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The Consequences of the Global Financial CrisisThe Rhetoric of Reform and Regulation$

Wyn Grant and Graham K. Wilson

Print publication date: 2012

Print ISBN-13: 9780199641987

Published to Oxford Scholarship Online: September 2012

DOI: 10.1093/acprof:oso/9780199641987.001.0001

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Constructing Financial Markets: Reforming Over-the-Counter Derivatives Markets in the Aftermath of the Financial Crisis

Constructing Financial Markets: Reforming Over-the-Counter Derivatives Markets in the Aftermath of the Financial Crisis

(p.67) 5 Constructing Financial Markets: Reforming Over-the-Counter Derivatives Markets in the Aftermath of the Financial Crisis
The Consequences of the Global Financial Crisis

Glenn Morgan

Oxford University Press

Abstract and Keywords

The chapter focuses on financial transactions, addressing over-the-counter (OTC) trading of derivatives, which many analyses of the recent financial crisis argue produced significant problems. This area of financial activity grew massively from the 1990s facilitated by legal developments both in the United States and the United Kingdom that ruled out any state regulation of the market while at the same time affirming that the contracts made in the area were fully legally enforceable in US and UK law. At the same time, the private association, the International Swaps and Derivatives Association (ISDA), developed the Model Contract and international private soft law agreements that were generally respected by national legal systems and provided an agreed framework for OTC contracts. The chapter explores how this lack of public regulation was legitimated and the interests which lay behind this legitimation process. It then considers how the financial crisis and the role of OTC derivatives forced a reopening of the issue of how these markets should be regulated. The chapter explores the interplay between what may be described as technical fixes to regulatory problems on the one hand and on the other hand the efforts of private and public actors to defend their interests by shaping the new markets in particular ways.

Keywords:   OTC derivatives, financial crisis, private governance, regulation


Financial markets have been highly innovative over the last two decades. The number of new products and variations on products which have been launched over this period has been immense (see the discussion in Engelen et al., 2010). Newly invented products such as credit default swaps (CDS) and collateralized debt obligations (CDOs) went from zero transactions to transactions that were calculated to place billions of dollars at risk, all within the space of a few years. The speed of diffusion of these products across actors, institutions, and countries was dramatic and illustrated a basic problem in law and regulation. As the actors themselves were aware, if all such products had to be subject to regulatory approval or, even worse, had to be explicitly allowed for in law, the speed of innovation would slow to a crawl. This would have a variety of disadvantages to the originators of such products, for example, nobody would be able to accrue first-mover advantage and the possibility of rapidly establishing scale and reputation for these new products would be more difficult to achieve.

It is important to note that this represents a massive break from the way in which financial markets were conceived and regulated previously. At least since the New Deal, it has been recognized that financial innovation is not an unalloyed benefit to society. On the contrary, during the heyday of the Bretton Woods system, fixed exchange rates, controls on flows of capital, varying levels of state management of fiscal and monetary matters, and legal prohibitions on certain forms of activity and organization all inhibited (p.68) financial innovation in order to reduce the possibility of volatility, turmoil, and financial booms and busts. The collapse of this system as described in numerous accounts of the rise of neoliberalism (e.g., Blyth, 2002; Krippner, 2011) and the gradual establishment of deregulated financial markets, particularly in the United States and the United Kingdom, changed this situation. Much of the literature within political economy concentrates on these macro-processes. However, this broader change still required activities at a more micro-level in terms of particular markets, products, and firms if the potential was to be realized. The space for financial innovation still has to be made and imposed in contexts where there are competing actors with different interests and power capacities. How markets work in practice and with what effects requires attention to the details of those markets and not just the facilitating role which institutional and ideological change plays.

In this respect, the financial crisis gives us a useful opportunity to examine the interplay between the macro-level of regulation and government and the micro-level of markets and private actors. It reveals the limits of hegemony, that is, the degree to which the taken-for-granted structures in particular sectors of the financial market can be revealed as the outcome of distinctive forms of power and politics. The financial crisis shows starkly who benefits and who loses from a particular structure and then reveals to us how public and private actors struggle to build a new order in a new context.

This chapter focuses on a specific sector of the financial markets, which is concerned with Over-the-Counter (OTC) derivative products. What makes this a particularly interesting object of study is that in the run-up to the financial crisis, OTC products grew to a huge extent and were integrally involved with the overall expansion of CDOs, subprime mortgages, and the subsequent balance sheet difficulties encountered by many financial institutions. Early analyses of the collapse of 2008 identified OTC derivatives as the fundamental cause of the crash. How these markets operated became subject to more detailed scrutiny and what emerged was a complex interplay of politicians, regulators, financial institutions, and intermediaries struggling to shape and reshape law and regulation by using various resources, theories, and technologies.

The chapter has three parts. In the first part, the struggle over the legality of OTC derivatives is discussed and it is shown that in spite of resistance, the combined power of industry insiders and supportive federal officials led the United States to legitimate these products in a way that was particularly advantageous to those trading them. The result was that industry insiders (in the International Swaps and Derivatives Association, known as ISDA) created their own framework for managing these products. In the second part, the products themselves are discussed in more detail to show how and why they were capable of producing the sorts of profits that further (p.69) augmented the legitimacy of the market and the power of the institutions which were trading them. In the third part, the impact of the financial crisis on this market is discussed and in particular how issues of law and regulation surfaced again. This shows how in spite of the massive delegitimation which had taken place as a result of the crisis, private actors have still been able to limit the degree of legal and regulatory constraint to which they have been subject.

