy entrepreneurs (sometimes acting on false readings of the power context) who press for early, detailed rules;37 (2) simultaneous but separate preference formation processes; and (3) the difficulty that officials face in adjusting incompatible rules once they have been adopted. During rapid reform processes where politicians face pressure to strengthen regulation, the speed, precision, and legitimacy with which an existing and experienced transgovernmental focal forum can be expected to generate coordinated rules and harmonized norms make it more likely that the European Union and United States can avoid the sequence problem. The preexistence of such a forum makes it possible to delegate coordination to a third party within limited timeframes of reforms driven by high levels of public salience38 and otherwise constrain policy entrepreneurs seeking quick implementation. By contrast, building capacities to coordinate national (and regional) reforms in a fragmented field of regulatory bodies is likely to be a slower process and thus more vulnerable to the implementation-​ first sequence. The information problem’s main issue is whether EU and US officials have an accurate understanding of one another’s motivations, positions, and actions. Incorrect readings of the other jurisdiction’s actions can perversely affect negotiations, leading to tit-​for-​tat downward spirals or to dashed expectations with the attending bitterness and recriminations. In fragmented fields, the two rule-​ makers tend to rely on bilateral stock-​taking discussions, which lack third-​party or other “neutral” verification mechanisms. By contrast, the presence of a transgovernmental focal forum can be expected to offer procedurally based discussions, peer reviews, and existing relationships. While not always equivalent to neutral, third-​party observations, such mechanisms can be expected to improve the likelihood of mutual understandings and thus make it more probable to find realistic accommodation, such as deference arrangements, within the confines of post-​crisis domestic politics.   Newman and Posner, forthcoming.   Pagliari 2013a.

37 38



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To What Extent Does the Transnational Institutional Setting Explain EU-​US Regulatory Cooperation? This section and the next compare regulatory cooperation across four banking and derivatives issues: Basel III capital requirements with special attention to the credit valuation adjustment; banking structure and the rules governing foreign banking organizations; treatment of foreign central counterparties; and margin rules for non-​cleared OTC derivatives. In seeking explanations for the observed variance within and across the two regulatory areas (that is, banking and derivatives), two themes emerge from the comparison. The first theme is that the proposed explanation featuring the impact of preexisting transnational institutions, developed in the previous section, does fairly well against the evidence. EU and US officials appear to believe in the benefits of early and detailed consultation and coordination and the desirability to avoid implementation-​first sequences and tit-​for-​tat dynamics. Yet only in the Basel III case of credit valuation adjustments was there (1) a transnational forum capable of producing sufficiently detailed standards based on G20 principles, within a timeframe that would enable jurisdictions to wait for transnational process before making their own rules; and (2) a rule-​based, “third party” mechanism for managing conflicts over implementation—​that was acceptable to both the European Union and the United States. Moreover, the comparison suggests the importance of the pre-​crisis evolution of transnational institutions in providing EU and US officials with forums and mechanisms for managing regulatory conflicts; it also points to the challenges of creating robust transnational institutional capacities and standards within short timeframes. Two factors enabled the Basel III process to achieve the outcomes. The first is the BCBS’s capacities developed through the organization’s experience in handling two previous rounds of standard-setting. The second is the perceived legitimacy of Basel’s position as the central forum for the transnational coordination of banking regulation.39 Whereas in the European Union, there was already a strong precedent of using Basel Committee standards as a tool for internal harmonization;40 in the United States, where the implementation of Basel II was surrounded by a contentious political conflict,41 it was extraordinary that the US Treasury and others succeeded in convincing the Congress to allow regulators

  Büthe and Mattli 2011: 18–​41. On the BCBS’s emergence as a technical authority, see Porter 2003: 530–​547. 40   Newman and Posner 2015a: 13–​18. 41   Bair 2012; Foot and Walters 2010; Lavelle 2013. 39





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to delay the creation of new capital adequacy rules until after the finalization of Basel III. Specifically, the 2010 Dodd-​Frank encourages both banking and derivatives authorities to consult and coordinate internationally.42 Yet the sections of the law related to capital adequacy (sections 171 and 175) allow banking authorities much wider discretion over the timing of coordination compared to the more prescriptive provisions concerning derivatives (Title VII), which constrained the CFTC’s and the SEC’s latitude.43 The Basel Committee also exemplifies how previously developed capacities could be harnessed to foster mutual understandings and offer third-​party perspectives on and management mechanisms for conflicts over implementation. Monitoring the implementation of transnational standards by standard-​setting bodies and the FSB is an important new element of the post-​crisis financial architecture across regulatory areas.44 However, displaying confidence in its perceived role as the legitimate transnational authority, the Basel Committee’s Regulatory Consistency Assessment Program (RCAP) has gone the furthest in supplying critical assessments, notably in its December 2014 designation of the European Union as materially noncompliant with minimum standards of Basel III.45 Second, part of the critique stems from the EU’s interpretation of Basel III provisions on credit valuation adjustment, as transposed in EU legislation.46 The Basel III provisions are standards for capital charges deemed necessary to offset counterparty credit risk. They capitalize the risk of future changes in credit valuation adjustment (CVA).47 US officials’ strongly disagree with the EU interpretation and see it as a bid for competitive advantage. Yet, unlike in areas discussed below, US and EU officials have had sufficient confidence in a transnational institution, the Basel Committee, to revisit CVA standards and manage the conflict. The Basel III case contrasts sharply with the three other cases. In the conflict over the cross-​border interoperability of CCPs,48 the Committee on Payment and Settlement Systems (CPSS, now CPMI)-​IOSCO transnational standard-​setting process was too slow and produced insufficiently granular standards to prevent   Zaring 2016: 1263–​1271; Newman and Posner forthcoming: ch. 6.   Dodd-​Frank Wall Street and Consumer Protection Act, 111 Congress, Public Law 203, US Government Printing Office, July 11, 2010. One partial exception is the text (section 805) covering international coordination in the area of systemically important financial market utilities. As I discuss later, even though the language implies that coordination should come first, it did not. 44   Posner 2015. 45   BCBS 2014. In comparison to BCBS’s RCAPs, the FSB’s monitoring regime is anodyne. 46   Capital Requirements Directive IV Package, which includes EU Directive 2013/​36/​EU and the EU Regulation 575/​2013. 47   BCBS 2011; BCBS 2015. 48   Also see Gravelle and Pagliari, in this volume, for a discussion of this CCP conflict. 42 43



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an implementation-​first sequence. As the collaboration between two separate organizations (comprised of networks of officials from different sectors and with uneven levels of cohesion) and the relative obscurity of its existence implies, pre-​ crisis standard-setting by the CPSS and IOSCO lacked the Basel Committee’s stature as a focal forum and levels of institutionalization. In 2004, the collaboration had produced a set of relatively imprecise principles for CCPs, poorly suited as a basis of harmonized guidelines for the 2009 G20 mandate to clear standardized OTC derivatives.49 The CPSS and IOSCO folded new CCP principles into its April 2012 “Principles for Financial Market Infrastructures” or PFMI. The release was too late in the sense that the United States was well on its way to implementing the G20 principles and thus to initiating an implementation-​first sequence—​despite provisions (section 805) in the 2010 Dodd-​Frank that suggest coordination ought to come first.50 Even if the United States had waited for the CPSS-​IOSCO publication, the principles lacked the kind of precision that might have helped the United States and European Union to manage the two main conflicts. First, EU officials rejected the US approach to foreign CCPs that handled US-​based contracts. Implemented in 2013, the US approach required foreign CCPs to register with the CFTC and undergo joint supervision. Second, the PFMI does not provide guidance for the European Union and United States to deal with their conflict over margin models. Unlike in the case of Basel III, where there was an obvious and trusted transnational forum for managing conflicts, EU and US officials addressed the CCP issues in bilateral negotiations. It took officials three years to make progress. After indicating in 2015 that they would make adjustments to the dual-​registration/​ cooperative supervision formula, US officials finally struck a compromise with their EU counterparts in February 2016.51 Yet, as already noted, the three years of bilateral discussions were generally acrimonious and plagued by mistrust, suspicion, and threats of retaliation. It is instructive to compare again with the Basel III case. In the banking case, EU and US differences over CVA stood to benefit from a rules-​based review with the potential to improve mutual understandings of one another’s positions and to help (though not necessarily) adjudicate between competing interpretations. In the CCP case, transatlantic officials used a “data-​driven” process in which both sides did their own studies on agreed topics. Thus, in the absence of an acceptable transnational forum, the two parties engaged in a contentious game of trying to convince the other, based on one’s own data, that their respective margins model was superior.52 Only in December   CPSS-​IOSCO 2004.   Dodd-​Frank Wall Street and Consumer Protection Act, 111 Congress, Public Law 203, US Government Printing Office, July 11, 2010. 51   Massad 2015a; Brunsden and Stafford 2016. 52   Massad 2015b. 49 50





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2015 did the standoff show signs of ending, when one side finally budged from its original stance.53 The ongoing case of margins of non-​cleared OTC derivatives could be destined to follow a similar path. The G20 mandate for margins was added in November 2011, more than two years after the other items of the OTC derivatives agenda. Given the novelty of the issue, a BCBS-​IOSCO effort was starting largely from scratch. Perhaps because of the Basel Committee’s role, the collaboration produced its standards within two years, which is impressive even with the extension of the original implementation deadlines. Nevertheless, while comparatively detailed, the BCBS-​IOSCO standards are notably general when giving guidance on cross-​border interoperability.54 Recognizing the extraordinary complexities (as discussed later in this chapter) and without an obvious transnational forum, EU and US officials, this time in conjunction with Japanese counterparts, sought coordination among themselves, and the European Union was at the time of writing unable to implement the reforms within the agreed timeline.55 Finally, the case of banking structure and the treatment of foreign bank organizations is illuminating, especially when paired closely with the case of CCP interoperability. The two cases are similar in that they are about conflicts over creating cross-​border interoperability for systemically important financial intermediaries. The EU-​US post-​crisis politics, however, differ in two important ways. In requiring large foreign banking organizations to create US subsidiaries with separate capital, the Federal Reserve Board has opted for a national treatment/​nondiscrimination approach to cross-​border interoperability and a more fragmented banking market.56 The decision appears to resonate with changing understandings of home-​host relations, an issue long discussed in the Basel Committee.57 The changing norm appears to acknowledge a legitimate need for host jurisdictions of international banking centers to require additional measures on prudential matters.58 Indeed, in the foreign banking

  Stafford 2015.   BCBS-​IOSCO 2013: 4. Principle 6: “Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework.” Principle 7: “Regulatory regimes should interact so as to result in sufficiently consistent and non-​duplicative regulatory margin requirements for non-​centrally cleared derivatives across jurisdictions.” 55   FSB 2016. 56   Tarullo 2012. See http://​www.federalreserve.gov/​bankinforeg/​topics/​fbo_​supervision.htm. 57   The thinking on home-​host issues began with the Basel Concordat of 1973 and can be found in a series of BCBS documents. BCBS 1992, 2012. See Newman and Posner forthcoming: ch. 6. 58   On heightened post-​crisis concerns about prudential systemic risks, see Gravelle and Pagliari, in this volume. 53 54



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organization instance, US authorities argue that as the lender and liquidity provider of last resort, the FRB must protect itself against firms abusing access to its instruments.59 Likewise, other jurisdictions have accepted the ring-​fencing of deposit-​taking units in the United Kingdom and Switzerland, which they justify by the high proportion of bank assets to GDP and thus the need to protect payment systems. While the US measure is opposed by EU officials who could well retaliate once new legislation is passed,60 EU and US negotiations have not descended into a dynamic characterized by suspicion of protectionism and bids for competitive advantage, as they have in the CCP discussions. It is thus a twist that, facing the expanding territorialization of CCPs,61 EU and US officials seem determined to establish a mutual deference arrangement, a more permissive arrangement requiring greater levels of confidence among regulators than the one emerging in banking. In sum, the cases discussed in this section suggest the importance of preexisting transnational institutional development in shaping regulatory negotiations and cooperation. Specifically, early and sufficiently granular coordination have been more readily supplied in processes involving the BCBS, a transnational financial regulatory forum with extensive experience, capacities, and legitimacy. In other regulatory areas, US and EU officials have not been able to avoid the implementation-​first sequence—​despite explicit efforts by OTC Derivatives Regulators Group and others to do so by catalyzing early consultations.62 The BCBS has also been able to fill a felt need for third-​party mechanisms, which have likely contributed to an improvement in mutual understandings. As in other areas of international politics, better awareness of motivations, constraints, and actions does not necessarily enhance the likelihood of greater harmonization or more liberal deference arrangements; but it is likely to limit expectation gaps that can easily descend into unwanted dynamics of mutual retaliation. There are multiple reasons why IOSCO, the obvious candidate, was not in a position and did not have the capacities to play a post-​crisis role similar to that of the Basel Committee. Although a full examination of these reasons is beyond the scope of this chapter, they include the fact that US SEC officials who largely shaped much of IOSCO’s historical evolution deliberately constrained its scope and institutional development to ensure that the organization would stay clear   Tarullo 2012.   Barker, Brunsden, and Arnold 2016. EU retaliation would be a challenge. In the United States, the FRB can argue that foreign banks operate in the United States under the principles of nondiscrimination and national treatment. In the European Union, however, because the single passport enables branches of European banks to operate freely across national borders, requiring “third-​ country” banks to hold separate capital reserves in subsidiaries could be seen as discriminatory. 61   Helleiner 2014a. 62   ODRG 2014. 59 60





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of prudential regulatory issues.63 Lastly, the empirical findings of this section are all the more plausible given that at least one other study, entirely independent of this one, arrives at similar conclusions: Knaack (2015: 1238) attributes transatlantic coordination failure in the area of derivatives regulation to the relative “weakness and incompleteness of government networks.”

Alternative and Complementary Explanations The second theme to emerge from this comparative study echoes the editors’ points about the nature of the politics of derivatives regulation. Post-​crisis patterns of cooperation are not monocausal, and interaction effects can be empirically critical. Understanding them is conceptually and theoretically enriching. The analysis has thus far been focused on how the transnational institutional context interacts with inter-​state configurations and dynamics. This section extends the analysis to other potential explanations, notably those highlighting complexity and vital interest incompatibility. Of course, some explanations are stronger than others. The role of individuals—​especially former CFTC Chairman Gensler in his capacity as policy entrepreneur, rule implementer, and negotiator—​has been invoked by scholars, journalists, and participants as a factor behind the difficulty of finding common ground for coordination.64 As a policy entrepreneur and regulatory authority, Gensler influenced the US Dodd-​Frank Act provisions on derivatives regulation65 and was instrumental in their relatively quick and uncoordinated implementation into detailed rules; and he was part of the mix of individuals who added to the vituperative and confrontational tone of derivatives negotiations. Nevertheless, for at least two reasons, the evidence militates against an explanation focused on the individuals involved. First, the argument suffers from a logical flaw. Gensler’s early interactions with European counterparts were fairly harmonious and his (and former European Commissioner Michel Barnier’s) more diplomatic 2014 replacements have not been able to deliver easy fixes to the outstanding conflicts. Second, the argument prioritizes the explanatory role of individuals without taking into account the deeper causal processes at work. The absence of a transgovernmental focal forum created opportunities for policy entrepreneurs like Gensler who, without the constraints fostered by the legitimacy of a Basel-​like coordination process, was able to pursue his agenda that resulted in the implementation-​first sequence. By contrast, the US   Coleman and Underhill 1995; Singer 2007; Mügge 2010.   Woolley and Ziegler 2012; Protess 2014. 65   Woolley and Ziegler 2012; Newman and Posner forthcoming: ch. 6. 63 64



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Treasury, leading a coalition of multinational firms and regulatory authorities, was able to prevail in banking in large part because it could argue that there was a legitimate process of coordination underway.66 Thus, variance in transnational institutional context helps to explain which policy entrepreneurs could succeed. Another possible explanation attributes negotiation patterns, partially or largely, to the challenges and incentives inherent to issue areas.67 The logic, rooted in asset specificity theory and institutional economics, is that issue areas give rise to different incentives and cooperation problems and require different kinds of institutional solutions. There is no doubt that the problems confronting negotiators in derivatives regulation differ from those of other sectors. Yet research cautions against putting too much emphasis on inherent differences as international politics can change dramatically over time in the same issue area. For example, as the European Union centralized regulation and developed capacities in the late 1990s and early 2000s, there was significant change in transatlantic relations of accounting standards, auditing rules, and conglomerates.68 In banking, moreover, the core problems, negotiations, and politics that generated the first and second Basel accords were different.69 The politics of derivatives regulation is, likewise, a story of great change over time. The shift toward direct official regulation in the European Union and the United States has pressured officials to negotiate new terms of cross-​border interoperability; whereas before the crisis, transnational standards were largely set by private associations in conjunction with minimalist IOSCO principles largely reflecting US approaches (editors’ introduction). Interestingly, in his 2004 testimony before the Committee on Financial Services of the US House of Representatives, the European Commission’s Alexander Schaub did not list derivatives among the financial regulatory conflicts in need of urgent or future management.70 In 2016 US‒EU discord over derivatives regulation is among the most, if not the most, acrimonious and challenging issues facing officials seeking to balance competing goals of financial stability and continued internationalization. In this study, moreover, the case of Basel III/​CVA, a rule with far-​reaching implications for the shape of OTC derivatives markets but managed within a BCBS-​led process, suggests that variance in cross-​border politics has more to do with the institutional context than the nature of the issue area. The main point is that since an issue area is a “constant,” other factors must be responsible for variance over time in cross-​border regulatory politics.   Newman and Posner, forthcoming.   Simmons 2001. 68   Posner 2009. 69   Wood 2005; Singer 2007. 70   Schaub 2004. 66 67





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One such factor emphasized in the scholarly literature is level of complexity.71 In highlighting the centrality of increasing complexity in contemporary financial governance, Tony Porter points out the growing number of transnational bodies, creating an expanded set of standards, and a more articulated architecture, marked by greater differentiation and specialization and clearer linkages among the players and rules.72 He also notes greater complexity in the relationship between the transnational, domestic, and regional rule-​making processes. On the surface, the sheer number of issues confronting negotiators appears to be an obvious and fundamental factor in any explanation for the challenging politics of derivatives regulation. According to the FSB, six bodies73 have created or are working on 25 sets of standards, and these numbers only include standards developed with public officials and not the separate standard-​setting processes of industry associations.74 Even more impressive than the numbers are the types of problems facing regulatory authorities. A good example is the issue of margins, which is at the center of efforts to establish the terms for cross-​border trading of uncleared swaps. The goal, from the standpoint of a US CFTC commissioner, is to balance sound regulation at home with seamless trading between entities from different jurisdictions. It is imperative that we get all aspects of our margin requirements right, and that includes getting the cross-​border element of the requirements right. The swaps market is a global one—​the market has organically evolved to rely on the ability of US entities to trade with European entities as a matter of course. It is incumbent on us that our rules not severely restrict this flow of commerce, just as it is incumbent on us that our rules provide rigorous regulations on this market for the protection of investors, consumers, and the broader financial system.75 Figuring out how to achieve this seemingly straightforward goal is strikingly complex. Examining the details consuming US authorities reveals the high level of complexity in resolving the coordination problems with the   Porter 2014a, b, 2003; Carruthers 2013; Morgan 2012.   Porter 2014b. 73   The OTC Derivatives Supervisors Group, IOSCO, CPMI (formerly, CPSS), the FSB, the CGFS, and BCBS. 74   According to the FSB, standard-setting for derivatives markets has five workstreams: Standardization (7), Reporting to Trade Repositories (6), Central Clearing (7), Exchange and Platform Trading (2), Capital and Margins Requirements (3). FSB 2014a, 2015. 75   Bowen 2015. 71 72



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European Union.76 The CFTC’s rules that must ultimately satisfy EU authorities (if there is going to be a substituted compliance/​mutual recognition regime) must also: (a) establish a rubric for assessing whether another jurisdiction’s rules and supervision are comparable to US ones. The challenge here has been to balance the CFTC’s impulse to meet statutory obligation by prescribing specific requirements with the stated goal of accepting foreign regimes that generate roughly equivalent outcomes;77 (b) identify which market participants might be exempt from US rules and thus eligible for substituted compliance. This is the so-​called US-​person’s rule and involves the formidable challenge of deciding which entities will have to comply with US rules and which can be exempted and therefore regulated under another jurisdiction;78 and (c) coordinate with other US authorities. Because of a fragmented regulatory structure, the CFTC shares jurisdiction with the so-​called prudential regulators. Its rules are thus applicable to only a fraction of the swaps market participants. It must thereby coordinate its rules with those of the other regulators to prevent regulatory arbitrage at home. As this example suggests, these types of complexities are formidable and central to the cross-​border politics of derivatives markets. Nevertheless, the argument that complexity is a driving force for this study’s observed variance is not compelling. Scholars have long noted that international capital markets involve different and arguably more complex technical issues than banking markets.79 However, as already noted, other factors, such as US domestic decisions not to directly regulate derivatives, are at least as important in explaining the pre-​crisis absence of a transgovernmental focal forum for the sector. And, more to the point, when officials, market participants, and analysts attribute the relative difficulty of derivatives market regulatory coordination to the complexities of the issues, what they are actually observing is a greater mismatch between management capacities and problems at hand. The evidence of this comparative study indicates that officials have managed complex problems better in areas where pre-​crisis transnational developments left them with more robust institutional arrangements. Again, the comparison of the conflicts involving the cross-​border interoperability of CCPs and banks is especially insightful because both are   Section on CFTC’s proposal, June 2015, cross-​border trades of uncleared swaps.   Giancarlo 2015. 78   Gravelle and Pagliari, in this volume. 79   For example, Porter 2003: 536–​537. 76 77





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financial intermediaries with systemic importance—​yet coordination proved more difficult in the case of the former. A final possible argument attributes the pattern of cooperation in implementing G20 principles for derivatives regulation to intractable conflicts of interests. As previous sections of this chapter established, the proposition is unmistakably right in the sense that the European Union and the United States have clashing preferences over a range of regulatory issues. From the vantage point of 2016, moreover, the conflicts can easily appear to reflect different material interests and concerns about public welfare, and serve as a further reminder that the old terms of financial regulatory cooperation may not be viable in the post-​crisis world.80 Nonetheless, the conflict of interests argument would only be satisfactory to the extent that the European Union and United States had entered the reform period with well-​formed preferences. If that were the case, we could understand the largely conflictual pattern of cooperation without reference to the transnational institutional context and the processes it structured. The two polities, however, did not have fixed preferences, and therefore, a complete explanation must include systematic analysis of interest-​and conflict-​formation processes.81 A theme runs through the voluminous literature on the politics of post-​crisis regulatory reform: Facing high levels of public salience and of uncertainty, policymakers scrambled and satisficed in putting together reform packages. The degree to which such an atmosphere resulted in continuity of market-​friendly regulatory approaches will be debated for some time to come.82 At this juncture, what is clear is that the detailed rules about market access and equivalence verification at the heart of the transatlantic regulatory conflicts were indeterminate and fluid in 2009. It would simply not have been possible in that year to predict the preferences that eventually emerged, whether by looking at internal financial systems and institutional arrangements or by identifying local positions within global finance.83 In no area is this truer than in the regulation of derivatives where, as the editors’ chapter highlights, policymakers ultimately shifted away from a decades-​old regime that embraced the discipline of markets.84 Yet it is also true in banking where new attention to macro-​prudential regulation led to a rethinking of best practices across most areas of banking governance. The key questions, then (and the one taken up in this chapter’s investigation), revolve around when, why, and in what order unformed regulatory preferences   Helleiner and Pagliari 2011.   Sell 2003; Shaffer 2013; Kirshner 2015. 82   Helleiner 2014b. 83   Fioretes 2010; Howarth and Quaglia 2013. 84   Pagliari 2013a. 80 81



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hardened into either relatively compatible approaches or incompatible preferences and thus conflicts over how to manage them. Many of the answers lie in differences in transnational institutional context. As the empirical sections suggest, the presence of a transgovernmental focal forum helped banking officials avoid implementation-​first sequences and, in doing so, supported the development of relatively compatible preferences. Where incompatibilities arose, BCBS processes offered a conducive environment for discussing and managing them. By contrast, a fragmented and underdeveloped transnational institutional landscape of derivatives regulation enabled the relatively early hardening of US preferences and ultimately a dynamic characterized by mutual suspicion, fear, and retribution. Without a transnational process perceived in Washington as legitimate, the Treasury lacked political ammunition to prevent the implementation-​first sequence. Once in place, uncoordinated US regulations and rules narrowed the leeway for authorities to make accommodations in negotiations with EU counterparts. Indeed, US preferences had congealed as the economic and political sunk costs accrued. Financial services companies had invested in new technologies and legislators and regulatory authorities, operating in a political system with multiple veto players and expansive pieces of legislation, could not easily revisit set rules.

Conclusion This chapter’s analysis and findings underscore central themes of this volume. First, the chapter helps to capture the pattern of cooperation over the implementation of G20 principles for derivatives. The detailed four-​case comparison, including cases from the area of banking, helps to establish where derivatives negotiations are distinctive and to grasp what is interesting and puzzling. In particular, the comparison reveals that in the area of derivatives, there is a relatively heavy reliance on bilateral discussions of high-​profile conflicts, an extended duration of and difficulty in managing them, and a comparatively unusual atmosphere of misperception and distrust. Second, the comparison also shows that, more so than in banking, the processes by which the European Union and United States formed preferences over the detailed rules for CCPs and margins for uncleared OTC derivatives exacerbated differences in regulatory approaches and intensified conflicts. Implementation-​first sequences, in particular, worsened the potential for mutually acceptable accommodation and contributed substantially to the widely observed fragmentation of derivatives markets along political frontiers. While providing some sustenance for critics wary that transnational standards and monitoring fall short of promise, the trend toward territorialization of derivatives





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markets is no doubt a surprising outcome for negotiators who expected a return to global markets. This chapter helps to illuminate why and how it happened. Lastly, the findings highlight the role of complex causal processes in explaining national and regional implementation of G20 principles. Individual agency, inter-​state power configuration, complexity, and interest incompatibility are all part of the explanation for why implementing principles for derivatives regulation stand out. The findings also, however, highlight the merits of a transnational institutional explanation—​attentive to temporality, varied levels of development and process. The analysis and evidence suggest that the effects of bipolarity, the actions of policy entrepreneurs, the capacities to manage complexity, and the intensity of conflicts are, to an important degree, contingent on transnational institutional context; variance in the evolution of the transnational landscape across regulatory areas altered the impact of each of these causal factors.

Acknowledgments For their comments on earlier drafts, the author thanks Liliana Andonova, Lori Crasnic, Nikhil Kalyanpur, David Kempthorne, Jonathan Kirshner, Matthias Matthijs, Silvia Merler, Kathleen McNamara, Daniel Mügge, Tony Porter, Nicolas Véron, Gillian Weiss, Alasdair Young, and David Zaring. The author is also grateful to the editors—​Eric Helleiner, Stefano Pagliari, and Irene Spagna—​ and the other contributors to this volume. While the author alone wrote the entirety of this chapter and is therefore responsible for its content, he acknowledges that many of his ideas stem from long-​term collaboration with Abraham Newman (Newman and Posner, forthcoming).

Works Cited Bach, David, and Abraham Newman. 2007. “The European Regulatory State and Global Public Policy:  Micro-​Institutions, Macro-​Influence.” Journal of European Public Policy 14(6): 827–​846. Bair, S. 2012. Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself. New York: Free Press. Barker, Alex, Jim Brunsden, and Martin Arnold. 2016. “EU to Retaliate against US Bank Capital Rules.” Financial Times, November 21. https://​www.ft.com/​content/​26078750​b003-​11e6-​a37c-​f4a01f1b0fa1. BCBS. 1992. “Minimum Standards for the Supervision of International Banking Groups and Their Cross-​Border Establishments.” July. http://​www.bis.org/​publ/​bcbsc314.pdf. BCBS. 2011. “Basel III: A Global Framework for More Resilient Banks and Banking Systems.” June. http://​www.bis.org/​publ/​bcbs189.pdf. BCBS. 2012. “Core Principles for Effective Banking Supervision.” September. http://​www.bis. org/​publ/​bcbs230.pdf.



