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First Draft – Please do not cite without the authors prior permission.

Comments very welcome to john.biggins@ucd.ie

Locking Out the Gatekeepers…Or Locking Them In? The ISDA Credit Derivatives Determinations Committees and OTC Derivatives Market Reforms

John Biggins

UCD Centre for Regulation and Governance School of Law

University College Dublin Abstract

The Global Financial Crisis has resulted in new policy initiatives at both the public and private levels in the over-the-counter derivatives markets. While at first these initiatives appear to be somewhat divorced from one another, in fact they are subtly linked. Perhaps the most significant outcome of this will be to potentially ensure that a systemically significant proportion of the over-the-counter credit default swaps market will remain largely under the auspices of private regulation under the new regulatory structures. Accordingly, while some of the commentary surrounding the OTC CDS markets has implied that they must be brought under the control of direct public regulation or even outlawed altogether, the reality is somewhat different and may actually operate to retain the pre-crisis status quo to an, as yet undeterminable, extent. Exactly what this private initiative may represent in this context will be explored from certain theoretical and normative perspectives.

Researcher on the initiative Private Transnational Regulation: Constitutional Foundations and Governance Design funded by the Hague Institute for the Internationalisation of Law (HILL) [http://www,privateregulation.eu] E: john.biggins@ucd.ie . This paper arises from research conducted on a case study within the umbrella of the HILL initiative, „Regulating Derivatives for Better Corporate Governance‟. I am very grateful to Colin Scott for initial comments. However, the views expressed in this particular paper are mine alone and do not necessarily represent the views of any other individual or organization, including HILL. Errors and omissions are also mine alone.

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Introduction The Global Financial Crisis (GFC) has, amongst other things, presented a prime opportunity for legislators, regulators and scholars to take stock of pre-GFC prevailing regulatory frameworks, including in the over-the-counter derivatives (OTCD) markets and its interplay with emerging public regulatory measures. Recent public regulatory proposals, particularly in the United States (US) and European Union (EU) ostensibly aim to reinstitute some semblance of public control over the operation of the OTCD markets. At first glance, these reforms appear largely to implicitly exclude certain private actors, most notably the dominant private transnational trade association operating in this space, International Swaps and Derivatives Association (ISDA), from involvement in emerging regulatory processes. Taken in isolation, the public regulatory reforms on both sides of the Atlantic thus suggest that primary responsibility for managing conduct in the OTCD markets will now fall to Central Clearing Counterparties (CCP‟s) and Trade Repositories (TR‟s). This paper seeks to demonstrate that the regulatory picture may be significantly more complex with attendant implications. I suggest that considerable power may remain vested in certain OTCD market actors performing a significant gatekeeping function, in spite, or because, of public regulatory reforms. This paper will emphasize the role of the recently established „Credit Derivatives Determinations Committees‟ created under the auspices of ISDA. What might appear to be a mundane technical measure in an opaque market actually arguably carries considerable normative baggage. This paper is split into two parts. The first part of this paper elaborates the policy problem associated OTCD, particularly OTC credit default swaps (CDS), in the wake of the GFC. This has precipitated both public and private policy responses. The second part of this paper contains an overview of the broad contours of OTCD public regulatory reforms and how these might be expected to impact on the OTC CDS markets. The paper will then attempt to establish the general role of ISDA‟s historical relationship with public regulation in order to offer a necessary context. This will be followed by a specific examination of ISDA‟s recent industry initiative pertaining to the OTC CDS markets, exemplified by the creation of Credit Derivatives Determinations Committees. Subsequently, attempts will be made to conceptualize the position of these recently established committees operating under the auspices of ISDA in the context of gatekeeper theory. It is contended that these committees may be performing a verification role somewhat similar in spirit to credit ratings agencies and could be considered a new addition to the family of financial market gatekeepers. In particular, it will be contended that recent public regulatory reform proposals may have subtly granted these ISDA Credit Derivatives Determinations Committees, similar to CRA‟s, the authority to issue „regulatory licenses‟ in the OTC CDS markets, thus illustrating the persistence of a somewhat subliminal public-private regulatory balance which is in the process of being calibrated in these markets. Therefore, there are indications that, rather than necessarily being „locked out‟, private industry actors, originally partly blamed for the GFC in the first place, have seemingly nevertheless been very much „locked in‟ to the new regulatory scheme. Additionally, however, these ISDA Credit Derivatives Determinations Committees may also be performing a role which goes beyond verification, diverging in certain respects from the CRA model. Consequently, there will be examination of