Over-the-Counter Derivatives and the Growth of Credit Default Swaps

From the early 1980s, an alternative way of trading derivatives emerged to challenge regulated exchanges such as the Chicago Board of Trade and the Chicago Mercantile Exchange, the existence of which went back over a century. Regulated exchanges were, as their name suggests, regulated by national regulators, in the United States, the Commodity and Futures Trade Commission (CFTC). They traded in standard contracts and the exchange itself mediated between contracting parties. Membership required a firm to pay a fee to the exchange and to deposit margin with the exchange, which varied on a daily basis depending on price movements in the market. Margins at the level of particular deals, particular participants, and at the level of the exchange itself in principle provided a buffer against the collapse of one dealer bringing down the whole system. In order for such exchanges to work, it was important that contracts had to be standardized—by amounts, by duration, by risk category. Prices were transparent, so participants knew what was happening across the market and made money through the speed of their response to market movements and the degree of risk which they were willing to take on as well as through the fees they earned by providing hedging facilities for their clients.

Over-the-Counter trading grew as an alternative to exchange trading and in quantitative terms soon outstripped it. For example, measured by amounts outstanding in US dollars, the OTC derivatives market in June 2009 was worth approximately $604 trillion dollars compared to around $72 trillion dollars outstanding on organized exchanges (Bank for International Settlements, 2009a, 2009b). Why did this occur? This is a complex question which requires much further research. However, there are two elements that are relevant. The first is the nature of OTC contracts and in particular their flexibility and profitability. The second element is the nature of regulation of these contracts—or more precisely the lack of regulation.

In relation to OTC contracts themselves, as invented in the 1980s, they were bilateral—between two parties who determined the nature of the product (p.70) traded and the price of the product. A theme which is continuously emphasized by proponents of OTC trading is its flexibility. This refers to a number of features of the relationship between buyer and seller. The actual content of the trade is determined by the two parties to the contract. This means that there are no fixed terms to contracts and no fixed units; parties to the contract make deals for as short or as long as they want, as big or as small as they want. Similarly, there is no general transparency in the OTC market which would allow a buyer to compare the price of the product easily across different dealers. Because deals are negotiated bilaterally, information on the nature of the contract such as price is only shared between the two participants in the contract, not more widely. This makes the price opaque and opens up the potential for information asymmetries between buyers and sellers (a point developed further later in the chapter). The parties to the OTC contract can create whatever sort of underlying assets they wish—a crucial point when in the period from 2001, CDOs based on packages of asset-backed securities (particularly those associated with subprime mortgages) and backed by CDS, a particular type of OTC-traded derivative was being developed in investment banks at a rapid rate.

Key to this was the regulatory position of OTC markets which developed in the 1990s up to the financial crash. In the United States, the OTC derivatives market had developed during the 1980s and 1990s in a state of legal uncertainty about the enforceability of the contracts through the courts (Stout, 1999, 2009; Awrey, 2010), which potentially left US derivative traders at a competitive disadvantage compared to those based in the United Kingdom where the situation was more regularized.

By 1998, it was clear that there was going to be some sort of clearing up of the legal position on OTC markets with Brooksley Born, head of the CFTC proposing an end to OTC and OTC traders themselves supporting the legal enforceability of the contracts. According to an article in the New York Times (Goodman, 2008), Born’s efforts in 1997–8 to institute regulation over OTC derivatives were fiercely opposed by key figures such as Alan Greenspan at the Fed, Robert Rubin and Larry Summers in the Clinton Treasury department, and Arthur Levitt at the Securities and Exchange Commission (SEC) who in turn were strongly supported in their opposition by the industry. Born’s original proposal to include the banning of OTC markets in a new law was rejected and she left the CFTC in 1999. A report from the President’s Working Group on Financial Markets (consisting of Summers, Greenspan, Levitt, and Rainer) was published in November 1999 (President’s Working Group on Markets, 1999). This report argued in favor of clearing up the legal position of OTC derivatives in the US system and, further, of legally taking them out of the purview of any of the US regulators, particularly the CFTC; both of these recommendations were followed in the Commodity Futures Modernization (p.71) Act (CFMA) 2000. Stout states that “the CFMA not only declared financial derivatives exempt from CFTC or SEC oversight, it also declared all financial derivatives legally enforceable. The CFMA thus eliminated in one fell swoop, a legal constraint on derivatives speculation that dated back not just decades, but centuries. It was this change in the law—not some flash of genius on Wall Street—that created today’s $600 trillion financial derivatives market” (Stout, 2009). Glass also describes this Act as a “famous victory” for swap dealers who “have historically opposed increased regulation of OTC derivatives” (Glass, 2009: S85). Tett states that CFMA specifically “stressed that ‘swaps’ were not futures or securities and thus could not be controlled by the CFTC or SEC or any other single regulators. ‘Congress nailed the door shut in 2000 [on unified regulation], with the passage of the Commodities Futures Modernization Act’ observed ISDA lobbyist Mark Brickell. The derivatives sector was jubilant” (Tett, 2009: 87).