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BCBS. 2014. “Assessment of Basel III Regulations—​European Union.” December. http://​www. bis.org/​bcbs/​publ/​d300.pdf. BCBS. 2015. “Review of the Credit Valuation Adjustment Risk Framework.” July. http://​www.bis. org/​bcbs/​publ/​d325.htm. BCBS and IOSCO. 2013. “Margin Requirements for Non-​ Centrally Cleared Derivatives.” September. http://​www.bis.org/​publ/​bcbs261.pdf. Bowen, Sharon. 2015. Concurring Statement of Commissioner Sharon Y. Bowen on Cross Border Margin, Washington, DC, June 29. http://​www.cftc.gov/​PressRoom/​SpeechesTestimony/​ bowenstatement062915. Braithwaite, Tom, Michael Mackenzie, Alex Barker, Philip Stafford, and Gina Chon. 2013. “US Rules ‘Endanger’ Derivatives Reforms.” Financial Times, September 26. https://​www. ft.com/​content/​dda5f480-​26c4-​11e3-​bbeb-​00144feab7de. Brummer, C. 2012. Soft Law and the Global Financial System:  Rulemaking in the 21st Century. New York: Cambridge University Press. Brunsden, Jim, and Philip Stafford. 2016. “EU and US Strike Derivatives Regulation Deal.” Financial Times, February 10. https://​www.ft.com/​content/​b7f72eda-​cfef-​11e5-​92a1​c5e23ef99c77. Büthe, Tim, and Walter Mattli. 2011. The New Global Rulers: The Privatization of Regulation in the World Economy. Princeton, NJ: Princeton University Press. Carruthers, Bruce. 2013. “Diverging Derivatives:  Law, Governance and Modern Financial Markets.” Journal of Comparative Economics 41:386–​400. CFTC and SEC. 2012. “Joint Report on International Swap Regulation.” Washington, DC:  Commodity Futures Trading Commissions, Securities and Exchange Commission. July 31. http://​www.cftc.gov/​idc/​groups/​public/​@swaps/​documents/​file/​dfstudy_​isr_​ 013112.pdf. Coleman, William D., and Geoffrey R. D. Underhill. 1995. “Globalization, Regionalism and the Regulation of Securities Markets.” Journal of European Public Policy 2(3): 488–​513. CPSS and IOSCO. 2004. “Recommendations for Central Counterparties.” March. Basel and Madrid: BIS and IOSCO. http://​www.bis.org/​cpmi/​publ/​d61.pdf. CPSS-​IOSCO. 2012. “Principles for Financial Market Infrastructure.” April. Basel and Madrid: BIS and IOSCO. http://​www.bis.org/​cpmi/​publ/​d101a.pdf. CPSS and IOSCO. 2013. “Authorities’ Access to Trade Repository Data.” August. Basel and Madrid: BIS and IOSCO. http://​www.bis.org/​cpmi/​publ/​d110.pdf. Drezner, D. 2007. All Politics Is Global:  Explaining International Regulatory Regimes. Princeton, NJ: Princeton University Press. Farrell, H., and A. Newman. 2010. “Making Global Markets:  Historical Institutionalism in International Political Economy.” Review of International Political Economy 17(4): 609–​638. Farrell, H., and A. L. Newman. 2014. “Domestic Institutions beyond the Nation-​State: Charting the New Interdependence Approach.” World Politics 66:331–​363. Fioretes, Orfeo. 2010. “Capitalist Diversity and the International Regulation of Hedge Funds.” Review of International Political Economy 17(4): 696–​723. Fioretes, Orfeo. 2011. “Historical Institutionalism in International Relations.” International Organization 62(2): 367–​399. Foot, R., and A. Walter. 2010. China, the United States, and Global Order. Cambridge: Cambridge University Press. FSB. 2014a. “OTC Derivatives Market Reforms:  Eighth Progress Report on Implementation.” November 7. Basel: FSB. http://​www.fsb.org/​wp-​content/​uploads/​r_​141107.pdf. FSB. 2014b. “Jurisdictions’ Ability to Defer to Each Other’s OTC Derivatives Market Regulatory Regimes.” FSB report to G20 Finance Ministers and Central Bank Governors, September 18, 1–​38. http://​www.fsb.org/​2014/​09/​r_​140918/​. FSB. 2015. “OTC Derivatives Market Reforms: Ninth Progress Report on Implementation.” July 24. Basel:  FSB. http://​www.fsb.org/​wp-​content/​uploads/​OTC-​Derivatives-​Ninth-​July-​ 2015-​Progress-​Report.pdf.





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3

Global Markets, National Toolkits Extraterritorial Derivatives Rule-​Making in Response to the Global Financial Crisis Matthew Gravelle and Stefano Pagliari

The regulation of global derivatives markets in the aftermath of the global financial crisis period has been marked by paradox. On the one hand, the attempt to rein in the risks associated with derivatives transactions has been a highly cooperative international endeavor, as demonstrated by the large number of international regulatory standards that have been negotiated within multiple international institutions such as the G20, FSB, and IOSCO. On the other hand, the implementation of these same international commitments at the national level has been highly conflictual. In particular, different countries have accused each other of seeking to extend their regulatory oversight over foreign firms and markets beyond their territorial remit instead of relying on the regulation and supervision provided by foreign regulatory authorities that had committed to the same regulatory agenda. A number of G20 members have identified the resolution of these cross-​border regulatory issues as “the most significant implementation issue,”1 while multiple international regulatory initiatives have been launched in recent years to rein in the extraterritorial application of national rules. The emergence of these “regulatory land grabs” within the remit of what is a rather harmonized package of global regulatory standards is particularly evident in the two most important set of rules introduced since the financial crisis, that is, the regulatory frameworks introduced in the United States and European Union. Both the US and EU regulatory authorities have come to encompass within their regulatory net a number of firms that are not legally domiciled in the two respective jurisdictions. In principle, both the US and EU post-​crisis legislative frameworks included mutual recognition tools (called “substituted   FSB 2014b: 26.

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compliance” in the United States and “equivalence and recognition” in the European Union) to allow foreign actors to comply only with foreign rules if those rules were found to be substantially similar in delivering the outcomes that regulators seek. However, the analysis in this chapter demonstrates how in practice the application of these mutual recognition tools has frequently failed to rein back the extraterritorial application of US and EU rules. What explains the emergence and continuation of these extraterritorial measures in the regulation of global OTC derivatives markets? This chapter will argue that the emergence of extraterritoriality in the regulation of derivatives markets in the United States and European Union reflects the challenges that regulatory authorities have faced to implement the new prudential agenda in a manner that addresses the highly internationalized nature of derivatives markets. The analysis below will highlight how the attempt to implement the newly designed post-​crisis prudential regulatory frameworks in a manner that preempts their hollowing out through regulatory arbitrage has led regulatory authorities to adopt different degrees of extraterritoriality in their regulatory approach. This chapter will illustrate how these concerns can explain why the degrees of extraterritoriality in the post-​crisis agenda have varied not only between the rules introduced in the United States and in the European Union but also across different regulatory requirements introduced by these two jurisdictions. The chapter is structured as follows. The next section will review the main debates and international policy initiatives concerning the territorial reach of derivatives regulation in the implementation of the G20 agenda. The rest of the chapter will zoom in on the policies introduced in the United States and European Union to regulate three key sets of actors in the derivatives markets: foreign dealers, CCPs, and trading platforms.

Extraterritoriality and the Implementation of the G20 Agenda One of the defining features of contemporary OTC derivatives markets that differentiate these markets from other segments of the international financial system is their international nature. As Elisse Walter from the US SEC has stated, in OTC markets “cross-​border transactions are the norm, not the exception.”2 In fact, BIS data on the structure of the OTC market at the peak of the post-​crisis reform activity indicates that trades involving uniquely domestic counterparties account for less than half of the trading in most FSB member jurisdictions.3   Walter 2013.   FSB 2014b: 24.

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Given the international scope of derivatives transactions, a key issue concerning the design of regulatory policies governing these markets is the jurisdictional scope of the rules. What domestic and foreign market actors (such as dealers or market infrastructures) or transactions should come under the scope of a jurisdiction’s regulatory framework in order to achieve its policy objectives? This question has become a particularly salient one in recent years. As different countries have come to introduce new regulatory frameworks in order to meet the commitments negotiated at the international level under the umbrella of the G20, these new rules and requirements have frequently included definitional and scoping provisions that result in those new rules being applied to market participants as well as market infrastructures (namely, trading venues and CCPs) that are not legally domiciled within the territory where the rules have legal effect. The presence of overlapping national regulatory policies has often been presented by the authorities involved in the implementation of the G20 agenda as a threat to the achievement of its policy objectives. The potential fragmentation of derivatives markets across overlapping national regulatory spaces makes both compliance by market participants and the monitoring and enforcement of compliance on a cross-​border basis legally and logistically difficult. As the head of the UK Financial Conduct Authority Martin Wheatley stated in September 2013:  “Does it make hard-​nosed, practical sense for any one national regulator to attempt to regulate all derivatives activity with any link to its jurisdiction? . . . The clear risk is that a patchwork quilt of national and regional rules runs the risk of becoming unworkable. A mess.”4 In the meantime, the presence of overlapping regulatory policies has begun to have meaningful implications for the structure of global derivatives markets by incentivizing market actors to restructure or avoid engaging in certain cross-​border transactions, which has had the effect of fragmenting particular international derivatives markets across jurisdictional lines. The FSB documented in 2014 a “reorganisation of business activities along jurisdictional lines reflecting steps taken by some counterparties and infrastructure providers to minimize their own or their clients’ exposure to requirements in place in certain jurisdictions.”5 This extraterritorial application of national rules is a departure from pre-​crisis trends in the international regulation of securities markets. In particular, the period of the 15 years or so preceding the crisis was a time when EU and US authorities increasingly allowed foreign companies to operate within their jurisdiction on the basis of the regulation and supervision provided by their home country regulators.6 This change in the approach to the territorial boundaries   Wheatley 2013.   FSB 2014a: 26. 6   Posner 2009: 655. 4 5





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of derivatives market regulations is particularly puzzling when analyzed from the perspective of some of the most prominent interpretations of the politics of financial regulation within the international political economy literature. First, challenging perspectives that focus on the significance of international cooperation via transnational regulatory institutions, the emergence of extraterritoriality in the regulation of derivatives markets has coincided with what is arguably the peak of international regulatory coordination in the regulation of securities and derivatives markets. During this period, a variety of technocratic fora (such as the OTC Derivatives Regulators’ Forum, IOSCO, the BCBS, and the FSB) have produced a wide-​ranging set of international standards defining how countries should meet the G20 agenda, and they have taken action to monitor the track record of different countries in implementing these standards at the domestic level. A number of these initiatives have been specifically designed to encourage national regulatory authorities to refrain from imposing rules on foreign firms by promoting greater deference to equivalent rules implemented by foreign regulators. In a key political signal, G20 leaders agreed at the St. Petersburg Summit in September 2013 that “jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, in a non-​ discriminatory way, paying due respect to home country regulation regimes.”7 Following the request by the G20, the FSB’s coordinating role in the implementation of the G20 agenda was expanded to include monitoring the status of its member jurisdictions’ existing processes and arrangements to defer to one another’s OTC derivatives regulation and to identify issue areas where greater deference was needed.8 Additional initiatives to achieve this objective have also been undertaken by the OTC Derivatives Regulators Group and IOSCO, which established a Task Force on Cross-​Border Regulation to analyze how host countries regulate the activity of foreign entities and the types of mutual recognition arrangements that could be used instead.9 The success of these initiatives, however, has been limited, and the FSB has acknowledged in 2014 that significant differences remained “on the circumstances under which deference would be applied, and how it would be applied.”10 It is puzzling that the same domestic regulatory agencies that have been involved in these international cooperative initiatives have resorted to extraterritorial implementation of their national regulatory frameworks rather than relying on the regulatory oversight of foreign counterparts.   G20 2013.   FSB 2014a. 9   IOSCO 2014. 10   FSB 2014a. 7 8



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Second, the observation of extraterritoriality in the implementation of the G20 agenda is at odds also with what has been identified in the literature as a key force shaping the regulation of derivatives markets: the preferences of transnational financial actors.11 Since the early stages of the domestic implementation of the G20 agenda, a number of leading international financial industry associations and firms have denounced the extension of regulatory requirements to foreign firms. These moves, they have argued, would increase the compliance burdens for firms as they needed to meet not only their home country rules but also the rules of the host country they sought to access. As argued by a group of major derivative dealers, extraterritorial rules would force them to comply with foreign rules that may be “incompatible with home country requirements, objectionable to home country supervisors, prohibitively expensive, impossible to achieve in the necessary timeframe and impractical from an operational perspective.”12 Financial industry associations have also highlighted how the extraterritorial implementation of post-​crisis commitments was at odds with the core objectives of the post-​crisis regulatory agenda, in particular, the G20’s call in 2010 “to ensure open capital markets and avoid financial protectionism.”13 Major international financial groups have therefore supported initiatives to allow firms to rely on the regulatory oversight provided by home regulators.14 For instance, in August 2013, ISDA released a set of principles designed to “guide the development of frameworks and processes for inter-​jurisdictional recognition of derivatives regulation through a principles-​based substituted compliance methodology.”15 As already argued, however, these initiatives had only limited impact in altering the course of regulators and to rein in extraterritoriality. A third perspective on the politics of financial regulation focuses on the role of competition between the main jurisdictions in the global derivatives markets. A number of authors have theorized how the manner in which different countries implement international regulatory standards is driven by the attempt to preserve the competitive position of their respective domestic financial industry or to minimize domestic firms’ adjustment costs.16 For example, in a recent contribution, Peter Knaack argued that “concerns about competitiveness have played a major role in the current spat between the United States and the EU” as both jurisdictions have been wary of the distributional consequences of accepting each other’s rules for the position of London and New York as major trading

  McKeen-​Edwards and Porter 2013; Tsingou 2006.   Sullivan and Cromwell LLP 2011. 13   EU-​US Coalition on Financial Regulation 2012. 14   Futures and Options Association et al. 2013. 15   ISDA 2013. 16   Simmons 2001; Drezner 2007. 11 12





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hubs in the global derivatives markets.17 From this perspective, an extraterritorial application of domestic regulatory requirements could be conceived as a defensive move to prevent other jurisdictions from attracting market share through the introduction of weaker regulations. As the analysis in the cases will illustrate, concerns about the impact of extraterritorial rules on the competitiveness of domestic firms seeking cross-​ border access have certainly been the main driver behind both the public and private actors’ mobilization on this issue. In particular, a number of infrastructures (trading venues and CCPs) seeking access to foreign markets have described the introduction of extraterritorial requirements by third-​country authorities as “protectionist” attempts to favor domestic champions and lobbied in favor of deference and mutual recognition. It is also worth noting that in certain instances trading platforms and CCPs have opposed agreements that would have given access to their home market to foreign competitors on the basis of laxer or unfinished regulations in the foreign platforms’ jurisdictions.18 At the same time, the international nature of most transactions in the derivatives markets has created a vast front of market participants both in the United States and in Europe who have denounced the costs imposed by these measures on their competitive position. In particular, major US banks,19 hedge funds, asset managers,20 and non-​financial end-​users21 have claimed that the attempt of US regulators to extend the scope of Dodd-​Frank rules to a broad range of foreign firms doing business with US counterparts would lead foreign actors to prefer doing business with non-​US firms, thus causing them to lose business in key international markets. Indeed, since the crisis, a number of foreign financial institutions have reduced the volume of their trades with US firms in order to avoid the burden of becoming subject to US rules.22 Overall, while international competitive concerns have certainly been an important issue in the implementation of the G20 commitments, the introduction of extraterritorial rules by home country authorities has often been a burden rather than a safeguard for the competitive position of firms seeking to compete in the global derivatives markets. Market actors’ interests have only rarely complemented the extraterritorial application of market rules, and where that overlap is observable, it is limited to a small cross-​section of firms.

  Knaack 2015.   Ackerman 2014. 19   Meyer and van Duyn 2011. 20   R awlings 2013; Investment Company Institute and ICI Global 2013. 21   Coalition for Derivatives End-​Users and European Association of Corporate Treasurers 2013. 22   Jeffs and Williams 2012; Davies 2013. 17 18



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A fourth key perspective on the politics of financial regulation identifies the sources of the cross-​border conflict in the regulation of derivatives markets in developments that have occurred within the major jurisdictions, rather than across them, and, in particular, the greater role of elected officials in the design of the post-​crisis rules both in the United States and European Union. In particular, Knaack has highlighted how legislators lacked the same incentives and expertise of regulators to engage in cross-​border harmonization. According to Knaack, the involvement of legislators has also shaped implementation, as both Dodd-​Frank in the United States and EMIR in the European Union provided regulators with a mandate to extend the perimeter of their oversight to a range of foreign market players.23 At the same time, as detailed more extensively in the case studies, the primary legislation introduced in both the United States and Europe has explicitly introduced provisions granting regulators the authority to curb the extraterritorial reach of their rules through the use of mutual recognition tools. What needs to be explained is why regulatory authorities have been reluctant to make use of these powers and to recognize each other’s rules as equivalent. Moreover, as the cases will illustrate, regulatory authorities themselves have often been the key actors driving the expanded extraterritorial scope of certain provisions, despite the opposition coming from large segments of the financial industry and their elected principals. In order to explain regulators’ extraterritorial implementation of G20 rules, the analysis in this chapter focuses instead on the incentives of these regulatory actors. A number of authors analyzing the politics of international financial regulation have theorized the role of regulators as bureaucratic entities seeking to balance the competing demands coming from the financial industry and politicians.24 Changes in the approach of regulators are often understood as deriving from the change in the relative importance of these two forces. But the way in which regulators interpret their tools and course of action is also influenced by changes in their mandate. From this perspective, the response to the crisis has not only expanded the scope of the regulatory intervention in the derivatives market but also introduced a strong prudential bias into the rationale for regulating a market that had previously been generally seen as raising market integrity and conduct issues, relating primarily to contract law. Since the crisis, the recognition of the systemic externalities in derivatives markets has led to the institutionalization in legislation of a new policy objective: to limit the extent to which events occurring in the derivatives markets destabilize the broader financial system. This   Knaack 2015.   Kapstein 1989; Singer 2004; Kleibl 2013.

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overriding objective has influenced the choice of regulatory tools across jurisdictions, including the territorial scope of regulatory requirements needed to realize this policy goal. Indeed, while investor protection or market integrity issues can be addressed primarily through measures aimed at domestic firms or firms offering services to domestic clients, the international nature of derivatives markets means that systemic risk can be imported or exported across borders, leaving financial institutions exposed to disruptions affecting foreign affiliates. As the former chairman of the CFTC Gary Gensler argued, a number of high-​ profile episodes of financial instability before and after the financial crisis such as LTCM, Bear Stearns, AIG, and the “London Whale” served as a “stark reminder of how trades overseas can quickly reverberate with losses coming back into the United States.”25 From this perspective, the emergence of a strong prudential mandate in the regulation of derivatives markets has moved derivatives market policymakers and regulators toward the approach that has dominated the regulation of banks, where, as Coffee puts it, “unlike securities and derivatives regulators, banking regulators have largely ignored or disdained substituted compliance, preferring to rely on a more traditional territorial approach.”26 As Posner argues in this volume, unlike in the case of banking regulation, the incentives for authorities to introduce extraterritorial regulatory requirement has been enhanced by other factors such the timing of the introduction of regulatory requirements at the national level (which has preceded in many cases rather than followed the design of international standards), and the absence of granular and high-​level standards in this area similar to the ones developed in the area of banking regulation by the BCBS over the years.27 It is, however, important to foreground that the characteristics of the international institutional context in the derivatives markets and the lack of strong international standards only became an obstacle to the sharing of regulatory sovereignty once regulators acquired a stronger prudential mandate. In order to probe this argument further, the chapter turns toward developments in the two major derivatives markets, the United States and the European Union. This focus is justified in terms of the importance of the combined importance of these jurisdictions, which accounted for close to 95% of the USD 630 trillion global derivatives market at the time these rules were being designed and implemented,28 as well the broader implications of their regulatory policies. The disagreements between them have been identified as having a direct impact on   Gensler 2012.   Coffee 2014: 13. 27   Posner, in this volume. See also Knaack 2015. 28   Committee on Capital Markets Regulation 2014. 25 26



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implementation of the G20 agenda in a number of smaller markets.29 The next sections will investigate the regulatory frameworks introduced after the crisis by authorities in the United States and European Union to regulate foreign dealers and market participants, foreign clearinghouses, and foreign trading platforms, exploring the extent to which these rules have been extraterritorial in nature, as well what factors explain these outcomes.

Dealers and Market Participants The first area where the implementation of the G20 commitments has been characterized by significant extraterritoriality is the definitions of which firms and transactions are captured by different sets of national rules. In the United States, the territorial boundaries of the regulation, and in particular the extent to which it should cover market actors and transactions outside of the United States, entered the congressional agenda during the early stages of the drafting of the Dodd-​Frank, when dealer banks pleaded in front of Congress to avoid “the prescriptive imposition of U.S. rules on foreign markets.” In particular, banks stated that this could have the effect of “potentially curtailing U.S. access to foreign markets” and it may “invite retaliatory measures that could compromise the ability of U.S. exchanges to compete for international business.”30 This request was supported by Republican Representative Spencer Bachus, who introduced an amendment to curtail the extent to which overseas operations would come into the scope of Dodd-​ Frank.31 On the other side, Democratic Representative Barney Frank justified an extraterritorial implementation of the new rules on the grounds that “there may well be cases where non-​U.S. residents are engaging in transactions that have an effect on us and we would find them insufficiently regulated internationally and I would not want to prohibit our regulators from stepping in.”32 The compromise language adopted within Dodd-​Frank (section 722d) seemed to reassure the banks by explicitly stating that the new derivatives rules would not apply to their overseas trading operations. At the same time, the legislation still brought under the oversight of US authorities foreign activities that had “a direct and significant connection with activities in, or effect on, commerce of the United States” or where extraterritorial application was “necessary or appropriate to prevent the evasion of any provision   FSB 2011.   Rosen 2009. 31   Bachus 2009. 32   Cited in Gupta, Beck, Miller, Harper, and Holbrook 2014. 29 30





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of this Act.” Coffee has described this provision as “an extreme case of the exception swallowing the rule.”33 Critics of the extraterritorial language contained within Dodd-​Frank turned their attention toward the CFTC, the regulatory agency in charge (together with the SEC) of interpreting and defining the scope of these provisions. Contrary to the expectations of market actors, the “Proposed Interpretative Guidance” of Dodd-​Frank’s cross-​border regulation published by the CFTC in July 2012 further expanded the extraterritorial scope of the US regulation.34 The proposed rules subjected any swap involving a “US person” to Dodd-​Frank’s clearing, trade execution, and reporting requirements notwithstanding the location where the transaction was booked or the legal status of the US person’s counterparty. Moreover, any foreign person (including non-​US affiliates of US dealer banks) whose swap trading with US persons exceeded the same threshold applicable to US persons would be required to register with the CFTC and comply with Dodd-​Frank requirements, such as capital adequacy and the risk mitigation requirements for the OTC markets. The central issue determining the territorial scope of Dodd-​Frank, therefore, concerned the definition of who should be regarded as a “US person.” The CFTC provided an expansive definition that included not only resident market actors but also entities that had their “principal place of business in the United States,” non-​US firms where the direct or indirect owner was a US person, and the foreign branches of US banks.35 Speaking in front of Congress in December 2012, the CFTC Chairman Gary Gensler justified the extraterritorial approach by stating that if US rules did not also cover offshore affiliates of US firms, this would “basically blow a hole out of the bottom” of the new rules because US dealers would structure trades through exempt foreign entities.36 The CFTC approach faced almost unanimous opposition from both major US banks acting as dealers in the derivatives markets,37 as well as their foreign competitors,38 with the major financial industry associations representing both US and foreign dealers (i.e., SIFMA, ISDA, and Institute of International Bankers) unsuccessfully challenging the CFTC cross-​border rules in a federal district court.39 In an attempt to limit the extraterritorial impact of the legislation, US and foreign derivatives dealers turned to a footnote in the CFTC’s final cross-​border guidance.40 They focused on what footnote 513 did not say about   Coffee 2014.   CFTC 2012. 35   CFTC 2013g. 36   Cited in Trindle 2012. 37   Sullivan and Cromwell LLP 2011. 38   Barclays Bank PLC et al. 2011. 39   Miedema 2014; Price and Puaar 2013. 40   CFTC 2013c. 33 34



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the application of Dodd-​Frank requirements, as it mentioned “branches” but not “affiliates,” which are considered legally separate from the parent company. Banks interpreted the rule to mean that swap transactions could be arranged by traders in the United States and escape CFTC oversight as long as they were executed or “booked” through overseas affiliates.41 As a result, some of the largest banks started to change the terms of certain swap agreements made by their offshore units and remove guarantees to ensure that liabilities would formally lie entirely with the offshore operation.42 This strategy was described as meaning that “a client might strike a derivatives deal with Goldman in New York in the morning, and that afternoon, with no disclosure, a Goldman office in London or Singapore or Hong Kong could take over the deal. With each shift, the trade could fall under different regulators.”43 To prevent this potential regulatory arbitrage, the CFTC further expanded the extraterritorial scope of its oversight by taking two additional measures. First, the CFTC explicitly challenged the banks’ interpretation of footnote 513 in a November 2013 staff advisory, which clarified that all transactions “arranged, negotiated, or executed” (called “ANE transactions”) by US agents had to come under US trading rules, even if the transaction was conducted through a foreign affiliate or on behalf of an overseas client.44 Gensler explained the change in the CFTC approach in this way: “a U.S. swap dealer on the 32nd floor of a New York building and a foreign-​based swap dealer on the 31st floor of the same building have to follow the same rules when arranging, negotiating or executing a swap. One elevator bank, one set of rules.”45 Second, in June 2015, the CFTC proposed new rules requiring foreign affiliates of US banks to adhere to US margin rules even where the US parent company had revoked its formal guarantee but the results were consolidated in the financial statements of the parent firm.46 The new CFTC Chairman Massad justified this measure on the ground that “risk created offshore can flow back into the U.S.”47 In October 2016, the CFTC finalized a proposed rule that further defined “US Person” and a “Foreign Consolidated Subsidiary” for the purposes of Dodd-​Frank. The proposed rule is consistent with the intent of the margin rules in that it reaches certain de-​guaranteed foreign affiliates and clarifies that trades with such entities also count toward the relevant Dodd-​Frank thresholds. Furthermore, the rule proposes to extend certain Dodd-​Frank conduct   Schmidt and Brush 2013.   Burne 2014. 43   Levinson 2015. 44   CFTC 2013a; Schmidt and Brush 2013. 45   Norris 2013. 46   CFTC 2015. 47   Ackerman 2015. 41 42





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requirements to what it called “ANE transactions” (i.e., those using US agents), thereby taking the interpretive guidance the CFTC gave in relation to footnote 513 by applying it to business conduct standards, and holding out the possibility that the CFTC will eventually extend the scope of all Dodd-​Frank requirements to ANE transactions through a formal rule-​making (rather than through less formal staff guidance alone). 48 The extraterritoriality in the US approach toward the regulation of offshore branches and affiliates has also been reinforced by the reticence of US regulatory authorities to use the key policy tool available to limit their extraterritorial reach, namely the use of substituted compliance. In order to determine the “comparability” of foreign regulatory regimes, the CFTC stated in its cross-​border guidance that it would use an outcomes-​based approach in order to determine whether foreign regulatory frameworks were designed to meet the same regulatory objectives of the US regulations. In practice, however, the CFTC has only made very circumscribed use of substituted compliance.49 The CFTC approach to determine the equivalency of these rules has been described by financial market participants as difficult to meet and too prescriptive, being based in practice on a rule-​by-​rule comparison with foreign jurisdictions.50 As a result, these comparability determinations have not allowed foreign entities captured in the extraterritorial net of the CFTC to forgo compliance with most of the material US Dodd-​Frank requirements. The CFTC has during this period issued a series of time-​limited exemptions—​ including the application of Dodd-​Frank transaction level requirements to so-​ called ANE transactions. In sum, the expansion in the scope of the regulation to offshore branches and affiliates at key junctures and the minimal use of substituted compliance demonstrates the intent of US authorities to capture a wide array of offshore transactions, despite the costs this imposed upon US banks, and the implications for broader efforts at transatlantic regulatory cooperation. Notably, the extraterritorial approach informing US rules has been heavily criticized by policymakers   CFTC 2016a.   At the end of December 2013, CFTC (2013f) approved “comparability determinations” for a series of entity-​level requirements of Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland, allowing foreign swap dealers and major swap participants from these countries to rely on their home country rules for business conduct matters, which included swap record keeping, risk management policies, and chief compliance officer requirements. Moreover, at the same time, comparability determinations were made with respect to certain transaction-​level rules from the European Union (CFTC, 2013e) and Japan (CFTC, 2013d), but the CFTC declined to make comparability determinations in any jurisdiction for other key transaction-​level requirements, including clearing and trade execution. 50   Ackerman 2013. 48 49



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in Europe. Shortly after the publication of the proposed interpretative guidance in 2012, European Commissioner Michel Barnier warned of the danger that “American rules would take primacy over those in Europe,” and called on the CFTC to “rely on equivalent rules in host countries.”51 It should be noted, however, that the EU regime for dealers is, at the legislative level, remarkably similar in its intent. In particular, the provisions contained within EMIR applied where the two transacting entities are both established in non-​EU jurisdictions, if the contract had a “ ‘direct, substantial and foreseeable effect’ within the E.U. or where to do so is necessary to guard against anti-​evasion.”52 While the European legislation was drafted in a manner similar to Dodd-​ Frank, the implementation of the European Union’s rules has been more constrained, particularly in terms of the types of legal guarantees that bring offshore market participants into scope. Unlike the gradual evolution in the CFTC rules, the technical standards published by ESMA in 2013 to identify when OTC transactions between foreign firms would have “direct, substantial, and foreseeable effect” in the European Union considered the activities of an offshore unit to have an impact over its European parent company only in the presence of an “explicitly documented legal obligation.”53 Similar to the US framework, EMIR also included a mechanism to allow European rules to be waived when one of the counterparties was established in a non-​EU jurisdiction that the European Commission had determined to have an equivalent regulatory regime (Article 13 of EMIR). At a high level, the EU rules allowed for a more holistic application of mutual recognition than the US substituted compliance approach, by potentially granting market participants a broad carve-​out across their EMIR requirements if a foreign regime was equivalent rather than proceeding on a granular level. However, in practice, the process for determining which regimes were in fact equivalent has proved to be complex and subject to the same administrative and procedural delays as their US counterparts. In summary, this analysis of the rules concerning the definitions of firms and transactions captured by different national regulations reveals how both the US and EU rules have been meaningfully extraterritorial. While both frameworks made mutual recognition or substituted compliance available to market participants, the extent to which policymakers on both sides of the Atlantic have deployed this tool in a timely manner was limited. That said, in an important way the US rules have been more extraterritorial than the EU rules due to the unique anti-​arbitrage CFTC staff interpretation of footnote 513 and the CFTC’s efforts   Barnier 2012.   Coffee 2014; Helleiner 2014. 53   ESMA 2013a. 51 52





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to combat dealers’ attempts to skirt the rules through an expanding interpretation of a legal guarantee. What explains this outcome? The approach adopted by regulators in the United States and Europe both defied the imperative of international coordination and the influence of well-​organized business interests. As suggested throughout this case, the primary driver for the adoption of extraterritorial measures appears to have been prudential policymaking concerns about the low exit costs facing transatlantic dealer banks. Policymakers introduced extraterritorial provisions to prevent regulatory arbitrage where the application of requirements with clear prudential effect—​like swaps clearing, reporting and trading—​could otherwise have been circumvented by market participants. These concerns have been particularly acute for US authorities given the presence of London as the single biggest market where US dealers could arbitrage away from US regulations with relative ease.

