The present study is built around two general questions: What are credit default swaps legally, i.e. how should they be legally categorized (the legal-doctrinal question) and how should they be regulated (the regulatory-political question). Each of these bigger questions implies several smaller questions, the principal of which are outlined next.
1.3.1.1 Questions concerning Legal Doctrine
There are at least four sets of questions concerning the legal classification of credit default swaps. The first question concerns the fact that there remains significant
uncertainty and confusion regarding the legal characterization of CDSs. Before attempting to clarify the legal question itself, it is asked what factors have contributed to this uncertainty, and why the question is supposedly difficult. One obvious explanation is that CDSs are historically novel financial instruments, and they are contracted using a terminology that greatly differs from the terminology of traditional legal categories. This would explain, at least in part, why these products may be lacking clarifying legislation and why they cannot be easily fitted into traditional legal categories.
It will be argued, however, that this is really not a sufficient explanation. Given the tremendous growth of CDS markets globally, the lack of legal sources, whether statute or case law, is very surprising. The question is, Why is this so? Is it a mere coincidence or are there institutional factors pushing in that direction? The lack of specific legal sources implies that the question will have to be studied in terms of general sources and academic literature. The latter, as we have already seen, may be somewhat skewed when it comes to financial markets law. That raises the question of how that literature should be evaluated.
It will be argued that there is a further reason for the confusing situation, namely that CDSs fall in the intersection of a range of transactions that are legally different but that economically resemble each other. This leads to the second research question: What are the principal potential legal categories, and what are the arguments in favour and against applying each category to credit default swaps? The categories examined here are gambling, securities, letters of credit, guarantees, insurance, and derivatives. The last two will receive more detailed attention, but the other alternatives are not without interest either (except gambling, which is easily excluded in most jurisdictions). The category of securities is especially interest insofar as that seems to be the preferred option in important circles, but it will be argued that this view is fundamentally mistaken; this conclusion follows from an examination of the way in which secondary- market trading is conducted in CDS markets. In contrast, tripartite arrangements such as letters of credit and third-party guarantees cannot be easily excluded; the question here will focus on the distinction between two-party and three-party arrangements.
The subsequent chapters focus on the two principal alternatives advocated in the existing literature: one is the insurance-based understanding of CDSs,204
whereas the other isthe derivatives-based understanding according to which CDSs are essentially options or swaps.205 The overall argument in the present study is
that both views can be supported, but for different reasons.
Therefore, the third set of questions concerns the application of insurance law to CDSs. What are the arguments for applying or not applying it, and what would the insurance recharacterization of CDSs imply? This is one of the biggest and
204 See Kimball-Stanley 2008; Saunders 2010; Juurikkala 2011. 205 SeeSchwartz 2007; Shadab 2010: 419–421; Henderson 2009a.
OBJECTIVES AND SCOPE
most complex questions, as it implies a range of smaller questions, as will be seen in due course (see chapter 3). These questions may be separated into two principal groups. On the one hand, there are questions concerning the application of general insurance law principles (general demarcation criteria, the doctrine of insurable interest, and loss indemnification) to credit default swaps. On the other hand, there are specific questions surrounding recent documents and interventions, including the influential Potts opinion and the fluctuating position of leading regulatory authorities (mainly the New York insurance regulators, but some statements by the UK Financial Services Authority are also of interest).
The fourth set of questions concerns the derivatives-based view of CDSs (chapter 4). This view has attracted much attention in the US, which is where the most relevant legislative reforms have taken place. Nevertheless, it will be seen that there relevant legal sources are both scarce and conceptually confusing. In fact, the current legal and regulatory environment is a puzzling mixture of conflicting elements. In order to make more sense of the situation, attention is here given to the legislative history of derivatives regulation (mainly in the US, which has marked the pace globally). In addition to the legislative outcomes, one wishes to understand the principal factors that have shaped those outcomes. Among the various influence factors, the greatest attention here is given to the activities of the International Swaps and Derivatives Association (ISDA), which has been identified as the principal behind-the-scenes driver of the current legislative framework. The post-crisis Dodd-Frank legislation is also carefully examined, not only because it sets one of the main contexts for current policy evaluation, but also because it embodies intruiguing tensions concerning the legal classification of credit default swaps. It will also be seen that this question, which reflects a kind of political interpretationof the derivatives classification of CDSs, in a sense closes the circle of the legal-doctrinal perspective, as it sheds further light on the first question that was posed at the beginning, namely why there is such confusion surrounding this issue.