It is important to note that while public actors had given up any role in regulating these markets, private actors knew perfectly well that there needed to be a collective framework to facilitate the scale of trading that was developing. This collective framework was constructed by the industry body, known as the ISDA (for detailed accounts of the development of ISDA, see Flanagan, 2001; Morgan, 2008, 2010; Awrey, 2010). The membership of ISDA consisted of all those engaged in the trading of OTC contracts though its most powerful group were the large investment banks. ISDA produced what was termed a model agreement which was to be the agreed basis for any OTC contract between its members. ISDA aimed to ensure that this private “model agreement” was enforceable in any national jurisdiction where OTC contracts were traded, by lobbying legislators and jurists and changing laws if necessary. Where problems arose or new types of products required the rethinking of the model agreement, ISDA committees would come up with solutions satisfactory to the market insiders. ISDA would also represent the industry in discussions with governments and intergovernmental organizations. Thus, the regulatory vacuum was filled by the private actors in the industry creating an international framework for market stability and lobbying governments and others to ensure that control remained with them and did not become in their view “politicized.”

Markets, Products, and Power

It is important to identify the effects of this process in terms of politics and power. Effectively, what occurred was that the largest institutions in the financial sector became hugely more profitable (and more risky) as a result of their ability to trade these sorts of products without regulatory oversight. The (p.72) degree of profitability of the financial sector in the golden years between 2002 and 2007 created a coalition consisting of insiders to the industry, supporters of free markets inside the economic profession, and the regulatory bodies and governments content with the tax taken from these rich institutions and individuals. The cognitive and normative narratives of the advantages of free markets went along with powerful isomorphic forces as expressed by the Citicorp Chief Executive, Chuck Prince, who said in July 2007 “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Alongside this, there was a more prosaic instrumental narrative. In the United States and the United Kingdom, in particular, it was not just the bankers who were “dancing.” What Crouch (2009) has described as “privatized Keynesianism,” that is, the debt financing of personal (as opposed to state) consumption, was essential to providing consumers with a sense of increasing prosperity (Langley, 2008), particularly at a time when real incomes were stagnating for a large proportion of the population. For governments, expanding consumption and an expanding financial sector raised tax revenues while personal tax rates could be held steady or decreased thus providing both a political and an economic payoff. Neither governments nor the main financial institutions were willing to heed the warnings of isolated individuals betting against the market (Lewis, 2010) or more importantly the worries of institutions such as the Basel Committee about the degree of leverage and risk in the financial system.

These dynamics worked themselves out in a variety of ways across different parts of the financial markets. To take, for example, OTC CDS which were so central in the subprime crisis, at their peak in December 2007, CDS constituted almost 10 percent of the total notional amounts outstanding on OTC derivatives. CDS were “invented” very recently. Tett (2009: ch. 1) describes how in 1994 JP Morgan bankers first put together the concept of a contract which would protect it against the default of loans which it held on its books. Over the following few years, they worked through some of the technical details of such a product, first selling it in late 1997 (Phillips, 2008). The first separate entry for CDS contracts in the Bank for International Settlements (BIS) quarterly reports on the OTC derivatives market occurred in 2005 and it stated that notional amounts outstanding on these contracts were approximately $10 trillion by mid-2005. By December 2007, the notional amount outstanding on OTC CDS was around $58 trillion, an almost sixfold increase in the space of just over two years (Bank for International Settlements, 2007).

From the perspective taken in this chapter, it is important to understand how this market worked and where power, profitability, and risk lay. OTC CDS deals depended on a supply side in which there had been initial high levels of investment in expertise, model building, calculating systems, back-office, and (p.73) IT support. Because of the complexity and scale of these investments, only the largest financial institutions were capable of being “producers,” particularly of the more exotic OTC derivatives. It was they who built the products and proceeded to market and sell them to other financial institutions. However, once they had made such investments the marginal costs of selling more contracts was practically zero in “production” terms. There was no “production” limit to the market; the only limit was how many such contracts the markets could absorb at the prices which the producers wanted to charge.

These large financial institutions aided by interdealer brokers who sought to intermediate between potential buyers and sellers of these products brought into existence this particular market and constructed it in a way which was highly profitable to them. Broadly conceived, one of the counterparties would be willing to take on the risk of default on a particular bond in return for a steady flow of income; the other party would be willing to pay a regular fee in return for the possibility of being repaid in full if the bond defaulted. The main purchasers of risk in the period included AIG (Financial Products division), parts of the big banks themselves, and the monolines (specialized insurance companies that had traditionally provided financial guarantees to buyers of municipal bonds but who extended that to buyers of CDOs in the period up to 2007–8). The other counterparties to the contract included those institutions engaged in genuine hedging as well as hedge funds speculating on defaults and/or changes in spreads on the contracts. Where the large financial institutions and the interdealer brokers intermediated between the two counterparties by negotiating two separate back-to-back contracts, they aimed to squeeze the payments to the risk taker as low as possible and push the payment obligations of the risk seller as high as possible. Because the markets were not transparent and prices were not visible across the trading community and more particularly among the ultimate buyers and sellers of the contracts, there was little price competition pressure. In 2009, an FT (Financial Times) article commented that “dealers had every incentive to keep the market opaque and bespoke, which boosted margins—and profits” (Bullock et al., 2009).

The intermediating financial institutions had the highest chance of collecting the most relevant information on particular buyers and sellers, on spreads being offered and accepted, on the specifics of risk in contracts and adjusting their spreads, and their willingness to hold risk themselves. They used this information to set prices that were highly profitable to themselves. They also used it toward the end of the boom period to readjust significantly their market position in OTC CDS as they began to perceive the fragility of the boom and the likelihood of the coming crisis.

Traders in these financial institutions became so powerful (and so wealthy) since it was their job to find the buyers and the sellers, to make the market, and in this way to create profits (and their own bonuses) through a combination (p.74) of fee income and spread differentials on contracts that had varying durations. In theory, if not in practice, the systems were in place to process as many deals as the traders could push through. OTC CDS markets were therefore strongly driven by the supply-side organizing the market, creating the products, and drawing in other actors.