Central Counterparties Among the key components of the new rules governing derivatives since the crisis is the requirement that certain OTC derivatives or swaps should be centrally cleared through a CCP. The derivatives market is highly internationalized and features a decentralized market structure for central clearing, with multiple CCPs in multiple jurisdictions. The implementation of the clearing requirement has therefore generated a number of key questions with clear jurisdictional implications: Which CCPs should be allowed to satisfy the mandatory clearing requirement? And whose rules should govern these entities? Both the US and the EU rules required domestic market participants to use CCPs that were authorized by domestic authorities. The specific conditions under which a foreign CCP could receive such authorization so that domestic counterparties to a trade could clear through it and meet their home jurisdiction’s clearing requirement have varied across the United States and European Union. In the United States, section 722 of Dodd-​Frank was interpreted by the CFTC as requiring CCPs wishing to clear swaps for US market participants to register in the United States as a derivatives clearing organization (DCO).54 This extraterritorial provision reflected the clear prudential case for regulating CCPs clearing swaps, especially in the post-​crisis reform period where these institutions have become the nexus of the attempts to limit systemic risk in the swap markets. This approach has differed from the rules in place for foreign   CFTC 2012a.

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clearinghouses seeking to clear derivatives products that are listed on exchanges, products that are called “futures.” The greater transparency, level of standardization, and liquidity of futures products means that these have been not regarded as leading to the same types of opaque concentrations of risk—​requiring prudential measures—​as swaps. In the case of futures, the CFTC required foreign CCPs to register and fully comply with its rules only when they sought to clear futures products that listed on a US exchange. On the contrary, US rules simply required that foreign CCPs clearing for US persons were compliant with the relevant international standards if those CCPs sought to clear futures products that listed on a foreign exchange—​products that therefore fell outside CFTC’s market integrity and prudential mandate.55 From the perspective of foreign CCPs seeking to offer cross-​border clearing, the regime introduced by the CFTC raised the threat of having to comply with multiple and overlapping sets of regulations.56 Market actors have therefore called upon the CFTC to mitigate this extraterritorial impact of their respective rules by recognizing foreign CCPs based on their home country rules. In the United States, Dodd-​Frank (section 725(b)) granted the CFTC the authority to exempt a foreign DCO from registration if it determined that this CCP was subject to “comparable, comprehensive supervision and regulation” by government authorities in its home country. In August 2015, Australia’s ASX was the first foreign CCP to be exempted from the requirements of full registration as a DCO (under the so-​called exempt DCO regime) followed by Korean and Japanese CCPs. Furthermore, the CFTC made extensive use of targeted exemptions to allow non-​US CCPs to continue to clear swaps subject to mandatory clearing for US market actors on a transitional basis, while their final regulatory status under Dodd-​Frank was being determined. In Europe, EMIR required covered derivatives transactions to be cleared by an EU-​based CCP authorized or a non-​EU domiciled CCP recognized by ESMA, without distinguishing between the types of products cleared (futures vs. swaps) as in the United States. Moreover, the EU rules ensured that this rule would not be skirted by linking the new requirement to the new banking capital standards (Capital Requirement Directive IV), which imposed significantly higher capital requirements for exposures to third-​country CCPs not recognized under EMIR.57

55   The centrality of the clearing function in the execution chain gives the CFTC a clear interest in ensuring that CCPs (and their clearing members) are regulated appropriately in order to fulfill its market integrity mandate. This market integrity mandate, however, does not extend to transactions in futures products that are listed outside of the territorial United States. 56   Committee on Capital Markets Regulation 2013; Brummer 2013. 57   Pagliari 2013.





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Like Dodd-​Frank, the final text of EMIR included an “equivalence” regime in Article 25, designed to allow foreign CCPs to provide their services to EU counterparties on the basis of their home country regulation. The condition for this recognition was that the European Commission first determined that the legal and supervisory arrangements in a foreign CCP’s home jurisdiction were “equivalent” to EMIR.58 The process for issuing those authorizations for overseas CCPs became much more strained in the European Union than in the United States. In September and October 2013, ESMA provided its advice to the Commission concerning the equivalence of Australia, Canada, Switzerland, Hong Kong, India, Japan, Singapore, South Korea and the United States. ESMA did not find any of these jurisdictions to be entirely equivalent to EMIR, despite all the jurisdictions being G20 members and in the process of implementing the same G20 commitments. With regards to the US rules, the overall conclusion by ESMA was that, while on many policy matters the US rules provided for effective equivalence, on others—​particularly prudential issues regarding the calculation and posting of margin—​the US rules would need to be adjusted or supplemented at the CCP level in order to fully meet the conditions of access.59 Importantly, this requirement exported the EMIR rules to CCPs located in the United States. The European Commission ultimately accepted rules in ten jurisdictions ( Japan, Singapore, Australia, Hong Kong, India, South Africa, South Korea, Canada, Mexico, and Switzerland) as equivalent to EMIR over 2014‒2015 without attaching the same regulatory adjustments as a condition, on the basis that CCPs in those jurisdictions represented less risk to the EU market than US CCPs and a proportional approach was therefore appropriate. However, the same outcomes-​ based equivalence based on proportionality was not extended to the United States CFTC rules. This resulted in the emergence of a protracted and loud transatlantic dispute between the US and EU market authorities despite strong industry pressures and repeated efforts at an international agreement. In sum, both the United States and European Union have introduced in response to the crisis regulatory frameworks requiring foreign clearinghouses to be recognized in their own jurisdictions before domestic counterparties may use them to comply with their mandatory clearing requirements. However, the willingness to rein in this extraterritorial requirement through mutual recognition provisions has varied significantly between the two jurisdictions, with the European Union adopting a relatively higher degree of extraterritoriality in the application of its rules with regards to foreign—​and particularly American—​ CCPs. What explains this difference?   Quaglia 2015.   ESMA 2013b.

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A mix of prudential and commercial concerns informed the approach of European policymakers toward foreign CCPs during the crisis. As US authorities moved first in demanding that more derivatives transactions should be centrally cleared at the beginning of the crisis, European policymakers recognized the possibility that US incumbents could take control of the European market for clearing at the expense of smaller European competitors.60 Commercial considerations, and in particular the need to protect European CCPs against competition on the grounds of margin costs, have also influenced the negotiations over the equivalency of foreign rules. At the same time, European authorities also recognized the prudential implications of concentrating derivatives activity within CCPs that were outside European regulatory oversight, as this would leave European authorities with very limited powers to pre-​empt the build-​up of risk and to intervene should a foreign CCP used by EU firms come under financial stress.61 Prudential concerns regarding the potential for CCPs under the oversight of foreign authorities to channel systemic risk in the European markets also informed the disputes over mutual recognition of US CCPs in a manner that intersected with the commercial concern about where central clearing takes place. While a number of differences among the two CCP regimes initially hindered the mutual recognition between the US and the EU regime,62 the key issue was how the two jurisdictions calculated the margin posted by banks clearing their own derivatives trades. The European Union stood firm in arguing that its standards guarded more fully against the risk of default and contagion and denounced how the United States remained unwilling to “level up” its margin requirements.63 Indeed, the US authorities agreed CCPs should make targeted amendments to their margin rules to bring them into alignment with the EMIR rules, as a condition of equivalence and EU market access.64 It is also notable that at the time of writing US-​ domiciled CCPs regulated by the Securities and Exchange Commission (SEC) have not yet been recognized. Market participants have noted how European authorities had granted unconditional recognition to Singapore, which had implemented identical margin rules as the United States. This difference of treatment is, however, consistent with a prudential explanation. Unlike in the case of the regulation of dealers analyzed earlier, the opportunities for regulatory arbitrage in the clearing business are heavily influenced by the levels of clearing activity already present in a   Jones 2009.   European Commission 2009: 10. 62   Brummer 2013. 63   Rundle 2015. 64   CFTC 2016b. 60 61





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foreign jurisdiction. In particular, the presence of large futures exchanges and CCPs in the United States with high levels of what is called “open interest” and liquidity enabling the capital-​efficient use of market participants’ collateral produced strong network effects for EU banks as well as their US-​based branches and affiliates to participate in the cleared US markets. The same opportunities for regulatory arbitrage were weaker in the case of shallower clearing markets such as Singapore. The fact that European authorities have explicitly made their decisions on the equivalency of foreign jurisdictions on the basis of proportionality, taking a stricter line on the formal equivalence for large markets such as the United States that posed greater opportunity for regulatory arbitrage, as well as significant concentrations of exposures for EU firms that result from those network effects, highlights the importance of prudential concerns informing the decision of European policymakers.

Trading Venues In addition to the post-​crisis requirement that sufficiently standardized derivatives be cleared through CCPs, the G20 reforms have also created new obligations to execute many types of trades on regulated trading platforms. As with the regulatory framework governing CCPs discussed in the previous section, the implementation of this commitment raised the issue of how to regulate venues where counterparties transact on a cross-​border basis and to what extent countries should impose regulatory obligations on trading venues beyond their own jurisdiction. A particularly extraterritorial implementation of the trading requirement emerged in the United States in the rules for the new types of electronic platforms created for swaps that previously traded over-​the-​counter, called swap execution facilities (SEFs). In particular, a footnote (footnote 88)  included within the CFTC’s May 2013 rules for SEFs required that any trading platform, including those based overseas, on which US persons were executing swaps was required to register with the CFTC and comply with the US rules, even if the products being traded were not mandated by rule to be traded on these facilities.65 As a result of this rule, non-​US trading platforms were no longer permitted to allow market participants covered by the US rules to transact on their platforms without registering with the CFTC.

  CFTC 2013b.

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This measure was described as “an extraterritorial land grab by the CFTC”66 and it immediately attracted the opposition of derivatives market participants and foreign authorities. After negotiations with the European Commission, the CFTC committed in July 2013 to offer transitional relief to different EU-​ regulated multilateral trading facilities (MTFs) and to consult with the European Commission about granting regulatory relief to those foreign trading platforms that were subject to comparable regulatory requirements as SEFs.67 Following on this commitment, the CFTC announced in February 2014 that US financial firms could trade on “Qualified MTFs” (using the European term for an electronic trading venue) that were “appropriately overseen by home regulators and remain subject to regulations that are comparable to, and as comprehensive as, US law.”68 The implementation of this regime was problematic. In particular, in order to obtain the designation of “Qualified MTF,” the CFTC required European platforms to satisfy a number of conditions that were very similar to full registration.69 European platforms complained that the requirements for them to continue to give access to US firms were too onerous and the timeframe too inadequate to be worthwhile. 70 When the deadline for European platforms to register as a “Qualified MTF” with the CFTC passed in 2014, no European platform had opted to do so. In order to avoid having to comply with two distinct sets of rules, European swap trading venues instead notified US counterparties that they were no longer welcome to participate on their platform. As a result, the failure of the CFTC to relax the requirements imposed upon foreign swap trading platforms contributed toward a bifurcation of the liquidity in the transatlantic swaps market, with European firms only trading with each other on European platforms. A report produced by ISDA in April 2014 demonstrated that only 6% of Euro-​denominated swaps and 3% of sterling-​ denominated swaps that were subject to the US trading mandate were being traded on US trading platforms.71 This outcome is a puzzling contrast to the approach the CFTC has taken for derivatives exchanges trading standardized futures. Foreign derivatives exchanges that sought only indirect access to US clients through brokers can be granted full exemption under CFTC Regulation 30.10. This exemption was granted to several non-​US derivatives exchanges as well as the entire UK market.

  Stafford 2014.   CFTC and European Commission 2013. 68   Wetjen 2014. 69   CFTC 2014. 70   Parsons 2014. 71   ISDA 2014. 66 67





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A more extraterritorial regime was imposed upon non-​US exchanges seeking to allow US market participants to directly enter transactions into the exchange’s matching system (i.e., seeking direct access to US clients). In November 2010, the CFTC implemented Dodd-​Frank (section 738) by requiring these foreign exchanges (labeled “Foreign Boards of Trade” or FBOTs) to register with the commission and to comply with different regulatory requirements taking into account “whether the FBOT’s home regulatory authority supports and enforces regulatory objectives . . . that are substantially equivalent to those supported and enforced by the Commission.”72 While the FBOT regime was described as onerous by foreign exchanges,73 it is important to note that many nonetheless availed themselves of the opportunity to register. This is not the case with the US SEF regime, where no foreign entities applied to the stringent application of SEF rules within the “Qualified MTF” framework. How do we explain the different extent to which US policymakers have imposed regulatory requirements upon foreign swap trade execution facilities and foreign-​listed derivatives exchanges? As with the CCP market, there were again commercial interests—​particularly US SEFs—​with an interest in maintaining the CFTC’s extraterritorial approach to foreign swaps platforms to level the regulatory implications of accessing US persons, and this commonality of interest should not be discounted. However, it should also be noted that the major banks, which can reasonably be assumed to have had more market and structural power and a greater voice in lobbying efforts than smaller trade execution venues, did not get their way on the harmonization of cross-​border swaps execution rules. This puzzle fits the pattern observed in the previous cases where the mandate of regulatory agencies determines the extraterritorial scope of their intervention. In the case of the regulation of futures markets, the CFTC’s extension of its oversight over foreign exchanges was influenced by the extent to which these exchanges would have a direct impact on US market activity and the CFTC’s delivery of its market oversight mandate (i.e., by allowing or not allowing US market participants to be direct members). This is consistent with the CFTC’s approach to foreign CCPs clearing futures, which was, again, more extraterritorial where there was a clear US nexus and an implication for US market integrity (particularly for US-​listed futures). Conversely, the fact that the United States introduced a regulatory regime governing trading venues for swaps (SEFs) that was substantially more extraterritorial in scope than the US regime for traditional derivatives exchanges can be explained, from a prudential policymaking perspective, by the fact that swaps were thought to present greater risks   CFTC 2010: 70977.   Scheid 2010.

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compared to futures. Moreover, the risks of regulatory arbitrage toward foreign jurisdictions is particularly acute in the case of the trading of swaps, since European rules prescribing mandatory trading have been substantially delayed relative to the US rules.

Conclusion This chapter has sought to shed light on one of the most contested issues in the post-​crisis regulation of derivatives markets: regulators’ extraterritorial application of the rules introduced to implement the G20 agenda. In particular, this chapter has focused on the rules introduced in the two major centers for the trading of derivatives, the United States and the European Union, and investigated how these have regulated foreign dealers, CCPs, and trading venues. In each of these three cases, the US and EU post-​crisis rules have been shown to exhibit varying degrees of extraterritoriality in both the extent to which they capture firms and transactions beyond the two respective domestic territories, and the extent to which the rules impose requirements on foreign firms as a condition of access to the domestic market. While in principle, both the US and EU regulatory post-​crisis legislation have included mutual recognition to allow foreign actors to comply only with foreign rules, the analysis in this chapter has demonstrated how in practice the application of these tools has failed to rein in the extraterritorial application of US and EU rules. This chapter has argued that the emergence of extraterritoriality in the implementation of the G20 derivatives agenda has been influenced by the challenges that regulatory authorities have faced in fulfilling their new prudential mandate in the face of highly internationalized derivatives markets. While in some instances commercial interests have complemented the prudential reasons for regulators to export their rules on an extraterritorial basis, in most cases there has been a clash between the prudential motivations and subsequent extraterritorial undertakings of regulators, and the preferences of powerful industry voices. The emergence of a strong prudential imperative has frequently overridden other forces to influence the extent to which authorities have been willing to extend the scope of their regulatory authority over foreign firms, such as the commercial incentive to either protect domestic market actors or “level the playing field,” the preferences of transnational market participants to avoid duplicative requirements, and the role of transnational regulatory institutions in promoting greater deference to each other’s rules.





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Acknowledgments An earlier version of this chapter was presented at the workshop “The Politics of Regulating Global Derivatives Markets after the 2008 Crisis” at the Balsillie School of International Affairs, September 19, 2015. We would like to thank the participants for their valuable comments and feedback. This chapter is updated only up to December 16, 2015, when this chapter was submitted.

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FSB. 2014a. “Jurisdictions’ Ability to Defer to Each Other’s OTC Derivatives Market Regulatory Regimes FSB Report to G20 Finance Ministers and Central Bank Governors.” September 18. http://​www.fsb.org/​wp-​content/​uploads/​r_​140918.pdf?page_​moved=1. FSB. 2014b. “OTC Derivatives Market Reforms Seventh Progress Report on Implementation.” April 8. Basel: FSB. http://​www.fsb.org/​wp-​content/​uploads/​r_​140408.pdf. Futures and Options Association, British Bankers Association, International Swaps and Derivatives Association, International Capital Market Association, Investment Industry Association of Canada, London Metal Exchange, . . . Swiss Bankers Association. 2013. “Calling on IOSCO to Step Up to the Plate.” Financial Times website (FT.com), March 19. https://​www.ft.com/​ content/​575c1c84-​8fe7-​11e2-​ae9e-​00144feabdc0#axzz2NsaLfvIL. G20. 2013. “G20 Leaders’ Declaration.” Saint Petersburg Summit. September 5–​6. http://​www. g20.utoronto.ca/​2013/​2013-​0906-​declaration.html. Gensler, G. 2012. “Keynote Address on the Cross-​Border Application of Dodd-​Frank Swaps Market Reforms before the 2012 FINRA Annual Conference.” May 21. http://​www.cftc. gov/​PressRoom/​SpeechesTestimony/​opagensler-​113. Gupta, D., G. A. Beck, R. B. Miller, A. N. Harper, and B. A. Holbrook. 2014. Brief of Current and Former Members of Congress as Amicus Curiae in Support of Defendant Commodity Futures Trading Commission. United States District Court for the District of Columbia, March 21. Helleiner, E. 2014. “Towards Cooperative Decentralization? The Post-​Crisis Governance of Global OTC Derivatives. In Transnational Financial Regulation after the Crisis, edited by Tony Porter, 132–​153. Abingdon: Routledge. Investment Company Institute and ICI Global. 2013. Letter to the CFTC, RE:  Draft Final Guidance Regarding Compliance with Certain Swap Regulations (RIN 3038–​AD85). July 5. https://​www.ici.org/​pdf/​27358.pdf. IOSCO. 2014. “IOSCO Task Force on Cross-​Border Regulation Consultation Report.” CR09/​ 2014. http://​www.iosco.org/​library/​pubdocs/​pdf/​IOSCOPD466.pdf. ISDA. 2013. “Methodology for Regulatory Comparisons Inter-​jurisdictional Recognition of Derivatives Regulation through a Principles-​Based Substituted Compliance Methodology.” August 1.  http://​www2.isda.org/​attachment/​NTgwNw%3D%3D/​Methodology%20 for%20Regulatory%20Comparisons%2020130820.pdf. ISDA. 2014. “Made-​Available-​to-​Trade (MAT):  Evidence of Further Market Fragmentation.” April 4.  https://​www2.isda.org/​attachment/​NjQzOA==/​MAT%20Study%2020140404_​ FINAL%20W%20ALL%20EDITS.pdf. Jeffs, L., and N. Williams. 2012. “Dodd-​Frank Forces European Banks to Review US Deals.” Reuters, October 26. Jones, Huw. 2009. “France Wants ECB to Lead Derivatives Clearing Push.” Reuters, January 19. Kapstein, E. B. 1989. “Resolving the Regulator’s Dilemma: International Coordination of Banking Regulations.” International Organization 43(2): 323–​347. Kleibl, J. 2013. “The Politics of Financial Regulatory Agency Replacement.” Journal of Politics 75(2): 552–​566. Knaack, P. 2015. “Innovation and Deadlock in Global Financial Governance:  Transatlantic Coordination Failure in OTC Derivatives Regulation.” Review of International Political Economy 22(6): 1217–​1248. Levinson, C. 2015. “U.S. Banks Moved Billions in Trades beyond CFTC’s Reach.” Reuters, August 21. McKeen-​Edwards, H., and T. Porter. 2013. Transnational Financial Associations and the Governance of Global Finance: Assembling Wealth and Power. London: Routledge. Meyer, G., and A. van Duyn. 2011. “US Banks Plead to Limit Range of Swap Rules. Financial Times, May 16. Miedema, D. 2014. “U.S. Court Rules against Banks in Swap Rules Lawsuit.” Reuters, September 16. Norris, F. 2013. “A Swaps Tactic Is Foiled, and Banks Cry Foul.” New York Times, November 21.



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Pagliari, S. 2013. “A Wall around Europe? The European Regulatory Response to the Global Financial Crisis and the Turn in Transatlantic Relations.” Journal of European Integration 35(4): 391–​408. Parsons, J. 2014. “European Venues Cool on CFTC Registration.” Future & Options World. April 17. Posner, E. 2009. “Making Rules for Global Finance: Transatlantic Regulatory Cooperation at the Turn of the Millennium.” International Organization 63(4): 665–​699. Price, M., and A. Puaar. 2013. “CFTC Suit Puts Non-​US Firms in Limbo.” Financial News, December 6. Quaglia, L. 2015. “The Politics of ‘Third Country Equivalence’ in Post-​Crisis Financial Services Regulation in the European Union.” West European Politics 38(1): 167–​184. Rawlings, P. 2013. “Fund Groups Press CFTC on ‘U.S. Persons.’” Compliance Reporter, February 8. Rosen, E. 2009. Statement of Edward J. Rosen, on behalf of Securities Industry and Financial Markets Association. House Committee on Agriculture Hearing to Review Derivatives, 111th Cong., February 4. https://​www.gpo.gov/​fdsys/​search/​pagedetails.action;jsessionid=hLGnNydTTb 2kVbZHlsq J5MHmFglMpzhRW15ttlnP38Bfyks6pp5Z!-​1180590231!-​937038866?st=credi t+derivatives&granuleId=CHRG-​111hhrg51698&packageId=CHRG-​111hhrg51698. Rundle, J. 2015. “Regulators Cast Shadow on US-​EU Recognition Hopes.” Financial News, March 26. Scheid, B. 2010. “Foreign Exchanges Eyeing CFTC Proposal Closely.” Megawatt Daily, November 15. Schmidt, R., and S. Brush. 2013. “Banks Said to Seize ‘Footnote 513’ to Keep Swaps Private.” Bloomberg, October 22. Simmons, B. 2001. “The International Politics of Harmonization:  The Case of Capital Market Regulation.” International Organization 55(3): 589–​620. Singer, D. 2004. “Capital Rules: The Domestic Politics of International Regulatory Harmonization.” International Organization 58: 531–​565. Stafford, P. 2014. “US Swaps Trading Rules Have ‘Split Market.’” Financial Times, January 21. Sullivan & Cromwell LLP. 2011. Letter to the SEC, RE:  Proposed Rule Relating to Further Definition of “Swap Dealer,” “Security-​Based Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant.” February 22. https://​www.sec.gov/​comments/​s7-​39-​10/​ s73910-​60.pdf. Trindle, J. 2012. “U.S. May Give Way on Swaps Rules.” Wall Street Journal, December 12. Tsingou, E. 2006. “The Governance of OTC Derivatives Markets.” In The Political Economy of Financial Market Regulation:  The Dynamics of Inclusion and Exclusion, edited by P. Mooslechner, H. Schuberth, and B. Weber, 89–​114. Cheltenham, UK: Edward Elgar. Walter, E. 2013. “Regulation of Cross-​Border OTC Derivatives Activities:  Finding the Middle Ground.” American Bar Association Spring Meeting, Washington, DC. April 6.  https://​ www.sec.gov/​news/​speech/​2013-​spch040613ebwhtm. Wetjen, M. 2014. “Acting Chairman Mark Wetjen’s Keynote Address to the 39th Annual International Futures Industry Conference:  The Necessity for Global Harmonized Derivatives Regulation.” March 11. http://​www.cftc.gov/​PressRoom/​SpeechesTestimony/​ opawetjen-​7. Wheatley, M. 2013. “Future into Focus.” Speech by Martin Wheatley, Chief Executive, the FCA, at the International Swaps and Derivatives Association (ISDA) Conference, London, September 19. https://​www.fca.org.uk/​news/​speeches/​future-​focus.



4

Power Plays from the Fringe East Asian Responses to Derivatives Regulatory Reform Yu-​wai Vic Li

At the global market’s fringe, OTC derivatives trades in East Asia account for around 8% of the global notional outstanding in 2014. The figure, however, belies the fast-​paced market growth after the subprime credit crisis. Notional outstanding jumped from USD 65 to USD 89.7 trillion between 2008 and 2012; Japan alone saw a 50% surge from USD 28.4 to USD 47.1 trillion. Trading volume similarly increased from USD 272.2 to USD 319.1 trillion in the same period. Foreign exchange (FX) products were the most actively traded, witnessing 80% of the turnover growth after the 2008 crisis and accounting for 76% of the region’s turnover in 2012. Interest rate derivatives took a distant second place (18%), followed by the tiny commodities (3%), equity linked (2%), and credit instruments (1%).1 Indeed, East Asia markets have become an increasingly important player in the global derivatives market and regulatory reform. Consider, for example, the increase of the region’s share of global FX transactions to 26% in 2016, upped from 20% in 2010. All five G20 member states in the region have implemented at least parts of the global reform agenda; Singapore and Hong Kong also voluntarily endorsed the G20 reform commitments.2 More important, Asian states’ responses to reforms of the leading powers (i.e., the United States and European Union) were critical to the successful implementation of the reforms since Western dealers have for years dominated the region. International political economy (IPE) researchers have mostly overlooked the political dynamics underlying the market trends, with focuses on the

  Calculation based on Celent Securities and Investment Team 2013; Ray 2013a, 2013b; Bank of Japan 2015. 2   The five, are namely, Australia, China, Japan, Indonesia, and South Korea. For details, see FSB 2016. 1

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regulatory development of international SSBs and the leading powers.3 On the other hand, regional specialists have attended to the unevenness of regulatory outcomes, or paid little attention to derivatives markets because of their small share in the national financial systems, often seeing the underdevelopment of the derivatives market segments as a blessing to the region. These neglects are partly understandable, since the US and European blueprints have dominated the development of global reform agendas. Despite the fact that East Asian states were brought into the G20 and SSBs shortly after the crisis, and regional jurisdictions with sizable derivatives markets, including Japan, Singapore, and Hong Kong, are present in the FSB and IOSCO, they have fallen short of shaping the larger regulatory framework. This, however, neither suggests an absence of political responses in the region nor complete regulatory fragmentation along national lines that has splintered the region from the global market. Indeed, as East Asia translated the G20 commitments into the national contexts and faced pressures from the leading powers to align the local frameworks with theirs, the Asian regulators have shown markedly different policy outlooks than their US and EU counterparts. The fact that Asia has never been an epicenter of derivatives-​triggered crises and the surging demands of the financial instruments at home have encouraged the region’s regulators to promote local market growth in concert with private financial interests. These have resulted in a flurry of responses, including vocal petitions opposing indiscriminate implementation of Dodd-​Frank and EMIR, calls to defer adoption of guidelines and seek exemptions from new market standards developed by international SSBs and leading powers, as well as more proactive moves aimed at blending the new international standards with local (national) ingredients, and outfitting domestic markets with infrastructures expected within new market standards. Such a diversity of reactions can hardly be explained by the fact that the region consists of a dozen jurisdictions with no region-​wide platform promoting harmonization.4 This market-​centered perspective of seeing the development of national rules largely in a political vacuum veils a multiplicity of interests in the region and its leading jurisdictions, and in the material and political concerns   See the review of Helleiner, Pagliari, and Spagna, in this volume. The capital and margin requirements of non-​centrally cleared derivatives have been developed by the BCBS and IOSCO. The latter also works with the Committee on Payments and Market Infrastructures (renamed from the Committee on Payment and Settlement Systems [CPSS]) in supervising the progress of development of the clearing and reporting regimes in accordance with the Principles for Financial Market Infrastructure (PFMI) released by the two bodies in April 2012. 4   These include economies with advanced and mature derivatives markets, including Japan, Hong Kong, Singapore, Australia, and New Zealand, as well as China, South Korea, and Southeast Asian states with relatively small market scales (in terms of notional outstanding and turnover). 3





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evident in the process of adapting to new regulatory environments.5 Equally, the political argument that the “emerging economies” (a label applied to most East Asian jurisdictions) are largely “rule-​takers” with little agency to shape the regulatory contours is undermined by the reality.6 To make sense of these seemingly complex developments, this chapter analyzes the inter-​state and domestic political dynamics, and argues that the East Asian states have engaged in a quest for and exercise of “power as autonomy” with the goals to foster domestic derivatives market growth and their competitive advantage in a region of rapidly growing derivatives trades. Specifically, this exercise of “power-​as-​autonomy” has evolved in two dimensions. As parts of the defensive move to circumvent pressure from the US and EU authorities, the Asian states reacted collectively to resist and mitigate the impact of the global reforms on local markets. They have leveraged the influence of Asian-​based US and European dealers whose business interests in Asia would likely have been severely compromised by the US and EU standards and exploited transatlantic divergence on seemingly technical matters. These helped hedge the impacts of extra-​regional regulatory burdens but represented only half of Asia’s power-​as-​autonomy in the derivatives market segment. To promote local market growth, individual jurisdictions also scrambled to develop their own governing frameworks that would best allow national regulators to retain control over market participants and processes, and to create regulatory environments that would best position domestic financiers to compete in the fast-​growing regional derivatives markets. This quintessentially inter-​state competitive dynamics were enabled by two unique domestic conditions in Asian jurisdictions—​low political salience of derivatives regulation and lobbying of private financial interests that sought to expand their derivatives trades and offer exclusive clearing and reporting services to counterparties. Both helped insulate the issue related to derivatives regulation from public scrutiny, making possible the flexing of policy and political autonomy by the national regulators. As such, the region has shown delays and inconsistent contents during the implementation of the global agendas. Conflicting requirements have emerged in leading Asian states that resulted in a fragmented terrain in clearing and reporting—​the two important pillars of global new derivatives regulation—​that would suggest more unevenness across jurisdictions. This does not bode well for the derivatives market reforms envisioned by the international SSBs and is to some extent unanticipated by leading states in their initial sketching of the global reform roadmap. While the region as a whole would see a gradual convergence toward the international standards, the subtle variations of reform pace   See, e.g., Celent Securities and Investment Team 2013; Cognizant 2014.   For a critical scrutiny of the rule-​taking roles ascribed to the emerging powers, see Chey 2015.

