EL DICCIONARIO DE COMPETENCIAS

Based on these and similar studies, several authors in the fields of economics and law have contributed to our understanding of the regulatory policy concerns related to credit default swaps. A frequent theme in this literature is the description of the benefits and costs created by CDSs. A representative example is the seminal article by Partnoy and Skeel, published on the eve of the financial crisis.136 _{Among the benefits of CDSs, these scholars include reducing lenders’}

risk exposure, facilitating access to capital, and providing market-based information about credit risks.137 _{Among the problems, they mention reducing}

132 _{Ayadi and Behr 2009: 189.} 133 _Ibid.

134 _{For example, Goderis et al. 2007. See further below, chapter 5.2.2.}

135 _{For example, Delatte, Gex and López-Villavicencio 2012. See further below, chapter}

5.2.5.

136 _{Partnoy and Skeel 2007.} 137 _{Ibid. 1022–1027.}

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incentives for banks to monitor, creation of incentives to affirmatively destroy value, opacity, industry self-protection, and systemic risk in the CDS market due to high leverage and interconnections.138

There is today a large literature on these issues. Among the more interesting contributions one should specifically mention Houman Shadab’s 2012 article on credit risk transfer governance, which examines governance problems in credit risk transfer markets broadly, distinguishing between “funded” and “unfunded” credit-risk transfer transactions (mainly securitization and CDSs, respectively).139

In addition to its contribution to theoretical systematization, Shadab’s analysis is interesting in that he is not excessively naive about CDSs, but he still goes on to argue that the existing (largely self-regulatory) governance mechanisms are sufficient.140

Many authors have proposed regulatory reforms. Some of these proposals are now partially outdated given the legislative changes that have taken place after the financial crisis. It is nevertheless useful to look at some examples of the directions taken in the literature. In the seminal study by Partnoy and Steel, there is only a sketch of “preliminary ideas” for reform;141 _{these include more disclosure}

regarding transactions and ISDA documents, a reform of credit ratings (this is relevant for CDOs), and a limitation of the privileges of derivatives in bankruptcy.142 _{The first and last of these ideas will be discussed later in detail,}

whereas the second is only relevant for CDOs, which fall outside the scope of this study.

David McIlroy mentions a much wider range of regulatory options, without however examining any of them in depth.143 _{They include, firstly, the}

standardization of CDSs, which is already significant, and is probably not the key issue. Secondly, there is the use of central counterparties and exchange trading, which McIlroy admits requires standardization and significant liquidity, and creates problems due to greater risk concentration. The third proposal is mandatory collateralization, which is an important issue, but probably the key question is not the existence of collateral, but the unhelpful and even destructive dynamics of bilateral collateral management with CDSs.144 _{Fourthly, we have co-}

insurance and “retaining skin in the game,” which is an interesting proposal for bank risk transfer incentives, but its efficacy is unclear, and McIlroy notes that it would be “difficult to enforce”.145 _{In order to reduce destructive incentives, he}

138 _{Ibid. 1032–1040.}

139 _{See Shadab 2012: 1037–1040.} 140 _{Ibid. 1040–1046.}

141 _{Partnoy and Skeel 2007: 1046.} 142 _{Ibid. 1046–1050.}

143 _{See McIlroy 2010: 310–314.} 144 _{See below, chapter 5.2.2.4.} 145 _{Ibid. 313.}

fifthly discusses negotiations with the defaulting reference entity, like in ordinary insurance.146 _{Finally, there are the proposals for prohibiting uncovered CDS}

protection and imposing large exposure counterparty limits (both as in insurance regulation), both of which are interesting proposals that will be examined later.

Noah Wynkoop’s 2008 article goes into much more detail in proposing compulsory disclosures and transaction reporting for credit derivatives.147

However, this study is not only outdated but it is also limited in its ambition; it acknowledges the systemic risk implications due to liquidity shocks and high leverage, but it rather optimistically assumes that transparency is enough to resolve the problems.148

Kristin N. Johnson’s 2011 article is more up-to-date, and it is also highly interesting in that it offers a more permanent theoretical contribution by comparing CDS markets with traditional “commons” situations, which in this case may give rise to a tragedy of commons due to the externalities of financial risk.149 _{This study has the advantage of systematically highlighting the externality}

problems, which cannot be reduced to opacity or leverage. Johnson’s policy proposal is also quite original: she advances a so-called community-governance model, which would be based on federally registered self-regulatory organizations.150 _{This is therefore a hybrid or co-regulatory model, which in the}

case of CDSs would probably involve the International Swaps and Derivatives Association (ISDA) as the likely candidate.

