Abstract
At the core of the 2008 financial crisis was a massive, un-publicly regulated market of complex financial products, which transmitted losses in the US residential mortgage market throughout the global financial system. How did the market for over-the-counter (OTC) derivatives grow so large and so risky with so little public supervision and regulation? At the heart of the matter, I contend, are changes in how both derivatives and risk have been understood as objects of governance. This article focuses on the decade preceding the passage of the 2000 Commodity Futures Modernization Act to demonstrate how competing and ultimately shifting understandings of both derivatives and financial risk put in place the conditions of possibility for the definitive deregulation of this market. Through a detailed interpretive analysis of regulatory documents, I show that changes in OTC derivatives regulation have been driven by changes in how regulators interpret derivatives themselves in a context of changing beliefs about risk and its management. Although regulators were acutely aware of OTC derivatives’ contribution to systemic risk as early as the early 1990s, they ultimately concluded that derivatives’ ability to serve as tools of risk management and generators of financial profits was consistent with their goal of promoting deep and liquid financial markets and thus took a decisively hands-off approach to regulation. The article concludes with a discussion of what shifts in interpretation and regulation of derivatives can tell us about the limits and potential for lasting post-crisis changes in financial governance.
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Notes
This article takes as its object of interest the lack of public regulation of the over-the-counter derivatives market, but that is not to say that the market was wholly unregulated; quite the contrary. Private rule-making through industry lobbying groups like the International Swaps and Derivatives Association (ISDA) provided standardized contracts for these products, helping to ensure that they were comparable and legally enforceable. Indeed, as this article argues, private regulation helped to stave off greater public regulation by signaling that the market was capable of governing itself.
For more on the differences and connections between OTC and exchange-traded derivatives, including their respective performances during the 2008 crisis, see Carruthers 2013.
This article focuses on the US regulatory story because Britain’s response to the proliferation of financial derivatives was quick and decisive compared to the interpretive and regulatory conflicts that characterized this period in the United States. The 1986 Financial Services Act made all financial derivatives—both over-the-counter and exchange-traded—legally enforceable in the United Kingdom. The Financial Services Act was part of a broader financial deregulatory effort under Margaret Thatcher, and in lieu of the public regulatory agencies established in the United States, it set up five “self-regulatory organizations” (SROs). While anti-fraud and anti-manipulation provisions still applied to OTC markets as enforced by the Securities and Investment Board, self-regulation of financial derivatives was achieved more decisively and earlier in the United Kingdom than in the United States (Schwartz and Smith 1997, p. 183; Peeters 1987, p. 389).
Attempts to deviate from US policy tend are either directly discouraged through bilateral foreign policy, such as the Japan-U.S. Yen-Dollar Commission of 1984, or indirectly punished by the globalizing financial system, as was illustrated when, faced with high levels of exchange and interest rate volatility in the late 1980s, the Japanese Diet overturned prior restrictions on derivatives trading to allow Japanese investors to participate in foreign derivatives markets, to create domestic derivatives markets, and to offer derivatives based on Japanese stock indices abroad (Miyazaki 2013, p. 14; Semkow 1989, p. 40). That being said, there were (and are) important national-level variations in derivatives policy, a phenomenon that is manifest in frequent calls throughout the 1990s, on the part of both industry participants and regulators, for cross-border harmonization of accounting standards, trading reporting, and the enforceability of specific contract provisions such as netting. However, these differences do not, for the most part, reflect significant differences in the legitimacy and legality of OTC derivatives on the whole.
None of these three changes (innovation, ideology, crisis) is individually sufficient to produce regulatory change. For example, after currency swaps emerged on the scene, interest rate swaps followed shortly in their wake. Although interest rate swaps represented an important financial innovation—eventually accounting for the majority of OTC derivatives trading volume—they were grouped together with currency swaps in regulatory discourse and governed the same way. Changes in regulators’ beliefs about the appropriate relationship between states and markets need not produce regulatory change in specific arenas either. For instance, while the post-crisis shift toward macroprudential regulation represents a change in how public regulators, especially in Europe, view their objects of governance (the financial system as a whole rather than individual firms), it has not produced major changes in how the shadow banking sector is regulated. And finally, while crises might lead one to expect regulatory change, they are not a guarantee of such change. Even the extent to which the 2008 financial crisis produced a substantively different approach to regulation is contested (see Moschella and Tsingou 2013; Helleiner et al. 2018).
