I.  Brief Overview of Derivatives and their Marketplace

 

            Derivatives are contracts.  Specifically, they “are financial contracts designed to create pure price exposure to an underlying commodity, asset, rate, index, or event.”[1]  “[T]heir purpose is to capture, in the form of price changes, some underlying price change or event.”[2]  The name “derivative” refers to the fact that the price of the contract is derived from the value of some underlying asset.[3] 

            Derivatives come in many flavors.  Types of derivative contracts include (but are not limited to) futures, forwards, options, swaps, and combinations thereof.[4]  These different types of derivatives derive their values from different types of underlying assets.  Derivatives are also traded in many different ways.  Some derivatives are traded on exchanges.  For example, many futures and options are traded on the Chicago Mercantile Exchange.[5]  Other derivatives, called over-the-counter (OTC) derivatives, are “bilateral, privately negotiated agreement[s]” which are traded privately.[6]  The details of these agreements only need to be known by the two parties to the trade.  OTC derivatives are used to transfer risk from one party to another.[7] 

            Although they are both classified as derivatives, there are many differences between OTC derivatives and non-OTC derivatives.  As an example, futures contracts are always exchange traded (and therefore not OTC derivatives), while swaps are always bilateral agreements (and thus OTC derivatives).[8]  Because they are exchange traded, futures are subject to one set of rules (those of the exchange), whereas OTC derivatives are subject to the rules of varying jurisdictions.[9]  These OTC derivatives commonly end up governed by the terms of the parties’ agreement(s).[10]  Another difference is that credit risk mitigation (such as mark-to-market accounting) is always mandated for futures, but is optional for swaps.[11]

            This diverse derivative market is shockingly huge.  A derivative is used to “link[] its holder to the risks and rewards of owning an underlying financial instrument without actually owning [it].”[12]  Because there is no need to own an underlying asset, the larger derivative market’s magnitude is not bound by the limits of real property.  Thus, there was over $614 trillion in notional value outstanding across all categories of OTC derivatives as of December 2009.[13]  The actual at risk amount is much lower than this, though, as entities often make bi-directional bets.  The credit default swap (CDS) market illustrates this.  Out of roughly $36 trillion notional outstanding, the net notional amount outstanding (the maximum transfer between sellers and buyers if a credit event occurs) in the CDS market was $2.6 trillion.[14]

            Although the OTC derivatives market is largely unregulated, it is not disorganized.  The International Swaps and Derivatives Association (“ISDA”) is the dominant organizational force in the OTC derivatives market.  ISDA is a trade organization for participants in the OTC derivative market.[15]  ISDA was chartered in 1985, and has grown to over 820 member institutions from around the world.[16]  Its membership includes most of the major institutions that deal in OTC derivatives, and also many of their counterparties (business, governments, and other users) that use OTC derivatives.[17]  “ISDA’s primary purpose is to encourage the prudent and efficient development of the [OTC] derivatives business.”[18]

            ISDA attempts to encourage this prudent and efficient development in a number of ways.  One primary method is “promoting practices conducive to the efficient conduct of the business.”[19]  This involves improving the documents used in these trades.[20]  ISDA also creates standards for the OTC derivative industry and provides legal definitions of terms used in derivative contracts.[21]

            ISDA’s most prominent role is publication of documents commonly relied upon in OTC derivative trades.  ISDA holds copyrights on this documentation and also derives revenue from it.[22]  The copyright-holding function has been described by those within the OTC derivative industry as a central reason for ISDA’s existence.[23]  ISDA also seeks favorable rulings on the terms of its published documentation; ISDA members may rely on these rulings.[24]  One example of this is netting provisions (briefly explained later); ISDA has sought declaratory judgments on the validity of netting in various jurisdictions.[25]  ISDA rarely comes down on one side in disputes between its members, but when it does weigh in on a contractual dispute, ISDA advocates a strict textualist interpretation of the documents it publishes.[26]

II.  Uses of Derivative Contracts

          Derivatives are very flexible instruments.  This flexibility allows different institutions to use derivatives for many different purposes.  There are three broad kinds of activities which use derivatives—dealing, hedging, and speculating.[27]  Hedging is used to offset or reduce risk from a current or planned transaction.[28]  Commercial banks commonly use derivatives for hedging.[29]  Also, end users relying on commodities, such as farmers, often use futures contracts to hedge the risk that the price of their commodities will fall before they reach the market.[30]  In that sense, hedging uses derivatives counter to an existing position in a larger market; the point of hedging is to reduce the magnitude of that position.  Derivatives are an easy, cheap mechanism to do this. 

            By contrast, a dealer takes an intermediate position; dealers sell contracts to customers and make their money off of transaction and origination fees.[31]  Markets for many OTC derivative contracts are presently organized around dealers called “market makers,” who publish bid and offer prices for these contracts to market participants.[32]

            Speculation might be the most notorious use of derivative contracts.  Speculators take a position against the market using derivative contracts and attempt to profit on the transactions.[33]  Note that, unlike hedging and dealing, speculators use derivatives to increase their gain (or loss) when the market moves.  The credit derivative market is a typical example of a market used by speculators.[34]  Hedge funds and other investors enter this market primarily to take positions.[35] 

            Speculation has likely fueled the recent explosive growth of the OTC derivative market.  In 1986, the United Kingdom passed legislation making all financial derivative contracts enforceable, regardless of their purpose.[36]  The United States followed suit on an ad hoc basis, and in 2000 made all financial derivative contracts enforceable via the Commodities Futures Modernization Act.[37]  Although the derivative market’s size has dramatically increased since 2000, the exact level of speculation within the $614 trillion OTC derivative market is difficult to determine.[38]  Dealers’ activities can generate speculative-type risks, and, further, speculative buys and sells are not reported as such.[39]  As a result, it is unclear exactly how much of the $614 trillion outstanding in the OTC derivative market can be traced to speculators. 