Having a strong and powerful sell-side does not, however, guarantee an equally extensive buy-side in the market. What was crucial for OTC CDS was that the buy-side was not restricted to those hedging risk on bonds which they held in their portfolio. Under English and US law, there was no requirement for Company A to have an actual “insurable interest” in the bonds issued by Company B; that is, it did not have to own any of the bonds. Clearly, from the point of view of a holder of bonds, to be able to hedge the credit risk was potentially useful depending on the spread. But this was a relatively limited market. The fact that it was not necessary to hold the bond to take out a CDS contract on it was crucial to extending the market dramatically. That this was successfully achieved is reflected in the fact that the total amount of CDS contracts outstanding far outweighed the total amount of bonds issued and the value at risk in the original assets. Zabel, for example, calculated that the “corporate bond, municipal bond and structured investment vehicles market totaled less than $25 trillion” and therefore $20 trillion of the total $45 trillion notional value of CDS contracts in 2007 were speculative “bets” on the possibility of a credit event of a specific credit asset not owned by either party to the CDS contract (Zabel, 2008). Stout states that “by the end of that year [2008], the notional value of the CDS market had reached $67 trillion. At the same time the total market value of all the underlying bonds issued by US companies outstanding was only $15 trillion” (Stout, 2009).

This reflects the fact that the demand-side of the CDS market was not simply a way of hedging risks that had been taken on as a result of a credit deal. It was also a way of speculating on price movements in the markets both in terms of the value of the underlying asset and in terms of the changing spreads of the CDS contract. Using CDS for speculation involved taking a short position on the asset in the belief that the odds on a form of credit default were not being estimated properly by the holders of the risk. Subsequent to the crisis, the identity of some of the individuals, hedge funds, and traders within financial institutions who took on these bets, against the market as a whole, have become identified, for example, most notably John Paulson (Lewis, 2010). CDS became classic instruments for taking short positions because they had known and limited costs (the premium which was being paid) but with the potential of a huge upside. For much of the period between 2002 and 2007, CDS contracts were being sold at a relatively low spread because the buyers of risk thought the probability of default was very low. Even with low costs, however, hedge funds betting against the market had to endure a long period (p.75) when they were hemorrhaging funds and receiving no returns. As risk and uncertainty started to be revealed in 2007, spreads widened, changing the nature of the market and who was willing to participate and on what terms. It was in this period that some of the key decisions were made that ultimately led to the variable effect of the 2008 collapse across financial institutions. Thus, Goldman Sachs, for example, began to reduce its own holdings of risky assets in the belief that the market had peaked; on the other hand, it continued to produce such assets and tried to sell them into the market implicitly and explicitly stating to its clients that this was still a good investment. It is this sort of conflict of interests that has brought Goldman into conflict with the regulators since and has led to fines and potential litigation. In July 2010, the SEC fined Goldman $500 million for omitting “key facts regarding a synthetic collateralized debt obligation (CDO) it marketed that hinged on the performance of subprime residential mortgage-backed securities. Goldman failed to disclose to investors vital information about the CDO, known as ABACUS 2007-AC1, particularly the role that hedge fund Paulson & Co. Inc. played in the portfolio selection process and the fact that Paulson had taken a short position against the CDO via a CDS product issued by Goldman” (SEC Press release available at http://www.sec.gov/news/press/2010/2010-123.htm).

A further crucial feature of this market related to the lack of regulation regarding the posting of collateral. Insurance companies work on the basis of matching assets to calculable risks. Insurance supervisors specify the reserves that are required to cover the risks taken by the insurance company and to link this to the premiums to be paid for cover. Insurance companies are therefore relatively low on leverage, high on reserves, and unspectacular in terms of profit and pay. A CDS contract, however, was explicitly not defined as an insurance contract and therefore not subject to insurance regulation. A CDS was created as a contract on a financial market which was constructed on the basis of finance theory and the mechanisms of these markets (Huault and Rainelli-Le Montagner, 2009). The guarantee that a risk holder of a CDS contract could meet the obligations of this contract was not vested in any state regulator but in the mechanisms of the market and in particular in the system of collateral depositing. Rules on collateral depositing were the province of ISDA and embedded in the Master Agreement and the various guidelines issued by ISDA. In principle, the seller would deposit with the buyer collateral (usually cash and government securities) as a demonstration of its ability to meet the terms of the contract. ISDA set out rules concerning how the level of collateral should move up or down depending on changing market conditions (Morgan, 2008).

How the collateral system developed in practice over the decade before the financial crisis reveals a rather complex and changing picture. One particular group of companies which were selling CDS products on ABS CDO, the so-called “monolines” (the biggest of which were Ambac and MBIA), posted no (p.76) collateral at all on the contracts which they struck. Monolines had emerged initially as insurers of municipal bond issuers and were regulated by the New York Insurance Department. The rules of this regulator would have made the posting of collateral prohibitively expensive but rather than not enter the market, the monolines, in Glass’s words, “for years fought pitched battles with the risk departments of the swap dealers and when the dust settled the rule was established that AAA-rated monolines did not post collateral on CDS” (Glass, 2009: S88). The AAA rating was given to the monolines by the rating agencies on the grounds that they had never defaulted and their financial underpinnings were sound. A similar rating was given to AIG FP, the London-based arm of the large US insurance group which sold large numbers of CDS contracts. Therefore, AIG FP also did not post collateral working on the basis that its parent company had sufficient funds to back up any potential problems.