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the actual constitution and activities of these committees and suggestions of some potential normative implications in the wake of the OTCD public regulatory reforms. Part I The Policy Issue: CDS as ‘Financial Weapons of Mass Destruction?’1 Firstly, a brief primer on OTC derivatives, particularly credit default swaps, and their regulation is offered. Derivatives are broadly operationally and legally segregated into the „exchange traded‟ and „over-the-counter (OTC)‟ markets.2 Exchange traded derivatives are relatively standardised instruments transacted on central platforms. Derivatives exchanges have traditionally been self regulatory organisations (SRO‟s),3 and in more recent times have been subject to a noticeable degree of public regulatory oversight.4 In contrast, OTC derivatives are often relatively more opaque instruments traded „off exchange‟ bi-laterally on the basis of individually negotiated and tailored agreements. In these OTC transactions, both parties typically bear the relevant risks5 as against one another. From the turn of the 21st century to the GFC, OTC instruments were, by and large, not substantially publicly regulated directly. Derivative instruments are not recent innovations 6 nor is their association with market crises, losses and scandals.7 Fundamentally, derivative instruments can be

1 Coined by Warren Buffet [http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf

– Last accessed 9th August 2011].

2 K.D. Krawiec, „More than Just “New Financial Bingo”: A Risk Based Approach to Understanding

Derivatives‟ (1997) 23 Journal of Corporation Law 1, at 6. 3 See, e.g., P. G. Mahoney, „The Exchange as Regulator‟ (1997) 83 Virginia Law Review 1453; S.C.

Pirrong, „The Self-Regulation of Commodity Exchanges: The Case of Market Manipulation‟ (1995) 38 Journal of Law and Economics 141. 4 See, e.g., J. W. Markham and D.J. Harty, „For Whom the Bell Tolls: The Demise of Exchange

Trading Floors and the Growth of ECN‟s‟ (2008) 33 Journal of Corporation Law 865; W.P. Albrecht, „Regulation of Exchange-Traded and OTC Derivatives: The Need for a Comparative Institution Approach‟ (1995) 21 Journal of Corporation Law 111. 5 Pierre-Louis above n. , at 48.

6 Though the explosion of financial, rather than commodity, derivatives trading since the 1980‟s may

warrant analytical segregation. See, e.g., D. Bryan and M. Rafferty, Capitalism with Derivatives: A Political Economy of Financial Derivatives, Capital and Class (New York: Palgrave MacMillan 2006). See also, e.g., G. Poitras, „From Antwerp to Chicago: The History of Exchange Traded Derivative Security Contracts‟ (2009) 20 Revue d'Histoire de Sciences Humaines (Journal for the History of the Social Sciences) 11 [http://www.sfu.ca/~poitras/franck_$$$$.pdf – Last accessed 4 July 2011]; D. MacKenzie and Y. Millo, „Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange‟ (2003) 109 American Journal of Sociology 107; E.J. Swan, Building the Global Market: A 4000 Year History of Derivatives (London: Kluwer 2000); M.D. West, „Private Ordering at the World‟s First Futures Exchange‟ (2000) 98 Michigan Law Review 2574; V.L. Hou, „Derivatives and Dialects: The Evolution of the Chinese Futures Market‟, (1997) 72 New York University Law Review 175; J. Lurie, „Private Associations, Internal Regulation and Progressivism: The Chicago Board of Trade, 1880-1923, as a Case Study‟ (1972) 16 American Journal of Legal History 215. 7 F. Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Philadelphia:

PublicAffairs, 2009); K.D. Krawiec, „The Return of the Rogue‟ (2009) 51 Arizona Law Review 127; J. Kim, „Can Risks be Reduced in the Derivatives Market? Lessons from the Deal Structure Analysis of Modern Financial Engineering Debacles‟ (2007) 6 DePaul Business and Commercial Law Journal 29; G.S. Shea, „Understanding Financial Derivatives during the South Sea Bubble: The Case of the South

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conceptualised as nothing more than „probabilistic bets on future events‟. 8 Elaborating a little further, derivatives could be described as contracts between two counterparties where:

„the payoffs to and from each counterparty depend on the outcome of one or more extrinsic, future, uncertain events or metrics – that is, they are “aleatory contracts” – and in which one counterparty expects such outcome to be opposite to that expected by the other counterparty‟.9

Derivatives contracts typically reference price movements in „underlying‟ stocks, bonds, currencies,10 interest rates,11 energy,12 the weather,13 as well as commodities,14 for example. Derivatives are typically used to engage in hedging,15 speculation16 and regulatory arbitrage.17 The derivatives at the heart of this paper