            In addition, derivatives are used for other activities of questionable public use.  Companies can use derivative trading for tax evasion, regulation avoidance, and accounting statement manipulation.[40]  For example, the tax code of the United States is riddled with inconsistency and loopholes in its treatment of derivatives.[41]  The result of this is that “well-advised taxpayers [can] continue to choose the specific form of derivative transaction that produces the desired economic result with the most favorable U.S. tax consequences.”[42]  Using derivatives to mask economic realities in this way is effectively a transfer of wealth from the public to a private party.  Such uses of derivatives do not fall into the three main categories, and it is, again, difficult to separate them from the larger OTC derivative market.[43]

            In spite of the many ways parties can use derivatives contrary to public interest, they play a vital role in modern economies.  Senator Christopher Dodd, during the debate on the recently passed financial reform legislation, recognized that “[the term] derivatives unfortunately has become [perjorative], and it shouldn’t. [Derivatives] are very critical components for capital formation, job growth, and wealth in our country. Hedging against risk is absolutely essential.”[44]  Members of both parties during the debate over this legislation agreed that end users who used derivatives for hedging should not have to face obstacles to continue doing so, while derivative contracts further removed from end users (and so more likely to be speculative or otherwise contrary to public interest) should be regulated.[45]  Put more simply, current political thought seeks to enable hedging of risk (as decreasing risk in our economy and so leading to easier credit and job growth) while making speculating more difficult (because it increases risk in our economy and potentially leads to bailouts if not regulated).

III.  ISDA’s OTC Derivative Documentation

            ISDA’s OTC derivative documentation is the industry standard, and is the result of the industry fixing a bottleneck in the derivative trading process.  One major difference between early OTC and exchange-traded derivative contracts was the amount of negotiation required.  For exchange-traded derivatives, the terms were standardized for each type of contract.[46]  However, for OTC derivatives, every term was (and technically still is) subject to negotiation.[47]  This is because OTC contracts are bespoke and can be (and often are) tailor-made to the specific risks to be hedged or speculated upon.[48]  Because of all this potential negotiation, OTC derivative deals were, prior to ISDA’s work, typically fifteen to twenty-five page contracts which were all separately negotiated.[49]  Simplifying the negotiation in each transaction was a large part of the reason behind forming ISDA. 

            The template documentation ISDA publishes is the standard for the OTC derivative industry.  Most derivative transaction contracts are patterned after ISDA’s documentation, and so have much in common.  An excellent overview of ISDA’s documentation was written by Professor Gelpern:

Today’s [form] of ISDA documentation emerged in the early 1990s.  A standard-form Master Agreement written to work under U.S. or English law was first released in 1992.  The Master is neither product-nor party-specific; it is designed as the fixed generic core of every trading relationship, which may last for ten to fifteen years.  It links to other, more tailored, modules by reference.  Prospective counterparties supplement this core with a Schedule, which addresses credit and legal risks specific to the contracting firms, but is not product-specific.  A Credit Support Annex governs collateral arrangements between the parties.  Definitions booklets … are product-specific collections of standard terms promulgated by ISDA and incorporated by reference in individual transactions.  Short-form Confirmations set out the terms of individual transactions between specific parties; they incorporate the relevant Definitions by reference.  Long-form Confirmations are more elaborate; they are used between parties that have no Master in place, as well as for new products where ISDA is yet to promulgate definitions.  Long-form Confirmations still incorporate standard ISDA terms by reference, but the result is customized to the transaction.  User’s Guides to ISDA documentation, true to their name, explain the contracts.[50]

 

In order to learn the full terms of a single derivative transaction, one must look at the Master Agreement, Schedule, and Confirmation.[51]  Only the Confirmation will necessarily be unique for that transaction.[52]

            As the above excerpt indicates, ISDA’s published documentation leads to contracts that are often called “modular.”[53]  The various template documents that ISDA publishes have been described as “building blocks” that allow users to utilize them as flexibly as needed for their desired transactions.[54] ISDA members are free to depart from ISDA’s standard documentation if needed or desired; these departures, though, still tend to produce modular contracts.[55]

A.  The ISDA Master Agreement

            The ISDA Master Agreement was the first piece of documentation published by ISDA, and remains their most influential document.  One prominent financial journalist says simply that “[t]he ISDA Master Agreement is fundamental to, and provides a template for, the derivatives market.”[56]  The Master Agreement is typically used between a derivatives dealer and a counterparty when discussions begin surrounding an OTC derivative trade.[57]  When two parties sign a Master Agreement, they agree to the terms of an ongoing legal and credit relationship between one another.[58]  This saves negotiation time and costs on future transactions, as all terms of the Master Agreement are assumed for subsequent transactions.[59]  A drawback to this, however, is that if a party defaults on one transaction under a Master Agreement, they default on all transactions under that Master Agreement.[60] 

            One Master Agreement can incorporate any number of subsequent derivative transactions, regardless of the type of these subsequent transactions; it is “multi-product.”[61]  Parties can enter into as many Master Agreements as they want, but will typically only sign one to cover a host of transactions between themselves.[62] 

            The Master Agreement incorporates a number of other documents by reference; this is a manifestation of the modular architecture devised by ISDA.  The Master Agreement itself includes references to the Schedule to the Master Agreement (“Schedule”) and any number of Confirmations.[63]  The Schedule and each Confirmation will themselves refer back to the Master Agreement; this is how these modules are incorporated into the Master Agreement.[64]

            The Master Agreement also contains a number of terms and provisions governing the legal and credit relationship between the parties.  The 2002 ISDA Master Agreement added provisions for netting payments from multiple transactions, place of payments, default, and other termination scenarios.[65]  Since dealers are often counterparties in these transactions, they will frequently include terms in these contracts favorable to themselves (ie, enabling them to call for collateral) in case the creditworthiness of the counterparty to the trade declines.[66]  The Master Agreement also contains a “Credit Event Upon Merger” provision, which allows a party to terminate all outstanding trades if the other party enters into a merger (or similar event) which results in that party’s creditworthiness being “materially weaker.”[67]  The term “materially weaker” is left undefined in ISDA’s documentation.[68] 