What constituted a “sophisticated” investor was not specified in either the Treasury Amendment or the letter that provided the justification for exempting financial derivatives from regulatory requirements under the CEA. Despite its frequent use in regulatory discourse, the term did not receive greater clarification until the case of Salomon Forex, Inc. v. Tauber, decided by the Fourth Circuit Court of Appeals in 1993 (Salomon Forex, Inc. v. Tauber 1993). Salmon Forex, Inc., a large foreign exchange trading firm, sued Lazlo Tauber, an individual trader for breach of contract over sixty-eight currency options and futures trades. Tauber argued that he was not responsible for his debt since the trades were illegal, having been conducted over-the-counter, rather than on an organized exchange as required by the CEA. The court ruled that the currency derivatives in question were legal, despite being carried out off of organized exchanges, because Tauber, despite being an individual rather than a large bank, was a “sophisticated trader.” This decision was based on the fact that Tauber maintained foreign bank accounts to facilitate his trading, monitored his trades using a computer network that tracked exchange rates, and offset transactions rather than actually receiving the currency in question, suggesting his motives had more to do with speculation and profit-seeking than insurance.
The vast majority of the derivatives business in the United States was concentrated in New York, falling under the jurisdiction of the New York Fed.
Corrigan’s address to the New York State Banker’s Association was preceded by a significant meeting between Corrigan and J.P. Morgan derivatives enthusiasts Peter Hancock and Dennis Weatherstone. Gillian Tett (2009, p. 24) portrays this meeting as being motivated primarily by information-gathering, which is consistent with the fairly neutral position taken by the SEC at the time. Accounts in the financial press from the time, however, suggest that the meeting quickly turned antagonistic, with the J.P. Morgan bankers adopting an attitude of condescension. As Kevin Muehring and Saul Hansell (1992) related in the Institutional Investor: “The responses [Corrigan] heard back were not comforting. They [bankers] admitted they didn’t really understand derivatives or how much money they could lose if something went haywire. To be helpful, they offered to introduce Corrigan to their head of derivatives traders. Big blunder. The million-dollar-a-year swaps experts proceeded to brush off Corrigan’s concerns as if he were some Luddite in a pin-striped suit: ‘Jerry, Jerry baby, you don’t understand the business. We know what we’re doing. Now don’t go and spoil the party.’ Thus does one top banker, who was hastily deployed to placate Corrigan, characterize the swappers’ condescending attitude.”
The Institutional Investor article referenced above (Muehring and Hansell 1992), for example, outlined a scenario for financial crisis that closely parallels what happened in 2008:
The World Derivatives Nightmare I is that derivatives trading itself could cause a major bank to fail. It would take some doing, but a bank could conceivably wipe out its capital this way. The regulators’ Worst Derivatives Nightmare II is in some ways a lot more hair-curling, because it is less predictable and therefore would be harder to cope with. That is the prospect that derivatives, simply because they now invisibly permeate the entire financial system, could turn an ordinarily containable situation—one that isn’t even caused by them—into a full-blown financial crisis.… Suppose more competition prompts several large dealers to build huge books of derivatives on a particular market. And suppose they all make the same mistaken assumption in their kindred hedging models, counting on liquidity that isn’t there. Presumably this would send derivatives prices and the underlying market into turmoil. Then if a bank actually defaulted on its counterparty obligations, those defaults would go ripping across countless banks’ balance sheets. Who knows what financial chaos would result? regulators worry.
Corrigan’s speech was followed up by a strongly worded letter from New York Fed executive vice-president Chester Feldberg to all New York bank CEOs, stating that the Fed had found “basic internal-control weaknesses” in derivatives-trading operations (Muehring and Hansell 1992).
Becketti (1993, p. 38) ultimately concluded that:
The challenge posed by the apparent complexity of derivatives valuation may well be overstated. Even the most complicated derivatives are composed of individual building blocks—individual options and forwards—which are well understood, and the values of these complex derivatives literally are equal to the sums of the values of the individual pieces. In fact, the ability to express the value of a derivative in a mathematical formula can be regarded as evidence that valuing derivatives is less complicated than evaluating the quality of some traditional bank assets.
Beese himself did not advocate this, nor did the SEC, but his speech references groups of commentators who called for this.
President George H.W. Bush’s (1992) signing statement is evidence that the intent of this bill was primarily to clarify the legality of derivatives:
The bill also gives the Commodity Futures Trading Commission (CFTC) exemptive authority to remove the cloud of legal uncertainty over the financial instruments known as swap agreements. This uncertainty has threatened to disrupt the huge, global market for these transactions. The bill also will permit exemptions from the Commodity Exchange Act for hybrid financial products that can compete with futures products without the need for futures-style regulation.
The law did not, however, fully resolve the interpretive question of who constituted “appropriate persons,” as the Orange County case will show.
This was the estimated cost over 10 years of bank failures between 1989 and 1992, plus interest payments, with taxpayers covering 75% of that total (Nash 1989).
Mullins would later go on to become a partner in Long-Term Capital Management.