Sea Subscription Shares‟ (2007) 59 Oxford Economic Papers i.73; P. Harrison, „What can we Learn for Today from 300 Year Old Writings about Stock Markets?‟ (2004) 36 History of Political Economy 667; F.R. Edwards, „Hedge Funds and the Collapse of Long Term Capital Management‟ (1999) 13 Journal of Economic Perspectives 189; A. Tickle, „Creative Finance and the Local State: The Hammersmith and Fulham Swaps Affair‟ (1998) 17 Political Geography 865; N. Leeson, Rogue Trader: How I Brought Down Barings Bank and Shook the Financial World (London: Time Warner 1997); J. Philippe, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County (San Diego: Academic Press 1995); P.M. Garber, „Famous First Bubbles‟ (1990) 4 Journal of Economic Perspectives 35; P.M. Garber, „Tulipmania‟ (1989) 97 Journal of Political Economy 535. 8 L.A. Stout, „Derivatives and the Legal Origin of the 2008 Credit Crisis‟ (2011) 1 Harvard Business

Law Review 301, at 304. See also, e.g., C.M. Baker, „Regulating the Invisible: The Case of Over the Counter Derivatives‟ (2010) 85 Notre Dame Law Review 1287, at 1299. For more long winded explanations see, e.g., N.M. Feder, „Deconstructing Over-the-Counter Derivatives‟ (2002) 3 Columbia Business Law Review 677; J.L. Motes III, „A Primer on the Trade and Regulation of Derivative Instruments‟, (1996) 49 SMU Law Review 579. 9 T.E. Lynch, Derivatives: A Twenty First Century Understanding (Indiana University School of Law –

Bloomington Legal Studies Research Paper Series, Research Paper No. 187, March 2011) [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1785634 – Last accessed 30 June 2011]. 10

L.N.C. Pierre-Louis, „Controlling a Financial Jurassic Park: Obtaining Jurisdiction Over Derivatives By Regulating Illegal Foreign Currency Boiler Rooms‟ (2007) 8 UC Davis Business Law Journal 35. 11

L. Vitale, „Interest Rate Swaps under the Commodity Exchange Act‟ (2001) 51 Case Western Reserve Law Review 539. 12

A. Brunet and M. Shafe, „Beyond Enron: Regulation in Energy Derivatives Trading‟ (2007) 27 Northwestern Journal of International Law and Business 665; United States Senate Permanent Subcommittee on Investigations: Committee on Homeland Security and Governmental Affairs, Report on Excessive Speculation in the Natural Gas Market (110

th Congress, 2007)

[http://hsgac.senate.gov/public/_files/REPORTExcessiveSpeculationintheNaturalGasMarket.pdf - Last accessed 18 April 2011]. 13

See, e.g., S. Randalls, „Weather Profits: Weather Derivatives and the Commercialisation of Meteorology‟ (2010) 40 Social Studies of Science 705. 14

For example, agricultural commodities. See, e.g., J. Clapp and E. Helleiner, „Troubled Futures? The Global Food Crisis and the Politics of Agricultural Derivatives Regulation‟ (2011) Review of International Political Economy (forthcoming).(on file with authors). 15

Lynch (2011a) above n. 9, at 27-28; Feder above n. , at 717; F. Partnoy, „Adding Derivatives to the Corporate Law Mix‟ (2000) 34 Georgia Law Review 599; K. D. Krawiec, „Derivatives, Corporate Hedging and Shareholder Wealth: Motigliani-Miller Forty Years Later‟ (1998) University of Illinois Law Review 1039. Though corporate decisions to hedge will be based on complex trade offs. See, e.g., H.T.C. Hu, „Hedging Expectations: “Derivative Reality” and the Law and Finance of the Corporate Objective‟ (1995) 21 Journal of Corporation Law 3. 16

On the contested concept of speculation see, e.g., A.S. Kyle, „Informed Speculation with Imperfect Competition‟ (1989) 56 Review of Economic Studies 317; O.D. Hart and D.M. Kreps, „Price Destabilizing Speculation‟ (1986) 94 Journal of Political Economy 927; S. Grossman and J. Stiglitz, „On the Impossibility of Informationally Efficient Markets‟ (1980) 70 American Economic Review 393.

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are those instruments which reference the credit quality of other third party entities or instruments, known as credit default swaps (CDS). CDS operate in similar spirit to insurance. They are private bilateral OTC contracts whereby:

„[A] protection buyer makes quarterly payments to a protection seller who, in return, agrees to pay the protection buyer a certain amount if a credit event takes place… A credit event is a negative development involving the credit risk of a reference entity not a party to the CDS‟.18

