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The LAW of DERIVATIVES

AND REGULATION
Financial Market Law - Lecture 10
Prof. Dr. Kern Alexander

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Main Points

• Changing focus of regulatory law

• the design of derivative contracts

• Derivatives and risk control

• The crisis and regulating derivatives

• The risks posed by centralized clearing of derivatives

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Liquidity (UK FSA revised rules on liquidity

requirements for banks and financial firms)

• Financial Services Authority “Strengthening Liquidity Standards”.

• Group Wide Liquidity.

• Liquidity requirements in Basel III (Net stable funding ratio, and

Liquidity ratios)

• London – world’s leading international financial centre and place

where most derivative contracts are traded. Importance of English
law

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What is a Derivative?

• S. Henderson “A Financial Arrangement the Value of which is derived

from another Financial Instrument Index or Measure of Economic
Value”.

• “ Derivative instrument” – Financial Services and Markets Act 2000

(regulated activities) order 2001 (SI 2001 / 544) as amended.

• A Practitioner’s Guide to the FSA Regulation of Registered

Investment Business,
Tim Cornick 2 Edn 2004 p31.

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The Perennial Problem of regulating financial risk

taking
– “I am very well convinced, that no circumstances can ever lay a man under the necessity of
selling or buying for time, no man can so much as have an inclination that way, unless he
be imbued with something of the spirit of Gaming, or unless he knows a secret by which he
thinks he can make an unjust advantage of the person he sells to or purchases from; and
therefore, sir, I look upon putting a final end to this practice to be one of the principal aims
of this Bill”.

Sir William Yonge on Sir John Barnard’s Act [To prevent the infamous practice of stock
jobbing].

– “We must act, we must act quickly and finally, in our progress towards a resumption of
work, we require two safeguards against a return to the evils of the old order. There must
be a strict supervision of all banking and credits and investments. There must be an end to
speculation with other people’s money. And there must be provision for adequate but
sound currency”.

Franklin D Roosevelt Inaugural speech March 1933.

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UK Financial Services and Markets Act 2000

– Change in UK financial law 2000 was impelled by:

– Initiatives such as the EU Second Banking Directive proposing change in regulation of financial
services by imposition of minimum or key standards, the introduction of home state control and the
consequential adoption of the single European passport as a concept.
– The collapse of Barings Bank (1995).

– Objective of the Act was to focus regulation in a single regulator in the guise of the Financial Services
Authority.

– Main objectives were:

– To instil market confidence

– To increase public awareness
– To protect consumers
– To reduce financial crime
– Options, futures and contracts for differences including interest rate and exchange rate
swaps are included in the definition of investments.

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Historical Context for derivatives in financial

markets
– Mainly indentified with the late twentieth century.

– Inception of International Swaps & Derivatives Association (ISDA) 1985.

– Collapse of Bretton Woods.

– Growth of derivatives activity:

– Expansion of the euromarkets.

– Declining credit ratings and access to the capital markets.
– Communications technology.

– Bank Haus Herstatt and Franklin National Bank 1974 (settlement risk
problem).
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Derivatives from 1970–1985

The four main uses of derivatives:

– Speculation
– Hedge
– Manage asset liability
– Arbitrage

– 1980 swap between The World Bank and IBM. cross currency swap.

– Swaps to overcome UK exchange controls. Parallel loans.

– Deutsche Bank Luxembourg swap.

– Complexity of documentation.
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Standardisation Under ISDA

– Complexity needed to be balanced by volume.

– The BASEL Committee and requirements for standardisation.

– Foundation of ISDA.

– Standardisation and the ISDA building blocks.

– The 1987 Agreement, the 1992 Agreement and the 2002 Agreement.

– The Credit Support Annex.

– Confirmations.

– Definitions.

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Other Derivatives Documentation or Related

Documentation
– FBF Master Agreement (French).
– Rahmenvertrag (German).
– Overseas Securities Lending Agreement (Stock Loan).
– Global Master Securities Lending Agreement (Stock Loan).
– Global Master Repurchase Agreement (Repo Transactions).
– The effect of standardisation:
– Volume of trades
– Personnel involved in documentation
– Complex trades treated as straight forward ‘Vanilla’
– Coverage by trade associations.
– Integration or trade associations into structure of the industry.
– Trade association influence.
– Use of the swap as an enabling device in relation to complex transactions.

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Derivatives and Regulation Prior to the Current

Financial Crisis
– Derivatives source of financial innovation
– 4 main types
– equity derivatives (or swaps)
– interest rate swaps (largest of the derivatives markets)
– foreign exchange swaps
– credit default swaps (CDS) - created in 1990s and grew
enormously in 2000s, with synthetic instruments
– Derivatives regulation before crisis mainly had focused on disclosure
of positions, but generally light touch.