B.  The Schedule to the Master Agreement

            The Schedule contains provisions which modify the terms of the Master Agreement, and it is incorporated into the Master Agreement by reference.  The Schedule has two sections.[69]  One section is a preprinted form containing provisions which the parties may elect to include in their Master Agreement.[70]  The other is a section pursuant to which the parties may include more provisions or otherwise modify the preprinted portion of the Schedule.[71]  The Schedule also contains many important elective terms governing the credit relationship between the parties, such as the “Credit Support Annex”, wherein the parties may agree to provide collateral under certain conditions.[72]  This, like the rest of the Schedule, is considered part of the Master Agreement.[73]

C.  Confirmations

            The economic terms of a trade are reflected in the Confirmation.[74]  The Master Agreement incorporates one to many Confirmations by reference, and each Confirmation refers back to the Master Agreement.  The parties must come to a specific agreement on the economic terms within each confirmation; failure to be exact on these terms can result in one party demanding performance which the other party feels it is not obligated to perform.  For example, failure to specify the precise entity in a credit default swap can lead to these conflicts in performance.[75] 

            There are two types of confirmation documents:  long-form and short-form.[76]  Long-form Confirmations themselves contain all the terms necessary to document the economic terms of the transaction.[77]  Short-form Confirmations incorporate standard terms and provisions which are defined elsewhere; therefore, the Confirmation document itself does not document all the economic terms of the transaction.[78]

            Confirmations are often negotiated informally.  Confirmations, especially for simpler transactions, are commonly agreed to via telephone.[79]  Typically, the dealer will generate the confirmation and send it to the counterparty.[80]  If the counterparty does not provide objections or comments within a specified period of time (usually no more than a few days after receipt of the confirmation), the counterparty will be determined to have accepted the terms set out in the confirmation absent manifest error.[81] 

            Although the Master Agreement, Schedule, and Confirmations are the most important documents ISDA publishes, they do publish a variety of other documentation as well.  ISDA Definitions are booklets of standard definitions and other terms and provisions.[82]  Typically one booklet is limited to one kind of derivative transaction (ie, credit default swaps).[83]  ISDA User Guides are explanations of provisions in documents published by ISDA.[84]  User Guides also contain suggestions for additional provisions parties might want to include in their agreements.[85]  Protocols are also published by ISDA, and enable users to amend all outstanding contracts using ISDA’s documentation.[86]

IV.  The Pitfalls of OTC Derivative Trading

            OTC derivative trading has played a major role in many financial “disasters,” even prior to the financial crisis of 2008 and 2009.  In 1998, the hedge fund Long Term Capital Management collapsed with approximately $1.4 trillion of derivative contracts on their books.[87]  Prior to 1996, Sumitomo bank of Japan manipulated the global copper market by using derivatives.[88]  The late ’90s Asian financial crisis was exacerbated by speculative use of exchange rate derivatives.[89]  Barings bank, one of Europe’s oldest financial institutions, was brought down by a rogue derivative trader.[90]  Enron’s bankruptcy was caused in part by derivatives, and worsened by its role as a commodity derivatives dealer.[91]  More recently, Greece used derivatives to enable itself to take on more debt, which led it to the brink of default and shook sovereign bond markets throughout Europe.[92]  One senator also repeated a widely-held view that derivatives were “at a minimum the accelerant that complicated and expanded the financial crisis” which ultimately brought down Lehman Brothers and A.I.G.[93] 

            The very nature of OTC derivatives trading gives rise to a number of risks.  Derivatives lead to excessive leverage, both in individual financial institutions and the broader economy.  They also give rise to counterparty risk, which is the risk that a trading partner might not honor the terms of the contract (whether by choice or not).  The complex structure of OTC derivative documentation itself creates risk.  These significant risks are dangerous both to those who engage in derivative trading and to the larger world economy. 

A.  Risk caused by excessive leverage

            Derivative trading makes entities more leveraged (more debt for each dollar of equity).  Leverage allows for higher returns, but also results in higher risk for the leveraged entity.[94]  This leverage occurs because derivatives allow speculators to take a large price position while committing little capital.[95]  Hedgers and dealers also increase their leverage, but their activities do not increase the magnitude of their positions in their markets.[96]  Because OTC derivative markets, unlike most exchanges, presently have no margin requirements, over-leveraging is easier to accomplish.[97]  Some OTC derivative contracts do not even have collateral requirements, which further allows companies trading in these contracts to leverage themselves.[98] 

            The ISDA has attempted to reduce the leverage inherent in derivative trading by introducing a netting provision into its contracts.  Netting, in theory, reduces the risk faced by bi-directional bets.[99]  For example, assume Company A has $15 worth of positive bets and $10 worth of negative bets on an event with Company B.  When that event happens, Company A’s $10 of payments to Company B would be netted against Company B’s $15 of payments to Company A.  As a result of this netting, rather than cash flowing in both directions, Company B would simply pay Company A $5 (or default).[100]  Netting reduces both leverage and counterparty risk by reducing both the magnitude of payments and the need for performance by both parties.[101]  Note, however, that netting is only effective for bi-directional bets; directional bets, such as those speculators take, are not able to be netted. 

