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The Inherent Limits of ‘Legal Devices’: Lessons for the Public Sector’s Central Counterparty Prescription for the OTC Derivatives Markets

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Abstract

In the wake of the financial crisis considerable momentum has built up behind proposals to extend central counterparty (CCP) clearing in the over-the-counter derivatives markets. However, implementation is proving complex. This paper argues that one cause of this complexity is that the public sector is seeking to incorporate into legislation (and require the wider use of) a privately owned and operated risk management mechanism. As a matter of law, the paper argues that CCP clearing can be understood as a market-generated ‘legal device’; in other words, one designed to support the markets by means of the interaction of various private law techniques. Following this analysis through, the paper highlights the benefits and drawbacks which derive from the legal techniques underlying CCP clearing (standardisation of contracts, asset-backing, netting and so on) and argues that these qualities are inherent to the device. It concludes that the inherent capacity of CCP clearing gives rise to a qualitatively different set of challenges for policymakers to those arising from technical implementation and it explains that both types of problem need to be addressed if the CCP prescription is to be effective.

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References

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  26. Committee on Payment and Settlement Systems, supra n. 29, at p. 24.

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  29. Ibid., at p. 4.

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  35. For example, see European Commission, ‘Ensuring Efficient, Safe and Sound Derivatives Markets: Future Policy Actions’ (October 2009), COM(2009) 563, at p. 3 (‘a comprehensive policy on derivatives is necessary in order to avoid market participants exploiting differences in rules, i.e. regulatory arbitrage’).

  36. For a helpful chronological discussion of the national and international proposals about extending CCP clearing for CDS, see European Central Bank/Eurosystem, supra n. 7, at pp. 76–79.

  37. FSA and HM Treasury, Reforming OTC Derivative Markets: A UK Perspective (December 2009), at p. 11, available at: <http://www.fsa.gov.uk/pubs/other/reform_otc_derivatives.pdf>.

  38. Ibid., at p. 11.

  39. Ibid., Annex 3 (Overview of CCP clearing for OTC derivatives markets), at pp. 1–2.

  40. Included in a list of areas where the ‘Bank believes change is needed’, Bank of England, Financial Stability Report (June 2009), at p. 36, available at: <http://www.bankofengland.co.uk/publications/fsr/2009/fsr25.htm>.

  41. Ibid., at p. 54.

  42. See, for example, Bank of England, Financial Stability Report (April 2007), at p. 54, stating that ‘there are several challenges associated with CCP in OTC, as compared with exchange-traded, derivatives markets’, available at: <http://www.bankofengland.co.uk/publications/fsr/2007/index.htm>.

  43. McCreevy, supra n. 18.

  44. Proposal for a Regulation (EC) on OTC derivatives, central counterparties and trade repositories (Proposed Derivatives Regulation), COM(2010) 484/5; 2010/0250 (COD).

  45. Proposed Derivatives Regulation, Title II, Art. 3(1). Clearing will be required for contracts between a financial and non-financial counterparty unless the latter’s transactions relate to its commercial activities or fall below a certain threshold, which is to be defined separately: Proposed Derivatives Regulation, Title II, Art. 7(2) and (4).

  46. Ibid., Title II, Art. 6(1), and Title II, Art. 7(1) (non-financial counterparties only have to report positions above a threshold, which will be fixed separately).

  47. This term is defined as derivatives that ‘share common, essential characteristics’. In a complex and innovative market, this may not prove to be a very practical definition. Proposed Derivatives Regulation, Title I, Art. 2(4).

  48. Ibid., Title II, Art. 4.

  49. House of Lords European Union Committee, The Future Regulation of Derivatives Markets; Is the EU on the Right Track? Report with Evidence, HL Paper 93 (10th Report of Session 2009–10, 31 March 2010), at p. 2 (hereafter, the ‘HL EU Committee Report’). This report saw the Committee scrutinise two Communications published by the European Commission: European Commission, ‘Ensuring Efficient, Safe and Sound Derivatives Markets’ (July 2009), COM(2009) 332, and European Commission, ‘Ensuring Efficient, Safe and Sound Derivatives Markets: Future Policy Actions’ (October 2009), COM(2009) 563.

  50. Ibid., at p. 26.

  51. Ibid., at p. 30.

  52. Ibid., at p. 31. Discussed further in section 3 below.

  53. Ibid., at p. 31.

  54. European Commission, ‘Commission Proposal on OTC Derivatives and Market Infrastructures — Frequently Asked Questions’ (15 September 2010) MEMO/10/410.

  55. H.R. 4173, signed into law by President Obama on 21 July 2010 (hereafter the ‘Dodd-Frank Act’). The scope of the Act is captured by its long title: ‘An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.’