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and provision of national regulatory frameworks would invariably complicate the post-​crisis endeavors to govern the derivatives market, pointing to a future not considered ideal by the SSBs.7 To illustrate the argument, this chapter primarily draws on the experiences of Japan, Singapore, Hong Kong, the top three derivatives market in East Asia. Each one has established its niche in the regional and global derivatives markets and was extensively involved in the politicking earlier described. Japan constitutes a leading hub outside of the Atlantic time zones and made up 6.5% of global turnover in 2012. It was also the first jurisdiction in the region with apparently full implementation of relevant G20 initiatives. Singapore and Hong Kong, by contrast, are aspiring players of smaller scale, each capturing around 4%‒5% of global trading volume. Whereas Singapore specializes in commodities and FX derivatives trading, Hong Kong has benefited from the strong demands for offshore renminbi products and oriented toward FX and equity contracts. The next section briefly reviews the different strands of literature that have considered East Asia’s positions in the global regulatory reforms before introducing the relevance of power-​as-​autonomy as an analytical perspective of understanding the politics of derivatives regulation of East Asia. The collective responses of key jurisdictions and the inter-​state and domestic dynamics in implementing the reform agendas will then be elaborated upon.

Approaches to East Asia in Global Regulatory Reforms Studies of East Asian responses toward the global regulatory reforms have concentrated on three major topics—​(1) uneven implementation of global rules; (2) the strengthening of national and regional resilience since the 1990s Asian Financial Crisis (AFC) (often viewed through the lens of reducing the regional vulnerability to the subprime crisis); (3)  and the changing roles of emerging powers during the post-​crisis global regulatory reforms. While each topic offers important insights, they are inadequate to capture the East Asian political dynamics of post-​crisis derivatives regulation. The first strand of literature on East Asian uneven adoption of international financial standards traces the political economic determinants of implementation deviations. While early contributions usually left unquestioned the leverage of leading powers in extracting the compliant behavior of other economies, and unduly overlooked the domestic politics of the adopting states, post-​AFC   Helleiner 2014c.

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studies have turned to interrogate how domestic determinants shaped national uptakes of global regulation. Andrew Walter explains the variation of implementation outcomes in Asian states with reference to the ease of third-​party monitoring and private-​sector compliance costs. Hyoung-​kyu Chey analyzes the political conditions in which cosmetic compliance would arise, including divergence of the national regulator and SSBs’ preferences and incapacity to handle severe compliance failure.8 The focus on incomplete implementation, while rightly stressing the importance of the domestic context, draws attention away from the gradual convergence among the leading Asian jurisdictions toward the global derivatives regulation framework at uneven paces from the late 2000s. It also overlooks the evolving power plays at both national and regional levels in response to the changing regulatory frameworks of the leading powers. Further, there were important differences between the much-​studied area of banking supervision in this cluster of literature and the evolving derivatives regulation in East Asia. Whereas in banking supervision the national regulators confronted mostly domestic banks that dominated local markets and that were in need of an improvement to their financial positions, the Asian derivatives markets were seen to pose little harm to national regulators and have been populated with foreign dealers and financial firms that acted as counterparties, or providers of specialized services. In fact, the region had been immune to the market incidents triggered by derivatives trading before and during the subprime crisis, seeing the crisis largely as an external one, since most economies had escaped the destructive forces of derivatives.9 As a result, derivatives market reform had not acquired high political salience when compared to other post-​crisis regulatory agendas, such as the international monetary system reform. This also distinguished East Asia from the United States and Europe, where the derivatives reform had found a place on the high political agenda and spurred extensive public debate. The second set of research contrasts the experiences of Asian economies during the AFC and the subprime crisis and the emergence of regional financial mechanisms that contributed to the region’s resiliency in the midst of global   Walter 2008; Chey 2006, 2014.   Although Singapore and Hong Kong were affected by the Lehman Brothers’ “minibonds,” the multi-​layered credit/​interest swaps that had gone default immediately after the bank’s downfall and incurred losses to thousands of retail investors, subsequent investigations of regulatory failures and lawsuits against the distributors after Lehman’s bankruptcy had not triggered intense political outcries. Similarly, South Korea experienced what is known as the “knock-​in, knock-​out” incident of OTC currency options in 2008, resulting in massive losses of domestic small and medium enterprises. Yet given the tiny OTC market (0.8% of global trading volume), as compared to the exchange-​traded derivatives segment handling 20% of the global turnover in 2012, the incident did not generate serious concerns among local investors. For details, see Ewins et al. 2010; Ray 2013b. 8 9



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market volatility. The strengthening of financial regulations, for example, is seen as protecting the region from the subprime fallout.10 These studies, however, have often assumed that Asia was on the sidelines during global regulatory reforms and had little influence on the agendas advanced by the SSBs and leading powers where the global crisis erupted. This has led to a neglect of the impact of the global reforms on East Asia, and the region’s responses to SSBs’ initiatives. Rarely these studies have touched on derivatives market development and regulatory trends. The region’s “financial backwardness” and the “conservative” risk management style are seen to have helped insulate the spillover of toxic derivatives products originating from the leading powers,11 and effective regulation of FX derivatives was a means to manage capital volatility, with South Korea being a prime example in East Asia.12 However, the supposed differences in the levels of financial development and risk appetite between East Asia and the United States and Europe are untenable on closer inspection of the market trends, and the keen interest of Asian dealer banks in expanding their derivatives businesses as their regulators appeared supportive of such pursuit and their US and European counterparts were forced by home regulations to withdraw from the region’s markets. The local exchanges and brokers also expected new business opportunities in offering services related to clearing trades on CCPs and keeping records at TRs. Moreover, the Asian regulators often appeared to be staunch allies with their own regulatees in efforts to push back initiatives that might constrain business opportunities. As such, contrary to the view that Asian regulators were born risk-​averse to exotic financial instruments like OTC derivatives, they have actually displayed preferences markedly divergent from the United States and Europe in derivatives regulation. While financial stability did remain their primary concern, the moderate market size of Asia’s derivatives markets and strong growth potential afforded the region’s regulators to assume a market-​ friendly outlook and be receptive to the lobbying of financiers and supportive of derivatives market growth. The final stream of studies analyzes the roles of East Asian states in global regulatory debates since the mid-​2000s. A large part of these studies distinguish rule-​taking Asian states from the rule-​making and rule-​setting leading states. For example, the assessments of Andrew Walter and Saori Katada saw China and Japan as behaving cooperatively in global regulatory deliberation.13 There are, 10   MacIntyre, Pempel, and Ravenhill 2008; Arner and Schou-​ Zibell 2011; Pempel and Tsunekaka 2015. 11   See, e.g., Tsunekawa 2015; Kawai and Prasad 2011. 12   Walter 2010; Gallagher 2015. 13   Walter 2010; Katada 2010.





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however, few efforts to understand the nuanced roles and power leverage of the Asian powers in the different phases of global financial regulation. Indeed, the trend of relegating Asian states into rule-​taking roles is not without challenges. Chey has recently argued that the involvement of emerging economies in international SSBs has not only incentivized their compliance through exposure to monitoring pressure (i.e., taking rules) but also helped enhance the preference for compatibility between economies and international rule-​setting bodies even if they have been merely “insider passive adopters.”14 This suggests that while the regulatory preferences of international bodies (and leading states) might initially diverge from those of the emerging powers, there is the possibility that they might be drawn closer over time. On the other hand, advances in the study of international monetary relations have examined how Asian states have sought power-​as-​autonomy, a pursuit or an exercise of policy independence in order “to act freely, insulated from outside pressure in policy formulation and implementation.” This kind of power stands opposed to “power-​as-​influence” that concerns behavioral change of others.15 The growing reserve use of renminbi, for example, has been conceived as a strategic move of the Chinese authorities to offer new policy options available to foreign governments and investors, and to enhance economic autonomy from the USD-​dominant currency system.16 Kevin Gallagher also analyzes the emerging powers’ exercise of “countervailing monetary power” through strategies like coalition building or exploiting cleavages of global institutions, which helped create policy space for enacting capital controls in coping with the cross-​border capital volatility in the late 2000s.17

Power-​as-​Autonomy in Regulating Derivatives These recent contributions have shed light on the interplay between the leading and emerging states in the realm of monetary affairs, but the power dynamics between East Asian states, leading states, and international SSBs in financial regulatory reforms has remained a little-​explored area. In the financial domain, emerging economies have taken defensive efforts to create policy space so as to shield themselves from the influence of multilateral rules governing the global markets.18 This defensive use of financial statecraft,   Chey 2014, 2015.   Cohen 2006; Helleiner and Pagliari 2011. 16   Chin 2014; Kirshner 2014. 17   Gallagher 2015. 18   Armijo and Katada 2015. 14 15



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however, could also extend beyond the “systemic” context as Leslie Armijo and Saori Katada conceived. To be sure, the leading states have dominated the development of regulatory agendas and some of the preferences of Asian states were not entertained in the early sketches of the global frameworks.19 Yet this does not imply that Asian states were entirely “powerless” in adjusting to the new regulatory environment. Indeed, as East Asian jurisdictions endorsed the G20 reform agendas, they met the implementation challenge in order to fulfill their commitments to global reform and faced pressures from the leading powers to align domestic regulations with theirs such that there would be few regulatory loopholes or arbitrage opportunities across the different regions. The East Asian states, however, could not afford to comply entirely with the US and EU standards, not only because of the growing demands for derivatives in the region but also due to the pressures exerted by local dealer banks and brokers as well as bourses keen to venture into the clearing and reporting services. In an effort to maintain the market interests at home and competitive edges in the global marketplace, they have quested for and to some extent attained political and policy autonomy during the implementation phase of the derivatives market reform. This capacity was enhanced not only by the considerable policy and technical complexity of the underlying issues but also the disagreements between the leading states and the varying preferences of the financial industry players at play.20 In such a fluid environment, the Asian states were able to employ several strategies that have helped push back the demands of the United States and European Union. These endeavors entailed two dimensions: (1) resisting pressures from and minimizing the impacts of the leading powers; and (2) affirming controls over domestic derivatives markets as they took up the G20 derivatives agendas. The first dimension was primarily defensive in nature, involving hedging acts that sought to mitigate the adverse impacts of the reforms of leading states. The second dimension entailed proactive moves that boosted domestic market growth through a partial and selective implementation of the derivatives reforms without deviating from the commitment to the G20 agendas. This resulted in delays and inconsistencies of domestic rules but has served the post-​ crisis era interests of both the domestic regulators and financiers. In general terms, these moves reflect an exercise of power-​as-​autonomy of East Asian states in financial regulatory affairs for purposes other than reducing dependence on the leading powers and (partial) insulation from the external   Chey 2015.   See the volume’s introductory chapter for an overview of the many political and market players involved. 19 20





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markets (as observed in the monetary domain). They are unrealistic options especially since no Asian jurisdictions could afford to be completely cut off from the global capital pool and financial expertise concentrated in the hands of the US and EU dealer banks. The Asian states also lacked the sophisticated regulatory expertise necessary to counter the US and EU regulations with an alternative roadmap or any material basis to make a credible threat of market closure to resist the leading power’s regulations. So, while they embraced the G20 agendas and sought to promote domestic market development, they also needed to mindfully manage existing connections with US and EU financiers (and the extraterritorial reaches of Dodd-​Frank and EMIR). The next section discusses these inter-​state dynamics before turning to the domestic settings.

Pushing Back the Leading States Despite their apparent commitment to the G20 agendas, the East Asian regulatory authorities saw the introduction of Dodd-​Frank and EMIR essentially as an imposition of regulatory power over national authorities (i.e., the extraterritoriality issue). This generated their collective responses, calling on the international SSBs and leading powers to develop general principles acceptable to the region’s markets before they turned to develop the domestic legislation.21 While this yielded mixed results, they have more effectively resisted pressures from the United States and European Union through leveraging the influence of foreign firms with extensive derivatives businesses in the region and manipulating the unresolved transatlantic disagreements. As the G20 2012  year-​end deadline was approaching, regulators making up the OTC Derivatives Working Group (ODRG) ( Japan, Singapore, and Hong Kong included) gathered to discuss their concerns about the impacts of cross-​border supervision, and explore arrangements for avoiding duplicative or conflicting rules, such as mutual recognition and exemption to substitute for compliance decisions. This resulted in some agreements, notably the treatment of the regulatory gap and the “stricter-​rule-​applies principle.”22 Yet the “Path Forward” announcement between the US and EU authorities in July 2013 raised further questions about the basis of determining which rule was stricter, and whether the principle applied to the overall regulatory regime or just certain kinds of counterparties.23   Vaghela 2015a.   Australia, Brazil, the EU, Ontario, Quebec, and Switzerland also participated in the meetings. See ODRG 2013. 23   Sawyer 2013. 21 22



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The little progress in resolving the extraterritoriality issue spurred considerable concerns among the Asian regulators about the regional market outlook. In addition to eroding rule-​making autonomy and incurring competitive disadvantages for Asian financiers that were less financially sound and sophisticated than their US and EU counterparts, derivatives transactions between US and European dealers and local end-​users would face increased regulatory complexity or higher capital charges if the local regulations were not recognized by the United States and European Union. These risked a “deglobalization of finance to regionalism” dominated by leading powers and further marginalizing the Asian market.24 On the market front, Asian Securities Industry and Financial Market Association (ASIFMA), the region’s largest industry association with over 70 members, including leading banks and brokers, was especially wary of the impacts of US and EU initiatives on capital market development and industry interests. Mark Austen, ASIFMA’s chief executive, warned that the Western OTC reforms were poised to “destroy” the Asian markets before they reached maturity.25 In 2015, 55% of ISDA-​surveyed respondents saw regulatory fragmentation as underway and predicted that the complexity in Asian markets would significantly increase transaction costs and uncertainty across the entire region.26 Another industry survey conducted in March 2016 revealed a worsening of liquidity condition in the region after US and EU regulations were introduced, and that a majority of Asian end-​users perceived these foreign clearing and reporting requirements as the biggest challenges to the regional market development.27

Enhanced Political Leverage from Foreign Dealers In response to these looming possibilities, the Asian derivatives regulators pressed the United States and European Union for clarification of the approach and scope of its extra-​territorial rules. Their leverage was strengthened by US and EU dealer banks who felt pinched by their home regulations, especially provisions pertaining to businesses with third country counterparties. As local derivatives users were unsure of, or tried to avoid the CTFC rules when entering into transactions with US counterparties, they turned away from US dealers and switched to European or local firms that were not yet been bound by their home regulations.28 This led to a notable decline in swap trading with US dealers   A. Lee 2013a.   Grant 2013; Vaghela 2015a. 26   Maxwell 2015. 27   ISDA 2016a. 28   Steinbeck-​Reeves 2013. 24 25





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and forced US financials to consider spinning off local businesses as subsidiaries, cutting legal links with the parent companies, so as to insulate their Asian derivatives activities from Dodd-​Frank rules that applied to overseas branches of US banks.29 Goldman Sachs, for example, formed a subsidiary in Hong Kong; other investment banks planned to follow. Industry associations like ISDA and SIFMA, the US counterpart of ASIFMA, launched a lawsuit challenging the legal standing of CFTC cross-​border rules. Although the case was dismissed by the US courts, these were welcomed by Asian regulators and dealers who also sought to “dodge” Dodd-​Frank whenever possible.30 In a series of collective and individual letters sent to US authorities, the Asian regulators complained about the unrealistic swap-​dealer registration requirements for non-​US parties and the elastic definition of a “US person”—​a critical and contestable issue that raised much confusion about exactly which market entities would fall under the CFTC rulings. They also laid out analyses of different reconciliation proposals and substituted compliance was repeatedly raised as a preferred arrangement.31 The regulators’ petition and pressures from US firms bore fruit after a series of meetings with the CFTC. The CFTC moderated its position, granting a time-​ limited exemption from complying with the Dodd-​Frank provisions to non-​US swap dealers and issuing guidance that allowed the CFTC to recognize substituted compliance by foreign jurisdictions if they maintained comparable laws and regulations. The first set of comparability determinations was announced in December 2013, in which six jurisdictions (including Australia, Hong Kong, and Japan) gained “entity-​level” determination; Japan and the European Union also received “transaction-​level” recognition. It should be noted, however, that these jurisdictions were not entirely free from the impact of Dodd-​Frank. Although the CFTC maintained that comparability was determined on an outcome basis, it did not compromise on clearing, leading to a different kind of inter-​state political dynamic that will be discussed later.32 As the Asian authorities scored some success in mitigating the impact of US extraterritorial rules, their pushing back of the EMIR began to take more priority. In their assessment, the European approach of addressing the equivalence question was far more demanding than the US regime. Unlike Dodd-​Frank,   Davis 2013.   Vaghela 2014e. 31   Hall 2015. 32   Entity-​level determination looks at whether the swap dealers have met the expected regulatory obligations of the CFTC, such as proper risk management, data keeping, and monitoring of position limits. Transaction-​level requirements concern the process by which trades are handled, including trading relationship documentation, portfolio reconciliation and compression, and keeping daily records. Linklaters 2014. 29 30



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which granted the CFTC authority to make decisions regarding comparability of foreign rules with those of the United States, the EMIR adopted a different approach that assessed whether foreign jurisdictions as a whole had developed equivalent rules to those governing the EU member states. This essentially amounted to an “all-​or-​nothing” regime in which the Asian jurisdictions might be unfairly assessed according to the benchmarks evolved in the European context. Especially disturbing to them were the many “discriminatory” exemptions that favored European firms and end-​users. EMIR, for example, exempted some European end-​users from a range of obligations like margin requirements for uncleared contracts.33 Moreover, the European financial institutions operating in Asia, which provided vast liquidity to Asian end-​users, had seen a sharp shrinking of their businesses in the Asian markets in view of the forthcoming European regulations. The Japanese regulator and banks threatened to find alternatives if the bilateral margining rules on third-​country entities were to be introduced without amendments.34 Indeed, except in the clearing and reporting regimes, where European authorities had showed some willingness to negotiate with the Asian states (resulting in the first recognition decision extended to non-​EU CCPs in 2015), the adamant defending of the equivalence approach and lack of regional outreach by the European Securities and Markets Authority (ESMA) had frustrated its Asian counterparts. As one commented, “I don’t always agree with the CFTC but at least I know who to complain to when I don’t like their rules.”35 These triggered strong complaints in an attempt to obtain a compromise with the European Union. In a letter to the European Commissioner, the region’s regulators maintained that the EU standards were “not relevant, appropriate or even feasible” to Asian CCPs. Clearly aware of the damaging impacts of the EMIR rules on European dealers, the Asian regulators also warned the European Union that “contraction of market liquidity will directly impact on EU established financial institutions and subsidiaries carrying on business in the Asia-​Pacific region.”36

Exploiting the Leading State’s Divides Besides resorting to leverage of market participants, the Asian authorities exploited the transatlantic disagreements over implementation details. This strategy has worked well in defending their clause to postpone application of   International Financial Law Review 2013.   Vaghela 2014d. 35   Woolner 2013. 36   Grant 2013; Vaghela 2015a. 33 34





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extraterritorial rules, notably because the Asian states largely endorsed the general reform principles of the G20, but there have been continuing disagreements over specifics concerning the more technical facets of derivatives reform, such as margin and capital requirements and electronic trading platforms. With regard to margin requirements of non-​cleared derivatives, the Asian regulators stated that the region could not address the matter until the United States and European Union finalized their uncleared margin levels and evened out their own differences throughout their negotiations with the BCSB and IOSCO. They took a wait-​and-​see approach in the face of a G20 2015 year-​end deadline for introducing home margin requirements and pressed for exemptions for foreign exchange transactions settled physically.37 The second demand gained ground, especially when the CFTC maintained a waiver of FX swaps and forwards not only for clearing obligations but also for higher margin levels. This deviation from the European Union and BCSB and IOSCO’s expectations provided a sound rationale for Asian authorities to expect their views to be treated in more or less the same way that the United States had. Attempts of the US Congress to scale back some of the margin requirement provisions of Dodd-​ Frank also generated uncertainties to the benefit of the region’s regulators who were unwilling to act on the issue.38 In fact, the recourse to disagreement between the leading powers proved to be effective, as BCSB postponed the global margin requirements from March 2015 to September 2016. Although this worried some derivatives dealers in the region, the Asian states considered this decision a victory to slow down the global reform.39 Whereas Japan followed the US and Canadian implementation schedule of introducing margin requirements in September 2016, Australia, Singapore, and Hong Kong kept postponing their actions until early December when the three national regulatory authorities released on the same day margining rules that would be in alignment with the BSCB-​IOSCO deadline of March 2017.40 As for electronic trading platforms (ETPs), although the CFTC declined to offer comparability determination scheduled to be put in practice in late 2013 that led to vocal East Asian opposition, the region’s regulators were also aware of the different expectations of Dodd-​Frank and EMIR, specifically the reporting requirements and level of discretion the platform operators had in practice.41 This technical divergence not only raised questions over which model Asia   Noyes 2014.   Gallagher 2015: 163–​165. 39   Vaghela 2015d. 40   FSB 2016; Madigan 2016. 41   Stafford 2014a; Vaghela 2013b. 37 38



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should follow when designing theirs, it also spurred calls to defer the implementation of ETPs in Asian jurisdictions. In a petition issued through the IOSCO’s Asia Pacific Regional Committee (comprised exclusively of the region’s securities regulators), they appealed to the CFTC to adhere to its previous commitment to a collaborative approach endorsed in the Path Forward roadmap, or risk fragmentation of liquidity across jurisdictions.42 In fact, a few months after the SEF was introduced, interest rate swap (IRS) trade between the United States and European Union dropped 77% according to ASIFMA, heightening the divide between the US and EU authorities. This led to a temporary measure in the form of CFTC no-​action relief, which permitted US firms to trade with European ETPs not registered with the US authorities. While this did not settle the issue, it did provide space for the East Asian states to defer the mandate until the leading powers came to an agreement. As an ISDA official explained: “Past experience shows there is little to be gained by moving ahead of US and European regulation. So, to preserve flexibility, most Asia-​Pacific regulators will likely prefer to wait for US and European rules to be finalised before drafting their own rules.”43 In the meantime, the Asian clients were trading with subsidiaries of US dealers based in the European Union that had waivers exempting them from SEF rules, and they showed no intent to follow the CFTC framework.44 These maneuvers of Asian states, however, were largely defensive in nature and served to minimize the regulatory impacts of the US and EU initiatives. In part, their success represents a suboptimal and unintended consequence of the regulatory bilateralism between the United States and European Union as Posner examines.45 Other than obtaining CFTC’s comparability decisions, delaying the margin requirements, and introducing ETPs, the pushing back also encountered unyielding responses. In order to fulfill their commitments to the G20 agendas and advance their interests in derivatives markets, the Asian regulators have devoted considerable efforts to building requisite infrastructures and obtaining recognitions from the leading powers.