            Leverage is especially dangerous due to its ability to negatively affect the investments and wealth of third parties.  Higher leverage increases the risk of bankruptcy for an entity if their trades have negative results.[102]  Bankruptcy causes those who invested in that entity to lose their investments, and it can also cause lenders (and other counterparties) to lose money.[103]  In this way, harm from derivatives trading can spread to those who consciously stayed away from the OTC derivative marketplace.  This type of harm is called “systemic risk,” and presents a problem to the entire economy.[104]

            This type of “systemic risk” is often linked to speculative activity.  Unlike hedging, speculating increases the amount of risk in the economy; this is reflected in the common law “rule against difference contracts,” which rendered a contract unenforceable unless one of the parties to the contract had an actual interest in the subject of the contract.[105]  Modern regulation did away with the rule against difference contracts and set the stage for various financial crises linked to excessive leverage brought on by irresponsible use of derivatives.[106]  Because of the demonstrated systemwide effects of excessive leverage, though, these negative externalities caused by derivative trading are a promising target for regulation.[107]

B.  Risks stemming from counterparties

            Counterparty risks are both inherent in bilateral (OTC) derivative trading and exacerbated by provisions common to derivative contracts.  The inherent risk arises because

[d]erivatives contracts bind counterparties together for the duration of the contract. The duration varies depending on product type and market segment, ranging from e.g. a few days … to several decades for certain interest rate derivative contracts. Throughout the life of the contract counterparties build up claims against each other as the rights and obligations contained in the contract evolve with the price of the underlying the contract is derived from. This gives rise to counterparty credit risk, i.e. the risk that the counterparty may not honour its obligations under the contract.[108]

 

This counterparty risk is exacerbated due to the complete lack of transparency in OTC derivative markets.  Since these markets are opaque, it is difficult to properly evaluate the risk of dealing with a particular counterparty, especially if that party is trading with other entities.[109]  This opacity makes counterparty risk very difficult to accurately price into markets due to its unpredictability.[110]

            Counterparty risk can also arise because a party to a trade consciously decides to no longer honor the terms of the contract.  An increasingly frequent pattern sees counterparties alleging that financial institutions sold them derivative contracts that were too “complex” for them to understand.[111]  For example, the Italian village of Baschi is suing BNP Paribas in an attempt to close an interest-rate swap which BNP Paribas offered.  This swap is draining the village’s treasury.[112]  Many other Italian municipalities are similarly burdened with liabilities stemming from ill-conceived derivative trades, many of which they allege were too complex for them to understand and value properly.[113]  There is precedent for waiving liabilities stemming from derivative contracts on grounds of complexity; in the 1990s, the United Kingdom House of Lords determined that interest-rate swaps entered into by two municipalities were unenforceable.[114]  Banks selling these complex products argue that they only target “sophisticated” investors; if these contracts are found to be unenforceable elsewhere, it could force banks to rethink how they define a “sophisticated investor.”[115]

            The overall creditworthiness of a trading partner further can exacerbate counterparty risk.  As a party becomes less creditworthy, they become less likely to meet their contractual obligations.[116]  Parties try to mitigate the risk of their counterparties being unable to fulfill these obligations by various contractual terms.[117]  These terms are not always successful, though, and so a defaulting counterparty can have a significant negative impact on a derivative trading strategy.[118]

            For example, a common term to mitigate counterparty risk enables one party to the trade to call for collateral from its counterparty.  However, if one party does not properly plan for a risk of posting collateral, these terms can cause a credit death spiral as collateral calls increase; this was a leading cause of death for insurer A.I.G.[119]  There, a unit of A.I.G. underwrote credit-default swaps with provisions requiring A.I.G. to post collateral if the values of the underlying assets dropped below certain levels.[120]  Even though A.I.G. officials argue that these swaps retained their value in the long-term, the credit upheaval in September, 2008 pushed the value of the underlying assets beneath these thresholds; as a result, A.I.G. was required to post collateral under the terms of these trades, most notably to Goldman Sachs.[121]  This caused A.I.G. to suffer a liquidity crisis, and eventually required the U.S. government to back A.I.G.’s sides of trades in order to avoid an economy-wide meltdown stemming from systemic risk.[122]

            “Cross Default” provisions, and other contractual provisions, are examples of terms that deal with the parties’ creditworthiness.  If a “Cross Default” provision is elected into, one party can terminate all outstanding trades[123] if their counterparty defaults on a loan obligation over a certain threshold, whether the default was part of this series of transactions or not.[124]  If these involuntarily terminated trades were made with leverage, the lenders providing the leverage can demand the defaulting party to repay their debt, further straining the defaulting party’s cash position.[125]  Other contractual provisions (such as the Credit Event Upon Merger provision) can also result in a trading partner getting an option to terminate all outstanding trades if certain events occur. 

            When necessary, dispute resolution between counterparties for derivative trades depends on the type of derivative and the terms of the contract specifying the trade.  Exchange-traded derivatives in the United States are usually governed by the Commodities Futures Trading Commission (“CFTC”), and under the rules of its exchange, disputes are arbitrated by the National Futures Association.[126]  Most OTC derivative disputes are litigated; the ISDA Master Agreement defaults to giving courts in London and New York jurisdiction over disputes stemming from derivative deals.[127]  Some actual agreements, though, are modified to provide for arbitration.[128]

C.  Risks stemming from contractual structure

            The structure of ISDA’s documentation, and the terms contained therein, inject more risks into OTC derivative trading.  Due to the modular nature of ISDA’s documentation, many terms to which the firms are bound are simply not known by those actually transacting a trade.[129]  Similarly, those negotiating the Master Agreement may never see the Confirmations containing the actual economic terms of each trade; there is simply no need, as it is outside of their area of specialization.[130]  However, this kind of compartmentalization can increase the cost of drafting mistakes, and also increases the risk of necessary parties never seeing particular legally binding terms.[131]

            These are not just theoretical mistakes.  In one case, a Polish company was bound by the terms of the ISDA Master Agreement (and UK law) even though the Polish company had never read the ISDA Master Agreement.[132]  More famously, A.I.G.’s risk management officers did not realize that the collateral calls which sunk the insurer were terms in their contracts.[133]  Phil Angelides, chairman of a federal commission investigating the 2008 financial crisis, saw this as evidence of “the failure of leadership and effective management at A.I.G.”[134]  Whether this siloing of information led to a wrongful perception of incompetence or an increase in damage caused by incompetent management is debatable, but neither outcome is desirable.  Even though the OTC derivative market is very caveat emptor, legal advice is often necessary to ensure that the negotiated agreement accurately reflects the transaction which the parties are trying to accomplish.[135]

V.  Possible Improvements to OTC Derivative Trading

 

            An analysis of the risks of the OTC derivative market reveals several possible regulatory improvements, many of which are reflected in the recent financial reform legislation.  The two clearest needs are for increased transparency in these markets and for greater standardization in contracts. 