There are several types of CDS instruments, the most common being so called „single-name‟ CDS where the reference entity is a single corporate entity or sovereign.19 Other types of CDS include „multi name‟ CDS, as well as CDS contracts referencing other financial instruments such as collateralised debt obligations of asset backed securities (CDO of ABS).20 Most CDS are documented under standard form contracts promulgated by the International Swaps and Derivatives Association (ISDA), to which we will return later. The market for CDS was relatively negligible just over a decade ago and grew exponentially in the early years of this century. According to the Bank for International Settlements (BIS), as of December 2010 the notional value of total outstanding CDS contracts was 29 trillion US dollars, substantially less than levels pertaining immediately prior to the GFC but still very significant.21 It is patently clear that, in alliance with OTCD more generally, CDS have come to occupy a centrality in financial markets22 thus it may be worth briefly surveying the touted benefits and drawbacks associated with their existence, as well as attempting to conceptualise their wider role in the GFC before moving to the core regulatory considerations with which this paper is concerned. The primary theoretical benefit associated with CDS instruments is their penchant for facilitating the hedging of credit risk by financial market participants, thus shifting that credit risk to investors who may be best equipped to assume it. This may promote efficiency and improvements in capital allocation in financial markets.23 Furthermore,

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For example, equity derivatives can be used to sidestep share ownership and disclosure rules. See, e.g., B. Clarke, „”Corporate Governance” an Oxymoron? The Role of Corporate Governance in the Current Banking Crisis‟ in The Future of Financial Regulation, eds. I. MacNeill and J.O‟Brien (Harte: Portland 2010) p. 257; H.T.C. Hu and B. Black, „The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership‟ (2006) 79 Southern California Law Review 811. See also, F. Partnoy, „Financial Derivatives and the Costs of Regulatory Arbitrage‟ (1997) 22 Journal of Corporation Law 211. 18

H.B. Shadab, „Guilty By Association? Regulating Credit Default Swaps‟ (2010) 4 Entrepreneurial Business Law Journal 407, at 431. 19

As of 2 August 2011, the top ten reference entities and instruments for CDS when measured in terms of net notional values were: Italy, France, Spain, Brazil, Germany, United Kingdom, General Electric Corp., Mexico, Japan and CDS written on individual loans [http://www.isdacdsmarketplace.com/exposures_and_activity/top_10_cds_positions - Last accessed 2nd August 2011]. 20

Shadab above n.18, at 432. 21

See, Bank for International Settlements, Amounts Outstanding of Over-the-Counter Derivatives by Risk Category and Instrument [http://www.bis.org/statistics/otcder/dt1920a.pdf - Last accessed 2nd August 2011]. 22

It has been suggested that financial derivatives may be transforming capitalism and have been labeled a form of „capitalist money‟ and the „new gold‟. See, e.g., D.Bryan and M. Rafferty. „Financial Derivatives and the Theory of Money‟ (2007) 36 Economy and Society 134; D. Bryan and M. Rafferty, „Financial Derivatives: The New Gold?‟ (2006) 10 Competition and Change 265. 23

Ibid., at 75.

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CDS are thought to increase liquidity, particularly amongst financial institutions. Additionally, although CDS markets appear relatively opaque, insofar as CDS pricing is disclosed to the market this can act as a useful source of information on the financial health of a reference entity.24 However, CDS also potentially embody deleterious implications for the functioning of financial markets. A prime example of this is the phenomenon of the „negative empty creditor‟ or „Darth Vader monitor‟ arising in circumstances where, say, a bank has lent to a corporate entity while simultaneously entering CDS contracts with a view to mitigating credit risk but where the benefits of triggering the CDS contracts outweigh paybacks associated with ensuring the borrower remains a going concern. Thus, if the borrower does experience financial difficulties and there is a reasonable prospect of an orderly out of court settlement, this may be vetoed by the lender as it would be in the lenders‟ best interests to force the borrower into bankruptcy. Such activities may skew incentives in the market for debt and betray the spirit underlying most bankruptcy laws which are typically predicated on the principle that creditors have an interest in avoiding downside risk.25 More general challenges also attend to the use of CDS. Due to the fact that CDS have traditionally been concluded OTC, there have been concerns regarding the opacity of the market and the quality of self regulation dating back a number of years. For example, operational deficiencies in the back offices of derivatives market participants had become a significant worry for public regulators prior to the GFC. These deficiencies ultimately resulted in the „Confirmations Crisis‟ in CDS markets in the mid 2000‟s necessitating public regulatory coordination under the latent threat of intervention. Operational risk, especially in the CDS market at this time thus arguably embodied the capacity to translate into a systemic risk,26 substantially due to concentration.27 Concentration of particular participants in the CDS market can therefore generate the potential for moral hazard, as well as implicating that the failure of a counterparty to a CDS may trigger a wave of cascading defaults across the financial markets,28 an especially pressing concern where such a failure relates to a systemically significant hedge fund29 or major derivatives dealer.30 This could