The report noted that the risks involved in derivatives activities (market, credit, operational, and legal risk) were the same as those facing banks and securities firms, and did not mention derivatives’ contribution to systemic risk in this discussion (Global Derivatives Study Group 1993).
“Supervisory authorities, who have studied the systemic issues posed by derivatives, have defined systemic risk as ‘the risk that a disruption (at a firm, in a market segment, to a settlement system, etc.) causes widespread difficulties at other firms, in other market segments or in the financial system as a whole.’ This definition makes it clear that systemic risk arises in the course of ordinary market activities. Therefore it may be difficult to eliminate without curtailing these activities” (Global Derivatives Study Group 1993, p. 39)
Recommendations for dealers and end-users included: value derivatives positions at market; quantify market risk under adverse market conditions/stress tests; use master agreements with close-out netting provisions; independent (of dealing) market and credit risk functions; measure, manage, report risks in a timely manner; and voluntarily adopt accounting and disclosure practice for international harmonization and transparency.
Recommendation 16 for market participants reads: “Dealers and end-users must ensure that their derivatives activities are undertaken by professionals in sufficient number and with the appropriate experience, skill levels, and degrees of specialization. These professionals include specialists who transact and manage the risks involved, their supervisors, and those responsible for processing, reporting, controlling, and auditing the activities [.…] Derivatives support functions are technical and generally require a level of expertise higher than for other financial instruments or activities” (Global Derivatives Study Group 1993, p. 17).
“I must say, however, that I am less sanguine than the authors of the [G-30] report with regard to systemic risk issues [.…] Individual market participants are fully capable of making prudent decisions concerning their own business but they do not have a natural inclination or, more important, responsibility to look at the ‘big picture’” (Schapiro 1993, p. 13).
“The Group of Thirty’s study on derivatives makes a significant contribution to the better understanding and management of the derivatives market. I have long believed that the real issue is not how regulators should regulate this market, but how dealers and end-users should manage it” (Beese 1993d, p. 8).
“Derivatives serve an important function in the global financial marketplace, providing end-users with opportunities to better manage financial risks associated with business transactions.… This combination of global involvement, concentration, and linkages means that the sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole” (United States General Accounting Office 1994, p. 7).
“GAO also noted that in such a rapidly growing and dynamic industry, new participants are likely to enter the market. Some of these new entrants may not be as knowledgeable as present dealers or may take on unwarranted risk in an attempt to gain market share or increase profits. In either case, systemic risk could increase” (United States General Accounting Office 1994, p. 7).
“Strong corporate governance is critical to the success of any risk-management system but it is particularly crucial for managing potentially volatile derivatives activities. Primary responsibility for risk management rests with boards of directors and senior management.… The issue is one of striking a proper balance between (1) allowing the US financial services industry to grow and innovate and (2) protecting the safety and soundness of the nation’s financial system” (United States General Accounting Office 1994, p. 8).
See, for example, this statement from SEC Commissioner J. Carter Beese (1993b, p.1): “There seems to be a common misperception that the regulators, like Marshall Dillon, are about to run the outlaws out of town. The question, however, is not how to run them out of town, but how to make sure that we have stable, but innovative, markets.… Most of us now recognize that these products can allow users to manage risk in a far more sophisticated and effective manner than they had been able to before.”
“Although it is possible that national policies could change and inhibit such a free flow of funds, the trend toward interlinked global markets seems unstoppable at this point” (Beese 1992, p 2.).
“This is not just an exclusive club of cutting-edge players anymore. Firms in businesses as diverse as fast food restaurants, oil, mining, and tractor companies have come to Washington to tell Congress how indispensable these products have become to their operation. McDonalds uses OTC derivatives to reduce risks it takes in its overseas operations. KLLM Transport, a national trucking company, uses OTC derivatives to limit the effects on its business of volatility in the price of oil. Even Sallie Mae advertised in Smithsonian, a favorite among Washington policy wonks, that swaps have become indispensable in meeting its mission to provide affordable student loans” (Beese 1993b, p. 3). Kramer (1993, p. 12) made a similar argument in the same year: “While this market began with only the most sophisticated institutions, the customer base may be reaching the next tier of institutions. These products may not be suitable for all institutions, and it is important for dealers to keep this in mind as they shop these products.”