  56. Dodd-Frank Act, s 712(a)(1) and (2).

  57. As regards swaps: Dodd-Frank Act, s 723(a), inserting a new Commodity Exchange Act (7 U.S.C. 2), s 2(h)(1)(A). As regards security-based swaps: Dodd-Frank Act, s 763, inserting a new Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), s 3C(a)(1).

  58. As regards swaps: Dodd-Frank Act, s 727, inserting a new Commodity Exchange Act (7 U.S.C. 2(a)), s 2(a)(13). As regards security-based swaps: Dodd-Frank Act, s 763, inserting a new Securities Exchange Act of 1934 (15 U.S.C. 78m), s 13(m).

  59. The meaning of which is explained in section 3 of the paper. As regards swaps: Dodd-Frank Act, s 731, inserting new Commodity Exchange Act (7 U.S.C. 1 et seq.), s 4s(e)(2)(A) and (B). As regards security-based swaps: Dodd-Frank Act, s 764, inserting new Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), s 15F(e)(2)(A) and (B).

  60. As regards swaps: Dodd-Frank Act, s 723. As regards security-based swaps: Dodd-Frank Act, s 763.

  61. As regards swaps: Dodd-Frank Act, s 723, inserting a new Commodity Exchange Act (7 U.S.C. 2), s 2(h)(7). As regards security-based swaps: Dodd-Frank Act, s 763, inserting a new Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), s 3C(g).

  62. See definition of ‘Major Swap Participant’, referencing ‘substantial position’ at Dodd-Frank Act, s 721, referenced in the definition of ‘financial entity’ at Dodd-Frank Act, s 723, inserting a new Commodity Exchange Act (7 U.S.C. 2), s 2(h)(7).

  63. DLA Piper, ‘Dodd-Frank Alert: Regulators Take Centre Stage’ (2010), at p. 1, available at: <http://www.dlapiper.com/files/upload/dodd-frank-act.pdf>.

  64. In particular, as regards the importance of a coordinated approach to standard setting for CCPs. International coordination is facilitated in this respect by the work of the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organisation of Securities Commissions (IOSCO), which are currently engaged in an ongoing review (at the G20’s request) of their recommendations for CCPs in light of the proposed extension of CCP clearing. The European Commission has recently emphasised the need for global coordination in terms of these reforms, referencing the awaited review by CPSS/IOSCO. The same document also mentions the OTC Derivatives Regulators’ Forum which ‘was established to promote cooperation between regulators’: European Commission Proposal on OTC Derivatives, supra n. 62. The House of Lords European Union Committee has welcomed the Commission’s ‘acknowledgement of the need to develop a coordinated global approach in line with the work of CPSS and IOSCO’: HL EU Committee Report, supra n. 57, at p. 42. US legislation also acknowledges the need for international coordination. The Dodd-Frank Act, s 722, addresses the extraterritorial application of the legislation (but leaves key issues open). The Dodd-Frank Act, s 719(c), requires the CFTC and SEC within 18 months of the Act to jointly conduct a study into swap regulation, clearing house and clearing agency regulation in the US, Asia and Europe identifying ‘areas of regulation that could be harmonized’.

  65. See HL EU Committee Report, supra n. 57, at p. 46, Appendix 2 (List of Witnesses).

  66. As explained in European Commission, ‘Explanatory Memorandum to the Proposal for a Regulation on OTC derivatives, central counterparties and trade repositories’, COM(2010) 484/5, 2010/0250(COD), at pp. 3–4.

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  69. Black explores the ‘hybridity’ of decentred financial regulation by focusing on the ‘extremely wide range of actors who are or potentially could be involved in the regulatory process’, Black, ibid., at p. 262.

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  77. Riles, supra n. 85.

  78. Ibid., at pp. 610–612.

  79. As discussed in D. McBarnet, ‘Financial Engineering or Legal Engineering? Legal Work, Legal Integrity and the Banking Crisis’, in MacNeil and O’Brien, eds., supra n. 85, at pp. 70–72.

  80. Murray, supra n. 12, at pp. 291–293. See also the discussion of close-out netting in the context of the repo markets, in Benjamin, supra n. 13, at pp. 320–321.

  81. European Central Bank/Eurosystem, Glossary of Terms Related to Payment, Clearing and Settlement Systems (December 2009), at p. 4.

  82. See the detailed discussion of how these two alternatives work in a variety of different clearing systems provided by LCH in M. Yates, ‘UK Settlement’, in Blair and Walker, eds., supra n. 2, at pp. 321–324.

  83. For a discussion of a number of different English law techniques of transfer in the context of the financial markets, including novation, see Benjamin, supra n. 13, at pp. 528–531.

  84. FSA and HM Treasury, supra n. 43, at p. 6.

  85. For example, as provided for in the Dodd-Frank Act, s 725(c), inserting a new Commodity Exchange Act (7 U.S.C. 7a-1(c)), s 5b(c)(2)(K) and (L), addressing the record-keeping and disclosure obligations of clearing houses. This provides that certain information is to be made public and disclosed to the CFTC, including the terms and conditions of each contract cleared, margin-setting methodology and daily settlement prices and volume.

