The lack of regulation of the over-the-counter (OTC) derivatives market acted as a major transmission mechanism and a contributor to the 2007-2008 crisis (FCIC, 2011). As the G20 in Pittsburgh observed: ‘the crisis demonstrated the potential for contagion arising from the interconnectedness of OTC derivatives market participants and the limited transparency of counterparty relationships’ (G20, 2009d). This massive unregulated market added layers of leverage, obscured risk, and transmitted contagion when the credit crunch began, and investors either demanded payment of Credit Default Swaps. The securities contributed to a system where large financial institutions were not only too big to fail, but too interconnected to fail (Gensler, 2010, 2011). The derivatives market was unregulated then, and today it remains a huge potential transmission mechanism for booms and busts, worth US$638 trillion in notional value in June 2012 (BIS, 2013).
Post-crisis, the G20, central bankers and regulators signalled a resolve to deal with OTC derivatives. In Pittsburgh, the G20 leaders agreed: ‘All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties ... non-centrally cleared contracts should be subject to higher capital requirements’ (G20, 2010d). All G20 states agreed to adopt OTC derivatives
regulation by the end of 2012, a potential strong second-order change. The G20 and FSB agreed to regulate a vast part of the global financial marketplace that until this juncture had no oversight or regulation at all. This would not prove to be easy; those who called for regulation in the past, such as Brooksley Born, had failed (PBS, 2009).
Fashioning a globally consistent regulatory structure for derivatives, as demanded by the G20 and as urged by the FSB epistemic community, would be complex, and the outcome would also demonstrate a dynamic touched upon at the start of this chapter: The greater the policy- making distance between the FSB as coordinator and the actual national policy makers in a market, the greater the chance of disputes, the greater the likelihood of a suboptimal
narrative, and the weaker the regulatory hold the FSB would have over the final policy outcome. As a result of these differing dynamics, although the policy being implemented is a real and marked improvement, the reforms have been undermined by domestic interests. FSB success in this case is only partial, and the reforms are of a second-order magnitude.
5.6.1 Consistency and a minimum of exemptions
In order to be a success, the derivatives reforms should capture a majority of derivatives contracts within OTC Central Counterparties (CCPs) and exchanges if it is to significantly enhance potential market stability. To succeed, the FSB needs the U.S., the U.K., the EU, and Japan to agree comparable regulatory standards and parameters (since these are the most important markets). In addition, to secure their goal, the FSB-supported OTC derivatives regulation needs to ensure practically all derivative contracts are standardised, trade via transparent Central Counter Parties (CCPs) and require similar margin collateral for riskier nonstandard trades (so-called skin in the game). If successful, standardization of most derivatives contracts and use of exchanges for contracts could impact the gaming of the system and help ensure stability. In general, the larger the number of exemptions from the proposed rules, the greater the opacity of the market, the less liquid it may be, the more inefficient it could be, the more prone to shocks and crises it will continue to be in times of stress, and the less it can be considered a success.
As of September 2013, the original completion deadline of end-2012 had not been met by all FSB jurisdictions, but a great deal is in place in major markets. Market infrastructure is in place in most markets, and the implementation of global clearing CCP mechanisms is underway. In the European Union, regulations on derivatives and CCP trade repositories are in place. Japan, too, passed the main OTC legislation and regulations, in 2012. In the U.S., the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) adopted a number of the necessary final rules (FSB, 2012a). Hong Kong is not far behind. The U.S. and the EU have agreed their approaches and to recognize each other’s standards as equivalent (Trindle and Fairless, 2013). To be clear: FSB states missed their self-imposed deadlines, but the process is a long way towards completion and states have built entirely new regulatory structures relatively swiftly in the face of concerted resistance from banks and brokers.
The goal of the reform: ‘All standardized over-the-counter derivatives should benefit from central clearing’ (Gensler, 2010). Forcing most if not all derivatives through CCPs is still being resisted with some success by banking and broker dealers. Achieving a functioning commonality of approach and a minimum of exemptions requires resistance by regulators against pushback from bankers, dealers, and end users, all of whom have sought to weaken the stringency of the FSB-supported OTC CCP reforms.