In the late 1990s and early 2000s, the BIS became increasingly concerned about the threat to financial stability arising from the growth of the OTC CDS markets. In a series of reports beginning in 1998 and continuing through to the period just before the Lehman collapse, BIS and the associated Basel Committee on Banking Supervision probed the problems of the OTC markets including issues concerned with the back office such as collateral, settlement, and clearing (BIS, 1998, 2007; Basel Committee, 2005, 2008). The cautious approach of BIS and the Basel Committee was not sufficiently direct to lead to action by national governments but it did appear to coincide with a concern within ISDA to firstly track the amount of collateral being posted and secondly to encourage members to post more. ISDA began, from 2000, to conduct regular Margin and Collateral Surveys which were published on the ISDA website. These surveys indicate that there has been a gradual rise over the period in collateral agreements from an estimated 12,000 in 2000 to around 150,000 in 2009 (ISDA, 2009: 2). Up until 2007, the total estimated collateral in the whole OTC market according to ISDA was approximately $1.3 trillion, though since then it has tripled, an indication of the more cautious attitude to collateral which has emerged after the crisis. This compares to a total notional commitment for CDS contracts alone of $57 trillion and a total of $516 trillion for the market as a whole according to BIS data (Bank for International Settlements, 2009b: 7). The ISDA Margin Survey in 2009 shows that in the period from 2004 to 2007, the total reported collateral went up from $1.017 trillion in 2004 to $1.209 trillion in 2005 to $1.329 trillion in 2006 and to $1.335 in 2007 (ISDA, 2009). At the same time, the OTC global market had more than doubled from $251.823 trillion in December 2004 to $595.341 trillion in December 2007 (Bank for International Settlements, 2009b: 7). As the crisis revealed, collateral levels were far too low when the underlying assets began to fail on a systemic basis and sellers of protection were called on to recompense the purchasers of CDS contracts.

(p.77) However, contracts did contain conditionality clauses on the posting of margin and collateral. While under normal conditions these postings were very low, should conditions change they could rise steeply. As well as linking the scale of collateral requiring to be posted to the value of the underlying assets (so that as this fell and the likelihood of the CDS seller having to recompense the CDS buyer rose, so more collateral was required), the level of collateral to be posted was linked with the credit rating of the CDS seller since this indicated to other actors in the market whether the seller had the capital to meet any obligations potentially arising from defaults in the assets which underlay the CDS. If the rating of a seller was lowered, the seller would suddenly become subject to a potentially heavy call for collateral (as eventually happened to AIG in September 2008, leaving a huge hole in AIG’s balance sheet and requiring a massive injection of capital from the US government; AIG, 2009; Boyle, 2011). This potential for collateral shift would be exacerbated because institutional investors would have to sell off the underlying assets (i.e., the CDO) if the rating changed down from Triple A. Such sell-offs clearly led to a further fall in their value, requiring further posting of collateral by the CDS sellers to meet the gap between the guaranteed price and the market value.

The OTC CDS market was therefore a very particular type of market. It was dominated by a small number of CDS market makers for whom it was highly profitable, feeding a large number of market participants (both buyers and sellers) with different requirements. This feeding process was structured by an opaque pricing system where what was actually being sold also became increasingly complex and difficult to understand, particularly in terms of the interdependencies of risk. Ultimately, the scale of profits was so large because risks were underprovisioned and underpriced; risks were underprovisioned because regulation was absent and it was left to the private actors to set their own levels of provision, which they set very low; risks were underpriced for reasons that related to sustaining and growing businesses in an environment where external monitoring of pricing was nonexistent. Thus, when the underlying risky assets (i.e., the subprime mortgages) lost value, the consequences were magnified because of the lack of adequate provisioning and the degree of speculative activity drawn to the area by the underpricing of risk.

The Financial Crisis and the Response of Regulators and Politicians

The previous section has identified what was at stake in the boom period. The lack of regulation and law enabled the investment banks to build a model of superprofitability in the sphere of OTC trading in CDS products with very little monitoring or supervision. From early on in the financial crisis, a (p.78) consensus emerged across the most important governments and regulators (the United States, the United Kingdom, and the EU, working through the G20) that failure to regulate OTC markets had been central to what had happened. The key regulatory mechanism to attack the problems arising from OTC derivatives and CDS contracts in particular was the forcing of more of this business onto regulated exchanges and central clearing houses (Helleiner et al., 2010). The Obama Administration through the Treasury Secretary, Geithner, pledged to pursue legislation to require clearing of all standardized derivatives through regulated central counterparties (CCPs) as well as requiring what are described as robust margin requirements. Under the proposed system there would be more recordkeeping and reporting requirements including an audit trail on all OTC derivatives as well as pressure to move as many contracts as possible not just into CCPs but if possible into regulated exchanges. The EU also supported the idea of CCPs. This agreement was the basis of intensive international cooperation through the G20 in April 2009 which declared that “we will promote the standardization and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision” (G20, 2009). This was reinforced at the September 2009 meeting of the G20 in Pittsburgh,

What the governments and regulators particularly wanted to achieve was a situation where the failure of a counterparty could be contained and would not spread out and contaminate the system as a whole. One obvious route in this direction would have been to ban OTC products and insist instead that derivatives be traded on regulated exchanges. In the United States, this argument was briefly pushed by Barney Frank in the House, but in spite of the crash and in spite of the clear role of OTC CDS contracts in the crash, this argument did not garner significant support. To force everything onto regulated exchanges would have closed down large areas of business for big banks. In spite of the strong words at the G20 April 2009 summit, no major political leader has actually pushed for this complete ban. The anticipated push-back by the financial institutions, the interdealer brokers, and some of the clients, together with the support of many economists and commentators for the idea that the OTC market was efficient, seemed too powerful even in the immediate aftermath of the crisis to take on directly.

