Brookings-Wharton Papers on Financial Services 2002 (2002) 213-252
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ISDA, NASD, CFMA, and SDNY:
The Four Horsemen of Derivatives Regulation?
IT IS DIFFICULT to predict the future regulation of derivatives markets, especially given that current parameters are largely unknown. For example, derivatives markets include (1) both over-the-counter (OTC) and exchange-traded options, forwards, and combinations of each, which range greatly in complexity; (2) a vast array of underlying instruments and indexes, including interest rates, foreign exchange, securities, and commodities; (3) both institutional and individual participants, who vary greatly in sophistication; (4) numerous regulators, both governmental and self-regulatory, often with overlapping jurisdiction; and (5) multiple purposes for transactions, including speculation, hedging, arbitrage, and regulatory arbitrage. 1 Even the size of the market is seemingly incalculable, with conservative estimates topping $100 trillion. 2
Yet derivatives are not new, and their rich history presents several unifying themes, many of which are likely to map into the future. Regulation can evolve along four different paths, depending on the timing and source of applicable legal rules. Legal rules applicable to derivatives can be generated either ex ante or ex post, from entities that are either public or private, as depicted in table 1. [End Page 213]
First are private ex ante legal rules developed primarily by the International Swaps and Derivatives Association (ISDA) for OTC derivatives (and by various exchanges and self-regulatory organizations for exchange-traded derivatives). The recent trend has been toward increased privatization of derivatives regulation, with trading volumes shifting from exchanges to OTC transactions, and this trend is likely to continue. Privately negotiated contracts based on ISDA-form agreements should continue to dominate ex ante legal rules in the derivatives market. For example, the nascent credit derivatives markets are governed primarily by these types of contracts. 3
Second are private ex post legal rules applied by arbitrators in disputes, particularly those of the National Association of Securities Dealers (NASD). Although securities firms generally favor arbitration of disputes with customers and employees, derivatives dealers seem not to favor arbitration, even in complex disputes. Arbitration has numerous drawbacks, especially uncertainty, and likely will not predominate in future adjudication of disputes, especially if judges continue along the current path of ex post legal rules in the public adjudication of derivatives disputes. To the extent arbitration continues, the most important issue is likely to concern the treatment of suitability claims by institutions.
Third are public ex ante legal rules, encompassing securities, commodities, and banking laws and regulations, including derivatives-specific rules. Historically, public regulation in these areas has not achieved its goals; instead, public legal rules too often have generated perverse incentives related to regulatory arbitrage, regulatory licenses, and regulatory competition. 4 Of particular significance now is the Commodity Futures [End Page 214] Modernization Act of 2000 (CFMA), which—among other things—legalized the trading of security futures (that is, futures contracts on individual equity securities). The proposed rules for margin requirements under the CFMA need reworking, as described in detail below.
Fourth are public ex post legal rules, including rulings by courts adjudicating derivatives disputes. Thus far, judges have shied away from deciding important issues in derivatives disputes, and end users of derivatives increasingly avoid litigation—even when losses are large—because of the high costs of discovery and motion practice. Nevertheless, several important cases are outstanding, and it is likely that a federal district court judge—probably one in the Southern District of New York (SDNY), where many such cases are heard—could write an opinion deciding dispositive motions in one of those cases, thereby reconfiguring the regulatory map. 5
This article addresses each of these four regulatory paths in turn: ISDA, NASD, CFMA, and SDNY. Although these paths are likely to diverge, they present some common themes. Future derivatives regulation likely will be dominated by private legal rules. To the extent that public legal rules impose substantial costs on market participants, those rules will create incentives for regulatory arbitrage transactions. The same is true of public legal rules...