The Dynamics of OTC Derivatives Regulation: Bridging the Public-Private Divide

1. The Dynamics of OTC Derivatives Regulation: Bridging the Public-Private Divide Dan Awrey Presentation to the Oxford Extra-Legal Governance Institute November 5th, 2009

2. The Dynamics of OTC Derivatives RegulationBackground • The size, complexity and systemic importance of OTC derivatives markets have increased exponentially in recent years. • Notional value (June 1987): USD $225 Billion. • Notional value (December 2008): USD $592 Trillion.* • Identified by many as conduits for the avarice, hubris and miscalculation which triggered the current global financial crisis. • Financial regulators have thus found themselves under considerable pressure to enhance their regulation of OTC derivatives markets. • The U.S., for example, recently proposed restricting derivatives trading to regulated exchanges. * Source: ISDA/BIS

3. The Dynamics of OTC Derivatives RegulationProject Overview • The Research Question: whom to entrust with the responsibility for OTC derivatives regulation? • Examining the respective roles of public and private ordering in achieving the optimal mode of regulating OTC derivatives markets. • The Contribution: illustrating the importance of bridging the public-private divide. • The alignment of incentives. • Facilitating the long term transfer of information and expertise. • The Evaluative Framework: welfare economics. • All potential modes of regulation should be evaluated on the basis of their expected costs and benefits with a view to maximizing net social welfare. • Emphasis on constrained efficiency reflective of real world limitations facing policymakers.

4. Benefits Risk management Completion of asset markets Enhanced price discovery Absorbing systemic risk * All these benefits rely on assumptions respecting the extent to which Efficient Markets Theory (EMT) reflects the reality of financial markets. Costs Private risks Asymmetries of information Dealers v. end-users F/S disclosure Overinvestment Excess leverage Systemic risks Regulatory arbitrage The Dynamics of OTC Derivatives RegulationThe Costs and Benefits of OTC Derivatives

5. The Dynamics of OTC Derivatives RegulationThe Pre-Crisis Regulatory Environment • Important distinction between exchange-traded and OTC derivatives. • OTC derivatives subject to minimal public regulatory intervention beyond prescribed regulatory capital treatment. • U.S. experience: turf war. • U.K. experience: light touch. • Private actors have stepped in to fill the regulatory void. • ISDA. • Ad hoc industry groups (ie. The Group of Fourteen). • Private providers of trade execution, confirmation, clearing, settlement and data repository services.

6. Strengths Competitive equilibrium Nimble, flexible, responsive Incentives to acquire information and expertise Ability to transcend jurisdictional boundaries Weaknesses Conflicts of interest Divergence of private and social welfare Absence of legitimacy Bureaucratic failure Toothless enforcement The Dynamics of OTC Derivatives RegulationThe Strengths and Weaknesses of Private Ordering

7. Strengths Unparalleled coercive powers of the state (Democratic) Legitimacy Expert generators of regulation Already overcome collective action and coordination problems Weaknesses Conflicts of interest Lack of information and expertise Inherent jurisdictional constraints The Dynamics of OTC Derivatives RegulationThe Strengths and Weaknesses of Public Ordering

8. The Dynamics of OTC Derivatives RegulationBridging the Public-Private Divide • The current global financial crisis has spurred a series of reform proposals aimed at: • Minimizing systemic risks. • Reducing asymmetries of information. • Curbing opportunistic behavior. • Each of these proposals must evaluated on the basis of their costs (including lost benefits) relative to the reduction in harmful effects. • Yet few proposals appear to be motivated by the desire to achieve the socially optimal mode of regulating OTC derivatives markets or addressing key challenges in terms of: • Conflicts of interest and the corresponding need to align the incentives of both public and private actors. • Lack of sufficient information and expertise.

9. The Dynamics of OTC Derivatives RegulationBridging the Public-Private Divide • How do we move forward? • Abandon the largely artificial distinction between public and private ordering. • Craft a tailored mode of regulation which draws upon the respective strengths of, and works constructively with the interplay between, public and private systems of ordering. • A tentative proposal: ‘coerced’ self-regulation. • Public governance and oversight of self-regulatory infrastructure. • Regulatory objectives established by public actors. • Technical regulation designed within the context of a dialogic process between public and private actors. • Regulation can promulgated, monitored and enforced at either the public or private level, depending on perceived needs.

10. The Dynamics of OTC Derivatives RegulationBridging the Public-Private Divide • Aligning the incentives of public and private actors. • Ex ante role in promulgation engenders higher ex post commitment to compliance. • Omnipresent threat of more burdensome public regulation would incentivize private actors to design technical regulation consistent with public regulatory objectives and then comply with it. • Parallels to vertical regulatory competition theory (Roe: 2004). • Facilitating the long term transfer of information and expertise. • Cultivating a dialogic relationship will lead to technical knowledge transfer. • Pays dividends in terms of enhanced cooperation and information sharing from private actors. • Assists private actors to better understand regulatory objectives.

11. The Dynamics of OTC Derivatives RegulationBridging the Public-Private Divide • Encouraging signs:The Over-the-Counter Derivatives Markets Act (U.S.). • Registration of centralized counterparties, repositories and alternative execution facilities. • Registrants must comply with a set of “core principles”. • Primary responsibility for generating technical regulation in compliance with core principles arguably falls to registrants. • HOWEVER, its still too early to tell… • Outstanding questions. • To what extent will reputational enforcement mechanisms work in the context of diffuse, heterogeneous and constantly changing OTC derivatives markets? • How do we constrain private actors who perceive coerced self-regulation (or any other mode of regulation) as being too burdensome from engaging in regulatory arbitrage?

12. The Dynamics of OTC Derivatives RegulationBridging the Public-Private Divide Discussion.