1.3.1.2 Questions Concerning Regulatory Policy
The questions regarding the regulation of credit default swaps are here grouped into two categories. There is firstly the preliminary question regarding the regulatory motive or justification of regulation, i.e. whether there is any need for regulating CDSs or changing the way in which they are regulated. This is a highly complex question, because it is connected to a range of broader issues surrounding corporate governance, financial markets and financial innovations. The present study seeks to identify and critically examine the principal regulatory concerns, which form as it were the necessary background material for the evaluation of different regulatory policy alternatives (see chapter 5). This question is given great attention here, because the issue of CDS regulation cannot be considered in the abstract without taking the existing regulatory situation into
consideration, including its weaknesses that go beyond the problems posed by CDSs.
The second set of questions concerns specific regulatory approaches and alternatives (chapter 6). The present study focuses on the four following approaches: industry self-governance led by the International Swaps and Derivatives Association (ISDA), disclosure and transparency regulation, compulsory central counterparty (CCP) clearing, and heavier interventions along the lines of insurance regulation. The first three of these are the principal governance regimes currently in place for CDS markets, and the last one is partially reflected in the European short selling regulation.
More specifically, the section on ISDA-led self-regulation provides an introduction to the current ISDA architecture, and it seeks to identify its advantages and disadvantages. The latter can be distinguished into two types of disadvantages, namely doubts concerning the functionality of the architecture, and legitimacy problems. Possible reform avenues are also considered within the self-regulatory approach. The section on transparency regulation summarizes the principal post-crisis reforms in Europe and the US, and evaluates their sufficiency for resolving problems surrounding credit default swaps. The importance of transparency can hardly be overstated, but it will be argued that there are significant limits to what it can achieve. Central counterparty clearing forms the principal novel element in the post-crisis legislative framework, which is why it merits careful evaluation. It will however be criticized in light of the doubts concerning its applicability and safety for CDS markets.
Special attention is given here to the possibility of insurance-based regulation of CDS protection selling, because, as we saw earlier, the existing literature has largely neglected this possibility even though it is a central issue from an economic point of view.206 The approach chosen here is to examine whether there
is scope for a targeted regulatory scheme that would adapt the relevant insurance regulation principles to the peculiarities of credit default swaps (as is already done in some other insurance categories). It will also be asked whether these principles might be developed within the existing regulatory frameworks without the necessity of new legislative reforms.
If we compare these regulatory approaches that form the core of this part of the study, we may observe a kind of progression between them, ranging from practically no regulation towards relatively intrusive intervention. They are also broadly related to the three archetypical regulatory strategies, namely self-
206 See Jarrow 2011 (analyzing CDSs from the viewpoint of insurance economics). This
perspective has only been given modest attention by Kimball-Stanley 2008 and Saunders 2010, who fail to address the practical difficulties and weaknesses of this approach. On the other hand, the zealous critique of insurance regulation of CDSs by Henderson 2009a is excessive, and it has not received an adequate response.
OBJECTIVES AND SCOPE
regulation, co-regulation, and command-and-control regulation.207 This
progression towards heavier intervention is analytically important, because the mode of analysis here is holistic and comparative; in other words, the question is not so much whether one or other strategy might be the perfect solution (which is highly unlikely) as what their advantages and disadvantages are. There is a great need for such comparative analysis, because each approach has its strengths and weaknesses, yet the existing literature has tended to focus on specific proposals without paying attention to the alternatives.208
Importantly, the four regulatory strategies considered here must not be considered as mutually exclusive, because they may complement each other. For example, the first three of them are together currently applicable to most CDS contracts; moreover, if the contract references European sovereign debt, then the restrictions imposed by the European short selling regulation may be relevant. A possible exception to this cumulative logic would be the imposition of insurance- like regulation on CDS protection selling—for example by way of compulsory loss reserving and large counterparty limits—but in fact even in that case the other regimes would not necessarily be excluded. Moreover, insurance-based principles might be employed to further develop the regulation of institutions acting as central counterparties for CDSs.