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The Perennial Problem of derivatives

“Congress is considering oversight of derivatives as part of a broader

revamping of financial industry rules. Gensler wants the senate to
toughen a Bill passed by the House in December that would impose
stricter trading rules on dealers including JPMorgan Chase and
Goldman Sachs while allowing exceptions Gensler imposes for End
users, typically non financial companies that use derivatives to hedge
risk.

Gensler’s goal is to move OTC derivatives to transparent trading

systems that regulators can monitor. Once traded he wants most deals
to be processed through Clearing Houses which are privately owned
third parties that guarantee transactions and keep track of collateral and
margins”.

Bloomberg article on Gary Gensler, February 2010.

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Derivatives (Dodd Frank Act – Title VII)

1. Requires a swap to be cleared if the CFTC or SEC, as applicable,

determines that it requires to be cleared and a clearinghouse (CCP)
accepts it for clearing, except for commercial hedgers.
2. Swaps subject to the clearing requirement must be executed on an
exchange or swap execution facility
3. Impose registration, minimum capital, initial and variation margin,
reporting, recordkeeping, and business conduct requirements on
firms that deal in derivatives or are major participants in those
markets
4. Effectively requires banks to ‘push out’ certain swaps activities to
affiliates: however, banks can retain swaps activities that are for
hedging purposes or relate to traditional bank investment categories
(eg., interest rates, foreign exchange, bullion, among others, and
CDS so long as it is cleared).

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European Commission Communication on

Derivatives markets
– July 2009 publication of communication on derivatives markets. Followers by
a further communication in October 2009

– Conclusion that characteristics of the derivatives market had contributed to

financial instability

– Recommendations were made that:

– There should be central counterparty clearing.

– There should be standards designed to facilitate central counter party
clearing.
– There should be a central data repository to record details in relation to
over the counter transactions.
– There should be on exchange trading of OTC derivatives.

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OTC Derivative Regulation: The Mechanics of

Clearing
Original OTC trade

Clearing Member Clearing Member

Party A Party B
ISDA Master Agreement
Credit Support Annex
Confirmation of trade

Cleared trade
Clearing Member Clearing Member

Party A Clearing House Party B

ISDA master
Credit support annex
Clearing House Rules Give
up arrangement for trade

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Clearing for Non-Clearing Members

Original OTC trade

Non-clearing member: Party A Clearing member: Party B

ISDA
Credit Support Annex
Trade confirmation

Cleared trade

Non-clearing member: Party A Clearing member: Party B Clearing House

Clearing ISDA ISDA

Clearing Credit Support Annex Credit Support Annex
Trade confirmation Clearing House Rules

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Benefits of Derivatives Clearing

– 2nd December 2009 European Council said that it “Welcomes the paradigm shift in the
approach to derivatives markets… namely moving from so called “Light handed
regulation” to a more ambitious and comprehensive regulatory policy, that is aimed at
reducing counterparty and operational risks, increasing transparency of the derivatives
market and strengthening market integrity and oversight and, operationally is expected to
shift derivatives trading and clearing from predominantly OTC bilateral transactions
towards centralised trading and clearing infrastructures”.
– G20 commitment to have all standardised OTC derivatives contracts traded on exchange
or electronically by 2012 and non centrally cleared contracts to be subject to a higher
collateral requirement.
– A major weakness in the OTC derivative market is that there are relatively few players
involved in very large numbers of trades. Hedging can be cyclical meaning that if one
counterparty fails there is a domino effect.
– In December 2009 the United Kingdom government and the UK Financial Services
Authority published a joint paper setting out where derivatives regulation should be
headed. (The UK being home to 43% of global derivative activity).
– The European Commission’s main proposal is to shift OTC derivative trades to a
centrally cleared market.
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Benefits of Derivatives Clearing (cont’d)

– Where trades are not centrally cleared they are to be subject to a higher capital
charge. This will be reflected to changes to the capital requirements directive.
– Legislation will be promulgated to govern the activities of central clearing parties.
– British government and the FSA are not convinced that standard derivatives
should be traded on an organised trading platform but The European Commission
views this as a possibility.
– CCP clearing has been available for some years through swapclear which is part
of LCH (London Clearing House) Clearnet.
– A key innovation is the development of a default management process whereby
every member must participate in an auction of a defaulting members portfolio.
– Facility can also be offered whereby non clearing clients can be offered clearing
through a clearing member. If there is a default of this clearing member then
positions can be transferred to another clearer.

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The risks of Derivatives Clearing (cont’d)

Problems of Centralised Clearing

– Collateral intensive.

– Relatively complex documentation.

– Operational complexity.

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Appendix: Sources of UK regulatory law

– Bank of England Act 1946

– Banking Acts 1979 and 1987

– Bank of England Act 1998

– Financial Services Act 1986

– Financial Services and Markets Act 2000

– Directives from the European Economic Community

– Banking codes

– BASEL Committee standards.

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