This was reinforced in part by the speed of response of ISDA and some of the key private actors to the Lehman collapse. ISDA’s position as the collective voice of the industry and its organizational capacities (which included its strong links into government and policymaking as well as its effective committee structure of technical expertise) meant that, even within the chaos and fear that gripped the finance industry in the immediate aftermath of Lehman’s collapse, it was able to be proactive in some areas. This was most (p.79) obvious in the way in which within a month ISDA had organized a meeting whereby CDS contracts on Lehman’s were netted out among those holding them. This reduced dramatically the overall notional at-risk value of these contracts (for more details, see Morgan, 2010). ISDA followed this up by what it termed its Big Bang, an effort to put in place procedures and committees across the world that could deal rapidly with credit events. It also pursued “compression,” an effort to net down contracts, reducing duplication, and ensuring that at-risk totals did not look as huge and dangerous as was previously the case. Thus, private actors began a process of regularizing the market again as soon as they could.

Public actors focused on a series of interlinked proposals. The first was that most OTC transactions should be standardized so that they can then be moved onto CCPs. Standardization in itself was to prove highly controversial because OTC business had so much emphasized customization; now regulators were telling them to create standard categories of contract like on regulated exchanges. The purpose of the CCP was, again as with regulated exchanges, to place a buffer between the two sides of a contract so that if one side could not fulfill its obligations, this would not immediately contaminate the capital position of the other side. Instead, the CCP with a strong capital position would organize the netting out of contracts and bring an orderly end to the problem. CCPs would also serve another function in that they can provide details of contracts to the regulators. The aim of this is to ensure that risks in the system are visible and action can be taken by regulators to relieve pressure.

Associated with CCPs, though distinct from them, is the issue of electronic trading platforms (ETPs). These ETPs or Swap Execution Facilities (SEFs as they are described in the United States) provide multiple participants with the ability to execute or trade standardized derivatives. In theory, these entities can provide pre-trade transparency on price (though this is being hotly contested) as well as post-trade transparency on the price, volume, and time of the transactions executed under their systems. Once a deal is done on a platform, it is completed by being cleared through a CCP. Taken together, these reforms are meant to reduce systemic risk and increase transparency and efficiency in the market.

In terms of private actors, it is possible to identify a range of different responses as well as the emergence of a rather different array of financial institutions positioning themselves in this new market structure. Firstly, there are those actors who are most integrally embedded in the OTC markets such as interdealer brokers. This group is most vociferous in its efforts to defend the viability and utility of OTC contracts in some areas of business. It resists the idea that the bulk of OTC contracts can be standardized. For example, Terry Smith, chief executive of Tullett Prebon, one of the brokers (p.80) in the market, wrote in the FT that OTC market products are “of necessity bespoke instruments and contracts, traded in large amounts between professional participants: and as such, they are the antithesis of an exchange-traded product. If OTC business is driven to these unsuitable venues, markets will become less efficient, which is an outcome we should seek to avoid” (Smith, 2009). In his analysis, Glass also argues that “the intrinsic complexity of some OTC credit derivatives is likely to prevent electronic confirmation and CCP clearing from taking hold for those products” (Glass, 2009: S95; see also Johnson, 2009; Jones, 2009; Das, 2011; Huault and Rainelli-Le Montagner, 2011). Support for OTC trading has also come from nonfinancial firms such as the 160 firms represented in the letter of the European Association of Corporate Treasurers who wrote to the European Commission requesting that any new regulation not require them to put down collateral. Banks have supported this and continue to argue in favor of OTC markets, particularly in the area of currency and interest rate derivatives because CCPs are perceived as incurring cost and reducing flexibility compared to OTC markets. Even after two years of discussion, there is no agreement (at the time of writing July 2011) either in the United States or Europe as to exactly what can be standardized and what cannot.

A related element of this debate concerns what will happen to those contracts which it is deemed cannot be standardized and can therefore continue to be traded OTC. The regulators wish to create increased capital requirements for these but this is being strongly resisted not least by the buyers of these contracts who purchase them to hedge risks in various markets. Large multinationals and others claim this will increase their costs and penalize them when their type of business (particularly in interest rate and foreign exchange swaps) has been relatively stable and had no role in the financial crisis. Proponents of OTC also argue that the CCPs which are being created may concentrate risk and would become another set of institutions that would be “too big to fail” requiring government rescue.

The second group of private actors who have become more significant are those who are going to benefit from proposals to push more trading into a transparent format. These are not traders, buyers, or sellers but the organizations which construct the different sorts of platforms on which markets exist, prices are posted, exchanges take place, clearing occurs, contracts registered, and potential liabilities monitored and adjusted. Trade depositories, such as DTCC, have been developing for some time and are now aiming to become more highly involved with OTC business. Other organizations have predominantly provided clearing facilities for exchanges and they too are aiming to extend that perhaps into running exchanges themselves (such as LCH.Clearnet). Others have been based primarily in the running of exchanges with some having long expertise in derivatives trading (such as the Chicago Mercantile Exchange with its various markets overseas). Others were founded (p.81) much more recently. For example, Intercontinental Exchange (ICE) was founded in 2000 to deal in energy futures but following its IPO and the recent pressures to extend CCP and exchange coverage for derivatives, it has expanded in this area. In March 2009, ICE acquired The Clearing Corporation (TCC), which provides the clearing technology for ICE’s CDS clearing house, ICE Trust. On March 10, 2009, ICE Trust became the first clearing house to process North American CDS. In July of the same year, ICE introduced clearing for European CDS through ICE Clear Europe CDS.