24

F. Partnoy and D.A. Skeel Jnr., „The Promise and Perils of Credit Derivatives‟ (2007) 75 University of Cincinnati Law Review 1019, at 1024 – 1027. See also, e.g., R. Blanco, S. Brennan and I. W. Marsh, „An Empirical Analysis of the Dynamic Relation Between Investment Grade Bonds and Credit Default Swaps‟ (2005) 60 Journal of Finance 2255. 25

H.T.C. Hu and B. Black, „Equity and Debt Decoupling and Empty Voting II: Importance and Extensions‟ (2008) 156 University of Pennsylvania Law Review 625, at 731-735. See also Partnoy and Skeel above n. 24, at 1034-1035. 26

For a useful definition of systemic risk see, e.g., S.L. Schwarcz, „Systemic Risk‟ (2008) 97 Georgetown Law Journal 194, at 204. 27

For discussion see, e.g., S. Listokin, Can the Derivatives Market Self Regulate? Evidence From OTC Derivatives Confirmations (George Mason University School of Public Policy Working Paper, 2009) [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1499964 – Last accessed 2

nd August

2011]; K. Raisler, „How ISDA Took on the Confirmations Backlog‟ (2006) 25(2) International Financial Law Review 43. 28

K.N. Johnson, „Things Fall Apart: Regulating the Credit Default Swap Commons‟ (2011) 82 University of Colorado Law Review 167, at 212-214. 29

See, e.g., N.L. Wynkoop, „The Unregulables? The Perilous Confluence of Hedge Funds and Credit Derivatives‟ (2008) 76 Fordham Law Review 3095. 30

On the mechanics of dealer failure see, e.g., D. Duffie, „The Failure Mechanics of Dealer Banks‟ (2010) 24 Journal of Economic Perspectives 51.

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then result in negative externalities for society writ large where a derivatives market participant is deemed „too big‟ or „too interconnected‟ to fail. ‘Science Run Amok’, ‘Perfect Hedges’31 or Both? CDS and the GFC Notwithstanding the touted risks commonly associated with OTCD, there is some academic disagreement regarding the precise role played by these instruments, most notably CDS, in the GFC. The causes of the GFC are probably deep rooted and multifaceted, traceable to underlying structural and cognitive deficiencies, coupled with anthropological factors, in the financial markets32 leading to a catastrophic chain reaction of actual events.33 But what about the specific role of CDS instruments in the GFC? Unfortunately, the answer to this question is not straightforward. It is clear that CDS played a role in the GFC though there will inevitably be some disagreement as to exactly what that role was and how it manifested itself. Behavioural and cultural factors within financial institutions such as „irrational exuberance‟,34 difficult to verify ex ante, may go a long way in explaining the (perhaps inappropriate) extent of sale of CDS instruments by certain entities such as monoline insurers and American International Group (AIG) immediately prior to the GFC. Apart from that, it has been suggested that the market for CDS written against subprime mortgage instruments may not have been functioning efficiently as a general matter.35 Moreover, it has been highlighted that while banks claimed they

31

H.T.C. Hu, The Modern Process of Financial Innovation and the Regulation of OTC Derivatives (Washington: OTC Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks, US Senate Banking Committee – Subcommittee on Securities, Insurance and Investment, 21

st June

2009) pp. 5-6 [http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=a89592d9-cbaa-4930-8ce4-de1291688474 – Last accessed 10

th August 2011].

32 See, e.g., L. Dallas, Short-Termism, the Financial Crisis and Corporate Governance (University of

San Diego School of Law Research Paper No. 11-052, March 2011) [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1794190 – Last accessed 3

rd August 2011]; D. C.

Langevoort, „Chasing the Greased Pig Down Wall Street‟ (2011) Cornell Law Review (forthcoming) [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1639138 – Last accessed 3

rd August 2011]; G.P.

Miller and G. Rosenfeld, „Intellectual Hazard: How Conceptual Biases in Complex Organizations Contributed to the Crisis of 2008‟ (2010) 33 Harvard Journal of Law & Public Policy 807; A.E. Wilmarth Jnr., „The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis‟ (2009) 41 Connecticut Law Review 963; S.T. Omarova, „The Quiet Metamorphis: How Derivatives Changed the Business of Banking‟ (2009) 63 University of Miami Law Review 1041; E.K. Gerding, „Code, Crash and Open Source: The Outsourcing of Financial Regulation to Risk Models and the Global Financial Crisis‟ (2009) 84 Washington Law Review 127; E. Avgouleas, „The Global Financial Crisis, Behavioural Finance and Financial Regulation: In Search of a New Orthodoxy‟ (2009) 9 Journal of Corporate Law Studies 23. 33

