Regulating Derivatives: A Fundamental Rethinking

Many regard derivatives as exotic and uniquely risky financial instruments. That perception has given rise to a regulatory patchwork described as confusing, incomplete, and contradictory. This paper, Regulating Derivatives: A Fundamental Rethinking, rethinks how derivatives should be regulated.

The paper begins by de-mystifying derivatives. The outstanding scholarship discusses derivatives according to somewhat arcane industry-derived categories, which do not provide an analytical foundation for regulating derivatives. To provide that foundation, this paper shows that derivatives can be deconstructed more intuitively, by their economic functions, into two categories of traditional legal instruments—option contracts and guarantees.

Like option contracts and guarantees, most derivatives are neither exotic nor uniquely risky. The perception that derivatives are inherently riskier than other financial instruments is based on anecdotal information and has never been rigorously tested. Some argue that derivatives are inherently riskier than other financial instruments because they are bets. However, virtually all financial instruments are bets. Others argue that derivatives are inherently riskier because they are much more volatile than other financial instruments, which can create the possibility of indeterminate liability. That argument fails to recognize that derivatives counterparties usually can estimate the limits of their potential liability. In the United States, the disclosure of this liability is an accounting requirement, and accountants have devised a range of methodologies to estimate potential liability for even the most complex derivatives.

There is little doubt, however, that derivatives sometimes can create very significant risk. The paper explains why that risk is primarily limited to derivatives that function as financial guarantees. Credit-default swap (“CDS”) derivatives epitomize this subset of guarantees.

Although all guarantees are risky because they ensure future events, non-financial guarantees normally ensure reasonably predictable events. However, financial guarantees—and thus CDS—not only are exposed to less predictable risks but also are more subject to cognitive biases. For example, because they do not actually transfer their property at the time they make a guarantee, financial guarantors may view their risk-taking more abstractly than, say, a lender that advances its own funds to a borrower. This “abstraction bias” causes financial guarantors (and thus guarantors under CDS contracts) to underestimate the risk, even after discounting for the fact that payment on a guarantee is a contingent obligation. Empirical findings confirm that abstraction bias is real and that it can influence even sophisticated financial guarantors.

The paper also explains why financial guarantee risk—and thus CDS risk—is magnified when the contract has one or more systemically important counterparties. CDS contracts often have at least one systemically important counterparty. This can magnify the risk because systemically important counterparties tend to do business with like counterparties, creating an interconnectedness that drives systemic risk, which can threaten financial stability.

The absence of an insurable-interest requirement can even further magnify CDS risk. The insurable-interest requirement mandates that a person taking out insurance must derive some benefit from the continued existence of the insured person or property. This requirement helps to reduce moral hazard by reducing the incentive for the person taking out the insurance to kill the insured person or destroy the insured property in order to collect on the insurance policy.

There currently is no legal requirement, however, that a party guaranteed by a CDS contract have an “insurable interest” in the underlying financial obligation. A CDS contract for which the guaranteed party lacks such an insurable interest is often called a “naked” CDS. Naked CDS contracts can be used for speculation, which is thought to magnify risk by creating an unlimited multiplier effect. A derivatives speculator, for example, might receive fees for guaranteeing the same $100,000 bond under ten different naked CDS contracts. Naked CDS is also thought to magnify risk by fostering moral hazard.

The paper next analyzes how CDS contracts that have one or more systemically important counterparties should be regulated, and how the absence of an insurable interest should affect that regulation. This analysis begins, from first principles, by building a normative framework for designing financial regulation. The framework takes into account, among other things, the goal of correcting market failures and the costs and benefits of doing so.

The paper then uses that normative framework to design CDS regulation. It explains, for example, how and why that regulation should set limits on the CDS credit exposure of systemically important firms. It also explains how that regulation could help to correct the cognitive biases, including abstraction bias, which motivate excessive CDS risk-taking. The paper also uses that framework to design regulation to control naked CDS and its associated risks. Finally, recognizing that even the best regulation cannot eliminate CDS risk, the paper examines how to regulate the failures that inevitably will occur.

An annex to the paper proposes the text of a model law to implement the paper’s regulatory recommendations. The model law is intended to complement and enhance the existing G20 regulatory scheme for derivatives, which is followed by the United States and many other countries. This follows the well-respected approach of building normative legal improvements onto an established positive law foundation.

The complete paper is available for download here.