            One way to improve the operation of OTC derivative markets is to make the markets more transparent.  Transparency refers to the information participants have about the trades being conducted in the market.  Currently, information in OTC markets is valuable and hoarded by the participants.[136]  For example, when brought before the Angelides commission, The CFO of Goldman Sachs refused to produce information regarding how it had valued derivatives in September, 2008, and to whom it paid collateral at this time.[137]  This information inefficiency could allow a party making a bi-directional bet to profit on both sides of a trade, by representing one set of figures to one party and a different set to another.[138]  Goldman Sachs has similarly not shared financial information from its broader derivatives trading operations.[139]  While Goldman claims that it does not possess the information requested, the way entities who trade OTC derivatives hoard information has caused many to cast a suspicious eye on Goldman’s claim.[140] 

            Increasing market efficiency is generally considered a desirable goal.  Typically, the more freely information flows, the more efficiently markets operate.[141]  This has an added bonus in that participants in more efficient markets reduce the risk faced by all participants in that market.[142]  A more efficient OTC derivative market, in turn, would be less disruptive to the financial system as a whole—it would reduce the systemic risk in our economy.[143] 

            One way to increase the transparency of OTC derivative markets would be to move these trades to a central clearing house or an exchange.  This would enable the reporting of aggregated data, and would ease the dissemination of market information.  The New York Stock Exchange (NYSE) performs a similar function for securities and options, and has rules requiring market makers to disclose information about their markets, in addition to other rules governing disclosure.[144] 

            The financial reform legislation centralizes transactions between dealers and “other large market participants” into clearinghouses and exchanges, where possible.[145]  Doing so for large market participants reduces the systemic risk derivatives bring to the economy (by reducing the amount of leverage entities with many counterparties can take on).  Exempting smaller market participants (which are often end users seeking to hedge risks cheaply) from this requirement allows them to move forward without significant disruption to their business model.[146]  Congress included this exemption in an effort to prevent economic contraction which might be caused by increased costs for end users to hedge risk.[147]  Centralized trading of OTC derivatives will require greater standardization in the contracts; where contracts are too unusual, complex, or otherwise unable to be centrally traded, the parties must report detailed data about the trade to a centralized entity.[148]  This brings up a difficulty with centralized clearing of derivatives; some derivatives are simply too complex to centrally clear and report.[149]  The pending legislation attempts to deal with this by giving regulators the power to remove obstacles to centralized reporting, but how this will work in practice remains unclear.[150]

            Transparency will also enable regulators to better police OTC derivative markets.  The recent financial reform legislation places the Securities Exchange Commission (SEC) in charge of swaps which involve securities and the CFTC in charge of all other swaps.[151]  The goal of the derivatives portion of this legislation is to use regulation to reduce the likelihood or severity of the “next” A.I.G. style crisis.[152]  Increased transparency gives regulators information about the markets which they are charged with policing.  However, given the complexities of the OTC derivatives market, it is possible that the newly transparent data will overload the regulators, and they will be unable to use it effectively.[153]  Studies of the financial crisis of 2008, such as the one overseen by Mr. Angelides, can guide regulators and help them make sense of the deluge of information they will face.[154] 

                Another problem with giving regulators so much substantive authority is that the rules governed by the derivatives market will ultimately lie in the hands of unelected officials; Senator Kaufman noted that the reform’s “ultimate success or failure will depend on the actions and follow-through of these regulators for many years to come.”[155]  This leads to a risk that the will Congress currently has to reform derivatives trading will not be reflected in the final rules put forth by the regulators.[156]

            Increasing transparency and regulatory oversight are also tools to reduce the risk of over-leveraging.  The recently passed financial reform legislation requires regulators to set margin requirements for swaps that are not traded through a clearinghouse.[157]  Compare this with the case of A.I.G., which was able to write uncleared swaps which included collateral calls (similar to margin requirements) about which their risk management officers did not even know.[158]  These collateral calls amounted to hidden leverage for the insurer, and had catastrophic consequences when they saw the light of day.  The proposed capital requirements will allow regulators to cap the leverage provided by derivatives at any given time.[159]  Because uncleared swaps, unlike cleared ones, are subject to margin requirements, the legislation will encourage market participants to do more trading in transparent and regulated markets.[160]  These requirements only apply to major market participants and dealers; smaller participants do not inject a similar kind of systemic risk into the economy.[161]  The financial reform legislation does, however, allow banks and other entities to use derivatives as needed to hedge their own risks.[162]

            Further standardizing the contracts used in OTC derivative trades would further lessen the risk caused by derivatives, and would also make it easier to centrally trade them.  The goal of contract standardization would be to make contracts fungible among various groups of trading partners.[163]  This would have two very beneficial effects:  it would be easier to centrally trade these standardized contracts, and more meaningful reporting could be done about these trades.  There are two dimensions to standardizing these contracts:  standardizing the legal terms of the contracts (such as applicable law and dispute resolution procedures), and standardizing the economic terms of the contracts (such as coupon and duration).[164]  Standardization would allow contracts traded among different parties to be substitutable with each other, which could potentially reduce the “need” for such a large outstanding notional amount of OTC derivative contracts.[165]  Standardization would also result in more predictable contracts.[166]  It would also lead to better information flow, due to the increased ease of centrally trading these contracts.  The pending financial reform legislation recognizes this need for standardization prior to centralized trading, and requires regulators to approve classes of swaps prior to centralizing their trading.[167]  The main downside to standardization is technical; in the eyes of users of these contracts, there are an infinite number of some kinds of swaps.[168]  For example, credit-default swaps with different durations are valued differently, and, if the duration is standardized, each days’ issued swaps would have different values.[169]  This makes it extremely difficult to list these meaningfully on an exchange.[170]  However, these difficulties are not present for trading these at a central clearinghouse.[171]



[1]      Derivatives Primer, http://www.financialpolicy.org/dscprimer.htm (last visited June 26, 2010).