For good overviews of the various proximate causes of the GFC see, e.g., E. Helleiner, „Understanding the 2007-2008 Global Financial Crisis: Lessons for Scholars of International Political Economy‟ (2011) 14 Annual Review of Political Science 67; M. Kacperczk and P. Schabl, „Commercial Paper During the Financial Crisis of 2007-2009‟ (2010) 24 Journal of Economic Perspectives 29; V. Acharya et al., „The Financial Crisis of 2007-2009: Causes and Remedies‟ (2009) 18 Financial Markets, Institutions and Instruments 89; M.K. Brunnermeier, „Deciphering the Liquidity and Credit Crunch 2007-2008‟ (2009) 23 Journal of Economic Perspectives 77; D.W. Arner, „The Global Credit Crisis of 2008: Causes and Consequences‟ (2009) 43 International Lawyer 91. 34

UK Financial Services Authority, The Turner Review: A Regulatory Response to the Global Banking Crisis (London: UKFSA, March 2009) p. 29 [http://www.fsa.gov.uk/pubs/other/turner_review.pdf - Last accessed 3rd August 2011]. 35

R.M. Stulz, „Credit Default Swaps and the Credit Crisis‟ (2010) 24 Journal of Economic Perspectives 73, at 77.

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were primarily engaging CDS to hedge exposure to mortgage based collateralised debt obligations (CDO‟s),36 the size of the CDS market in late 2007, for example, indicated that the majority of activity engaged in by the market participants was likely dominated in fact by so called „naked‟ or „uncovered‟ CDS, in other words where no exposure to CDO‟s or reference entities existed and CDS were entered for purely speculative purposes.37 This may have served to dangerously heighten risk levels in the financial markets,38 as well as contributing to procyclicality when the crisis struck.39 All the same, the actual chain of events paints a more complicated picture. CDS were not necessarily the main cause of the failures of Lehman Brothers and Bear Stearns and, in the case of Lehman, the settlement of CDS obligations referencing Lehman as well as the settlement of its own derivatives portfolio have seemingly occurred relatively smoothly.40 When it comes to the monoline insurers and AIG, CDS are definitely a more significant consideration though it might be the case that the circumstances surrounding these entities exposure to CDS was at least somewhat sui generis. AIG conducted its CDS business through a subsidiary, AAA rated AIG Financial Products (AIGFP) and, similar to monolines such as Ambac, AIGFP managed to largely avoid raising the hackles of either public insurance or financial regulators.41 AIGFP and the monolines took on far more risk through CDS, as well as through other activities, than they were equipped to absorb, particularly CDS referencing CDO‟s.42 This may have at least been partly driven by staff incentive structures within AIG, creating so called „superstar‟43 traders. But AIG was ultimately unable to meet the extent of collateral calls on these exposures in the wake of credit ratings downgrades.44 But even in the case of AIG, CDS exposures may not have been the only source of its own downfall per se45 and the AIG transactions were not, strictly speaking, substantially „naked‟ or purely speculative

36

For discussion of these instruments see, e.g., D. Faber, And Then the Roof Caved In: How Wall Street‟s Greed and Stupidity Brought Capitalism to its Knees (New Jersey: Wiley 2009) pp. 96-103; D. Smith, The Age of Instability: The Global Financial Crisis and What Comes Next (London: Profile 2010) p. 100. 37

J. Crotty, „Structural Causes of the Global Financial Crisis: A Critical Assessment of the New Financial Architecture‟ (2009) 33 Cambridge Journal of Economics 563; Shadab above n. , at 457-458. 38

Stout (2011a) above n. 8, at 324-329. L.A. Stout, Testimony Before the United States Senate Committee on Agriculture, Forestry and Nutrition (Washington: June 2009) p. 4. 39

On this tendency see, Turner Review above n. , at 109-110. 40

Stulz above n. 35, at 80, 83. 41

O. Arewa, „Risky Business: The Credit Crisis and Failure Part 1‟ (2010) 104 Northwestern University Law Review Colloquy 398, at 417. 42

United States Government Accountability Office (GAO), Systemic Risk: Regulatory Oversight and Recent Initiatives to Address Risk Posed By Credit Default Swaps (Testimony Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, 5 March 2009) pp. 12-17. 43

D. Malhotra, G. Ku and J.K. Murnighan, „When Winning is Everything‟ (2008) 86 Harvard Business Review 78; D.C. Langevoort, „Taming the Animal Spirits of the Stock Markets: A Behavioural Approach to Securities Regulation‟ (2002) 97 Northwestern University Law Review 135; C.R.P. Pouncy, „The Rational Rogue: Neoclassical Economic Ideology in the Regulation of the Financial Professional‟ (2002) 26 Vermont Law Review 263; R.H. Thaler and E.J. Johnson, „Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice‟ (1990) 36 Management Science 643; S. Rosen, „The Economics of Superstars‟ (1981) 71 American Economic Review 845. 44

W.K. Sjostrum Jnr., „The AIG Bailout‟ (2009) 66 Washington and Lee Law Review 943, at 952-961; Brunnermeier above n. 33, at 87. 45

Stulz above n. 35, at 83; Shadab above n. 18, at 458.