East Asia Embraced “New” Finance The defensive power plays of Asian states mitigated the adverse impacts of US and EU reforms, providing the critical policy space for the drive of national   IOSCO Asia Pacific Regional Committee 2014.   Noyes 2014. 44   Vaghela 2013a. 45   Posner, in this volume. 42 43





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regulators to foster derivatives market growth as they attempted to “localize” the G20 reform initiatives in their own fashion. Their maneuverability at home was in part contributed to by distinctive political conditions dissimilar to the United States and European Union. First, there has been a much narrower degree of “public-​ness” of derivatives regulation in the domestic arena, where dealers and financial firms accounted for over 90% of the region’s total turnover in 2012.46 The low degree of political salience, however, not only implied an indifference toward derivatives regulation among East Asian publics, the regulators also face little legislative scrutiny and challenges from other bureaucratic players whom either lacked the policy expertise to oversee the matter or showed little concern about the issue. Second, enabled by a relatively high level of policymaking and political autonomy, the regulators reacted to and enacted policies in favor of the domestic financial interests, notably the local stock exchanges and banks, who sought respectively to capture the lucrative clearing business and compete with their foreign counterparts for derivatives product development.47 These private interests complemented the national regulators’ pursuits to foster derivatives market growth and resist foreign pressure, resulting in a scramble among Asian jurisdictions to launch local CCPs and TRs in spite of the lack of relevant regulatory frameworks and unresolved operational concerns about the governance of these new market nodes. As a result, while most Asian clearing and reporting hubs operate as de jure private entities, all were founded with the backing of the national authorities, who viewed the national CCPs and TRs not just as “symbols of modernization”48 but also as platforms that affirmed the regulators’ oversight of domestic financial conditions and flows of capital and trade data. This applies even to Japan—​Asia’s largest derivatives market with a notable record of implementing the G20 agendas ahead of the United States and European Union. As early as May 2010, the Japanese Financial Service Authority ( JSFA) had already obtained the legal basis to regulate clearing and reporting activities. Mandatory clearing was effective from 2013—​five months ahead of the US implementation schedule. But in view of substantial market demand for CDSs, the JFSA was inclined to concentrate all onshore clearing with the two leading domestic clearers, the Japan Securities Clearing Corporation ( JSCC) and Tokyo Financial Exchange. In the words of an analyst, “clearing for complex derivatives is more profitable than equities clearing, so are a potential growth   For analysis of the US and European contexts, see Helleiner 2014a.   It is plausible that these financial interest groups align differently in different derivatives product categories. But due the chapter’s focus on jurisdiction-​level responses and length limit, they would not be examined here. 48   Helleiner 2014b: 146. 46 47



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opportunity [for the two domestic CCPs].”49 The plan invariably invited challenges from CFTC, who saw discrimination against foreign clearinghouses, arguing that creating a regional CCP would compromise the operational efficiency of the US and EU clearinghouse. But the Tokyo-​based bourses saw otherwise and pressed on with the plan, launching the CDS clearer in July 2011.50 In another instance, JFSA encouraged talks to promote interoperability between the Japanese platform and the London Clearinghouse (LCH) in order to tap the latter’s expertise in interest rate products. The talks broke down, however, in late 2011 after JFSA’s decision to restrict LCH’s onshore yen-​ denominated derivatives clearing business to overseas subsidiaries of Japanese firms.51 Short of the partnership, the JSCC remained committed to the project and this was welcomed by the JFSA, since a Japanese-​operated CCP would ensure all domestic transactions falling under the regulator’s oversight and banks could access the clearing services locally in the local currency (and without posting margins to foreign clearers). As an official explained: “If economics was the only thing we were to consider, maybe fragmentation would not occur. But in the current environment, politicians and regulators in every country have noted that the last resort in any crisis is the domestic taxpayer. That means regulators feel the responsibility.”52 In fact, the expanding business of JSCC has helped the growth of the onshore derivatives market. Together with local dealer banks, the clearer ventured into new CDS products in order to attract the much larger pool of domestic corporate users who got used to transactions without clearing. This evidently succeeded, with the total number of CDS contracts spiking eight times after 2011.53 Singapore and Hong Kong, the two smaller markets after Japan, endorsed some of the multilateral agenda but have taken a rather flexible approach in implementation such that the reform would not undermine their market niches and hamper market development in response to financiers’ growing interests in specific derivatives market segments. In Singapore, a clearing facility for commodities and FX was created years before the subprime crisis in order to consolidate the city’s position as the leading hub in Southeast Asia for commodities and FX trading. Shortly after the G20 Pittsburgh resolution in 2009, the Singapore Exchange (SGX) extended clearing services for IRS and non-​deliverable forwards of multiple currencies in the next year.54 A TR was also set up for all asset   Lindsay 2009.   Jaidev 2011. 51   Stafford 2014c. 52   Jaidev 2011. 53   Acworth 2012; JSCC 2015. 54   Acworth 2012. In 2012, 60% and 43% of commodities and FX derivatives turnover in Asia ex-​ Japan were concentrated in Singapore, see Celent Securities and Investment Team 2013. 49 50





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classes, including a commodity register that was uncommon in other regional markets. In order to maintain the primacy of the SGX in the clearing business, the authorities repeatedly postponed entry of foreign competitors until late 2014 when the SGX dominated the market.55 Equally, clearing and reporting has remained mostly voluntary as the Monetary Authority of Singapore (MAS) was yet to finalize the legislation after multiple consultations with the financial community. In an effort to maintain the city-​states’ competitive advantage in commodities and FX derivatives trades, the MAS has introduced a number of exemptions since mandatory reporting was introduced in October 2013; its latest proposal suggested only mandatory clearing for specific interest rate derivatives while leaving out the commodities and FX species.56 The Singaporean authorities also appeared to capitalize on the city’s “regulatory lag” so as to make room for local dealers to attract Asian end-​ users or financials who wanted to avoid the pertinent Dodd-​Frank and EMIR provisions.57 The exemption of energy and commodities in clearing, for example, was widely seen to serve the interests of Singaporean dealers who were handling an increasing share of the contracts in the region but were reluctant to join international CCPs recognized by the US and EU authorities. This included DBS, the largest bank in the city and Southeast Asia, who displayed little interest in keeping track of US regulations and pulled back from the US market to avoid being sucked into the CFTC rules.58 Similarly to Singapore, the Hong Kong Monetary Authority (HKMA) and Securities and Future Commission (SFC), the de facto central bank and securities regulator, contemplated the regulatory framework while the city’s niche in derivatives markets matured. The HKMA developed a TR in December 2010 with a link that connected exclusively with the OTC Clear, a CCP housed in the Hong Kong Exchange (HKEX), the government-​majority-​owned bourse. Interim reporting requirements were introduced in 2013 to ensure that transactions were reported to the TR.59 As in Singapore, the clearing and reporting regimes were crafted to cover only the IRSs and non-​deliverable forwards (NDFs), the less-​traded species, as opposed to other FX products that made up about 58% of the city’s derivatives market. It would only be until July 2017 that mandatory clearings of IRSs and NDFs would take effect, and reporting requirements apply to all OTC derivative transactions in Hong Kong.60

  The Trade 2015.   MAS 2015. 57   Brown and Grant 2010; Brinded 2010. 58   Johnson 2014: 604. 59   ISDA 2017: 57–​65. 60   Ibid. 55 56



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This served to minimize the impact on the largest market segment and enabled dealers and brokers to introduce offshore renminbi products, a distinctive competitive edge promoted by the HKMA and SFC in order to outcompete regional rivals with fast-​growing renminbi businesses. A 2014 consultation to expand the FX products species mandatory for clearing and reporting was a light-​touch response as their reporting is set to be voluntary until 2016 and exemptions should be given to local entities.61 And to ensure the first-​mover advantage of OTC Clear in the clearing business, the authorities have shied away from licensing foreign CCPs, citing the risks of offshore clearinghouses handling domestic products; all renminbi-​denominated products were to be cleared by the HKEX-​owned clearing platform.62 The “gateway” strategy of betting on the expanding offshore footprint of the renminbi proved successful. HKEX and offshore subsidiaries of Chinese banks benefited from new products linked with renminbi. The OTC Clear became the first CCP worldwide to clear cross-​currency swaps such as the USD-​renminbi pair, on top of its main business in IRSs and renminbi NDFs in August 2016.63 Several weeks later, the SFC finally licensed three foreign clearinghouses with an ostensible goal to “provide a variety of choices for market participants.” The city’s edge in equity derivatives, totaling one-​third of the Asia (excluding Japan) turnover, was also reinforced by demands among foreign investors looking for exposure to China’s equities in the offshore market.64 It is worth noting that Asian jurisdictions with smaller market turnovers shared the same tendency to foster derivatives markets. While some did not build their own CCPs, this was often because of the lack of economies of scale and specialized expertise in managing the platform. Taiwan, for example, was initially reluctant to consider a national clearinghouse, worried that fallouts of CCP malfunctioning would destabilize the whole financial system. But it soon changed its view as offshore renminbi derivatives businesses were sliced up between Hong Kong and Singapore, and a deal with China to step up financial cooperation was concluded in 2013. China and South Korea had their CCPs clearing a small range of products since 2014, serving mostly the local market participants.65

  Ibid.   Ibid. 63   Vaghela 2015b. The three non-​local CCPs were JSSC, LCH Clearnet, and Chicago Mercantile Exchange, see ISDA 2017: 64. 64   Price 2014. 65   Cookson 2010. 61 62





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Reconciling to Clear with Leading Powers The Asian regulators were not unaware of the problems of a region with many national CCPs and TRs. The different clearing and reporting requirements, together with divergent rules on capital structure and default management of CCPs, have alerted the US and EU authorities about the stability and interoperability of the Asian market infrastructures.66 More important, as the leading powers insisted on the extraterritorial reach of their rules, East Asian states have sought recognition of their clearinghouses from the US and EU authorities. This, however, was motivated more by inter-​jurisdiction competitive pressures than the leverage of US and EU regulatory powers. Since the Asian derivatives markets were still dependent on US and European dealers who, in turn, were the primary targets of Dodd-​Frank and EMIR, recognition from the US and EU authorities would help the Asian CCPs to maintain their existing business connections with US and EU counterparties that might relocate to other jurisdictions and to avoid the appearance of promoting regulatory arbitrage as their basis of success.67 In order for the region’s newly founded CCPs to legally clear for “US persons” (and be free from the requirement to register as DCOs with CFTC), Asian CCPs have taken two routes even though the guidelines were not available from the CFTC. In what appears to be another replay of regional “race for money,” Singapore’s SGX outmaneuvered neighboring jurisdictions by becoming the region’s first CCP to obtain the DCO status in December 2013. This surprised other regulators who saw Singapore’s move as a “coup” while they remained confused by the US stance toward, and expectations of, foreign CCPs.68 JSCC, for example, has waited for its application approval since early 2014 and has received only temporary waivers (i.e., the “no action relief letters”) from CFTC. Hong Kong’s OTC Clear took the other route and sought CFTC’s exemption from registering as a DCO, as this would save a significant disclosure of operational information that the local regulator and clearinghouse officials were unwilling to share with the US authorities. This, however, was procedurally uncertain as there was no CTFC guidance until the summer of 2015, when the Australian clearinghouse, Australian Securities Exchange (ASX), was granted the first exemption status. The success of ASX encouraged the JSCC to switch tactics and follow the approach of Hong Kong and Australia. This proved to be an easier route than obtaining the DCO status. Together with Hong Kong’s OTC Clear,   Vaghela 2014b.   Interview with HKEX and Hong Kong SFC officials, Hong Kong, July 2015. 68   Vaghela 2014a. 66 67



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JSCC received its long-​awaited exemption decision from CFTC in late 2015, making it a qualified clearinghouse to engage in transactions with US entities.69 Similarly, Asia’s leading markets reacted to EMIR’s CCP and clearing rules in a competitive fashion. To retain their eligibility to clear transactions with EU parties, nearly all Asian CCPs submitted applications to gain EU third-​country recognition despite facing ESMA’s tight deadline of mid-​September 2013 and a more complicated process. But their regulators were wary of the lack of transparency and clarity surrounding the benchmarks and process non-​EU CCPs would be assessed on. To enhance their leverage on the matter, IOSCO’s Asia Pacific Regional Committee, led by the top securities official of Hong Kong, petitioned the European Union, arguing that the EU dealer banks would face rising business costs in Asia, and that most of the Asian CCPs would serve domestic and regional markets; where EU parties were involved, their clients would be based in the region.70 In fact, Hong Kong was especially sensitive to the EMIR framework as it lagged behind Singapore and Japan in developing legislation governing clearing obligations. This raised worries that the EU-​related transactions might relocate elsewhere. However, while the Asian regulators anticipated challenges both to the immature CCPs and growth of domestic derivatives markets in the event no equivalence arrangements were concluded, they also foresaw that the European Union would face tremendous pressure from European firms that would be inadmissible to the region’s clearing regimes and therefore excluded from Asian business.71 As a result, the ASIFMA, with most European dealer banks as members, has forcefully challenged the ESMA over its requirements that non-​EU CCPs should be expected to follow the EMIR, but not the international standards prescribed by the CPSS and IOSCO that were regarded by Asian states as the “lowest common denominator” when setting up local CCPs.72 A BNP Paribus executive also observed the inconsistencies of the EMIR’s framework. In his words: “Notes on equivalence for Hong Kong and Singapore seem to be a little different from our original understanding of the EMIR structure. Equivalence was supposed to be at a jurisdictional level but the recent advice pushes responsibility for equivalence on the individual CCPs.”73 These pressures from the Asian authorities and   Thomas 2015. The ASX’s approval suggests that the CFTC would consider whether non-​US CCPs have applied the PFMI developed by BIS’s Committee on Payments and Settlement Systems (now renamed CPMI) and IOSCO. South Korea’s Korea Exchange also shared the same situation of JSCC and Hong Kong’s OTC Clear, with exemption status granted from DCO registration in late 2015. 70   IOSCO Asia Pacific Regional Committee 2013a, 2013b. 71   A. Lee 2014. 72   A. Lee 2013b. 73   J. Lee 2013. 69





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European dealers have galvanized the ESMA to consider a shift to look at equivalence of regulatory outcomes. In what appeared to be ESMA’s compromise, the clearinghouses of Japan, Hong Kong, and Singapore were recommended for “conditional equivalence” in late 2013.74 The European Commission then extended the equivalence status to the clearing regimes of Australia, Japan, Hong Kong, and Singapore in October 2014, a move applauded by the East Asian states and European banks operating in the region. Their clearinghouses were recognized as third-​country CCPs in April 2015, the first batch announced by ESMA.75 These conciliatory dynamics between the European Union and Asian powers suggest that the “market power” of leading jurisdictions is not without limit. Although it is often viewed as inducing compliance, the domestic-​oriented nature of Asian derivatives markets and their dependence on European banks curiously translated into a leverage working in favor of the Asian regulators.

Asian Regulators to Cherry-​Pick At the same time East Asian jurisdictions reconciled the local CCP rules with leading powers, they also took opportunities to cherry-​pick arrangements at the operational level that helped maintain the regulators’ control over the pace of market growth and benefit the domestic financial interests. This was particularly salient for issues of high stakes to domestic financiers and those on which the United States and European Union have yet to reach agreement. In Japan, the JFSA deviated from the best practices complied with by their Western counterparts in order to ensure that the competitive edge enjoyed by local dealers persisted. In their first compliance assessment for jurisdictions outside the United States and European Union, CPMI and IOSCO observed that while the country has incorporated the PFMI in building up the domestic clearing and reporting regimes, there were “gaps and inconsistencies [between the PFMI and domestic frameworks that] may result in ambiguous supervisory expectations for CCPs and TRs.”76 For example, Japanese banks tended not to participate in portfolio compression—​a voluntary transaction-​level process that reduced the notional exposures of contracts, as they enjoyed the higher capital

  Henderson 2013.   Following the recognition of the CCPs of the leading Asian jurisdictions, the ESMA issued a similar decision for Korea Exchange of South Korea in April 2016. See European Commission 2014; European Securities and Markets Authority 2016. 76   Committee on Payments and Market Infrastructure and Board of the International Organization of Securities Commissions 2015: 2; see also A. Lee 2015 on the background of the exercise. 74 75



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reserves and implicit government backing and hence did not share the same sense of urgency as the US and EU dealers in meeting the leverage ratio of the Basel III Accord.77 For the same reasons, leading domestic dealers like Mizuho and Mitsubishi UFJ Financial downplayed the importance of credit value adjustment in derivatives transactions that would reduce the counterparty credit risks. Indeed, Japanese financial executives saw the practice of little use and conceded that they would only selectively apply on very high-​risk contracts under JFSA mandates. This irked foreign banks that were concerned about their compliance with the Basel tier-​one capital requirement in which derivatives exposure constituted an important part of the leverage ratio calculation.78 In fact, even for the seemingly uncontroversial switch from voice to electronic trading, the Asian regulators have factored the local dealers’ concern into their plans and seized on the US and EU disagreements on the matter to carve out arrangements that would pose very little impact on existing market practices. While Japan had planned to introduce electronic trading in late 2015, the decision was amended in July 2014 and required only firms with outstanding portfolios larger than six trillion yen to comply. A  May 2015 revision further relaxed the kind of contracts to be brokered electronically, including only swaps of longer times to maturity and one benchmark as compared to the US rule that covered species of all maturities. These were carried out in the name of ensuring a “smooth” transition that would ensure the entire market did not land on the new platform overnight. Yet the domestic brokers acknowledged that JFSA’s decision was largely a response to concerns among domestic brokers, who still settled most of their trades on the phone and faced liquidity risks if a full switch was mandated across all product categories.79 The two smaller jurisdictions, Singapore and Hong Kong, similarly implemented the global reform agendas with discretion in order to retain favorable regulatory environments to local dealers and brokers. Despite the potential of fragmenting the broad market picture that the clearing and reporting hubs were supposed to present, the two city-​states were not shy of tinkering with specific provisions through extending exemptions to certain market participants and activities.

77   Steinbeck-​Reeves 2015; Vaghela 2015c; Stafford 2014b. The Basel Accord requires banks to hold at least 3% of the total notional values of OTC contracts; the US regulations demand an additional 2% capital buffer for important banks. Hence, the more efficient the portfolio compression is, the smaller the amounts banks would need to set aside for the purpose of meeting the regulation. 78   Vaghela 2015e; Woolner 2015b. 79   Woolner 2015a.





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Following Japan’s advances on electronic trading, Singapore’s MAS assessed whether to follow suit but complained that a mandatory migration to a centralized ETP would involve high on-​boarding costs to dealers who were used to sealing their deals on the phone. The arrangement would also risk stifling the growth in booking trades for regional markets, especially with corporate end-​users from neighboring Southeast Asian states with virtually no domestic derivatives markets. As such, the recent MAS framework going through the legislative process only contained initiatives to promote market transparency, falling short of forcing the migration of all derivatives trades on to a common platform.80 Singapore also shared Hong Kong’s problem in delineating reporting requirements for “nexus trade” (i.e., deals which were executed and booked in separate jurisdictions) often carried out by foreign banks in the two city-​ states. The issue was unique to Asia, as derivatives dealers and end-​users often dispersed different trade processes in multiple jurisdictions. In the absence of any views from the US or EU regulators, the Asian authorities developed an approach of their own. This led to considerable confusion as the two city-​ states made no effort to reconcile their rules for several years (including the number of parties to be reported and the extent to which collateral information was disclosed).81 After many controversies, a trader-​focused approach was put in place but was hampered by the lack of agreement to avoid duplicative reporting. As a result, although the reporting regulations of Singapore and Hong Kong have been recognized by the leading powers, the rules are largely location-​specific. There also was no regional attempt to promote harmonization. The situation is further complicated by the indifference of JFSA to the matter; they have seen no particular urgency to account for offshore booking and a similar stance of the US and EU authorities.82 Invariably, these cherry-​picking of rules has been unfortunate for international SSBs and leading powers, who have aspired to see consistency of rules in the post-​crisis global derivatives regulation. But, as the foregoing analysis suggests, the outcome has been motivated by domestic financial interests and the inter-​jurisdictional dynamics to outcompete one’s regional peers. Even though all Asian states have shown good faith to the G20 agendas, their quest for and exercise of power-​as-​autonomy in laying out specific provisions have ended up further fragmenting the regional regulatory landscape.

  Grant 2014; Stafford 2015.   ISDA 2016b. 82   Marsh 2015; Vaghela 2014c. 80 81



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Conclusion The post-​crisis East Asian responses to the derivatives regulatory reforms reveal a different picture of inter-​state power relations, especially those between the leading states and emerging jurisdictions that are often viewed to be “rule-​ takers”—​states possessing little leverage in shaping the frameworks developed by international SSBs and the United States and European Union.83 Far from being “passive adopters” and constrained by a lack of regulatory expertise, Asian jurisdictions have engaged in power plays with the leading states from the fringe of the global derivatives market. As the East Asian states endorsed the G20 agendas, they actively circumvented the impact of Dodd-​Frank and EMIR, and fostered the development of local derivatives markets at their own pace and with their own infrastructure and provisions. These apparently contradictory moves are viewed in this study as a quest for and exercise of power-​as-​autonomy by Asian jurisdictions. In pushing back against Dodd-​Frank and EMIR, they voiced discontents collectively and were helped by Asian-​based foreign firms whose business was significantly challenged by home regulations. The Asian regulators also exploited the ongoing discord between the United States and European Union in defending their demands to postpone some of the reform initiatives. While this exposed the limit (and in a sense failure) of the “Euro-​American regulatory condominium,”84 it permitted the Asian authorities to turn their attention to market development at home, partnering with local financial interests and building from scratch new clearing and reporting hubs in order to capture the growth opportunities in the derivatives marketplace. On the other hand, in order to avoid significant losses of business activities associated with US and European dealers, which would be subject to Dodd-​Frank and EMIR rules, the Asian regulators sought reconciliation with the US and EU authorities over the clearing arrangements, while simultaneously improvising local-​specific rules in favor of the local dealers and brokers. This analysis highlights the importance of inter-​state and domestic political dynamics that several chapters in this volume have examined.85 While the two overlap and in fact reinforce each other in shaping the region’s development, it is the inter-​jurisdictional competitive concerns that have fundamentally driven the Asian state to engage in a quest for and exercise of policy autonomy. But this has not precluded a collective effort to push back and extract concessions from the United States and European Union.   Chey 2014, 2015.   Posner 2009. 85   See Helleiner, Posner, and Pagliari, in this volume. 83 84





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Aware of their secondary importance in the global derivatives market, the displays of regional unity among Asian jurisdictions seemed to have generated much-​needed leeway for national endeavors to pursue domestic market growth and their shares in the region. This competitive quest, however, would not have been possible in the absence of two important domestic conditions. The different crisis experience had resulted in low issue salience and little public concern over the potentially pernicious impacts of derivatives, and it facilitated the joining of forces of the Asian regulators, local dealers, and bourses. As with the leading powers, there was a notable shift of interest group dynamics in Asia after the subprime crisis. Yet the region’s authorities have assumed a posture which has been far more market-​friendly and supportive in comparison with the US and European counterparts. The emergence of “new” financial interests and their ability to shape the regulatory trajectory is equally noteworthy and shall receive more attention from IPE researchers that still see banks (and equity brokers to some extent) as the key players in the region’s financial systems. As derivatives and other “exotic” financial instruments have gained in importance, East Asia has seen more complex interest group dynamics than in previous decades. Similarly, the postures of Asian regulators toward derivatives regulation have revealed a completely different picture to that described in much of literature on East Asian political economy. Rather than being averse to new and risky finance, they took an opposite stance akin to the pre-​crisis US authorities. This is hardly explainable without considering the inter-​state dynamics between the Asia powers and the United States and European Union, and the domestic forces at play. Finally, the argument about the exercise of power-​as-​autonomy in derivatives regulation echoes recent scholarly contributions on the power exercises of emerging economies and implications of their ascent to the future of global financial regulations. The East Asian experience, however, expands the concept’s application beyond monetary affairs and the multilateral settings. It showcases the bilateral interplays between Asian states and the United States and European Union in the implementation of global financial rules and suggests a possibility that national regulators of globally minor or secondary markets could deflect, and sometimes, resist the will of the leading states through skillful political maneuvers.86 More generally, the East Asian power plays refine our understanding of the motivation behind states’ pursuits. Other than reducing dependence on leading states and seeking insulation (as has been extensively examined in the monetary   On monetary affairs, see, e.g., Chin 2014; Kirshner 2014. Discussion of financial statecraft of emerging powers in multilateral platforms can be found in Chey 2015; Gallagher 2015; Armijo and Katada 2015. 86



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domain), the simpler fact that states often intend to seek competitive advantage and compete for larger market shares has prevailed in derivatives regulation. This finding is probably also relevant to other relatively under-​addressed areas of post-​crisis agendas (such as credit rating agency reforms and hedge fund regulation), in which the Asian authorities have recently developed a keen interest in affirming controls over the domestic regulatory matters while at the same time subscribing to the global reform agendas. These developments point to a worrying trend toward territorialization of global derivatives reform.87 Aside from the frequent delays and inconsistencies of rules across jurisdictions, subtle variations in technical subjects regarding implementation and operational processes appear to last long in the region. The problem would remain unabated as the disagreements of the leading states persist and as more Asian states and financial interests jockey to find their places in the derivatives markets.

Acknowledgments I thank Eric Helleiner, Jonathan Kirshner, and the Waterloo derivatives workshop participants for valuable comments, as well as the research assistance of Daniel Wong, and I am grateful to Celent Asia for providing complimentary copies of the cross-​country industry analyses. This study benefits from the financial support of the Hong Kong Research Grant Council (Project number: 28402114). The information is up-​to-​date as of December 2016 unless otherwise stated.

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Helleiner, Eric, and Stefano Pagliari. 2011. “The End of an Era in International Financial Regulation? A Post-​Crisis Research Agenda.” International Organization 65:169–​200. Henderson, Richard. 2013. “ESMA Equivalency Caveat Blurs EMIR’s Third-​Country Impact.” The Trade. September 6.  https://​www.thetradenews.com/​Asset-​Classes/​Derivatives/​ ESMA-​equivalency-​caveat-​blurs-​EMIR-​s-​third-​country-​impact/​. International Financial Law Review. 2013. “EMIR:  Asian OTC’s Latest Threat.” International Financial Law Review, July 10. IOSCO Asia Pacific Regional Committee. 2013a. Letter to EU Commissioner Barnier on Recognition of Asia Pacific Central Counterparties under EMIR. June 6. IOSCO Asia Pacific Regional Committee. 2013b. Update to EU Commissioner Barnier on Further Action on Recognition of Asia Pacific Central Counterparties under EMIR. November 22. https://​www.iosco.org/​about/​aprc/​pdf/​20131122-​APRC-​letter-​to-​EU.pdf. IOSCO Asia Pacific Regional Committee. 2014. Letter to the CFTC on the Impact of the SEF rule on Asia Pacific Derivatives Markets. April 9. https://​www.iosco.org/​about/​aprc/​pdf/​ 20140409-​APRC-​letter-​to-​CFTC.pdf. ISDA. 2016a. “Snapshot of Asia-​Pacific.” ISDA Quarterly 2(2): 12–​16. ISDA. 2016b. “Pragmatic Approach.” ISDA Quarterly 2(2): 19–​23. ISDA. 2017. “Asia-​Pacific Regulatory Profiles.” January. https://​www2.isda.org/​attachment/​ OTE2NQ==/​APAC%20Regulatory%20Profiles%20-​%20January%202017.pdf. Jaidev, Ramaya. 2011. “JSCC still keen on CCP interoperability.” Risk.Net. December 8. https://​ www.risk.net/​infrastructure/​clearing/​2125988/​jscc-​still-​keen-​ccp-​interoperability. Johnson, Christian. 2014. “Regulatory Arbitrage, Extraterritorial Jurisdiction, and Dodd-​ Frank:  The Implications of US Global OTC Derivative Regulation.” Nevada Law Journal 14(2): Article 14. JSCC. 2015. “Statistics:  CDS Obligation Bearing.” January. http://​www.jscc.co.jp/​en/​data/​en/​ 2015/​05/​cds_​statistics_​201501.pdf. Katada, Saori N. 2010. “Mission Accomplished, or a Sisyphean Task? Japan’s Regulatory Responses to the Global Financial Crisis.” In Global Finance in Crisis:  The Politics of International Regulatory Change, edited by Eric Helleiner, Stefano Pagliari, and Hubert Zimmermann, 137–​152. London: Routledge. Kawai, Masahiro, and Edward Prasad, eds. 2011. Asian Perspectives on Financial Sector Reform and Regulation. Washington, DC: Brookings Institution. Kirshner, Jonathan. 2014. “Regional Hegemony and an Emerging RMB Zone.” In The Great Wall of Money: Power and Politics in China’s International Monetary Relations, edited by Eric Helleiner and Jonathan Kirshner, 213–​240. Ithaca, NY: Cornell University Press. Lee, Ashley. 2013a. “APAC Regulators to Protect Emerging Markets from Extraterritoriality.” International Financial Law Review, January 17. Lee, Ashley. 2013b. “SEC and ASIC Reveal EMIR Equivalency Concerns.” International Financial Law Review, July/​August. Lee, Ashley. 2014. “Asia-​Pacific Equivalence Prompts European OTC Optimism.” International Financial Law Review, October 31. Lee, Ashley. 2015. “APAC Comes Up to Speed on FMI Resolution.” International Financial Law Review, July 30. Lee, Justin. 2013. “Hong Kong Lags on ESMA Equivalence.” Risk.Net. October 11. http://​www. risk.net/​infrastructure/​clearing/​2299972/​hong-​kong-​lags-​esma-​equivalence. Lindsay, Whipp. 2009. “Japanese Clearers Seek CDS Slots.” Financial Times, April 22. Linklaters. 2014. “CTFC’s December 2013 Substituted Compliance Determinations and No-​ Action Relief.” January 7. http://​linklaters.com/​pdfs/​mkt/​newyork/​A17552864.pdf. MacIntyre, Andrew J., T. J. Pempel, and John Ravenhill, eds. 2008. Crisis as Catalyst:  Asian’s Dynamic Political Economy. Ithaca, NY: Cornell University Press. Madigan, Peter. 2016. “Fears Rise That Asia Will Miss March 2017 Margin Deadline.” Risk. Net.  September  16.  https://​www.risk.net/​regulation/​2471085/​fears-​rise-​asia-​w ill-​miss​march-​2017-​margin-​deadline.





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Marsh, Joe. 2015. “Data Quality ‘Jeopardizing’ Asia OTC Trade Reporting.” Risk.Net. May 28.  http:// ​ w ww.risk.net/ ​ d erivatives/ ​ 2 410204/ ​ d ata- ​ q uality- ​ j eopardising- ​ a sia- ​ o tc-​ trade-​reporting. MAS. 2015. “Consultation Paper on Draft Regulations for Mandatory Clearing of Derivatives Contracts.” July 1. Maxwell, Fiona. 2015. “ISDA:  Majority of Swap Users Believe Market Is Fragmenting.” Risk.Net. April 23. https://​www.risk.net/​derivatives/​2405460/​isda-​majority-​swaps​users-​believe-​market-​fragmenting. Noyes, Keith. 2014. “Non-​Cleared Margin Rules Pose Cross-​Border Challenge—​ISDA.” Risk. Net. December 10. https://​www.risk.net/​regulation/​2385696/​non-​cleared-​margin​rules-​pose-​cross-​border-​challenge-​isda. ODRG. 2013. “OTC Derivatives Regulators Group Report to the G20 Meeting of Finance Ministers and Central Bank Governor of April 18‒19.” http://​www.cftc.gov/​ucm/​groups/​ public/​@newsroom/​documents/​file/​odrg_​reporttog20_​0413.pdf. Pempel, T. J., and Keiichi Tsunekaka, eds. 2015. Two Crises, Different Outcomes:  East Asia and Global Finance. Ithaca, NY: Cornell University Press. Posner, Elliot. 2009. “Making Rules for Global Finance: Transatlantic Regulatory Cooperation at the Turn of the Millennium.” International Organization 63:665–​699. Price, Michelle. 2014. “HK-​Shanghai Stock Link Hurdles Spark Derivatives Boom.” Reuters, December 28. Ray, Arin. 2013a. “OTC Derivatives in the Advanced Asian Economies.” Celent Research. September. Ray. Arin. 2013b. “OTC Derivatives in the Emerging Asian Economies.” Celent Research. September. Sawyer, Nick. 2013. “Cross-​Border Stricter-​Rule-​Applies Approach Causing Confusion.” Risk. Net. September 30. https://​www.risk.net/​regulation/​2297356/​cross-​border-​stricter​rule-​applies-​approach-​causing-​confusion. Stafford, Philip. 2014a. “Quick View: Europe’s MTF Problem.” Financial Times, March 20. Stafford, Philip. 2014b. “Banks Turn to Compression to Meet New Basel Rules.” Financial Times, March 31. Stafford, Philip. 2014c. “LCH.Clearnet Plans Japan Clearing Expansion.” Financial Times, November 18. Stafford, Philip. 2015. “Singapore Decides against Swap Trading Switch.” Financial Times, February 11. Steinbeck-​Reeves, Michael. 2013. “Ripples from Western Derivatives Regulation Spreading across Asia.” Nikkei Asia Review, November 21. Steinbeck-​ Reeves, Michael. 2015. “Japan Is Where ‘Global’ Regulation Runs Out of Road.” DerivSource. May 27. http://​derivsource.com/​content/​japan-​where-​‘global’regulation-​runs-​out-​road. Thomas, Zoe. 2015. “CTFC Issues First Derivatives Clearing Exemption.” International Financial Law Review, August 20. The Trade. 2015. “Will Three Be a Crowd in Singapore?” August 5. https://​www.thetradenews. com/​Asset-​Classes/​Derivatives/​Will-​three-​be-​a-​crowd-​in-​Singapore-​/.​ Tsunekawa, Keiichi. 2015. “Japan:  The Political Economy of Long Stagnation.” In Two Crises, Different Outcomes:  East Asia and Global Finance, edited by T. J. Pempel and Keiichi Tsunekaka, 216–​234. Ithaca, NY: Cornell University Press. Vaghela, Viren. 2013a. “Divide and Rule.” Asia Risk, November: 24‒26. Vaghela, Viren. 2013b. “Crunch Time over SEFs as Asian Banks Weigh Up Costs of Participation.” Risk.Net. December 12. http://​www.risk.net/​derivatives/​2307863/​crunch-​time-​over-​sefs-​ asian-​banks-​weigh-​costs-​participation. Vaghela, Viren. 2014a. “Asian Clearinghouse Waiting for CFTC to Outline DCO Exemption.” Risk. Net. February 6.  http://​www.risk.net/​infrastructure/​clearing/​2327001/​asian-​clearing​houses-​waiting-​cftc-​outline-​dco-​exemption-​process.