“These products present risks that must be controlled and accounted for. Our challenge is to devise effective capital rules that will ensure that broker-dealers and their affiliates will remain financially stable and strong enough to withstand a potential market disruption caused by a firm failure, for whatever reason [.…] The most troubling issue for regulators and—I’ve heard—also for many CEOs is the credit risk firms take when they enter into these transactions [.…] The credit risk involved in these transactions is the first long-term risk brokerage houses have assumed on a systemic basis. It’s also the first time that broker-dealers have been in the business of credit assessment [.…] I recognize that credit risk can be measured, monitored and, in theory, controlled. But even banks have certainly shown that it’s not always as easy as it sounds [.…] The dealers in this market need to take this seriously” (Beese 1993b, pp. 2–3). Beese (1993a, p. 5) sided squarely with the self-regulatory perspective as far as risk management was concerned, noting that, “The biggest question is whether firms are adequately monitoring risk. I’ve spent a fair amount of time with OTC derivatives dealers over the last six months discussing these issues, and I have to admit: they make a good case that their risk management systems are in good shape.”
SEC Chair Arthur Levitt (1995), for example, attributed the Gibson Greetings collapse to fraud, rather than the normal operations of derivatives markets:
I remain committed to the need for regulators to pursue those who violate the securities laws. As an example of this, the SEC and CFTC brought enforcement actions against BT Securities Corporation in connection with the sale of derivatives to Gibson Greetings. We found that ‘Bankers Trust’ had violated antifraud and other provisions of the securities and commodities laws by, among other things, misleading Gibson about the value of the company’s OTC derivatives positions. We will not hesitate to act in such case—for the sake of investors, but also for the sake of our markets.
SEC Commissioner M.H. Wallman (1997) testified before the Senate Subcommittee on Securities that
the last time there were major movements in interest rate and foreign currency markets, several headline stories about losses from derivatives and other market risk sensitive instruments by corporate end-users and dealers alike surprised investors and the markets. These stories include the losses incurred by Bankers Trust, Dell Computers, Gibson Greetings, and Proctor & Gamble, among others. The surprise accompanying such losses demonstrates the need for more public disclosure of what market risks are and how the registrants in which the public invests its money are managing those risks.
See also Levitt 1997.
This view was similarly reflected in Brown-Hruska’s (2003) response to the Enron crisis, in which she praised “sophisticated and savvy” derivatives users and contended that “perhaps derivatives are a convenient scapegoat because of their relative complexity.” Greenspan’s (1994) testimony before the House Telecommunications and Finance Subcommittee similarly deflected blame away from derivative contracts.
See, for example, SEC Chair Arthur Levitt’s (1995) remarks to ISDA, which similarly emphasize that derivatives-related debacles should be attributed to failure of private oversight rather than to derivatives themselves:
Over the past two years, the headlines have been filled with significant derivatives losses by corporate and municipal end-users and dealers alike. The collapse of Britain’s Barings Bank; the problems at MetallGesellschaft, and, in the United States, the ‘Bankers Trust’ enforcement action are all still fresh in our minds. These events have heightened concern over whether derivatives are being used properly [.…] [W]e must avoid the temptation to demonize derivatives, which are a vital tool in modern financial markets. They are so useful in managing risk that if they didn’t exist, we would surely have to invent them. Like any financial instrument, derivatives require certain ground rules, and regulators can provide that. But we must resist the siren call for stringent regulation that occurs in the wake of every new loss—especially since the typical derivatives loss is less a failure of regulation, than a failure of oversight by the parties involved.
See, for example, SEC Director of the Division of Market Regulation Richard Lindsey’s (1998) testimony before the US Senate that, “The [Orange County] treasurer’s aggressive use of leverage compounded losses in the investment pools. The treasurer’s actions should have been identified and addressed by an effective internal controls system.”
LTCM was extremely highly leveraged when they collapsed, with $4.7 billion in equity capital, debt of $125 billion, and off-balance-sheet derivatives exposure of more than $1 trillion (Lowenstein 2000, p. 191.) Their strategy in fact had three pillars: very high amounts of leverage, financing through the repurchase (“repo”) market, and risk management through the use of the Value-at-Risk model (Jacque 2010, p. 250).
In a speech at the FIA/FOA Fourth International Derivatives Conference in London, Born (1997b) referenced pending legislation before Congress that would amend the CEA and could “dramatically reduce federal government oversight of our markets and, in my view could expose these markets to unnecessary risk.”
Included in those voting for the bill was Bernie Sanders.
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Acknowledgments
I would like to thank Bruce Carruthers and Stephen Nelson for their many iterations of comments on this article. In addition, I am grateful to Manuela Moschella, Abraham Newman, Stefano Pagliari, and Kevin Young for providing very thoughtful and detailed feedback on an earlier draft of this article as part of a Virtual IPES workshop in 2017—and to Rachel Wellhausen for putting together such an excellent group of commentators.
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Lockwood, E. From bombs to boons: changing views of risk and regulation in the pre-crisis OTC derivatives market. Theor Soc 49, 215–244 (2020). https://doi.org/10.1007/s11186-020-09386-1
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DOI: https://doi.org/10.1007/s11186-020-09386-1