Johnson’s proposal is interesting, because ISDA already wields significant self-regulatory power, and the community-governance model would subject that self-regulatory power to governmental oversight, including authority to alter the self-regulator rules.151 _{Johnson mentions that the Dodd-Frank central clearing rule}

is an example of this model,152 _{but a hybrid model could be a modest}

improvement for the situations where clearing is not compulsory.153 _This

proposal will be further discussed later in connection with the ISDA architecture. Colleen Baker has advanced a related proposal for OTC derivatives generally, focusing on the problem of regulatory cooperation.154 _{Firstly, she proposes domestic}

146 _{This is examined later critically. In this connection, McIlroy also notes, and doubts, the}

proposal of Ayadi and Behr 2009: 194 for demanding physical settlement instead of cash settlement. I would add that this would effectively dismantle ISDA’s dispute resolution regime, which avoids physical settlement. In this respect the proposal would have wider- ranging implications than it seems at first sight.

147 _{See Wynkoop 2008: 3123–3125.} 148 _{Ibid. 3105–3107.} 149 _{See Johnson 2011: 177–190.} 150 _{Ibid. 242–256.} 151 _{See ibid. 247.} 152 _{Ibid. 250–251.} 153 _{Ibid. 253.} 154 _{See Baker 2010.}

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regulatory cooperation (in the United States context) between the SEC and the CFTC, the two principal financial regulators in the US.155 _{Baker’s objective is}

simply to overcome regulatory turf wars, which for decades have plagued the financial regulatory landscape in the United States.156 _{She proposes the creation}

of a specialized OTC derivatives super-regulator, which ”would have regulatory jurisdiction over all major market participants, all currently unregulated OTC derivative products, and all significant market infrastructure institutions such as CCP clearing facilities and trade repositories.”157 _{Secondly (and this is relevant}

more generally), Baker proposes international regulatory cooperation in the form of public-private partnerships between states and private actors such as ISDA.158

She does not enter into great detail on this, but it is another example of the co- regulatory direction found in the post-crisis literature.

Some authors, including Timothy Lynch, have recommended more radical changes such as the prohibition or non-enforcement of purely speculative (non- hedging) OTC transactions.159 _{This perspective receives inspiration from the}

traditional approach of American law, whose leading scholarly advocates include Lynn Stout.160 _{In some respects, this proposal coincides with the view advanced}

in the CDS debate that uncovered CDSs should be prohibited, although Lynch would extend it to other OTC transactions that fall outside the present study.

This perspective will be discussed later in detail, but it can again be noted already that this proposal alone is not sufficient, because it fails to address other issues, including the stability and systemic risk problems associated with the use of CDSs for hedging purposes (transfer of real credit risks). Moreover, if the proposal were limited to mere non-enforcement of purely speculative transactions,161 _{then the contracts could be enforced through extra-legal means by}

way of a central counterparty, for example. Thus the regulatory logic would largely coincide with the obligation of clearing with a central counterparty, which turns out to be problematic, particularly for CDSs. Therefore, regardless of what one thinks of the overall direction proposed by Lynch and Stout, it should be understood that the regulatory consequences are very different depending on whether it is prohibition or non-enforcement that is adopted.

The viewpoint that has attracted perhaps the least systematic attention in the scholarly literature is the idea that CDSs are essentially similar to insurance. This is probably because the general tendency is to view that as an OTC derivative and to search for regulatory solutions from that ambit. The perspective of insurance

155 _{Ibid. 1338–1349.} 156 _{Ibid. 1294.} 157 _{Ibid. 1294.} 158 _{Ibid. 1369–1376.} 159 _{See Lynch 2011: 126–128.}

160 _{See for example Stout 1999; 2009.} 161 _{See Stout 2009: 33.}

regulation nevertheless receives brief positive observations from David McIlroy, as already mentioned; Robert Jarrow likewise proposes insurance-like regulations such as higher collateral and capital charges for CDS traders.162 _The

most explicit defence of the insurance perspective has come from Benjamin Saunders, who advocates the prudential regulation of CDS protection sellers.163

He also provides a brief comparison of prudential regulation as opposed to compulsory clearing.164 _{Nevertheless, Saunders’ article is quite short and does not}

examine the arguments against it, nor does it provide any detail on the possible adaptation of the regulatory regime for the peculiarities of credit risk insurance.

It should finally be pointed out that the review of the literature on regulatory issues uncovers some factual inaccuracies. Among them is the following claim regarding the position of CDS market participants in the current UK regulatory system:

Because derivative dealing is categorized as a regulated activity in the UK, all persons dealing in derivatives must be duly authorized by the FSA. This in turn subjects them to the conduct of business rules foreseen in the FSA Handbook (under COBS). Therefore, despite the absence of direct product regulation, participants in the OTC derivative market are as tightly regulated by the FSA as any authorized firm.165

I mention this because it seems not to be an isolated view.166 _{The flaw in this}

argument is quite evident. Although the fact of being a so-called authorized firm in UK financial markets does have some regulatory implications, the rules governing all authorized firms are generic and not especially demanding. These authorized firms include all the hedge funds that are (or were) broadly considered largely unregulated. In fact, the troubles of AIG were precisely due to the CDS activities of its (largely unregulated) London-based hedge fund.167 _Where

more demanding rules kick in is at the level, not of general authorization, but of permission to conduct specific financial activities.168