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Vaghela, Viren. 2014b. “Asia Dealers Review CCP Risk Management Approaches.” Risk. Net. April 7.  https://​www.risk.net/​regulation/​2337566/​asia-​dealers-​review-​ccp-​risk-​ management-​approaches. Vaghela, Viren. 2014c. “Divergent Nexus Rules Threaten Reporting Chaos in Asia.” Risk.Net. August 6.  http://​www.risk.net/​derivatives/​2359051/​divergent-​nexus-​rules-​threaten​reporting-​chaos-​asia. Vaghela, Viren. 2014d. “Japan Slams European Rules on Bilateral Swaps.” Asia Risk, September: 14‒15. Vaghela, Viren. 2014e. “Goldman, JPM to Set Up Booking Hubs in Asia.” Asia Risk, October: 12‒13. Vaghela, Viren. 2015a. “Disjointed OTC Reforms ‘Could Destroy Asia Derivatives Market’.” Risk.Net. January 22. http://​www.risk.net/​regulation/​2391491/​disjointed-​otc-​reforms-​could-​destroy-​ asia-​derivatives-​market. Vaghela, Viren. 2015b. “Hong Kong CCP to be First to Clear Cross-​Currency Swaps.” Risk.Net. May 22. http://​www.risk.net/​derivatives/​2409756/​hong-​kong-​ccp-​be-​first-​clear-​cross-​ currency-​swaps. Vaghela, Viren. 2015c. “Low CCP Compression Rates in Japan Vex Foreign Banks.” Risk.Net. June 4.  https://​www.risk.net/​derivatives/​2411301/​low-​ccp-​compression-​rates-​japan​vex-​foreign-​banks. Vaghela, Viren. 2015d. “Lack of Non-​ Cleared Margin Rules in Asia Sparks Dealer Concern.” Risk.Net. June 10. https://​www.risk.net/​derivatives/​2412041/​ lack-​of-​non-​cleared-​margin-​rules-​in-​asia-​sparks-​dealer-​concern. Vaghela, Viren. 2015e. “Japan Banks Still Not Pricing CVA into Derivatives Trades.”  Risk.Net. July 2.  http://​w ww.risk.net/​derivatives/​2415565/​japan-​banks-​still-​not-​pricing-​c va-​ derivatives-​trades. Walter, Andrew. 2008. Governing Finance: East Asia’s Adoption of International Standards. Ithaca, NY: Cornell University Press. Walter, Andrew. 2010. “Chinese Attitudes towards Global Financial Regulatory Cooperation:  Revisionist or Status Quo? In Global Finance in Crisis:  The Politics of International Regulatory Change, edited by Eric Helleiner, Stefano Pagliari, and Hubert Zimmermann, 153–​169. London: Routledge. Woolner, Aaron. 2013. “Minimum Threshold for OTC Business to the Solution to Equivalence Issue.” Risk.Net. December 9.  https://​www.risk.net/​infrastructure/​clearing/​2317894/​ minimum-​threshold-​otc-​business-​solution-​equivalency-​issue. Woolner, Aaron. 2015a. “Smooth Operator: Japan Looks to Ease into Electronic Trading.” Risk. Net. June 17. https://​www.risk.net/​regulation/​2413483/​smooth-​operator-​japan-​looks​ease-​electronic-​trading. Woolner, Aaron. 2015b. “Regional Banks Take the Slack from Global Firms’ Asia Retreat.” Risk.Net. July 16. https://​www.risk.net/​derivatives/​2417754/​regional-​banks-​take-​slack-​global-​firms​asia-​retreat.



5

The Second Half Interest Group Conflicts and Coalitions in the Implementation of the Dodd-​Frank Act Derivatives Rules Stefano Pagliari

The design of the “Dodd-​Frank Wall Street Reform and Consumer Protection Act” (hereinafter Dodd-​Frank) has been heralded as a turning point in the regulation of derivatives markets. In particular, the provisions included in Title VII of the 2,300-​page legislation overturned the decision taken a decade earlier by the US Congress to exempt OTC derivatives markets from federal regulatory oversight, a step that was subsequently recognized as contributing to the financial crisis.1 Dodd-​Frank introduced a comprehensive regulatory framework, which brought for the first time under the direct oversight of US regulators a broad range of actors and products that constitute the modern derivatives markets. While the signing of Dodd-​Frank into federal law by President Barack Obama in July 2010 has received considerable attention, this represented only an intermediate step in the process of reforming the regulation of derivatives markets in the United States after the crisis. Equally important in defining the true impact and effectiveness of the post-​crisis reforms was the implementation of the same Dodd-​Frank by US regulatory agencies. In the case of Dodd-​Frank derivatives rules, the centrality of the implementation phase was heightened by the significant latitude that the primary legislation designed by the US Congress granted regulators in defining how derivatives markets should be regulated. As a result, before the ink of Dodd-​Frank had even dried, critics of the legislation had identified in the implementation stage a key opportunity to amend and potentially

  FCIC 2011.

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turn the clock back on some of the measures introduced by Congress to regulate derivatives markets. This chapter will investigate the implementation of Dodd-​Frank derivatives rules between 2010 and 2015 and argue that this phase brought to a halt the tightening in the regulation of derivatives markets that had been set in motion by the financial crisis. In particular, the analysis will highlight how in a number of areas the implementation phase has led to a narrowing of the scope of the regulatory net cast by Dodd-​Frank over derivatives markets, by excluding a number of actors and transactions from regulatory requirements mandated by Congress, as well as by watering down the stringency of these requirements. At the same time, this whittling down of Dodd-​Frank derivatives rules has not been uniform. In a number of instances, regulators have been able to resist pressures to relax the regulatory requirements and to implement Dodd-​Frank without departing from their original proposal. What explains this outcome? Why have regulators implemented the congressional mandate narrowly in some areas while expanding the scope of the regulation in others? In order to answer these questions, this chapter will explore the diversity of interest groups within and outside the financial industry that have mobilized during the implementation stage. The argument put forward in this chapter is that the capacity of regulators to withstand pressures to whittle down the scope and strictness of Dodd-​Frank during the implementation phase has been influenced by the breadth and cohesiveness of the opposition front among different interest groups. More specifically, the presence of a cohesive opposition front from different groups from within and outside the financial industry to certain rules has weakened the capacity of regulators to defend their original proposal and increased the threat of Congress intervening to curtail the autonomy of regulators. By contrast, the presence of disagreements across interest groups has created policy space for regulators to withstand calls for these rules to be watered down. The chapter is structured as follows. The next section will provide an overview of the main trends in the regulation of derivatives markets in the United States before and after the signing of Dodd-​Frank into federal law. The following section will review the ecology of interest groups that have mobilized during the implementation of Dodd-​Frank and map the different patterns of conflict and coalitions that emerged. The second part of the chapter will illustrate the impact of this mobilization over the rule-​making process by analyzing three key sites of conflict that have characterized the implementation of Dodd-​Frank derivatives rules: the definition of swap dealers and major swap participants, the regulation of clearinghouses, and the regulation of swap trading platforms.





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The Political Economy of Dodd-​Frank Act Derivatives Reforms: A Tale of Two Halves The regulation of financial markets is often far from resembling a linear process. The extent to which policymakers have intervened to regulate different financial sectors and products has often alternated between periods of deregulation and re-​regulation. This cyclical characterization of financial regulatory policymaking also describes quite well the evolution of the regulation of derivatives markets in the United States over the last few decades. The regulation of OTC derivatives in the United States in the decades preceding the global financial crisis was characterized by a number of regulatory decisions to free different segments of derivatives markets from regulatory constraint, despite the numerous warning signs regarding the potential risks posed by activities in the OTC derivatives markets remaining outside of the oversight of federal regulators.2 This trend culminated in the passage of the Commodity Futures Modernization Act of 2000, when the US Congress eliminated oversight by both the CFTC and SEC over OTC derivatives markets, effectively shielding OTC derivatives from the direct reach of regulators.3 As the global financial crisis a decade later led policymakers to question the desirability of this decision, the regulation of derivatives markets has returned on the congressional agenda. Following the collapse of Lehman Brothers and the bailout of AIG, a number of legislative proposals were introduced within Congress to revise the decisions taken in the 1990s to exclude derivatives markets from regulatory oversight and—​in the words of Senator Harkin—​to “end the unregulated ‘casino capitalism’ that has turned the swaps industry into a ticking time bomb.”4 The legislation passed by the US Congress in June 2010 required the main participants and infrastructures in the derivatives markets (such as clearinghouses, trade execution facilities, and TRs) to register with federal regulators as well as to be subject to a variety of regulatory requirements. Moreover, the scope of the bill was not limited to regulating credit derivatives at the center of the crisis, but rather it encompassed nearly all commonly traded OTC derivatives, including derivatives on interest rates, currencies, commodities, securities, indices, and various other financial or economic interests or property. In so doing, Dodd-​Frank represented a reversal of the de-​regulatory approach that had characterized the 15 years preceding the crisis.

  Spagna, in this volume. See also GAO 1994.   Tett 2009; FCIC 2011: 48. 4   Snow 2008. 2 3



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The signing of Dodd-​Frank into law by President Barack Obama in July 2010 did not, however, represent the end of the post-​crisis regulation of derivatives in the United States. As CFTC Chairman Gensler stated in July 2010, “Even after the President signs the Wall Street reform bill, financial reform will be far from complete.”5 The legislation approved by Congress delegated significant rule-​making responsibilities to the hands of federal regulatory agencies, granting them a significant amount of discretion in defining which market actors and products would be covered by the regulatory requirements established in the legislation, as well as the level of stringency of these requirements. As a result, groups that had expressed discontent with the formulation of Dodd-​Frank identified the implementation stage as an opportunity to whittle down or rectify some of the provisions introduced by Congress. As Gensler acknowledged in October 2011, “a year after the Dodd-​Frank reforms became law, there are those who might like to roll them back and put us back in the regulatory environment that led to the crisis three years ago.”6 Gensler’s remarks were directed in particular toward those major actors within the financial industry that maintained a vested interest in limiting the regulatory burden imposed upon OTC derivatives markets. In the years before the crisis, key market players and financial industry associations such as the ISDA had played a primary role in lobbying Congress to keep these markets outside of the scope of official regulation.7 The high political salience that characterized financial regulation during the financial crisis had constrained the influence of the financial industry over the design of Dodd-​Frank and forced key players in the derivatives markets to fight largely a rearguard battle and to endorse many of the regulatory proposals presented.8 Now, the leverage of those groups with an interest in watering down Dodd-​Frank rules was significantly bolstered during the implementation stage as a result of three important changes in the policymaking context in which these rules were created. A first set of constraints on the implementation of Dodd-​Frank derivatives rules can be found in the characteristics of the institutional context in which these rules were implemented. Congress gave the primary responsibility for developing the approximately 60 pieces of regulations required to implement Dodd-​Frank derivatives rules within a stringent timeline to the CFTC, a relatively small regulatory agency with no experience of regulating OTC markets, but denied this agency the resources required to police this market. As Gensler argued, “the CFTC’s . . . staff is just 10% more in numbers than at our peak in   Gensler 2010.   Gensler 2011. 7   Tett 2009; Tsingou 2006; McKeen-​Edwards and Porter 2013. 8   Young 2013a. 5 6





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the 1990s, yet Congress has now directed the agency to oversee the swaps markets; that is eight times larger than the futures market.”9 The gap between the Herculean task involved in implementing Dodd-​Frank and the limited resources of regulators has contributed significantly toward slowing down the implementation process as well as increased the reliance of regulators on the expertise of the financial industry. Moreover, Dodd-​Frank required the CFTC to develop a number of rules in coordination with other regulatory agencies. During the implementation phase, the CFTC has found itself clashing with other regulatory agencies such as the SEC (e.g., on the threshold for determining swap dealers, the regulatory standards to be applied to swap trading platforms, as well as the application of rules to cross-​border transactions), banking regulators (on the application of margin requirements to non-​financial end-​users), and the Federal Energy Regulatory Commission. As a result, the conflict among the different regulatory agencies involved in the implementation of Dodd-​Frank has created additional opportunities for firms seeking to whittle down the stringency of these rules by exploiting the divisions among different regulators. A second change in the context within which regulators have found themselves operating during the implementation stage that was conducive to a watering down of Dodd-​Frank rules is a change in the role of Congress. While the involvement of Congress following the bailouts of 2008 played a central role in generating momentum in support of broadening the regulation of derivatives markets, Congress has played an active role during the implementation stage of trying to weaken the regulation of derivatives markets. A  key reason for the change was the election that enabled the Republican Party to take control over the House of Representatives in January 2011, including the key congressional committees (House Financial Services Committee and House Agriculture Committee) overseeing the work of the CFTC and SEC. During this stage, Republican Congressmen have come to identify in the regulation of derivatives—​and Dodd-​Frank more generally—​an important target against the Obama administration. Overall, at least 29 bills have been introduced within Congress in the period between the passage of Dodd-​Frank and June 2015 by Republican Congressmen (but in some cases with co-​sponsors from the Democratic Party) to delay the implementation of Dodd-​Frank by regulators (for instance, by requiring regulators to demonstrate they were engaging in real cost-​benefit analysis before finalizing rules) or to roll back how regulators were interpreting the congressional mandate. Representative Maxine Waters described this as a “death by a thousand   Natural Gas Intelligence 2012.

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cuts approach to undermine financial reform.”10 The fact that the Democratic Party maintained control of the Senate until the end of 2014 and of the White House until the end of 2016 meant that the large majority of bills seeking to roll back derivatives rules have failed to be approved or signed into law, but important exceptions remain. A particularly significant cut to Dodd-​Frank was inflicted by the legislation passed by Congress to largely repeal the “push-​out” rule—​also known as the “Lincoln Amendment” from the name of its author Senator Blanche Lincoln—​ which required banks that act as derivatives dealers to spin off their derivatives trading activities into independently capitalized entities outside of the government backstop provided by the FDIC deposit insurance and Federal Reserve discount window. This legislation—​which included more than 70 out of the 85 lines drafted by a major dealer bank (Citigroup)11—​was attached in December 2014 into the catch-​all USD 1.1 trillion 1,603-​page federal spending bill meant to finance the government in 2015. Critics of this legislation highlighted the parallel with the most important episode in the pre-​crisis de-​regulation of derivatives, the Commodity Futures Modernization Act of 2000, which was also signed into law at the end of the 106th Congress as part of a larger 11,000-​page omnibus appropriations bill.12 A third set of constraints on the implementation of Dodd-​Frank rules that strengthened the hand of the critics of the legislation came from the international context in which US regulators have found themselves operating. The fact that the United States has been a first-​mover in implementing a regulatory framework for derivatives markets ahead of Europe and other major derivatives markets has exposed US regulators to criticisms from both the financial industry and Congress that the implementation of Dodd-​Frank would have put US financial markets at a competitive disadvantage vis-​à-​vis their foreign competitors.13 For instance, in February 2011, both the House Agriculture Committee and the House Financial Services Committee held different hearings where regulators were criticized for introducing rules that would cause “hundreds of American companies to take their capital and jobs elsewhere” (Representative Bachus) and that “would literally spell the end of U.S.-​based derivatives markets” (Representative Garrett).14 As a result, US regulators have faced strong pressures to avoid the introduction of domestic rules that may undermine the competitiveness of US firms.   Zibel and Holzer 2012.   Lipton and Protess 2013. 12   Ackerman 2014. 13   Coleman 2003. 14   Holzer 2011. 10 11





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Overall, these changes that have occurred in the policymaking process during the implementation phase created conditions that could be regarded as conducive to a weakening of Dodd-​Frank and a strengthening of the hands of those within the financial industry that had a vested interest in rolling-​back derivatives rules. These factors in themselves, however, cannot fully explain the direction in which regulators have implemented the congressional mandate. For instance, calls upon regulators to avoid introducing rules more stringent than those in place in other jurisdictions have often fallen on deaf hears, such as in the case of the decision of regulators to expand the extraterritorial scope of Dodd-​Frank derivatives rules to avoid the risk of regulatory arbitrage.15 In other words, the changes that occurred in the implementation stage described in this section have constrained the policy space of regulators in implementing Dodd-​Frank, but they have not completely determined the course of action of regulators and their capacity to stand up to the opponents of Dodd-​Frank derivatives rules. In order to investigate the determinants of the implementation of Dodd-​Frank derivatives rules, the next section will explore how patterns of conflict and cooperation among different interest groups that have emerged during the implementation phase have influenced the conduct of regulators.

Mapping Interest Group Conflict and Solidarity in the Regulation of Derivatives Markets As a burgeoning literature on the politics of financial regulation has recognized, the financial industry is not just a passive recipient of regulatory policies, but it often represents a key force in actively influencing the design of regulatory policies.16 However, the financial industry is often neither the only voice mobilizing around the design of financial regulatory policies nor one that is always capable of speaking with a single voice. This insight is particularly important when it comes to analyzing the politics of derivatives regulation. Most analyses of the politics of financial regulation have focused on the lobbying and self-​regulatory initiatives by banks that act as dealers in the derivatives markets. This attention is understandable given the significant concentration of OTC derivatives markets, with just five banks accounting in 2014 for 95% of the total notional derivatives of USD 302 trillion ( JP Morgan, Citigroup, Goldman Sachs Group, Bank of America, and Morgan Stanley).17 Given the significant   See Gravelle and Pagliari, in this volume.   For a review of this literature, see Young 2013b. 17   Data from the Office of the Comptroller of the Currency, cited in Carney 2014. 15 16



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stream of revenues generated by derivatives activities,18 it is not surprising that these institutions and dealer-​dominated international financial associations such as ISDA have traditionally mobilized significant resources in seeking to shield OTC markets from the reach of regulators.19 As different studies have highlighted, however, dealer banks are not the only group that have mobilized over the design of derivatives rules.20 A second key set of voices within the financial community is represented by large derivatives exchanges such as CME Group and IntercontinentalExchange (ICE), which are also the owners of important clearinghouses. In fact, the history of the evolution in regulation of derivatives markets has often been characterized as a clash between New York‒based dealers and Chicago-​based exchanges. While the rise of OTC trades occurring bilaterally between financial institutions since the 1980s tilted the balance of power away from exchanges and in favor of dealer banks,21 Dodd-​Frank’s attempt to promote greater central clearing and exchange trading of standardized products has been interpreted as an opportunity for clearinghouses and exchanges to gain a larger share of the derivatives markets. A third set of financial actors active in the derivatives policy space is inter-​ dealer brokers such as ICAP, Tullett Prebon, BGC Partners, and GFI Group. These are financial intermediaries mediating between dealers, or between dealers and other wholesale market participants in the markets outside of centralized exchanges, while taking commissions for arranging trades. The position of these firms in the markets has been threatened by the push of Dodd-​Frank and the G20 agenda to have standardized transactions executed using electronic platforms, requiring them to transform into more closely regulated trading venues and to enter more directly in competition with derivatives exchanges. As a result, the financial crisis has also led these groups to increase their political mobilization in Washington, as well as encouraged the creation of new sectoral associations such as the Wholesale Markets Brokers Association of America (WMBAA) and the Swaps and Derivatives Market Association (SDMA).22 A fourth and final set of voices within the financial industry is represented by “buy-​side” financial firms. This category includes financial firms such as hedge funds, asset managers, proprietary trading firms, and insurance companies, which trade in derivatives primarily to manage financial risks such as interest rate or currency hedges, or to take a positional bet on these markets. As a result, the

  Greenberger 2012.   Tett 2009; Tsingou 2006; McKeen-​Edwards and Porter 2013. 20   Clapp and Helleiner 2012; Helleiner and Pagliari 2009; Pagliari and Young 2013; Helleiner 2014. 21   Clapp and Helleiner 2012; Tsingou 2006; Morgan 2010. 22   Protess 2011. 18 19





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interests of buy-​side financial firms have often been in conflict with those of the dealers that occupy the opposite side of their transactions, with the former calling for greater access, protection, and transparency in the derivatives markets. The ecology of business groups that has mobilized around the implementation of Dodd-​Frank derivatives rules is not, however, limited to financial industry groups. A particularly vocal set of interest groups in the post-​crisis debates has been non-​financial firms that rely on derivatives to hedge everyday risk, such as commodity price swings and interest rate fluctuations. These firms have mobilized in response to the crisis through a variety of existing sectoral associations as well as through a newly created umbrella group called the “Coalition for Derivatives End-​Users.” Among non-​financial groups, particularly significant has been the lobbying by energy and commodity groups (both producers or large users), including a number of large energy and commodity companies such as BP, Royal Dutch Shell, and Cargill, which straddle the line between end-​user and swap dealers.23 While formally supporting the introduction of a new regulatory framework for derivatives markets brought forward by Dodd-​ Frank, commercial end-​users have primarily mobilized to seek exemptions from these same rules. In the word of the National Association of Corporate Treasurers: “Don’t throw us in the same paddy wagon as Fannie Mae, Freddie Mac and AIG.”24 But other non-​financial groups, in particular agricultural and commodity firms, which have been mostly exposed to volatility in the price of agricultural products and other commodities in the years before the crisis, have also lobbied in favor of tougher rules against speculative activities in commodity derivatives markets, thus more directly clashing with the interests of financial firms.25 Finally, a sixth set of societal actors that have mobilized during the implementation of Dodd-​Frank include voices outside the business community altogether. These voices include a wide and diverse range of consumer protection associations, trade unions, faith-​based organizations, environmental nongovernmental organizations (NGOs), and NGOs with a specific focus on financial reforms, such as Better Markets and Americans for Financial Reforms. These voices have generally mobilized in support of more stringent interpretation of the rules implemented within Dodd-​Frank and in opposition to the financial industry. Existing studies have illustrated how the design of Dodd-​Frank by Congress reignited a number of long-​standing cleavages within the interest group community as well as generated new ones. To what extent has conflict among   Leff and Doering 2011; Meyer 2010; Baltimore 2012.   Bunge 2010b. 25   Helleiner, in this volume; see also Clapp and Helleiner 2012. 23 24



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different interest groups also characterized the implementation of Dodd-​Frank derivatives rules? Figure 5.1 presents a breakdown of the distribution across these six different groups of all the firms and associations that have lobbied the SEC and the CFTC during the implementation of Dodd-​Frank derivatives rules between 2010 and 2014. More specifically, this figure maps the identity of the groups that have either sent a comment letter in response to a public consultation or held an official meeting with these regulatory agencies to lobby over a proposed derivative rule.26 While this data in isolation does not capture the extent to which different groups were listened to by regulators during the implementation of Dodd-​Frank derivatives rules, the purpose of this exercise is to provide a systematic map of the diversity of groups that have mobilized during this phase. This figure highlights how the mobilization of interest groups in the implementation stage has certainly not been limited to the derivatives dealers that have dominated most analysis of pre-​crisis derivatives regulation. In terms of sheer number of organizations (figure 5.1 on the left), banks represent only 10% of the 1,160 different firms and associations across the six different groups that have lobbied regulators over the implementation of Dodd-​Frank derivatives rules. In fact, more than half of all the groups that have mobilized in this domain come from outside the financial industry entirely. While this figure provides a good indication of the population of firms that have mobilized over the implementation of derivatives rules, the resources that different groups have deployed in lobbying regulators has varied significantly across different groups. In particular, this analysis reveals how financial industry stakeholders account for more than half of the comment letters sent in response to a public consultation (figure 5.1 in the middle) and almost more than three-​ quarters of all the meetings with regulators (figure 5.1 on the right) held by the SEC and CFTC over derivatives rules during this period.

  This analysis follows on the approach adopted in previous work co-​authored with Kevin Young (Pagliari and Young 2014, 2016; Young and Pagliari 2017). In order to map the diversity of voices that have between regulators and different stakeholders, I have generated a new database containing 2,781 comment letters sent by stakeholders to the SEC and CFTC in response to 100 proposed rules released by these two regulatory agencies between 2010 and 2014 to implement the derivatives rules included in Dodd-​Frank, as well as the transcripts of 1,331 recorded meetings between representatives of one these two regulatory bodies and stakeholders on the design of these rules. For each of these letters and transcripts of meetings, I have coded the sectoral identity of the group lobbying over derivatives regulation. I have limited my analysis to individual letters and transcripts of meetings from organizations, thus not analyzing the lobbying by individuals writing in an individual capacity (e.g., concerned citizens or independent researchers). Overall, this coding has revealed how 1,631 different groups and policymakers have lobbied the CFTC and SEC over derivatives rules, with 1,160 groups belonging to one of the 6 categories (71%). 26



IDB 48 (4.14%)

Number of Firms by Sector Buy-side 232 (20%)

Number of Letters by Sector Ex&CI 260 (5.84%) Ex&CI 39 (3.36%)

NGO 122 (10.5%)

Number of Meetings by Sector

Buy-side 767 (17.2%)

Banks 1186 (26.6%)

Banks 1219 (34.5%) Ex&CI 250 (7.08%)

Banks 124 (10.7%)

IDB 36 (5.3%)

Buy-side 886 (25.1%)

NGO 312 (7.01%) NFC 773 (21.9%) NFC 595 (51.3%)

Figure 5.1  Firms lobbying CFTC and SEC over derivatives rules (2010–2014)

NFC 1692 (38%)

IDB 282 (7.99%)

NGO 119 (3.37%)



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200 Sector Banks Exchanges & Clearinghouses Financial Buy-Side Inter-Dealer Brokers & Intermediaries

100

Non-Business Groups

SIFMA ISDA Morgan Stanley Goldman Sachs Barclays Better Markets MFA CME JP Morgan Deutsche Bank UBS ICE Markit Citigroup Bank of America Blackrock ICAP IIB Citadel Credit Suisse

0

Figure 5.2  Groups most frequently lobbying (meetings + letters) the CFTC and SEC over implementation of derivatives rules (2010–2014)

Moreover, when we analyze the groups that have most frequently lobbied the CFTC and SEC during this period (figure 5.2), 12 of the top 20 groups are derivatives dealers and organizations closely representing this group, while only one group comes from outside the financial industry (the NGO Better Markets). The diversity of actors mobilizing in this domain should, however, not be equated with a diversity of views. In the same way that the post-​crisis regulation of derivatives has ignited new and old cleavages among firms and associations from different segments of the derivatives markets, it has also created opportunities for the emergence of new alliances across different segments of the business community. In particular, overlaps in the interests of different groups have emerged around common demands such as delaying the implementation of the requirements and limiting market disruption created by the new rules, as well as more specific regulatory interventions that undermined common sources of profits. In order to illustrate the alliances that emerged during the implementation of Dodd-​Frank derivatives rules, figure 5.3 maps all the instances in which different firms and associations have lobbied together the SEC and CFTC by co-​signing a response to a regulatory consultation or jointly meeting an SEC or CFTC official.





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Figure 5.3  Network of groups lobbying over SEC and CFTC derivatives rules.*

While the sectoral identity of a firm or association represents the primary determinant in the choice of allies, this network visualization reveals how a number of groups have reached across the sectoral divide in lobbying regulators. In particular, it is notable how dealer banks occupied a central position in the corporate networks, being able to form alliances both with buy-​side actors and with exchanges or clearinghouses. But alliances have also emerged between financial and non-​financial voices. In particular, financial buy-​side firms that enter the market to hedge certain financial positions have on a number of occasions lobbied together with non-​ financial end-​users. More broadly, the opposition of non-​financial end-​users to *  This network visualization only presents those groups that have lobbied together with another group at least once during the implementation of the Dodd-​Frank derivatives rules. The color represents the family that the different groups belong to, the size represents the frequency of lobbying. The thickness of the ties between different nodes represents the number of times different groups have lobbied together. Only the labels of the groups lobbying most frequently are included.