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CDS either, in the sense that the counterparties entering into these contracts with AIG were apparently usually hedging against CDO exposures, the collapse of their own counterparties, seeking to avail of regulatory capital exemptions and so forth. If AIGFP had behaved as a conventional dealer in these circumstances, it is theoretically plausible that these hedger-with-speculator derivatives transactions may have been welfare enhancing.46 However, somewhat crucially, AIGFP itself did not appear to „run a matched book‟ or have engaged in systematic hedging strategies so, in that sense, there is an argument to be made that AIG‟s own CDS exposures were, in reality, substantially „naked‟47 insofar as AIG „acted almost exclusively as a protection seller‟.48 Importantly, the sheer level of these exposures may have significantly „weighed against‟ the practicability of a private workout of AIG through a bankruptcy filing49 as it might have sparked a „counterparty run‟ or „collateral contagion‟50 fuelled by creditors seeking to simultaneously close out a large number of CDS contracts and recalibrate their own positions. Such herding behaviour could have acted to transmit contagion across the financial markets.51 Therefore, the most important bottom line outcome based consideration here is that speculation in the CDS markets ensured that significant risk had been substantially shifted to, and pooled in, AIG52 implicating AIG‟s systemic importance through interconnectedness, thereby precipitating a publicly funded bailout of the institution generating negative externalities. While technical arguments may thus rage about what AIG symbolised in terms of the efficiency of CDS markets, the observable actual fallout has raised a narrative and associated policy concerns about how the CDS market can go haywire and as to whether existing regulatory paradigms have been sufficient to capture the activity. These concerns are patently not, or should not be, just a private matter for a cadre of market participants. In the next part, the contours of historical and emerging public and private regulation in the OTCD markets, including the CDS segment, will be sketched out. The emergence of a particular private regulatory mechanism in the wake of the GFC will also be surveyed for signs that it may resemble an attempt to establish a new financial market gatekeeper with potentially challenging implications. Some normative considerations will follow. Part II Regulation in OTCD Markets and Public (and Private) Reform Proposals

46 T.E. Lynch, Gambling By Another Name? The Challenge of Purely Speculative Derivatives

(Indiana University Maurer School of Law-Bloomington Legal Research Paper Series No. 188, March 2011) pp. 11-13 [http://ssrn.com/abstract=1788219 – Last accessed 4

th August 2011]

47 M. Greenberger, „Overwhelming a Financial Regulatory Black Hole with Legislative Sunlight‟ (2011)

6 Journal of Business and Technology Law 127, at 143. 48

Johnson above n. 28, at 215. 49

S.J. Lubben, „Repeal the Safe Harbours‟ (2010) 18 American Bankruptcy Institute Law Review 319, at 320, 329; S.J. Lubben, „Systemic Risk and Chapter 11‟ (2009) 82 Temple Law Review 433, at 446. 50

M.J. Roe, „The Derivatives Market‟s Payment Priorities as Financial Crisis Accelerator‟ (2011) 63 Stanford Law Review 539, at 568-569. 51

On the mechanics of financial contagion see, e.g., F. Allen and D. Gale, „Financial Contagion‟ (2000) 108 Journal of Political Economy 1. 52

Lynch above n. 46, p. 32.

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Historically, both legislators53 and the common law courts54 viewed derivative instruments with suspicion on both risk based and moral grounds, particularly those entered with a purely speculative, rather than hedging, intent. Such instruments were characterised as closely resembling traditional wagers.55 For example, most OTC trading in the US was conducted in „bucketshops‟ which were ultimately outlawed,56 heralding the primacy of private ordering for the markets in the form of the organised self regulatory derivatives exchanges which eventually came under the ambit of public regulators.57 Accordingly, up until the latter part of the 20th century, in the large US and UK markets OTCD agreements ran the risk of being treated as unenforceable in the context of gambling legislation and/or deemed as illegal off-exchange instruments.58 By the 1980‟s however, new forms of derivatives, particularly swaps, were presenting challenges to the scope of existing public regulations, leading to a rapidly burgeoning market in these new OTC instruments. The UK responded to this challenge by substantially exempting OTCD trading between sophisticated counterparties from public regulatory intervention altogether, subject to general prohibitions on insider trading, market abuse and so forth.59 The US was somewhat silent for considerably longer on the regulatory challenge posed by new instruments to existing legislative frameworks.60 When the duelling federal regulatory agencies, the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) did attempt to respond during the 1990s, this generally served to foster further uncertainty amongst market participants. Consequently, direct public regulation of OTCD trading between sophisticated counterparties in the US was substantially abolished at the turn of the 21st century, as well as serving to override any relevant state level anti-bucket shop laws, again