[2]      Id.

[3]      ISDA, Product Descriptions and Frequently Asked Questions, http://www.isda.org/educat/faqs.html (last visited June 26, 2010) [hereniafter ISDA FAQ].

[4]      Derivatives Primer, supra note 1. 

[5]      Chicago Mercantile Exchange, http://www.cmegroup.com (last visited June 26, 2010).

[6]      ISDA FAQ, supra note 3.

[7]      Id.

[8]      Id.

[9]      Id.  The jurisdictions depend on the terms of the derivative contract itself or the parties’ locations. 

[10]    Id.

[11]    Id.

[12]    Allen C. Puwalski, Derivatives Risk in Commercial Banking, http://www.fdic.gov/bank/analytical/fyi/2003/032603fyi.html (last visited June 26, 2010).

[13]    Amounts Outstanding of Over-the-Counter (OTC) Derivatives,  http://www.bis.org/statistics/otcder/dt1920a.pdf (last visited June 26, 2010).  “The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument.”  Notional Amount, http://en.wikipedia.org/wiki/Notional_amount (last visited June 26, 2010).  Therefore, when we say that $614 trillion of OTC derivatives are outstanding, we mean that the contracts outstanding, if all were paid off at once, would require a transfer of $614 trillion.

[14]    Matt Phillips, CDS Market: Fun Facts to Drop in Cocktail Party Conversation, available at http://blogs.wsj.com/marketbeat/2010/03/10/cds-market-fun-facts-to-drop-in-cocktail-party-conversation/ (last visited July 5, 2010). 

[15]    International Swaps and Derivatives Association, http://en.wikipedia.org/wiki/International_Swaps_and_Derivatives_Association (last visited June 26, 2010) [hereinafter Wikipedia ISDA]. 

[16]    About ISDA, http://www.isda.org/ (last visited June 26, 2010). 

[17]    Id. 

[18]    Allen & Overy, An Introduction to the Documentation of OTC Derivatives: “Ten Themes”, 3 (May 2002), available at http://www.isda.org/educat/pdf/ten-themes.pdf

[19]    Id.

[20]    Id.

[21]    Wikipedia ISDA, supra note 15.

[22]    Anna Gelpern, Commentary, 51 Ariz. L. Rev. 57, 66 (2009). 

[23]    Id.

[24]    Id. at 67. 

[25]    Id.

[26]    Id.

[27]    See Puwalski, supra note 12.

[28]    Id.

[29]    Id.

[30]    Derivatives Primer, supra note 1.

[31]    Id.

[32]    Michael Chlistalla, OTC Derivatives, 6 (April 2010), available at http://www.dbresearch.de/PROD/DBR_INTERNET_EN-PROD/PROD0000000000256894.pdf.

[33]    See Puwalski, supra note 12.

[34]    David Mengle, Credit Derivatives:  An Overview, 18 (2007), available at http://www.frbatlanta.org/filelegacydocs/erq407_mengle.pdf. 

[35]    Id.

[36]    Lynn A. Stout, Regulate OTC Derivatives by Deregulating Them, Regulation 29, 30 (Fall 2009), available at http://www.cato.org/pubs/regulation/regv32n3/v32n3-1.pdf.

[37]    Id.

[38]    See Puwalski, supra note 12.

[39]    Id.

[40]    Derivatives Primer, supra note 1.

[41]    Yoram Keinan, United States Federal Taxation of Derivatives: One Way or Many?, 61 Tax Law. 81, 81-90 (Fall, 2007).  Prof. Keinan notes three tax issues, specifically, that allow derivatives to be used in this manner:  the timing of the transaction, the character of the transaction, and the source of the transaction.  Id.  

[42]    Id. at 87. 

[43]    Derivatives Primer, supra note 1. 

[44]    156 Cong Rec S 5870, 5875 (2010) [hereinafter Senate Hearings I]. 

[45]    For example, Senator Hutchinson of Texas said that financial reform legislation “must … protect end users such as airlines, utilities, manufacturers, and oil and gas companies, [which] use derivatives as a cost effective strategy to control price and risk.  Id. at 5881.  Representative Peters, similarly, noted that “commercial end users, who are those who use derivatives to hedge legitimate business risks, do not pose systemic risk and … solely use these contracts as a way to provide consumers with lower cost goods” while arguing in favor of easing access to derivative contracts for these users.  156 Cong Rec H 5233, 5244-45 (2010).  Senator Hagan further noted that the legislation heavily regulated users who “maintain[ed] a ‘substantial position’ in swaps, as well as … swaps creat[ing] ‘substantial counterparty exposure’ that could have ‘serious adverse effects on the financial stability of the United States banking system or financial markets.'”  Senator Hagan also noted that the legislation “also encompasses ‘financial entities’ that are highly leveraged relative to the amount of capital [they] hold[], [and] are not already subject to capital requirements set by a Federal banking regulator.”  156 Cong Rec S 5902, 5907 (2010) [hereinafter Senate Hearings II].  The characteristics highlighted by Mr. Hagan and present in the legislation are common to those accused of using derivatives for speculation. 

[46]    ISDA FAQ, supra note 3.

[47]    Id.  In practice, once a Master Agreement is signed, the terms of that Agreement usually control all subsequent transactions, greatly reducing the amount of negotiation. 

[48]    Chlistalla, supra note 32 at 4.