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measures that would have increased the costs of accessing derivatives markets has brought their demands to often overlap with a number of financial industry voices. Individual firms (such as BP) and associations such as the US Chamber of Commerce, ISDA, and the Working Group of Commercial Energy Firms have played a key role in bridging the lobbying efforts of financial and non-​ financial groups. The network visualization also reveals how the non-​financial end-​user community is not a cohesive set of voices. In particular, agricultural and commodity firms that have mobilized in favor of tougher rules against speculative activities in commodity derivatives markets have frequently joined forces with NGOs (for instance, through the “Commodity Markets Oversight Coalition”).27 The centrality of the banking industry and the relative importance of different groups in the regulatory policymaking over the implementation of derivatives rules have, however, varied significantly across different issues. Figure 5.4 illustrates the percentage of lobbying initiatives (both meetings and letters) from the six groups across different set of regulatory proposals released by the CFTC and SEC during the implementation of Dodd-​Frank derivatives rules. This figure reveals how the banking community has represented the largest group mobilizing only on a limited number of issues with significant implications for their profits, such as the cross-​border application of derivatives rules. In the majority of consultations, groups outside of the banking community have been the ones lobbying most frequently. For example, inter-​dealer brokers have been the most active group on the regulation of trade execution platforms (SEF) and exchanges or clearinghouses have dominated debates on the regulation of clearinghouses, while buy-​side firms have been the most active group on the implementation of the trading requirement. The balance between financial and non-​financial groups has also varied significantly across issues, with non-​financial firms representing the group lobbying most frequently on issues such as the definition of what firms should be covered by the regulation, margin requirements, exemptions from clearing, and position limits for commodity derivatives. The breakdown of the mobilization of interest groups across different individual issues also reveals the fragility and ad hoc basis of a number of coalitions emerging across issues. For instance, while non-​business groups have frequently lobbied together with NGOs on the regulation of position limits, the same alliance has not emerged over other issues such as clearing exemptions, reporting requirements, and margin requirements, where non-​business groups have

  Clapp and Helleiner 2012.

27





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Figure 5.4  Numbers and links among groups lobbying the CFTC and SEC (meetings + letters) across different derivatives rule-​making (2010–2014).*

instead joined forces with financial buy-​side users and other financial actors. Similar variations in the choice of lobbying partners can found in the coalitions linking together different segments of the financial industry across different issues related to the regulation of derivatives. How do these findings regarding the variations in the extent of the mobilization of different sectors and the alliances among firms and associations from different sectors matter in shaping the implementation of Dodd-​Frank derivatives rules? Neo-​pluralist scholarship has theorized how the business community’s ability to maintain a cohesive position influences its capacity to shape regulatory *  The external circle in this chord diagram represents the percentage of all the lobbying activities (meetings with regulators and responses to consultations) for each issue conducted from each of the six groups analyzed in the chapter. The links between different groups represent the instances in which each group has lobbied together with a firm or association representing a different group.



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policies.28 In particular, the presence of divisions across different segments of the financial industry as well as the opposition from groups outside finance have been understood to constrain the capacity of financial groups to resist the imposition of more stringent regulatory requirement. As different groups deploying resources battle each other, regulators have greater policy space to exploit divisions across different firms in pursuit of their own agenda and to withstand calls for rules to be watered down.29 Conversely, the leverage of financial firms over regulators is understood to be augmented by when these firms are able to join forces with other segments of the financial industry and of the broader business community through the creation of formal coalitions or informal alliances.30 To what extent can these insights concerning the impact of cohesion and contestation within the business community also shed light on the implementation of Dodd-​Frank derivatives rules? In order to probe this hypothesis, the rest of the chapter will investigate three key regulatory policies that have characterized the implementation of Dodd-​Frank derivatives rules. The analysis of these three case studies will focus in particular on assessing to what extent the implementation of different Dodd-​Frank derivatives rules can be linked to the balance between the different stakeholders that have mobilized in opposition or in support to different regulatory proposals.

Definition of Swap Dealers and Major Swap Participants One of the most fundamental changes to the regulation of derivatives markets brought by Dodd-​Frank consisted of the decision to bring a large range of market players involved in the trading of derivatives under the oversight of US regulators. But what market players should be captured within the regulatory net cast by Dodd-​Frank derivatives rules and required to comply with its prudential and business conduct requirements? Dodd-​Frank instructed regulators to cast the net widely to include both those firms marking a market on swaps (defined as “swap dealers”) as well as those firms that maintained “substantial positions” in swap markets that could have “serious adverse effects on the financial stability of the United States banking system or financial markets” (defined as “major swap participants”). The legislation passed by Congress, however, left to the CFTC and SEC the responsibility of jointly defining what entities would be captured by these two categories.   Lindblom 1977; Baumgartner et al. 2009; Falkner 2007; Roemer-​Mahler 2013.   Young 2012; Kastner 2014; Clapp and Helleiner 2012; Pagliari and Young 2014. 30   Hula 1999; Holyoke 2011; Baumgartner et al. 2009; Pagliari and Young 2013. 28 29





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A senior CFTC official declared at the beginning of the implementation stage that these definitions would be “extremely broad” in order to fulfill the congressional mandate “to decrease risk in the system and improve transparency by trying to make sure that no one’s evading the system and that we’ve got full coverage.”31 This broad interpretation of the congressional mandate has, however, been challenged by a broad range of firms seeking not to be captured by the regulatory net cast by regulators.32 As the CFTC Commissioner Chilton commented: “One thing that’s been evident . . . is that a lot of folks think that the line for regulation starts right behind them.”33 In particular, demands to be excluded from the definition of swap dealer and major swap participant were advanced by a large number of financial firms that included employee benefit plans, farm credit system institutions, Federal Home Loan Banks, small and mid-​size banks, life insurance firms, asset managers, and hedge funds,34 as well as numerous non-​financial end-​users. For instance, the Coalition for Derivatives End-​Users pressed for a “strong, clear exemption for end-​users” on the grounds that “end-​ user hedges do not create risk that demands and justifies the type of regulation imposed upon swap dealers.”35 Among non-​financial companies, energy firms were particularly vocal in mobilizing against the proposal by the CFTC requiring firms with a yearly gross notional amount above USD 100 million to register as swap dealers,36 claiming that a single swap to hedge a large container cargo of crude oil would have exceed this threshold.37 Energy firms called for this threshold to be increased more than thirty times.38 This increase in the threshold was opposed by the CFTC. Its chairman Gary Gensler cited Enron’s role in the derivatives markets before its 2001 collapse in justifying the extension of the rules also to some non-​bank players that acted as dealers, stating that if large energy firms were exempted from these rules, “we could look back to 2012 and call it the BP loophole instead of the Enron loophole.”39 Despite the opposition from Gensler, the pleading of commercial end-​ users for a higher threshold found support within Congress.40 In January 2012,   Scheid 2010d.   Rampton 2010. 33   Rampton and Doering 2010. 34   CFTC and SEC 2012: 30605. 35   Scheid 2010c. 36   CFTC and SEC 2010. 37   Protess 2012. 38   BP, Constellation Energy, and Shell pitched a USD 3.5 billion threshold, while the Coalition of Physical Energy Companies proposed a USD 3 billion figure. See Scheid 2011b. 39   Scheid 2012a. 40   O’Neil 2011. 31 32



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the House Agriculture Committee approved bipartisan legislation (H.R. 3527  “Protecting Main Street End-​Users from Excessive Regulation Act”) to narrow the definition of swap dealers and explicitly exempt end-​users. While this bill did not come to a vote in the Senate, the vast opposition to its initial rule and the bipartisan pressures from Congress combined to create significant pressures upon regulators to revise their approach. In March 2012, the CFTC bumped the threshold for mandatory registration from USD 100 million to up to USD 8 billion, a threshold comfortably higher than the trading volume of most energy companies.41 Beyond increasing the threshold for firms to qualify as swap dealers, additional amendments to the rules initially proposed by the SEC and CFTC have narrowed the regulatory net cast by Dodd-​Frank by exempting a number of trades and entities. First, the CFTC had initially introduced in 2012 a lower threshold when trades with “special entities” such as federal agencies, employee benefit plans, or state, city, county, or municipality (including municipally owned public power systems) would be required to come under the purview of the regulation (USD 25  million vs. USD 8 billion). This lower threshold had been opposed by non-​bank dealers such as regional utilities, natural gas distributors, and independent power generators,42 which also convinced the House of Representatives to pass a bill in June 2013 (H.R. 1038 Public Power Risk Management Act of 2013) to exempt firms conducting deals with special entities from mandatory registration as a swap dealer. In May 2014, the CFTC amended its proposed rules to exclude from the de minimis threshold for dealers those swaps concluded with “special entities.” Second, the CFTC revised its earlier proposed rule to exclude from the de minimis threshold those transactions conducted between affiliates within the same company. This narrowing of the scope of the rules followed the requests not only from financial stakeholders43 but also from a number of non-​financial corporations which centralized derivatives transactions for the different business units within the corporate group in a financial subsidiary that thus face the risk of being designated as swap dealers or major swap participants.44 Third, a similar exception was also given for swap transactions conducted by cooperatives on behalf of the members, including cooperative associations of producers and cooperative financial entities such as the Federal Home Loan Banks and the Farm Credit System institutions, which are the largest group of 41   CFTC and SEC 2012. The final rule stated that the threshold would go down to USD 3 billion after five years unless regulators had suggested a different threshold after a study. 42   Scheid 2012b. 43   CFTC and SEC 2012: 30624. 44   Kentz 2010; NGI’s Daily Gas Price Index 2011.





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lenders to US agriculture to receive significant support within the US House and Senate Agriculture Committee.45 These different exceptions and changes introduced to the definition of dealer and major swap participants had the effect of significantly limiting the net cast by Dodd-​Frank. While at the beginning of the implementation stage Gensler predicted that more than 200 firms would have to register with the CFTC, as of March 1, 2017, only 104 entities had registered with the CFTC as swap dealers and only 2 as major swap participants,46 including only 3 energy and commodity firms (BP, Cargill, and Shell). The consumer advocacy group Better Markets described the definitions of dealers and major swap participants set by US regulators as “an indefensible retreat from financial reform” and as “a poster child for . . . the influence that the financial industry has at the regulatory agencies.”47 However, as the analysis suggested, the lobbying leading to a weakening of the scope of the regulation was neither only nor primarily from financial industry groups. On the contrary, major dealer banks remained among the few voices (together with NGOs such as Americans for Financial Reform and Better Markets) cautioning against the narrowing down of the regulatory net and to exclude potential competitors.48 The analysis in this case suggests that this hollowing out of the definition of which actors should be covered by Dodd-​Frank rules reflected the lobbying efforts from a much larger front, which included commercial end-​users and financial buy-​side firms that successfully opposed an expansive interpretation of the congressional mandate.

Clearinghouses In order to mitigate the systemic risk emanating from the default of a counterparty in an OTC derivatives transaction, Dodd-​Frank mandated that all derivatives recognized as sufficiently standardized should be cleared into clearinghouse. While Dodd-​Frank elevated clearinghouses to central players in the new market architecture, concerns soon emerged that clearinghouses might concentrate financial risk rather than mitigating it. As Federal Reserve Chairman Ben   CFTC and SEC 2012: 30625; Stebbins 2012.   The list is available on the CFTC website: http://​www.cftc.gov/​LawRegulation/​DoddFrankAct/​ registerswapdealer. 47   Wagner 2012. 48   For instance, SIFMA was described in a meeting as advocating “that the exclusion should not be so broad that it permits corporate end users of swaps to accumulate very large swap positions without becoming major swap participants.” http://​www.cftc.gov/​LawRegulation/​DoddFrankAct/​ ExternalMeetings/​dfmeeting_​020411_​518. 45 46



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Bernanke put it, quoting Mark Twain: if you’re going to put all your eggs in one basket, “Watch that basket!”49 As a result, Dodd-​Frank (section 745b) directed regulators to design a number of regulatory requirements for clearinghouses. One key policy debate that has emerged during the implementation phase revolved around the issue of who should be given access to clearinghouses. During the design of Dodd-​Frank, the dominant position gained by the major dealers in a leading clearinghouse for credit default swaps (ICE US Trust) raised concerns among lawmakers that banks could exploit this position to narrow the scope of products considered eligible for clearing in order to keep these products traded in less transparent and more profitable OTC markets.50 In order to address this risk, Dodd-​Frank mandated regulators to establish eligibility standards for members of clearinghouses to ensure “fair and open access” to clearing services.51 In order to achieve this objective, in October 2010, the CFTC prohibited a clearinghouse from requiring more than USD 50 million in capital from any entity seeking to become a swaps clearing member, a threshold significantly lower than the minimum membership requirements in place in different major clearinghouses.52 Wall Street derivatives dealers mobilized against the proposed threshold, claiming it did not take into account the need to ensure that clearing members were large enough to be able to handle the wind-​down of large trading positions in a default scenario. In the words of Deutsche Bank managing director: “A [clearinghouse] is as good as its members. . . . The last one you bring in may actually be increasing the risk.”53 Large dealers also have opposed opening up clearinghouse membership to smaller members on the ground that these lacked “critical swap-​market expertise.”54 As a result, major dealer associations called for a much higher threshold than the one proposed by the CFTC (USD 300 million in the case of SIFMA, or USD 1 billion in the case of ISDA). On this issue, the position of dealers was supported by the same clearinghouses such as CME, LCH, and ICE,55 with the latter arguing that the purpose of Dodd-​Frank was to “make the financial system more stable,” not to promote competition between financial institutions.56 The lobbying by dealer banks and clearinghouses in support of restricting the access to CCPs was opposed by a number of voices within the financial industry.   Trindle 2011.   Morgenson 2009; Story 2010. 51   Greenberger 2012. 52   Ibid. 53   Bunge 2010a. 54   Greenberger 2012. 55   CFTC 2011: 69355. 56   Scheid 2010b. 49 50





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For instance, SDMA—​an association created in 2008 by a number of inter-​ dealer brokers, futures commission merchants, and investment managers—​ expressed concern about the issue. SDMA argued that in the absence of lower membership requirements large dealers would be able to maintain control of derivatives clearing organizations and effectively exclude smaller dealers and any potential new products they wanted to trade bilaterally, resulting in the continuation of “the same, OTC-​style, bilateral, closed, untransparent, opaque, risky system.”57 Overall, the USD 50 million threshold rule proposed by the CFTC was supported a number of buy-​side actors (such as hedge funds Managed Fund Association and Citadel), inter-​dealer brokers (SDMA), and voices outside of the financial industry (Better Markets, AFL-​CIO).58 The divisions that emerged within the financial industry on this issue widened the policy space for regulators to confirm in November 2011 the proposed USD 50  million threshold. The CFTC rejected the claim by dealers that this “would lead to a [clearinghouse] having to admit clearing members that are unable to participate in the default management process.”59 Moreover, the fact that during this period dealers and clearinghouses were not successful in soliciting action by Congress in favor of a higher threshold than the one proposed by the CFTC allowed regulators to maintain that a higher threshold “would be contrary to the Congressional mandate for open access to clearing.”60 The debate over the rules governing the access to clearinghouses was not the only contested issue surrounding the governance of clearinghouses that emerged during the implementation of Dodd-​Frank. Congress identified the nature of clearinghouses as profit-​seeking entities, thus creating incentives for these firms to bolster the volume of activities by accepting swaps not safe to be cleared or to lower risk management standards. As a result, Dodd-​Frank gave regulators the task to define a series of prudential requirements for CCPs to bolster the safety of clearinghouses. Similar to the debate on membership criteria, the rules proposed by the CFTC pitted different segments of the financial industry against each other. However, the impact of these prudential requirements in determining the distribution of costs in the event of a failure of a clearing member meant that this cleavage ran primarily between the clearinghouses and their members, rather than between large and small clearinghouse members. On one side, clearinghouses generally rejected the notion that their activities could create a potential threat to financial stability and opposed the calls for   Ibid.   Himaras 2010. 59   CFTC 2011: 69356. 60   Ibid. 57 58



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more stringent prudential requirements. On the other side, clearing members as well as large financial buy-​side firms have often called for clearinghouses to have more of their own money at risk to backstop potential failures by any of their clearing members, rather than distributing these losses to non-​defaulting clearing members.61 This cleavage was clearly on display when the CFTC proposed rules requiring clearinghouses to maintain sufficient financial resources to withstand the default by the member creating the largest financial exposure in order to meet their obligations to their clearing members. While this proposal was supported by different clearinghouses,62 financial industry associations such as the Futures Industry Association and ISDA, as well as pro-​reform groups such as Better Markets and Americans for Financial Reform, lobbied the CFTC to increase this requirement and require clearinghouses to maintain resources sufficient to withstand the default of the two clearing members representing the largest financial exposure to the clearing house.63 Derivative dealers also asked the CFTC to impose capital requirements upon the same clearinghouses, a measure that was opposed by the major clearinghouses that claimed capital requirements would be unnecessary.64 In both cases, regulators took advantage of the policy space created by the conflict between different key stakeholders and decided not to deviate from their original proposal. Regulators have been more likely to cave in to financial industry pressures when facing a cohesive opposition front to their proposed rules. For instance, the CFTC revised its proposed rules to allow clearinghouses to include US Treasuries and other high-​quality sovereign bonds to meet their liquidity obligation, a measure supported both by major clearinghouses and broader industry associations, but opposed only by pro-​reform NGOs such as Americans for Financial Reform. Overall, unlike the previous case, the implementation of the rules governing clearinghouses has not been characterized by a significant backing down of regulators from their initial interpretation of the congressional mandate. The analysis of the case presented in this section highlights the lack of a cohesive front among financial firms opposing the proposed regulation. This fragmentation in the position of the financial industry and the limited involvement of Congress on this issue created the policy space for regulators not to deviate from their original position.   Stafford 2014.   CFTC 2011: 69344. 63   CFTC 2011: 69344–​69345. 64   CFTC 2011: 69347. 61 62





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Swap Execution Facilities Another key objective of Dodd-​Frank was to inject greater transparency in the derivatives markets by shifting the trading of a greater part of these markets away from the over-​the-​counter markets and toward centralized trading venues. Recognizing that most swaps would be unsuitable for trading on traditional exchanges such as those dominating the trading of futures, section 723 of Dodd-​ Frank introduced a new category called “swap execution facility” (SEF). At the same time, the vagueness of the definition of SEF provided by Dodd-​Frank meant that regulators were left with much of the responsibility for determining what actors would be allowed to compete for a share of the lucrative business of trading and brokering swaps. It is therefore not a surprise that the definition of SEFs has been the subject of intense lobbying activities. As a market participant stated: “Everyone in the world has got a different view about what a SEF is. . . . Everyone thinks a SEF definitely includes them, and so [regulators] are getting lobbied in every direction about who’s a SEF and who’s not a SEF.”65 The development of SEFs was perceived as a threat to the established position of banks that dominated OTC markets by trading directly with their customers or with other banks through inter-​dealer brokers. But it also represented a market opportunity for many other actors. This included not only deep-​pocketed derivatives exchanges dominating the trading in smaller market for futures and now coveting a slice of the trading of swaps (in particular, interest-​rate swaps) but also a variety of platforms that were used for dealer-​to-​client trades such as Bloomberg, MarketAxess, and Tradeweb, as well as brokers of swaps between dealers such as ICAP, BGC Partners, Tradition, GFI, and Tullett Prebon. All these actors set as their priority to ensure that the definition of SEF crafted by regulators would accommodate their business model while limiting competition. A first conflict among the different dealer banks, trading platforms, inter-​ dealer brokers, and exchanges competing for the control of the trading of swaps emerged around the definition of what models of trade execution facilities would be consistent with the definition of SEF. High frequency trading firms and pro-​regulation NGOs such as Better Markets and Americans for Financial Reforms supported a definition of SEF that would privilege exchange-​like systems where buy and sell orders were matched continuously and prices were live on the bid and offer sides. According to these groups, this model provided the most accurate valuation of the market, reduced systemic risk, and resulted in better prices.66 This view, however, was opposed by the majority of groups   Lynch 2010b.   CFTC 2013: 33500–​33501.

65 66



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within the financial industry. Dealer banks, inter-​dealer brokers, and a number of large financial buy-​side users that traded swaps in very large sizes and that received from banks the capacity to execute highly customized deals claimed that the limited standardization of swaps compared to future markets made this model unfeasible.67 These groups called upon for regulators to accommodate in the definition of SEF also “request-​for-​quote” models where a buy-​side firm can request a swap price from only an individual dealer or small number of dealers, rather than making this position visible to the entire market. The vast opposition front to forcing swaps trading into exchange-​like platforms can explain the direction of the policymaking process during the implementation. The CFTC quickly shelved an initial plan requiring swaps trading more than 10 times a day to be executed on SEFs publicly listing bids and offers similar to stock market order books.68 The rule proposed by the CFTC allowed instead SEFs to adopt a “request for quote” system, thus allowing market participants to access multiple participants but not the entire market. Subsequent amendments to these rules have even further distanced which firms could qualify as a SEF from the type of exchange trading characteristic of the futures markets. The original CFTC proposal stated that voice-​based execution of transactions was inconsistent with Dodd-​Frank mandate to increase pre-​trade transparency and required instead trading to be arranged on open electronic platforms. This proposal saw the emergence of a conflict among trading platforms. On the one hand, the trading platforms parts of SDMA supported the ban, stating, “You can’t trade swaps by two paper cups and a string and have pre-​trade price transparency.” 69 On the other hand, major inter-​dealer brokers such as ICAP, GFI Group, and Tullet Prebon, which conducted much of their business in matching buyers and sellers over the phone, claimed that banning voice brokering would cause disruption to the markets.70 Importantly, the continuation of voice brokering was also supported by dealers as well as large end-​users such as the Working Group of Commercial Energy Firms.71 The mobilization of these groups contributed toward tilting the balance in favor of the continuation of voice brokering, as the CFTC came to revise its previous ruling to allow an SEF to negotiate trades away from screens. A third key dispute surrounding the definition of SEF regarded the number of counterparties that should be able to access these platforms. Dodd-​Frank stated   van Duyn and Meyer 2010; Saphir and Younglai 2010; ISDA 2011; Mackenzie and Alloway 2012. 68   Lynch 2010a. 69   Lynch 2010b. 70   CFTC 2013: 33500. 71   Scheid 2010a. 67





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that SEFs should be open to “multiple” participants, while leaving to regulators the responsibility to define how this term should be interpreted. At the beginning of the implementation phase, the CFTC stated that the text of Dodd-​Frank was inconsistent with the “one-​to-​many” platforms on which a single dealer was the counterparty to all swap contracts executed through the system, thus blocking the attempt of dealer banks to have their in-​house customer-​to-​dealer trading systems recognized as SEFs. Instead, the CFTC requested SEFs to send a quote to buy or sell a specific instrument to no less than five market participants.72 This threshold was criticized from different sides. On the one hand, pro-​ reform NGOs, high frequency trading firms, and brokers represented by the SDMA claimed that restricting the requirements to five market participants would allow the continuation of semi-​private prearranged deals with a few favored participants to the exclusion of the rest. They demanded instead that a request for a quote be transmitted to all market participants in order to increase price competition.73 On the opposite side, major dealer banks and their associations argued that sending out a request for a quote to a large number of parties would compromise the liquidity in the swap markets, as market participants would be afraid to make their positions known to others.74 The opposition to the threshold of five quotes extended well beyond dealer banks and it also included a large front of platforms and inter-​ dealer brokers (Tradeweb, Bloomberg. MarketAxess, WMBAA), buy-​side firms (Blackrock, MetLife, Freddie Mac), exchanges (CME), as well as non-​financial end-​users represented by the Coalition for Derivatives End Users.75 This coalition was able to achieve significant support within the House of Representatives Agriculture Committee, which passed unanimously a legislative proposal (H.R. 2586 Swap Execution Facility Clarification Act) that would have prevented regulators from requiring SEFs to have a minimum number of participants receiving a bid or offer.76 These pressures from a broad front of interest groups, with the support from Congress, contributed to a change of direction from the CFTC which in May 2013 “recognize[d]‌commenters’ concerns about the proposed five market participant requirement” and amended its rules to require that only two firms bid on swaps orders on “request for quote” platforms.77   Mackenzie and Meyer 2013.   CFTC 2013. 74   Mackenzie 2011; CFTC 2013: 33494; ISDA 2013. 75   CFTC 2013: 33495. 76   Scheid 2011a. 77   CFTC 2013: 33497. This threshold would apply only during a phase-​in compliance period and to no less than three market participants, following this period. 72 73



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Overall, despite Gensler’s claim that the reforms would represent “a significant shift toward market transparency from the status quo,”78 the definition of SEF crafted during implementation of Dodd-​Frank has safeguarded a number of elements that characterized the trading of derivatives before the crisis and which limited the transparency in these markets. The explanation of the outcome presented in this case study highlights how, although the centralization of swaps trading in SEFs has often been described by regulators as shifting the balance of power between banks and users of derivatives and being designed to “tip some of the information advantage from Wall Street to Main Street,”79 the banks and users of derivatives have often joined forces in opposing more radical changes to existing trading practices.

Conclusion As argued in the introduction to this chapter, the regulation of financial markets often evolves in a cyclical fashion alternating between periods of de-​regulation and those where financial rules are tightened. In the case of derivatives markets, the passage of Dodd-​Frank reversed the direction undertaken by US authorities in the previous two decades and expanded the control of regulatory authorities over these markets. This chapter has investigated to what extent the regulatory pendulum has swung back during the implementation of Dodd-​Frank derivatives rules. The analysis of the rules passed by the CFTC to implement the provisions of Dodd-​Frank concerning the regulation of derivatives markets suggests that the implementation phase has brought to a halt the tightening in the regulation of derivatives markets that was set in motion by the financial crisis. The chapter highlighted how the process of defining which actors should be covered by the key requirements at the core of Dodd-​Frank led regulators to exempt a large number of non-​financial as well as financial entities, thus limiting the scope of the regulatory net cast by Dodd-​Frank. Along the same lines, the analysis of the definition of the new SEFs demonstrated how a number of pre-​ crisis trading practices that Congress had challenged in drafting Dodd-​Frank will continue under the new rules. At the same time, this whittling down of Dodd-​ Frank derivatives rules has not been uniform, with a number of instances where the rules implemented were not significantly watered down during the implementation. For instance, the analysis of the implementation of the rules governing clearinghouses has not been characterized by a significant departure from the direction set by Congress in the drafting of Dodd-​Frank.   Gensler 2013.   Scheid 2011a.

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In order to explain the uneven pattern in the implementation of Dodd-​Frank derivatives rules, this study has investigated the lobbying of different stakeholders within and outside the financial industry during the implementation phase. While most analyses of the regulation of derivatives markets before the crisis have focused on the dealer banks that dominate OTC markets, the analysis in this chapter has highlighted the significant diversity of groups that have competed to influence the action of regulators during the implementation stage. This study has highlighted how the implementation stage has been characterized by the emergence of a number of formal and informal coalitions bringing together different segments of the financial industry, as well as between financial and non-​financial actors. The case studies have, in particular, revealed how the capacity of regulators to implement the congressional mandate in an expansive way has been hindered by the emergence of large opposition fronts linking different sectors that contested the reach of the rules proposed by regulators. Besides signaling the breadth of the opposition to the proposed rules, the presence of a unified front comprising groups from a variety of sectors has increased the likelihood that Congress would exercise pressures on regulators and would revise their mandate.80 At the same time, the analysis revealed that divergences between the interests of different segments of the financial industry as well as with the broader business community varied significantly across different regulatory proposals, as well as on different aspects of the same rules. The presence of disagreements across interest groups in some instances created policy space for regulators to carry forward their preferred policy and to withstand calls for their proposed rules to be watered down. These results provide empirical support to those studies that have identified a key influence over the design of financial regulation to be the diversity of views within the financial industry and ecology of interests groups. While the competition among different groups within and outside the financial industry often represents an important check on the influence of financial industry players, the centrality of different groups in the lobbying networks represents a key source of influence. From this perspective, while bank dealers that have dominated the politics of OTC derivatives markets in the years before the crisis have been only one among a wide range groups that have mobilized during the implementation phase, their capacity to link their interests to those of different financial and non-​ financial groups is an important element explaining the outcome of the regulatory process. For these reasons, the chapter also calls for greater attention to be paid to the origins of the patterns of conflict and solidarity within the financial regulatory policymaking, and in particular the capacity of major financial institutions to gain support from a wide range of voices outside and inside finance.   Singer 2004.

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Acknowledgments I am extremely grateful to the research assistance of Alexandra Laue that has helped make the data collection possible. I also would like to thank Christopher Gandrud and Kevin Young for their help, and all the participants at the workshop “The Politics of Regulating Global Derivatives Markets after the 2008 Crisis” at the Balsillie School of International Affairs (September 19, 2015) for their comments and feedback on the previous draft of this paper.