Banking industry proxies maintain most derivatives should remain custom products and be excluded from the new transparency, oversight, and CCP requirements on the basis that the securities are complex, bespoke, and not amenable to standardisation. This logic is flawed and is akin to suggesting that because cars are complex, each customer should be sold a custom-built vehicle, with no measure of standardization, price discovery, or safety and reliability (i.e., risk) data being available to the consumer. This is rent seeking behaviour by the banks. It is in the banks’ interest to maintain an opaque marketplace where information asymmetry between seller and buyer is the norm, as per Ackerlof’s Lemon Law (Ackerlof, 1970). The 2013 EU case against banks for OTC market fixing in this space is evidence that banks know this and sought to block reform (Chee, 2013).
Because of the pressure by the banks on the regulators, a number of types of derivatives have been excluded from the G20 OTC derivatives regulation. The exclusions include derivatives bought by industrial end users, and foreign exchange swaps and forwards transactions (Gensler, 2010). The former exclusion is directed at companies that buy or sell derivatives to hedge commodities used in the normal course of their businesses, such as multinational manufacturing firms or airlines. The latter exclusion, applying to foreign exchange derivatives and forwards, excludes US$4 trillion in transactions every day from stricter regulatory oversight by supervisors (BIS, 2012). The U.S. Treasury defends its decision, maintaining it is driven by the ‘distinctive characteristics of these instruments’ (U.S. Treasury, 2011). Not so, according to the critics; instead, the decision simply ‘invites more trouble’ in the years ahead (New York Times, 2011).
The FSB-led OTC derivatives policy shows the limits of the FSB-led control over a policy outside their area of regulatory responsibility. The central banking epistemic community understands this to be a major problem area and one where action is needed, but they passed the responsibility down to the SSBs (in this case, the International Organization of Securities Commissions [IOSCO]). This SSB is younger, larger (in terms of membership), weaker, and less cohesive than the FSB-BCBS nexus (Interview 34, 2013). The IOSCO does not,
therefore, exhibit the same strength as an epistemic community, nor are its members
(securities regulators) as strong institutionally and domestically. The IOSCO is being forced into action by the G20, it is not leading the action. The OTC policy response also requires major new legislative and national regulatory action, both of which are opportunities for level-two domestic interests to intervene and impact the policy process. These dynamics
result in a more mixed, less robust outcome monitored by the FSB and implementation is not being dealt with in the same detailed manner as the BCBS-overseen process for Basel III.
The monitoring and compliance process in the OTC derivatives space consists of semiannual reporting of the status of implementation by G20 states through the FSB standing committee process (FSB, 2012b). But the reporting stops short of qualitative judgments on actual implementation. The procedure does not evaluate the nature of regulations implemented by G20 states. It merely determines whether states have self-reported and enacted regulations as per FSB commitments. This reporting may still have a reputational effect of pressing
members of the community to comply (Downs and Jones, 2002). Monitoring also adds pressure to adhere to the deadlines and timelines. But the FSB OTC process does not determine the actual strength and consistency of the national laws and rules, resulting in a weaker process.
To conclude, these markets were hitherto completely unregulated. In 2013, laws and regulations are in place in all the major markets, which should result in a great deal more transparency, internationally coordinated OTC regulation, and capital margins for the
widespread use of custom products, in this key part of the shadow banking sector. Prior to the crisis, these steps were not feasible because resistance from vested banking and broker
interests was simply too great. The current status of a partial implementation of OTC derivatives reforms is a significant development—a high second-order change (Hall, 1993) even if the final outcome appears unsatisfying and remains less than a complete success.
Placement in the policy reform matrix: The FSB OTC derivatives policy shift in the matrix is considerable but still limited. It moves the left-hand ‘very weak’ up towards ’weakly globally harmonised’ on the right. This is a high second-order (perhaps borderline third-order) change because this is a new policy approach, not just an adjustment of an existing policy, and is therefore not strictly incremental change. However, exemptions are being seen. Because of these exemptions the danger remains that significant obscured systemic risk can still exist within these markets and the massive global casino they represent. Regulators and
participants still confront a continued lack of market transparency. Perhaps in the short term, risks will not precipitate crises because the market for these complex securities has yet to rebound. But if the markets recover and if they remain opaque and illiquid, then the risks inherent in them will resurface.
Very Weak Weak Strong Extremely Strong Strongly Globally Harmonised Strongly Nationally Based Weakly Globally Harmonised Regionally Harmonised X‐Axis ‐ Represents strength of regulatory response Derivatives Regulation