[49]    Allen & Overy, An Introduction to the Documentation of OTC Derivatives, 3 (2002), available at http://www.isda.org/educat/pdf/documentation_of_derivatives.pdf. 

[50]    Gelpern, supra note 22 at 64 (citations omitted). 

[51]    Understanding corporate finance: derivative contracts: documentation: the ISDA Master Agreement, http://www.hmrc.gov.uk/manuals/cfmmanual/CFM13100.htm (last visited June 26, 2010) [hereinafter Understanding Corporate Finance]. 

[52]    Id. 

[53]    Allen & Overy, supra note 18 at 2.  

[54]    Id.

[55]    Gelpern, supra note 22 at 65 (citing Allen & Overy supra note 18). 

[56]    Stacy-Marie Ishmael, Lehman, Metavante and the ISDA Master agreement, (2009), available at http://ftalphaville.ft.com/blog/2009/09/30/74606/lehman-metavante-and-the-isda-master-agreement/.

[57]    Wikipedia ISDA, supra note 15.

[58]    Allen & Overy, supra note 18 at 2. 

[59]    Understanding Corporate Finance, supra note 51. 

[60]    Id.

[61]    Allen & Overy, supra note 18 at 2.

[62]    Baker & McKenzie, Documentation of OTC Derivatives Under the ISDA Master Agreement:  A Primer for Corporate Counsel & Treasury, 3 (2003), available at http://www.bakernet.com/NR/rdonlyres/923702A4-DA33-4050-B249-FD7605FF0885/0/SwapsPractice_asof11Sept04.pdf. 

[63]    Allen & Overy, supra note 18 at 2. 

[64]    Id. 

[65]    Baker & McKenzie, supra note 62 at 4. 

[66]    Id. at 2. 

[67]    Id. at 6.

[68]    Id.

[69]    Id. at 4. 

[70]    Id. 

[71]    Id.

[72]    Id.

[73]    Id.

[74]    Allen & Overy, supra note 18 at 2. 

[75]    Mengle, supra note 34 at 4. 

[76]    Allen & Overy, supra note 18 at 3. 

[77]    Id. 

[78]    Id. 

[79]    Baker & McKenzie, supra note 62 at 3. 

[80]    Id.

[81]    Id. 

[82]    Allen & Overy, supra note 18 at 3. 

[83]    Id. 

[84]    Id. at 6. 

[85]    Id. 

[86]    Gelpern, supra note 22 at 65. 

[87]    Derivatives Primer, supra note 1. 

[88]    Id.

[89]    Id.

[90]    Id.

[91]    Id.  Enron’s bankruptcy was, at the time, the largest in U. S. history.  Id.

[92]    Alan Rappeport, Tom Braithwaite & David Oakley, Goldman role in Greek crisis probed, The Financial Times (March 8, 2010), available at http://www.ft.com/cms/s/0/ca979904-2216-11df-98dd-00144feab49a.html. 

[93]    Senate Hearings II, supra note 45 at 5915.  Hearings led by Phil Angelides to determine the causes of this financial crisis featured a two-day session entitled “The Role of Derivatives in the Financial Crisis.”  Joe Nocera, “Hearings That Aren’t Just Theater,The New York Times, July 2, 2010 (available at http://www.nytimes.com/2010/07/03/business/03nocera.html?_r=1&ref=todayspaper&pagewanted=all). 

[94]    Derivatives Primer, supra note 1. 

[95]    Id.

[96]    Remember, however, that dealers’ activities can result in speculative type risks.  Supra note 39. 

[97]    Derivatives Primer, supra note 1.  The flipside of this is that it is easier for end users to hedge against risk.  Imposing margin requirements might force end users to “choose market volatility instead of risk-controlling derivatives,” which could depress economic activity.  Senate Hearings I, supra note 44 at 5881. 

[98]    Derivatives Primer, supra note 1. 

[99]    Allen & Overy, supra note 18 at 4. 

[100] Id.

[101] Id.

[102] Derivatives Primer, supra note 1. 

[103] Id.

[104] Id.

[105] Stout, supra note 36.  Requiring one of the parties to the contract to have an actual interest in the subject matter of the contract significantly increases the likelihood that the contract has, at some level, a hedging purpose.  Id. at 31. 

[106] Id. at 32.  Also, see supra notes 36-37. 

[107] Derivatives Primer, supra note 1.  Congress has recently passed financial reform legislation which significantly enhances the regulatory structure around OTC derivative trading.  See infra notes 136-71. 

[108] Chlistalla, supra note 32 at 7.

[109] Id.

[110] Id.

[111] Rachel Sanderson, Guy Dinmore & Gillian Tett, Finance: An exposed position, The Financial Times (March 8, 2010), available at http://www.ft.com/cms/s/0/0d29fbdc-2aef-11df-886b-00144feabdc0.html?nclick_check=1.

[112] Id.

[113] Id.

[114] Id.

[115] Id.

[116] Baker & McKenzie, supra note 62 at 4-5. 

[117] Id.

[118] Id.

[119] Nocera, supra note 93. 

[120] Id. 

[121] Id.

[122] Id. 

[123]        “Termination of all outstanding trades” effectively gives these companies an option to lock in gains they have made (if any) or continuing under the terms of the current contract. 

[124] Baker & McKenzie, supra note 62 at 4-5. 

[125] Id.

[126] Stefano E. Cirielli, Arbitration, Financial Markets and Banking Disputes, 14 Am. Rev. Int’l Arb. 243, 280 (2003). 

[127] Id. at 280-81. 

[128] Id. at 281-82.  This modification is usually placed in the Schedule.  Id.

[129] Gelpern, supra note 22 at 65. 

[130] Id. at 70-71. 

[131] Id.

[132] Bruce Somer, Cases in US and UK point to emerging trends in derivatives industry, (2010), available at http://www.bakermckenzie.com/RRGoverningRecentDerivativesLitigationOct09/. 

[133] Nocera, supra note 93. 

