Comment and Discussion

Comment on Partnoy and Lyons Papers by Frank Edwards:

These excellent papers span a large area, so I am going to pick and choose where to make my remarks. I will summarize briefly what I believe these papers say and the issues that they raise.

Frank Partnoy begins by identifying two key trends that have created the problems he discusses in his paper. The first is that innovations in derivatives markets have made it possible to create synthetic instruments that are good (and less costly) substitutes for derivatives instruments that are already traded on exchanges. This has made it difficult to distinguish between derivatives instruments traded on and off exchanges (such as between interest rate futures and interest rate swaps). In addition, these innovations sometimes have made it difficult even to distinguish a "security" from a "derivatives contract" (such as stock-index future and a stock). As a result, it is often difficult to determine whether a particular financial instrument should or should not be regulated, and if it is to be regulated, the proper regulatory authority. The second trend has been the rapid growth of off-exchange derivatives markets relative to exchange-traded derivatives. Since the over-the-counter market is largely unregulated, the consequence of this rapid growth has been that an increasing proportion of derivatives trading is now unregulated.

The paper identifies several ramifications of these trends. First, there is a lot more uncertainty about which regulatory regime applies to which transaction. In the United States that question is largely predicated on the form or the characteristics of the instrument rather than on the instrument's function. For derivatives, jurisdiction is usually determined by where the transaction takes place, whether on or off exchange.

Second, since most derivatives are now traded off exchange, where there is an absence of public legal rules, there has been an increase in privately created legal rules to govern off-exchange derivatives transactions. For example, the International Swaps and Derivatives Association (ISDA) has developed private legal rules to govern the contractual rights and obligations of swap counterparties and to set out procedures and remedies in the event of a contractual breach. This development is a central focus in Partnoy's paper and raises the question of whether the increased use of privately created rules is superior to the use of public legal rules: does it make markets more or less efficient or more or less fair? Or, stated in a more complex way, what is the optimal combination of public and private rules? This is a central question throughout the paper.

The paper examines other issues as well, but I am only going to list four that I believe raise the most important policy questions:

• mdash First, should public rules that govern the trading of derivatives instruments differ depending on the relative sophistication of the parties to the transaction? In particular, should public rules treat institutional traders or counterparties different from retail customers, or should more protections be provided for retail traders than for institutions? This issue is becoming increasingly important throughout the world as trading in derivatives expands to other countries.

• mdash Second, is regulatory competition a constructive or a destructive force? Partnoy's opening comments suggest that he believes that regulatory competition may be a destructive force.

• mdash Third, is there a need for suitability rules that apply to derivatives transactions?

• mdash Fourth, is the recently enacted Commodity Futures Modernization Act of 2000 fundamentally flawed with respect to the margin requirements imposed on single-stock futures contracts? Partnoy argues that these margin requirements will be a disaster and instead proposes his own rather complex margin rules, which he believes will be more effective and result in more efficient markets.

To give you some idea of my thoughts, let me answer the rhetorical question that Partnoy poses at the conclusion of his paper: Are private legal rules the savior of modern derivatives markets? My answer to this question is an unequivocal "yes." Indeed, I would go further and say that this has always been the case.

Private legal rules are not a new development in derivatives markets. The so-called...