  86. FSA and HM Treasury, supra n. 43, at p. 9.

  87. Pickel, supra n. 6, at p. S72.

  88. G. Walker, in Blair and Walker, eds., supra n. 2, at p. 61.

  89. See the Memorandum by law firm Ashurst LLP, providing evidence to the House of Lords European Union Committee, reproduced at HL EU Committee Report, supra n. 57, p. 52, at p. 55.

  90. Bradley, supra n. 83, at p. 174.

  91. See also the work of Riles, who explores in some detail how standard contracts are used in practice, for example, contrasting the socio-legal view that they represent ‘the production of new legal regimes through the routinization of work and professional roles’ with the law and economics perspective that they represent ‘costs savings’, Riles, supra n. 85, at p. 624.

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  95. Ibid, at p. 26.

  96. For example, in the Memorandum by Ashurst LLP, supra n. 100, at p. 52.

  97. ‘Non-financial firms, in particular, have a legitimate need to transfer their risks using bespoke products.’ See Supplementary Letter from HM Treasury, HL EU Committee Report, supra n. 57, p. 17. Airlines, for example, use derivatives to address the risk associated with fluctuating aviation fuel prices. See the Memorandum by British Airways, providing evidence to the House of Lords European Union Committee, reproduced at HL EU Committee Report, supra n. 57, pp. 68–71.

  98. European Central Bank/Eurosystem, supra n. 7, at p. 79.

  99. Transcript, Examination of Witnesses R. Liddell (Chief Executive) and R. Cunningham (Director of Public Affairs) LCH.Clearnet, HL EU Committee Report, supra n. 57, pp. 46–7, Q126. (LCH.Clearnet’s witnesses stated that it is ‘easier’ to clear contracts if they are standardised but non-standardised contracts could be accepted for clearing too, as LCH.Clearnet does with its swap portfolio which was described by Mr Liddell as ‘simple and vanilla in its risk but not standardised in terms of transactions’).

  100. LCH.Clearnet has stated that ‘the fundamental requirement for eligibility is that the CCP can manage the default of a participant through the implementation of both its risk management and default management policies in a way that controls systemic risk’. It has stated that there are four main considerations for the clearing house in this regard, which can be summarised as: the assurance of market liquidity; availability and reliability of market prices; CCP default management procedures; and cost of providing clearing service and maintaining risk management structures. See Memorandum by LCH.Clearnet, providing evidence to the House of Lords European Union Committee, reproduced at HL EU Committee Report, supra n. 57, p. 39, at p 41. The Future and Options Association (FOA) gave the following as example of factors affecting clearing eligibility: ‘pricing transparency, liquidity, volatility, risk complexity, valuation capability and the risk management capacity of the CCP’. See Memorandum by the FOA, providing evidence to the House of Lords European Union Committee, reproduced at HL EU Committee Report, supra n. 57, p. 88, at p 90.

  101. HL EU Committee Report, supra n. 57, at pp. 31–32.

  102. Benjamin, supra n. 13, at p. 445.

  103. Ibid., at p. 331.

  104. Other resources which could be deployed in the event of a member’s insolvency include the CCP’s default fund and the capital resources of the CCP itself, as discussed at HL EU Committee Report, supra n. 57, at p. 29.

  105. Ibid., at p. 29.

  106. For a further discussion of ‘initial margin’ and ‘variation margins’, see P. Wood, English and International Set-Off (London, Sweet & Maxwell 1989), at p. 171 (noting that variation margins may be calculated daily or with greater frequency). The Turner Review found that the obligation in AIG’s derivative contracts to post more variation collateral as its credit worthiness fell contributed to the group’s ‘downward spiral’ in September 2008. See Turner Review, supra n. 10, at p. 22.

  107. Yates, supra n. 93, at p. 325.

  108. Benjamin, supra n. 13, at p. 450.

  109. Yates, supra n. 93, at p. 325. The implications of this point in the context of global custody are discussed in J. Benjamin and M. Yates, The Law of Global Custody (London, Butterworths LexisNexis 2002), at p. 25.

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  110. Yates, supra n. 93, at p. 325.

  111. See the detailed discussion of the law of property in the context of the financial markets in Benjamin, supra n. 13, at chapter 16. The distinction between a prime broker’s legal interest in clients’ securities and cash was the backdrop to a dispute about what happened to securities which had ‘leaked’ into cash at the time of the prime broker’s insolvency in In the Matter of Lehman Brothers International Europe (in administration), Anthony Victor Lomas and ors. v. RAB Market Cycles (Master Fund Limited) and anr. [2009] EWHC 2545 (Ch).