[134] Id.

[135] Baker & McKenzie, supra note 62 at 4.  More and more law firms now advise on derivative contracts.  I have relied on material from Allen & Overy (http://www.allenovery.com/AOWEB/AreasOfExpertise/PracticeHub.aspx?aofeID=304&practiceID=325&selectedPage=Derivatives and Structured Finance&prefLangID=410) and Baker & McKenzie (http://www.bakermckenzie.com/Securitization/); both firms work extensively with OTC derivatives.  These firms are becoming the rule rather than the exception; a brief survey of firms’ websites reveals that many firms which work in securities advertise experience working with OTC derivatives.  See, for example, Harwood Feffer (http://www.whesq.com/), Simmons & Simmons (http://www.simmons-simmons.com/index.cfm?fuseaction=service_industry.zone&page=606), and others. 

[136] Derivatives Primer, supra note 1. 

[137] Nocera, supra note 93. 

[138] Note that this works because derivatives are based on some underlying asset; the values of the underlying assets are questions of accounting principles.  In their dealings with A.I.G., Goldman Sachs claimed to mark their assets to market.  A.I.G. disputed these valuations, but ultimately Goldman Sachs received their collateral.  Id.  There is no evidence that Goldman Sachs used a different accounting method in its dealings with other counterparties, but the lack of transparency currently in OTC derivative markets makes such malfeasance possible. 

[139] Nocera, supra note 93. 

[140] Id. 

[141] Derivatives Primer, supra note 1. 

[142] Id.

[143] Id.

[144] For example, NYSE Rule 132 (Comparison and Settlement of Transactions Through A Fully-Interfaced or Qualified Clearing Agency) requires members trading on the exchange to submit their sides of each contract to a clearing agency.  Rule 121 (Records of DMM Units) requires market makers to keep detailed records of every transaction.  Rule 123 (Record of Orders) requires members themselves to keep records of every order they originate and receive.  These rules are just a sampling; stringent record-keeping and order submissions are common themes throughout the NYSE rules.  These rules are available at http://nyserules.nyse.com/NYSE/Rules/ (last visited June 26, 2010).

[145] House of Representatives Financial Services Committee, Over-the-Counter Derivatives Markets Act, 1 (2010), available at http://financialservices.house.gov/Key_Issues/Financial_Regulatory_Reform/FinancialRegulatoryReform/HR4173_summaries_by_title/Title_III_OTC_Derivatives_120309.pdf (last visited July 6, 2010) [hereniafter House Summary]. 

[146] Id. at 2.  Senator Lincoln noted that “[i]t is also important to note that few end users will be major swap participants, as we have excluded ‘positions held for hedging or mitigating commercial risk’ from being considered as a ‘substantial position’ under that definition.”  Senate Hearings II, supra note 45. 

[147] Senator Chambliss stated that “[forcing end users to centrally trade derivatives] simply transfers risk from one place to another and imposes costs on market participants who had nothing to do with creating the financial crisis. I truly fear that consumers will ultimately pay the price.”  Senate Hearings I, supra note 44.  Senators Lincoln and Dodd agreed, noting that “[end users which use derivatives to hedge risk] help to finance jobs and provide lending for communities all across this nation. That is why Congress provided regulators the authority to exempt these [end users].”  156 Cong Rec H 5233, 5248 (2010). 

[148] House Summary, supra note 145 at 2.  More stringent reporting requirements have been called a “major component” of the legislation.  Senate Hearings II, supra note 45 at 5920.  Compare with the NYSE’s reporting rules, supra note 144. 

[149] Senator Gregg noted that the financial reform legislation might cause a contraction in all derivatives, including those used for hedging, because “there are a lot of derivatives that obviously should go through clearinghouses but are too customized to go on exchanges.”  Senate Hearings I, supra note 44 at 5890. 

[150] House Summary, supra note 145 at 2. 

[151] Id. at 1.  The Financial Stability Oversight Council, created by the legislation, will step in to standardize rules where the two agencies conflict.  Senate Committee on Banking, Housing, and Urban Affairs, Summary: Restoring American Financial Stability, 6 (2010), available at http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf [hereinafter Senate Summary]. 

[152] Ronald D. Orol, “Crisis panel takes Goldman to task over derivatives data”, Marketwatch, July 1, 2010 (available at http://www.marketwatch.com/story/financial-crisis-panel-takes-goldman-sachs-to-task-2010-07-01). 

[153] Id. 

[154] Nocera, supra note 93. 

[155] Senate Hearings I, supra note 44 at 5886. 

[156] Senator Kaufman took another angle, opining that “if we elected another President who believed we should not have regulators and regulation, [major swap participants] would again have the ability to do what they did to cause a meltdown.”  Id.

[157] Senate summary, supra note 151 at 6.. 

[158] See supra notes 129-30. 

[159] House summary, supra note 145 at 2. 

[160] Senate summary, supra note 151 at 6.

[161] Id. 

[162] Stacy Kaper, “House Approves Historic Reg Reform Bill”, Insurance Networking News, July 1, 2010 (available at http://www.insurancenetworking.com/news/insurance_financial_reform_bill_regulatory_reform-25146-1.html).  Compare this with the “rule against difference contracts”, supra note 101.  Basically, the House is sanctioning hedging as a valid use of derivatives while attempting to curb speculation.  See also supra notes 145-50. 

[163] Chlistalla, supra note 32 at 9.

[164] Id. at 19. 

[165] Id. at 9. 

[166] Whether these more predictable contracts would be simpler is a matter for debate.  Given ISDA’s stated goal of “prudent and efficient development” of the derivatives business, simplicity would seem to be ISDA’s target.  Supra note 18.  But whether market forces would push derivatives contracts towards simplicity or complexity remains unresolved. 

[167] House Summary, supra note 145 at 2. 

[168] Chlistalla, supra note 32 at 20.

[169] Id.

[170] Id.

[171] Id.