ICE has also become involved in the broader merger and acquisition movement in stock exchanges which has been stimulated by the potential massive growth arising from the shift out of OTC markets. This is reflected in the bid for NYSE Euronext by Deutsche Borse in early 2011 which was accepted by the NYSE Euronext board but subsequently challenged by an alternative bid from a consortium of ICE and NASDAQ that in the end failed. A similar effort to increase scale and opportunities to benefit from these regulatory changes is reflected in the agreed merger between the London Stock Exchange group and TMX, the biggest exchange operator in Canada, though again this has been challenged by a bid from Canada-based banks and pension funds and has now collapsed. Although the merger and acquisition activity in this area is still in process, the basic logic is clear—to build massive exchange capabilities that can be adapted to new areas (such as OTC) and new regulatory requirements. Such large-scale organizations can maximize the scale and utilization of back and middle offices in order to cut costs and attract business as well as providing access to multiple products and services. They can set up ETFs, SEFs, and CCPs in various contexts leveraging their existing assets in terms of building and running exchanges, clearing and settlement systems. Although these organizations have diverse origins and different sorts of assets, they share a common interest in pushing OTCs into CCPs.

It is interesting to note that this reflects the introduction of a powerful new set of interests into the debate on changes in regulation to OTC markets. In the previous era, there was a clear demarcation between the regulated exchanges such as CME and Euronext and the OTC markets. Defending the OTC border, that is, the territory in which OTC can operate untrammeled may still be of concern to some providers but the bigger issue now is about the territory the other side of that line, that is, where various forms of market transparency and regulation are being proposed. The spur to the mergers is initially the recognition that this will be where the expansion will come and even if the exact parameters of these markets are yet to be agreed, it is important to get in a position to compete for that business. In effect, then, the regulators find themselves with a new and powerful set of globally organized allies (the exchanges) to make this new system work.

Where does this leave the big financial institutions that were so central to the previous system? In September 2009, a group of the largest banks (p.82) (subsequently formalized into what is now known as the G-14 and including Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan Chase, and Morgan Stanley) had promised the Fed to clear the majority of interest rate derivatives and CDS through CCPs by the end of the year. This reflected the Fed’s concern that financial institutions were dragging their feet and trying to limit their usage of CCPs in order to keep their costs down, their flexibility high, and their trades opaque. On April 5, 2011, Bloomberg reported the New York Fed Chairman, William Dudley, as stating that Wall Street’s largest banks and money managers had failed to fulfill their commitments to put more than 90 percent of eligible trades onto clearing houses by 2010. This followed a letter from the G-14 and industry associations which expressed concerns about achieving the end-2012 target because of potential inconsistencies, failure to take into account potential for operational risk, and market disruption if implementation proceeded at an unrealistic, expedited pace. This reflects a growing confidence among the banks that they can resist the tighter definitions of standardization and mandatory clearing which had appeared early in the crisis (see e.g., Huault and Rainelli‐Le Montagner account of the responses of the industry to the recent EU consultation on CCPs; Huault and Rainelli-Le Montagner, 2011).

As well as resisting standardization, the large banks and ISDA sought to ensure that they were the most powerful influences in the CCPs. Thus, ISDA’s response (ISDA April 29, 2011) to SEC proposals on the clearing houses has been to be critical of the SEC for setting a $50 million minimum for an entity to become a member of a clearing house. ISDA argues that (a) this is too small to deal with potential risk and (b) since the rule is ambiguous about whether the same $50 million can count for membership in multiple clearing houses leads to the potential for cross-contamination. Instead, ISDA proposes a far larger minimum capital requirement of $1 billion, a figure which has operated previously in such markets. It also argues that clearing members should not be able to circumvent these rules by arranging credit lines with larger organizations. These and other aspects of the G-14 proposals push the advantages of scale to the new market structure and can be seen as ways of reducing competition beyond the large players and sustaining the existing oligopolistic structure.

It seems that the US regulators and the Dodd–Frank Act have been successful in reshaping aspects of the terrain of OTC markets. The momentum for CCPs has been built and the large banks have begun a process of restructuring away from the previous opaque bilateral model into a more transparent era. New exchange-based entities have emerged to make CCPs a reality. However, as Wilson notes in his chapter in this book, “the devil is in the detail.” Fights are continuing over a whole range of key issues as the big financial institutions try to revive aspects of their pre-crash model of OTC trading while making some adaptations to the new political environment by engaging with the creation of ETPs, SEFs, and CCPs.

(p.83) Looked at from an international perspective, there are even more problems. In a Progress Report on Implementation of OTC Derivatives Market Reforms (April 2011), the Financial Stability Board (FSB) reported on its survey of country members. It stated that “the responses show substantial variation across jurisdictions in the pace of implementing the recommendations in the October Report and the resulting progress toward achieving the G-20 commitments on standardisation, central clearing, exchange or platform trading and reporting to trade depositories” (FSB, 2011: 1). The United States was reported to be furthest along in terms of implementation while in the EU the report stated that “legislation has been proposed and is expected to be adopted by end-2011 with respect to clearing and reporting to trade repositories and is in the pre-proposal consultation stage regarding trading” (Ibid.: 2). The clear problem among public actors is the potential that rules in different jurisdictions allow firms to pursue strategies of regulatory arbitrage, shifting to the countries with the lower standards.