  112. As noted in a recent Court of Appeal decision, the administrators of Lehman Brothers International Europe have written to 1,707 account holders who ‘are thought to have potential claims against LBIE for the return of trust property’, In the Matter of Lehman Brothers International (Europe) (in administration) [2009] EWCA (Civ) 1161 [8] (Patten LJ).

  113. As described at In the Matter of Lehman Brothers International (Europe) (in administration) [2008] EWHC 2869 (Ch) [13], citing the (anonymised) applicants’ evidence that ‘if the present situation continues for very much longer the funds are virtually certain to lose the confidence of their investors so that they will suffer revenue impairments… In summary, the funds will suffer economic loss, and so will their investors unless their positions are transferred soon.’

  114. FSA and HM Treasury, supra n. 43, at pp. 13–14.

  115. Wood, supra n. 117, at p. 170.

  116. Ibid., at p. 185.

  117. [1975] 2 All ER 390.

  118. British Eagle International Airlines Ltd [1975], at 404 (Lord Cross).

  119. Wood, supra n. 117, at p. 186.

  120. HL EU Committee Report, supra n. 57, at p. 29.

  121. At the time, Companies Act 1948, s 302.

  122. British Eagle International Airlines Ltd [1975], at 411 (Lord Cross).

  123. International Air Transport Association v. Ansett Australia Holdings Ltd [2008] HCA 3.

  124. International Air Transport Association [2008] HCA 3 [60] and [94] (Gummow, Hayne, Heydon, Crennan and Kiefel JJ).

  125. M. Bridge, ‘Clearing Houses and Insolvency’, 2 Law and Financial Markets Review (September 2008) p. 418, at p. 420.

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  126. Supplementary memorandum by the International Swaps and Derivatives Association (ISDA), HL EU Committee Report, supra n. 57, p. 34, at p. 36.

  127. Benjamin, supra n. 13, at p. 266.

  128. Turner Review, supra n. 10, at p. 82.

  129. As the FSA and HM Treasury note in their recent joint publication about CCPs in the OTC derivatives markets, extending their use ‘will further significantly increase the systemic importance of CCPs’ thereby heightening the importance of rules imposed on CCPs about their ‘capital, risk management, margining and operational standards’, FSA and HM Treasury, supra n. 43, at p. 14.

  130. Typical obligations therein are discussed in Yates, supra n. 93, at p. 320.

  131. Ibid., at p. 318.

  132. Ibid., and R. Goode, Commercial Law, 3rd edn. (London, Penguin 2004), at p. 158.

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  133. See Goode, ibid., at p. 159, citing, inter alia, Robinson v. Mollett (1875) LR 7 HL 802.

  134. Yates, supra n. 93, at p. 318.

  135. European Central Bank/Eurosystem, supra n. 7, at p. 52.

  136. FSA and HM Treasury, supra n. 43, at p. 13.

  137. See, for example, the conflicting decisions reached by the Court of Appeal in Perpetual Trustee Company Limited v. BNY Corporate Trustee Services Limited and ors [2009] EWCA Civ 1160 and by Judge Peck of the US Bankruptcy Court for the Southern District of New York in Ch 11 Case No. 08-13555. Adv. No. 09-01242 (25 January 2010), anticipated in Perpetual Trustee Company Limited v. BNY Corporate Trustee Services Limited [2009] EWHC 2953 (Ch) and discussed further in C. Brown and T. Cleary, ‘Impact of the Global Financial Crisis on OTC Derivatives in Structured Debt Transactions’, 5 Capital Markets Law Journal (2010) p. 218. The conflict of laws complexities arising in connection with global securities holdings and the use of financial collateral were pointed out presciently in Benjamin and Yates, supra n. 120, at chapter 5.

  138. There are currently divergent views about the location of CCPs. For example, the Turner Review argues that the European Commission’s proposal that there needs to be a CCP in the euro zone is ‘unnecessary for financial stability reasons’, Turner Review, supra n. 10, at pp. 82–83.

  139. I. MacNeil and J. O’Brien, ‘Introduction’, in MacNeil and O’Brien, eds., supra n. 85, at p. 1.

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  1. Department of Law, London School of Economics and Political Science, UK

    Joanne P. Braithwaite (Lecturer)

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With thanks to LSE colleagues Professors Niamh Moloney and Hugh Collins for their helpful comments on an earlier draft of this paper. Any errors are the author’s own. The law is stated as at 1 October 2010.

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Braithwaite, J.P. The Inherent Limits of ‘Legal Devices’: Lessons for the Public Sector’s Central Counterparty Prescription for the OTC Derivatives Markets. Eur Bus Org Law Rev 12, 87–119 (2011). https://doi.org/10.1017/S1566752911100038

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  • DOI: https://doi.org/10.1017/S1566752911100038

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