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6

The Politics and Practices of Central Clearing in OTC Derivatives Markets Erin Lockwood

An opaque global market for highly complex, securitized derivatives, the concentration of risk in a small handful of enormously powerful private actors, financial institutions deemed “too big to fail” and backstopped by public authorities, and questions about the adequacy of risk models and capital holdings—​all of these phenomena have been criticized as contributing to the 2008 global financial crisis. The regulatory proposals that came out of the G20 meetings during the crisis and its immediate aftermath targeted many of these aspects of global financial markets, recognizing the salience of systemic risk and the need to regulate financial markets at the level of networks, rather than institutions. A key element of these regulatory proposals was a call for non-​exchange-​traded derivatives to be “cleared” through intermediaries that would act as a single counterparty to both the buy-​side and the sell-​side, reducing counterparty risk and, in combination with new disclosure requirements, rendering the OTC derivatives market and its complex dynamics of risk more legible, tractable, and, ideally, manageable. Six years after the G20’s call for central clearing, the proposal has been implemented in the majority of the main financial centers.1 By 2016, 62% of all OTC contracts were conducted through CCPs, and the BIS estimated that the rate of clearing for interest rate derivatives had more than doubled (and perhaps even tripled) between 2008 and 2016 as a result of the clearing mandate.2 Central clearing is one of the most significant post-​crisis regulatory changes to a market that was, prior to the global financial crisis, notable for its nearly   As of June 2016, the central clearing mandate had been implemented for at least some categories of derivatives in Australia, China, the European Union, Hong Kong, India, Indonesia, Japan, Korea, Mexico, and the United States (FSB 2016: 22). 2   BIS 2016a: 22–​23. 1

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complete lack of public regulation and oversight. Nonetheless, the clearing requirement has been met with a series of unintended consequences and has reproduced many of the same characteristics of financial markets that were identified as exacerbating and magnifying the 2008 financial crisis. A perusal of the financial news and discussion surrounding the central clearing mandate in 2014‒2015 turns up a set of uncertainties and anxieties that could almost as easily come from discussions of investment banks and hedge funds in 2009: concerns about the concentration of trading and risk in a limited number of financial actors, the moral hazard and potential real economic costs of institutions deemed “too big to fail,” and questions about the limitations of risk models as a centerpiece of risk management strategies. What accounts for the recalcitrance of the OTC derivatives market to this regulatory change? Why has a key regulatory mandate, specifically intended to counteract the risk associated with waves of defaults in a highly complex network, ended up reproducing some of the same dynamics? I argue that focusing on the technologies and practices used to govern derivatives markets helps explain the absence of more radical regulatory policy shifts in derivatives regulation. Specifically, I contend that although there has been a significant shift in who regulates OTC markets, much less has changed at the level of the specific practices that govern these markets.3 CCPs are much more important players in the OTC market now than they were prior to the crisis, and they have changed the structure of trading in significant ways. Nonetheless, the tools they use to manage the risk of counterparty default are quite similar to those cited by key regulatory authorities prior to the crisis as guaranteeing the markets’ capacity to govern itself. While these tools may be reasonably well-​suited to organize and manage markets during ordinary times, their inadequacy during times of crisis, when complexity and uncertainty dominate over the regularities on which most risk management tools are premised, has already been demonstrated. Once we look beyond the shift from private to public regulation embodied in the central clearing mandate, central clearing can be seen as a compelling illustration of two of the major themes of this volume, as set out in the introductory chapter by Helleiner, Pagliari, and Spagna: (1) continuity where we might expect to see change; and (2) fragmented implementation

3   The issues associated with central clearing go beyond the continued reliance on pre-​crisis risk management practices. For example, some commentators have pointed to possible conflicts of interest between CCPs and their members, whereby CCPs may relax collateral requirements to attract more end-​users, undermining their capacity to manage systemic risk by containing losses associated with counterparty default (Yagiz 2014). However, I focus primarily on the former issue in this chapter to more specifically address the central question of continuity that motivates this volume.



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where cooperation and coordination would seem to be essential. While the persistent influence of a transnational community of public and private sector actors who imagine, endorse, and mandate key regulatory tools helps explain continuity in technologies of market governance, fragmentation in central clearing owes much to the enduring (or perhaps resurgent) significance of national-​level regulatory actors. Taken together, continuity at the level of practices and fragmentation among national jurisdictions helps account for the unexpected reproduction of potentially crisis-​prone financial market dynamics—​another theme introduced by Helleiner, Pagliari, and Spagna. This rest of this chapter proceeds in five parts. First, I  position my analysis in contrast to public and scholarly claims that the central clearing mandate should be understood primarily as a major shift in the regulatory landscape and a promising solution to the problem of counterparty and systemic risk, arguing that such a perspective overlooks important continuities in financial market governance. Next, I provide some context for the post-​crisis clearing requirement, paying particular attention to a set of practices (netting, collateralization, and risk modeling and management) that structured the market for OTC derivatives prior to the crisis—​and that were taken by regulators as evidence of the market’s capacity to regulate itself. Third, I briefly describe how the OTC market was implicated in the financial crisis and how central clearing emerged as a hallmark policy proposal. Fourth, I  sketch out some of the unintended consequences of central clearing, focusing on those that reproduce pre-​crisis dynamics. The final section analyzes these changes, emphasizing the continuities in the market for OTC derivatives that have persisted despite a significant regulatory change.

Tempering the Optimism of Central Clearing Optimists The clearing mandate represents something of a hard case for the argument that post-​crisis derivatives regulation is better characterized in terms of continuity rather than change. The rapid and widely shared consensus among international and national policymakers that most OTC derivatives should be centrally cleared represents, in some ways, a significant departure from the pre-​crisis regulatory environment. The mandate has been reasonably successful at altering the behavior of derivatives market participants. According to the FSB, 70% of interest rate derivatives and 79% of credit derivatives are being centrally cleared in the United States, though CCP usage varies widely across national jurisdictions and asset classes, with many jurisdictions reporting much lower levels of





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clearing, even for products for which an appropriate CCP exists.4 At a global level, the percentage of contracts cleared through CCPs has increased steadily from less than 10% in 2010 to 26% at end-​2013, 31% at end-​June 2015, and 62% at end-​June 2016, suggesting a widespread, if slow, change in the structure of the derivatives industry.5 More generally, the clearing mandate marks out an important ideational shift from a regulatory environment in which market self-​ regulation was held up as the ideal to one in which OTC derivatives were seen as the appropriate object of public regulation and governance. Prior to the crisis, regulatory authorities in the United States and the United Kingdom, in particular, insisted on the virtues of self-​regulation for derivatives markets.6 Just five years later, following the passage of Dodd-​Frank mandating central clearing in the United States, Federal Reserve Governor Daniel Tarullo called for even further public regulation of CCPs, noting that “it is essential that the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) complete their important work on strengthening the oversight of central counterparties as soon as possible.”7 For these reasons, policymakers were (and are) eager to hold up the central clearing requirement as, if not a panacea, at least a compelling solution to the problem of systemic risk. The BIS refers to central clearing as “a key element in global regulators’ agenda for reforming OTC derivatives markets to reduce systemic risks.”8 This rhetoric, which has its origins in the G20’s statements after the 2009 Pittsburgh Summit, is echoed by other transnational and national regulatory actors, with European Central Bank Executive Board member Gertrude Tumpel-​Gugerell referring to central clearing as “an essential part of the regulatory reform to make this market sufficiently transparent and to allow supervisors and overseers to effectively monitor the build-​up of systemic risk.”9 The IMF has been somewhat more circumspect in its assessment of this regulatory change, but nonetheless describes central clearing as reducing both counterparty and systemic risk.10 Market participants, too, referred to the central clearing mandate as a “significant change,”11 demanding “profound operational changes.”12 This optimism about the capacity of central clearing to reduce counterparty and systemic risk is shared by scholars of political economy, as well, particularly   FSB 2015b: 9; FSB 2015a: 12–​13.   BIS 2016a: 22. 6   See Spagna, in this volume. 7   Tarullo 2011. 8   BIS 2015: 2. 9   Tumpel-​Gugerell 2010. 10   IMF 2010. 11   See, e.g., Deloitte 2014. 12   KPMG 2012. 4 5



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in the immediate aftermath of the crisis and the regulatory changes it sparked. For example, writing in 2010, Eric Helleiner and Stefano Pagliari used central clearing as a key piece of evidence supporting their claim that the financial crisis instigated a significant shift in financial market governance, heralding the end of the era of self-​regulation “in the sense that public authorities have accepted formal responsibility over the regulation of derivatives markets.”13 Some economists were equally optimistic about the potential for central clearing to ensure greater transparency and ultimately mitigate counterparty risk. As Viral Acharya et al. write in the prologue to their 2010 volume on the Dodd-​Frank, “Centralized clearing of derivatives . . . should enable markets to deal better with counterparty risk, in terms of pricing it into bilateral contracts,” and they go on to describe the mandate as “welcome” and “admirable.”14 But while the clearing mandate marks an important shift in who is seen as the appropriate regulator of derivatives markets, we should be careful not to overstate the degree of regulatory change; focusing exclusively on which actors are charged with governing global finance can obscure continuities in the technologies and practices used to regulate derivatives markets, as well as the persistent influence of the transnational policy community. There are three reasons to temper optimism about central clearing. First, while mandated central clearing is a policy innovation, voluntary central clearing of OTC derivatives pre-​dates the crisis by many years and was originally interpreted by regulators in explicitly market-​friendly terms as evidence of derivatives markets’ capacity to self-​regulate. In 2006, for example, Federal Reserve Governor Randall Kroszner observed, “I have often cited CCPs for exchange-​traded derivatives as a prime example of how market forces can privately regulate financial risk very effectively.”15 In this sense, central clearing does not represent a dramatic break with the pre-​crisis regulatory deference to the private sector and its claims to responsible risk management. Indeed, the fact that CCPs are private, for-​ profit actors initially attracted criticism from the Bank of England, which in its 2010 Financial Stability Report wrote that “CCP treasury units should act not as profit centres, but invest in safe and liquid assets. User-​ownership and not-​for-​profit governance arrangements provide the strongest incentives for effective risk management, aligning CCPs’ interests with suppliers of capital.”16 Although the mandate for central clearing comes from national-​level regulators, CCPs remain private, and some prominent commentators have continued to question their current for-​profit status, even while acknowledging the   Helleiner and Pagliari 2010: 90; see also Helleiner 2011: 149.   Acharya et al. 2010: 8, 31. 15   Kroszner 2006. 16   Bank of England 2010: 10. 13 14





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multiple difficulties associated with nationalizing clearinghouses that serve global markets.17 A second reason to interpret the central clearing mandate in terms of continuity rather than change is that, aside from the admittedly significant elevation of the position of CCPs in global financial networks, it has done little to fundamentally reorder the centers and relations of power in the global financial system. As the pre-​crisis evaluation of central clearing as market-​friendly suggests, the clearing requirement did not meet with the strong opposition from the financial industry that more disruptive proposals (such as banning so-​called naked or unattached derivatives18) encountered. As Gillian Tett and Aline van Duyn wrote in 2009, “most senior financiers are willing to move some activity on to a clearing platform. Indeed, this shift was under way before last week’s announcement—​ventures offering clearing functions for credit derivatives started operating this year.”19 While the clearing requirement increases costs for derivatives dealers,20 it is relatively popular among end-​users,21 derivatives dealers, anxious about their counterparty exposure,22 and, not surprisingly, private exchanges with clearing capabilities. The clearing mandate reflects not only the enduring influence of the financial industry but also of the transnational policy community who acted quickly to shape the post-​crisis regulatory agenda.23 Although ISDA officials have raised concerns about some of the consequences of central clearing, the clearing mandate enjoys the support of the primary private regulator of the derivatives industry, as ISDA CEO Scott O’Malia recently testified before the House Agriculture Committee in the United States.24 Moreover, 17   See, e.g., Tucker 2014, who writes in the voice of an imaginary advocate for socializing CCPs:  “Quit pretending that clearing houses are something different from what they really are. They’re designed to insure the system against one variant of financial market tail risk. They need to be completely safe, with no doubts. They’re also in the business of managing externalities, and of leaning against the wind. If central banks should be part of the State, so should CCPs” (8). 18   Two bills were introduced in the US Congress in 2009 (the Prevent Unfair Manipulation of Prices Act of 2009 [H.R. 2448, 111th Congress] and the American Clean Energy and Security Act of 2009 [H.R. 2454, 111th Congress]) that would have banned trading of at least some forms of “unattached” derivatives, but neither passed. 19   Tett and van Duyn 2009. 20   Deloitte (2014: 5) calculates an additional €13.60 in transactions costs (margin requirements, capital requirements, compliance costs) per €1 million (notional value) of OTC contracts traded. 21   ISDA 2015a: 6. The ISDA survey reports that of five post-​crisis regulatory reforms (clearing, trade execution, trade reporting, increased margin for non-​cleared swaps, and cross-​border harmonization), clearing has the highest positive and lowest negative ratings among end-​users. 22   Helleiner and Pagliari, for example, point to a “widespread backlash against the lack of regulation in derivatives markets” (2010: 82–​83). 23   Tsingou 2010. 24   “I would like to stress that ISDA supports the intent of Dodd-​Frank to strengthen financial markets and reduce systemic risk. That includes the reporting of all derivatives trades and clearing of standardized derivatives products where appropriate” (O’Malia 2015).



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as Helleiner and Pagliari suggest, the United States, the United Kingdom, and the European Union were key national actors in pushing for mandated clearing, reinscribing their primacy in the global financial landscape.25 Finally, as I document in the rest of this chapter, we should avoid overstating the impact or benefits of the clearing mandate insofar as CCPs rely on many of the same risk management practices that preceded—​and failed to anticipate—​the 2008 financial crisis. The unintended consequences of the shift to central clearing and the uneven way in which it has been implemented globally have pushed back against the immediate post-​crisis optimism about CCPs’ capacity to address systemic risk. In the remainder of this chapter, I contend that, despite the shift from private to public regulation, the consequences of central clearing are better understood as reflecting continuity at the level of practice. In structuring the OTC market, these practices also delimit thinking about the techniques of market governance.

Pre-​Crisis Practices of Self-​Regulation Against the backdrop of the end of the Bretton Woods system, the liberalization of capital controls, the development of deep, liquid, and minimally regulated global capital markets, a global market in non-​exchange-​traded derivatives based on interest rates, exchange rates, and credit risk began to develop in the 1980s.26 Over-​the-​counter derivatives have historically been bilaterally traded, orchestrated through standardized, nationally enforceable contracts with each party to the contract potentially vulnerable to the risk of default by her counterparty (known as credit risk). Market participants took a series of measures to limit their exposures to counterparty default, most notably through netting arrangements, collateralization, and risk modeling. Prior to the financial crisis, these practices were cited by regulatory authorities as evidence of the market’s capacity to regulate itself.

Legitimizing Self-​Regulation Public regulators, especially in the United States under the leadership of Alan Greenspan, took an intentionally hands-​off approach to regulating the market for these products in the first decade after they were developed and became widespread. Regulatory intervention was thought to likely distort the efficient   Helleiner and Pagliari 2010: 74.   Some commodity derivatives are also traded over-​the-​counter, but the bulk of the OTC market is made up of interest rate, foreign exchange, and credit derivatives. 25 26





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allocation of risk, and regulators argued that market actors had sufficient incentives to manage credit risk on their own. Alan Greenspan’s 2003 address at the Conference on Bank Structure and Competition is illustrative of this regulatory attitude toward derivatives markets: “The success [of the OTC derivatives market] to date clearly could not have been achieved were it not for counterparties’ substantial freedom from regulatory constraints on the terms of their OTC contracts.”27 Greenspan recognized that the limited number of market participants in the OTC derivatives market and the concentration of certain types of contracts within “a handful of dealers” risked creating concentrations of counterparty risks, “rais[ing] the specter of the failure of one dealer imposing debilitating losses on its counterparties, including other deals, yielding a chain of defaults.”28 Nonetheless, he asserted that “derivatives market participants seem keenly aware of the counterparty credit risks associated with derivatives and take various measures to mitigate those risks,” noting that “market participants usually have strong incentives to monitor and control the risk they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by [public] authorities.”29 While perhaps most vocally championed in the United States, this anti-​ regulatory attitude was shared by the BCBS, the main international public actor to take up the issue of transnational market regulation, whose recommendations for national regulations emphasized “promoting a better foundation for self-​regulation.”30 The Bank of England similarly resisted proposals from the European Union calling for greater regulation of the financial sector.31 The self-​regulation of OTC markets prior to the crisis, in general, did not occur over public regulators’ objections but was rather endorsed and enabled by a shared worldview that held that efficiency and liquidity in the market were both normatively desirable and best ensured through minimal state intervention. The close relationship between the financial industry and state economies, especially in terms of extending credit to individuals and the use of finance as a growth strategy, meant that the financial industry’s interests and public economic authorities’ interests were often interpreted and represented as converging. As James Kwak notes, “it is difficult to prove that the deregulatory policies pursued by these agencies were clearly not in the public interest as knowable at the time.”32   Greenspan 2003: 2.   Ibid., 3–​4. 29   Ibid., 5. 30   Tsingou 2006: 177. 31   Zimmermann 2010: 121–​136. 32   Kwak 2013: 73. 27 28



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Prior to the crisis, the risk of counterparty default was addressed through a series of conventional industry practices, rooted in private authority, most notably the ISDA, an industry coordinating and lobbying group. ISDA provided parties to derivatives deals a standardized contract known as the Master Agreement that could be modified to fit the specifics of individual derivative dealings. Although the Master Agreement did not provide all the same functions as a formal, publically regulated derivatives exchange, which limits counterparty credit risk through the use of daily margin calls, the widespread use of the Master Agreement nonetheless fostered standardization and comparability of contracts, facilitating market liquidity.33

Netting The Master Agreement also played a critical role in legitimizing self-​regulation, mitigating regulators’ concerns about the concentration of counterparty risk in a handful of derivatives dealer banks by outlining provisions for terminating contracts in the event of counterparty default, most notably permitting parties to “net out” all of their open transactions with each other, rather than undertaking a series of payments back and forth that the defaulting party might not be able to complete.34 The practice of netting thus reduces one firm’s exposure to its counterparty. The use of these closeout netting agreements was endorsed by the Basel Supervisory Committee in 1994, which noted that “netting arrangements for . . . forward-​value contractual commitments such as foreign exchange contracts and swaps have the potential to improve both the efficiency and the stability of interbank settlements, by not only reducing costs but also credit and liquidity risks”35 and amended the 1988 Capital Accord to permit bilateral netting.36 The netting provision was also lauded by national regulators as an example of market-​based initiatives to reduce counter-​party risk. As Darryll Hendricks of the Federal Reserve Bank of New York concluded in 1994, “netting agreements unequivocally lead to reductions in current credit exposures, which make up the bulk of total credit exposures [and] under certain circumstances, netting agreements reduce fluctuations in the volatility of the credit exposures of dealer institutions, thereby lowering the volatility of the institutions’ credit

  ISDA estimated that by 2003 there were more than 54,000 signed bilateral derivatives contracts using the Master Agreement form (cited in Riles 2011: 75). 34   Zepeda 2014. 35   BCBS 1994: 7. 36   The 1988 Capital Accord had previously only permitted netting by novation, which replaced existing contracts between two counterparties for delivery of a specified amount of currency on a specified date by a single contract that took into account all of the original contracts. 33





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exposures on average . . . the second major components of total credit exposures to OTC derivatives.”37

Collateralization A second practice facilitated by the Master Agreement was the assignment of collateral to derivatives contracts, intended to reduce the risk of large losses in the event of counterparty default. As ISDA writes, “in the case of a privately negotiated derivatives transaction, the essential mechanism by which collateralization works is to provide an asset of value that is to the side of the primary transaction; in the event of default on the primary transaction, the collateral receiver has recourse to the collateral asset and can thus indirectly make good any loss suffered.”38 The Master Agreement’s Credit Support Annex was widely used to govern collateral agreements between counterparties, specifying the asset (most often cash or treasury bonds) that would be used to secure the counterparty’s obligation as well as the conditions under which the collateral-​receiving counterparty can use it to satisfy the obligation.39 Anneliese Riles notes that the Master Agreement and its Credit Support Annex governing collateralization aim “to serve as a basis for global self-​regulation.”40 Indeed, US Federal Reserve Chair Alan Greenspan specifically referenced industry collateralization practices, alongside netting and risk modeling and limits, as evidence of the OTC market’s capacity for self-​regulation: “Participants in the OTC derivatives markets typically manage their counterparty credit risks to dealers by transacting only with counterparties that are perceived to be highly creditworthy, by entering into legal agreements that provide for closeout netting of gains and losses, and with the exception of most exposures to the few Aaa-​rated dealers, by agreeing to collateralize net exposures above a threshold amount. . . . The widespread use of collateral, in particular, usually is a powerful means of limiting counterparty credit losses.”41 The use of collateralization to limit losses in the event of   Hendricks 1994: 17.   ISDA 2005: 7. 39   Riles 2011: 34–​35. 40   Ibid., 32. 41   Greenspan 2005. It should be noted, however, that Greenspan conceded that collateralization is less effective when counterparties hold very large positions in highly illiquid markets (e.g., LTCM in 1998), when closing out contracts may move markets, amplifying losses beyond the posted amount of collateral. For further references to the significance of collateral to self-​regulation, see Behof 1993: 21–​31 and Greenspan 1997: 37 38

Institutional participants in the off-​exchange markets also have demonstrated their ability to manage credit risks quite effectively through careful evaluation of counterparties, the setting of internal credit limits, and the judicious use of netting agreements and



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counterparty default was similarly encouraged by the BIS, which incentivized the practice by crediting counterparties for collateralization when calculating capital requirements.42

Risk Measures, Models, and Management As referenced by Greenspan, in addition to the ISDA Master Agreement and its termination and netting provisions, derivatives dealers relied heavily on credit assessments from credit rating agencies, private American corporations (Standard & Poor’s, Moody’s, and Fitch are the big three), to calculate counterparties’ creditworthiness. Credit rating played a particularly important role in the market for credit derivatives, contracts used to insure (or hedge) against the risk of default (the credit risk) attached to an underlying portfolio of assets.43 In addition to external measures of risk, derivatives market participants relied on internal (though broadly standardized) risk models, taking the risk of default into account. These were in turn tied to internal bank risk limits and capital requirements, as recommended by the BCBS in the 1988 Capital Accord, which focused on credit risk, and its 1996 Amendment covering market risk. Banks were required to keep specified amounts of capital to guard against unexpected losses, with the precise amount determined through a combination of risk-​weighted assets and models of market risk exposure. These models played an instrumental role in empowering derivatives traders as authoritative, responsible managers of the financial future.44 But while the use of technical risk models was perceived as a marker of the industry’s ability to effectively govern itself, this view masked considerable disagreement over the content of these models, including the underlying distribution of returns assumed by the model, the strategy for calibration, and the appropriate parameter values. The challenges associated with pricing counterparty risk were amplified for derivatives products containing multiple pooled securities. Determining the correlation between default probabilities for assets within a tranched product posed a particularly complex challenge, and while David Li’s Gaussian copula function was seized on by investors to price and sell collateralized debt obligations, it was not without its (prescient) critics. Quants like Paul Wilmott and Jon Gregory rightly questioned its underlying assumption that CDS markets

collateral. . . . Thus, there appears to be no need for government regulation of off-​exchange derivative transactions between institutional counterparties.   Riles 2011: 44.   Partnoy 2006: 73–​80. 44   Lockwood 2015. 42 43





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can accurately price default risk and its reliance on a short window of historical data.45 But technical disagreements like these did not rise to the level of bank managers, let alone regulators, and like netting, collateralization, and credit rating, risk modeling—​in conjunction with risk limits and capital requirements—​ was widely interpreted to be a sound private sector method of governing the future.46 In conjunction with risk limits and stress testing, risk-​model-​based capital requirements reassured regulators that the OTC markets should have the authority to govern themselves.47 The pre-​crisis OTC derivatives market was governed primarily through private industry practices that served to convince and reassure regulators that market actors had the necessary capability to govern themselves and to limit the potential crisis. Statements from the Fed chair and governors, the Bank of England, and the BCBS suggest that key regulators saw an unregulated OTC market as serving the public good, further forestalling the potential for more intrusive regulatory policies.48

Financial Crisis and the Origins of the Clearing Requirement Despite private and public sector confidence in private forms of risk management, their inadequacy was starkly revealed during the 2008 financial crisis, when waves of defaults by insufficiently collateralized counterparties spread through the derivatives market, hastened by reports of Bear Stearns’s and Lehman Brothers’ impending insolvency.49 The system of bilateral private contracts was recognized as overly complex and severely lacking in transparency, as contracts were unwound rapidly and without sufficient liquidity in the system to ensure full repayment or to accurately price the contracts counterparties had on their books. As losses dramatically exceeded those anticipated by risk models, capital cushions were quickly exhausted and bilateral netting and collateralization arrangements were insufficient to confine losses associated with counterparty   Madigan 2008; Salmon 2009.   Porter 2010: 62–​64. 47   BCBS 1996: 1; Greenspan 1999: “Some may now argue that the periodic emergence of financial panics implies a need to abandon models-​based approaches to regulatory capital and to return to traditional approaches based on regulatory risk measurement schemes. In my view, however, this would be a major mistake. Regulatory risk measurement schemes are simpler and much less accurate than banks’ risk measurement models.” 48   Market efficiency, wealth creation, and distribution of risk are all variously cited as public ends served by derivatives. 49   See, e.g., Kelly 2008; Borroughs 2008. 45 46



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default to the immediate parties to the contract. As Andrew Haldane of the Bank of England observed in early 2009: The financial system is . . . a network, with nodes defined by the financial institutions and links defined by the financial interconnections between these institutions. Evaluating risk within these networks is a complex science; indeed, it is the science of complexity. When assessing nodal risk, it is not enough to know your counterparty; you need to know your counterparty’s counterparty too. In other words, there are network externalities. In financial networks, these externalities are often referred to as contagion or spillovers. There have been many examples of such spillover during this crisis, with Lehman Brothers’ failure a particularly painful one.50 A full recounting of the role of OTC derivatives in magnifying the effects of the US subprime meltdown is beyond the scope of this chapter and has been documented elsewhere;51 for our purposes, it is most important to recognize that the crisis laid bare the correlations, complexity, interconnectedness, and uncertainty that had structured financial markets all along, even as standardized practices provided temporary stability.52 Risk management practices based on probabilistic estimates of credit risk, especially ones that had been based on a necessarily (given the relatively newness of derivatives markets) limited set of historical data from non-​crisis times, proved to be ill-​suited to the massively correlated defaults and unprecedented drying up of liquidity that swept the OTC markets in 2008‒2009. Accordingly, collateral and netting arrangements were quickly overwhelmed by the magnitude of losses. In response to this financial contagion and to systemic risk more broadly, the G20 and the Financial Stability Board called for a series of substantial reforms of OTC derivatives market, including that “all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-​2012 at the latest.”53 CCPs were represented as a means of reducing systemic risk by decreasing complexity, since the clearinghouse would serve as a counterparty to both buy-​ side and sell-​side market participants. In the event of counterparty default, the

  Haldane 2009a: 5.   See ch. 2, in this volume. 52   Nelson and Katzenstein 2014: 361–​392. 53   G20 2009; see also FSB 2010: “The proportion of the market that is standardised should be substantially increased in order to further the G20’s goals of increased central clearing and trading on organised platforms, and hence mitigate systemic risk and improve market transparency.” 50 51





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CCP guarantees the obligation through its own resources, including a default fund composed of the collateral (or “margin”) demanded of other banks, confining (in theory) the consequences of member default solely to the transactions involving that member and forestalling the contagion that spread through Haldane’s complex networks. Additionally, CCPs were thought to provide a much more efficient system of netting than when this is done primarily on a bilateral basis because each firm’s exposure to multiple other firms can be netted out multilaterally, rather than as a series of one-​on-​one transactions. This proposal was widely taken up for consideration by national regulatory agencies in global financial centers (e.g., the de Larosière report commissioned by the European Commission and the Turner Review in the United Kingdom54) and endorsed by key international organizations.55 The United States took the lead in implementing mandatory clearing of OTC swaps, with the passage of Dodd-​Frank.56 But even before this, central clearing was quickly seized on as a desirable policy. As early as December 2008, the SEC granted CCPs temporary exemptions from federal registration requirements to allow them to get up and running quickly and begin clearing derivatives.57 Rather than taking advantage of the United States’ unilateral increase in regulation, the European Union, with the crucial cooperation of British policymakers (given the centrality of London financial markets), also began the process of implementing mandatory clearing relatively quickly, culminating in 2012 with the passage of the Regulation on OTC Derivatives, Central Counterparties, and Trade Repositories (known as EMIR). While implementation of clearing across different classes of OTC contracts has been much slower in the European Union than in the United States (and, as I contend, has contributed to market fragmentation), both actors’ commitment to central clearing underscores the extent to which it was seen as a means to manage the counterparty and systemic risk that lay at the heart of the crisis. As of June 2016, public regulators in Australia, China, the European Union, Hong Kong, India, Indonesia, Japan, Korea, Mexico, and the United States have mandated central clearing for at least some OTC derivatives.58 Although only relatively recently implemented, central clearing requirements have already had a significant effect on the OTC market. As of June 2016, an estimated 64% of   The High-​Level Group on Financial Supervision in the EU 2009:  25; Financial Services Authority 2009: 82–​83. 55   See, e.g., IMF 2010. The IMF does note, however, that, “movement of contracts to a CCP is not a panacea, since it also concentrates the counterparty and operational risk associated with the CCP itself ” (91). 56   Dodd-​Frank Wall Street Reform and Consumer Protection Act, §723 2010: 300–​307. 57   SEC 2008. 58   FSB 2016: 22. 54



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all OTC derivatives were cleared through CCPs, with higher rates for interest rate swaps.59 The clearing requirement has increased the percentage of cleared OTC contracts, but it has been less successful at restructuring financial markets to make them less crisis-​prone.

The Unintended (but Familiar) Consequences of Central Clearing Regulatory and Market Fragmentation While ostensibly a move by public regulators to reclaim a measure of control over financial markets, the central clearing requirements have struggled to do just that. Rather than centralizing a market formerly seen as overly complex and decentralized, central clearing requirements have produced regulatory fragmentation, as different jurisdictions have imposed different clearing requirements on different timelines, raising questions about liquidity and the concentration of risk in the global market for derivatives.60 While nearly two-​thirds of the total volume of OTC derivatives contracts are cleared, the clearing rate is much lower for credit derivatives (37%) and foreign exchange and equity derivatives (