This is a particular issue with regard to the United Kingdom which in the period leading up to the crisis had overtaken the United States in terms of OTC activity and where the government and companies have a strong interest in preserving their market position. In its 2009 report, the UK FSA was cautious about the whole idea of “mandatory clearing” arguing that “the clearing of all standardized derivatives could lead to a situation where a … CCP is required to clear a product it is not able to risk manage adequately, with the potential for serious difficulties in the event of a default” (FSA, 2009). This view is not shared in the EU where recent consultations on a new directive to compel CCPs and to minimize OTC contracts have been ongoing. This clearly feeds into a wider concern that there will be significant differences between regulatory regimes in how they define “standardized” contracts, how they monitor CCPs, and following this the degree of variation in the structure of CCPs, particularly over rules concerning the capital to be committed to margins, etc. For example, Das states that “LCH.Clearnet chief executive Roger Liddell recently criticised newer US rival International Derivatives Clearinghouse for ‘reckless’ behaviour in setting low margin to win business” (Das, 2011: 16).


Overall, therefore, there has emerged more law and regulation around OTC trading in the aftermath of the crisis. Private actors rapidly saw off efforts to outlaw altogether such trades. Instead, they have been lobbying governments to provide themselves with some room for maneuver in the new context. They have also been relatively successful in undermining the argument that CDS could go entirely on to regulated exchanges. Exchanges are commodified (p.84) businesses; they offer high transparency and associated with that high competition and low profits (compared to the OTC markets), particularly where entry requirements to the exchange are set at a relatively low level (compared, e.g., to the $1 billion capital requirement suggested by the G-14). CCPs offered a hybrid solution that has in effect become the accepted goal of the private and public actors; because of their requirements for standardization, they reduce the ability of dealers to produce new customized versions of products though because they lack price transparency, they continue to offer higher levels of profitability than regulated exchanges. The CCP model, however, comes alongside the argument that nonstandardized products must be able to continue, an argument strongly pushed by the large banks and brokers. While regulators have responded by insisting on more stringent reserve requirements for any continued OTC-traded contracts and by demanding that all such deals be centrally registered, where the distinction between standardized and nonstandardized will exist is still being discussed and will make a significant difference both to the rate of expansion of CCPs and the adjustment required by the financial institutions to their own models of trading. Private actors have sought to keep some space for OTC trading; they have supported the development of CCPs which allows them to continue with bilateral trading and some opacity in pricing. What is remarkable is that all this has happened within three years of a massive financial crash, significantly attributable to trading in these instruments and in a context firstly where banks had to be bailed out by governments and secondly where banks are extremely unpopular. Nevertheless, they have been able to rescue and retain some key parts of the business model which contributed to all this. In spite of all the contestation, law has been reshaped to only a minimal extent and the power of the financial institutions, despite its weakening in the aftermath of the crash, has been reasserted.

On the face of it there has been broad consensus between private and public actors that OTC derivatives should move onto CCPs. However, with each category, there have emerged new struggles. The most important new feature among private actors has been the emergence of exchanges and other back-office organizations as central actors in this shift. The potential of CCPs for OTC trading has stimulated a further bout of reorganization among the platform providers and these have now become an important constituency in the progress of these reforms. The powerful actors in the old system—the banks, represented by the G-14 and ISDA—are engaged in a struggle to make sure that they retain as much of the new business as they can, at least in part through supporting rules which restrict the ability to become a member of a clearing house—and therefore to take part in trading OTCs—to highly capitalized institutions.

Looking at public action on a global scale, there is a large amount of activity among industry associations, ad hoc committees of supervisors and regulators, (p.85) together with committees and organizations based around BIS to create a coherent response. However, national responses are affected by national priorities, and in the case of EU countries by the emergence of a new level of EU supervisory authority. They are also affected by national concerns to have a share of the business and not to see a limited number of CCPs concentrated in just a couple of countries. It is too soon to see how these different national contexts may affect the distribution of the CCP business but it is certain that this will be highly competitive, another reason why exchange mergers are being pushed to maximize economies of scale and scope.

These different outcomes of reform impact differentially on the actors involved. As the response to the financial crisis has shown, private actors move quickly to repair markets (Morgan, 2010)—and within this it is the most powerful that move quickest and with most deliberation and calculation. Public actors have moved more slowly, and because of how the issue of national regulation and regulatory boundaries has become so strongly linked to issues of reform, gaining agreement on the detail of the reform to markets—as opposed to the principle of reducing OTC trading—has proved difficult. In the United States, the Obama Administration and the Dodd–Frank Act is pushing more derivatives business onto regulated exchanges and CCPs and at a faster speed than elsewhere. While offering support for this, the main European governments and the EU itself have not yet legislated for such changes. In London in particular, where cross-border OTC trading was so strong, there is the most opposition to CCPs and the most effort to keep nonstandardized contracts as a viable option.

In conclusion, even the most abstruse and technical of markets (as OTC may appear) are subject to social processes. This is not surprising; vast amounts of money changes hands in these markets and setting the rules in ways which suit the powerful actors while hiding behind technocratic and expert-driven discourses about market efficiency is an expected response. Politicians and regulators often find it difficult to respond coherently and this creates unevenness and uncertainty and with it the possibility of regulatory arbitrage. By studying these markets in more detail, it is possible to reveal the choices that are being made and, at least in part, to get behind discourses of efficiency to an understanding of the interests being served.


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