53

See, e.g., An Act to Prevent the Infamous Practice of Stockjobbing 1734 (Barnard‟s Act UK), 7 Geo. 2; Poitras above n. 6, at 18 describing a seventeenth century Dutch edict prohibiting selling „in blanco‟. 54

See, e.g., Irwin v Williar, 110 U.S. 499 (1884) as cited in Stout (2011a) above n. , at 312. 55

J. P. Raines and C.G. Leathers, „Financial Derivative Instruments and Social Ethics‟ (1994) 13 Journal of Business Ethics 197, at 198. There may often indeed appear to be a substantive closeness but parallel regulation of such activities, T.L. Hazen, „It is Time to Regulate Over-the-Counter Derivatives‟ (2011) 13 North Carolina Banking Institute 123; T.L. Hazen, „Disparate Regulatory Regimes for Parallel Activities: Securities Regulation, Derivatives Regulation, Gambling and Insurance‟ (2005) 24 Annual Review of Banking and Financial Law 375;T.A. Gabaldon, „John Law, With a Tulip, in the South Seas: Gambling and the Regulation of Euphoric Market Transactions‟ (2001) 26 Journal of Corporation Law 225. 56

See, e.g., B. Sapien, „Financial Weapons of Mass Destruction: From Bucket Shops to Credit Default Swaps‟ (2010) 19 Southern California Interdisciplinary Law Journal 411. 57

See, e.g., D. MacKenzie and Y. Millo, „Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange‟ (2003) 109 American Journal of Sociology 107; S.C. Pirrong, „The Self-Regulation of Commodity Exchanges: The Case of Market Manipulation‟ (1995) 38 Journal of Law and Economics 141; J. Lurie, „Private Associations, Internal Regulation and Progressivism: The Chicago Board of Trade, 1880-1923, as a Case Study‟ (1972) 16 American Journal of Legal History 215. 58

For example in the UK there was a fear that such instruments might fall foul of the Gaming Act 1892, as well as in light of provisions in the Gaming Act 1845, T. Spangler, Investment Management: Law and Practice (New York: OUP 2010) para. 8. 36. Greenberger above n. 47, at 131. 59

D. Awrey, „The FSA, Integrated Regulation and the Curious Case of OTC Derivatives‟ (2010) 13 University of Pennsylvania Journal of Business Law 1, at 39-47. 60

See, e.g., W.E. Gibson, „Are Swap Agreements Securities or Futures?: The Inadequacies of Applying the Traditional Regulatory Approach to OTC Derivatives Transactions‟ (1999) 24 Journal of Corporation Law 379; L.A. Stout, „Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives‟ (1999) 48 Duke Law Journal 701, at 764-767.

11

subject to the usual prohibitions on fraud.61 The derivatives related fallout from the GFC has principally buffeted the US62 and EU, the larger OTCD markets.63 Other areas, such as Australia, Canada,64 and East Asia have apparently not experienced notable OTCD related fallout. In light of, or in addition to, initiatives announced by various international actors,65 the US has moved on this issue through Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act,66 parts of which are now operational. The EU has also promulgated proposals for legislative action under a Regulation on OTC Derivatives, Central Counterparties and Trade Repositories, coupled with a Regulation on Short Selling and Certain Aspects of Credit Default Swaps expected to become operational in 2012.67 The later EU proposal includes specific provisions on CDS, particularly notification requirements with respect to CDS written against the debt obligations of EU Member States.68 Provisions common to the measures on both sides of the Atlantic demand that standardised OTCD will be subject to mandatory central counterparty clearing (CCP),69 subject to exemptions,

61

Greenberger above n. 47, at 141-143. Though there remains a theoretical threat that certain OTC derivative transactions could still fall foul of the patchwork of gambling and „anti-bucket shop‟ legislation within and between jurisdictions. See, e.g., A. Hudson, The Law on Financial Derivatives (London: Sweet & Maxwell 2002) pp. 235-241; F. Partnoy, „The Shifting Contours of Global Derivatives Regulation‟ (2001) 22 University of Pennsylvania Journal of International Economic Law 421, at 444-446; M.S. Bennett and M.J. Marin, „The Casablanca Paradigm: Regulatory Risk in the Asian Financial Derivatives Markets‟ (1999) 5 Stanford Journal of Law, Business and Finance 1, at 39-42. 62

On the US, see, e.g., E.A. Posner and A. Vermeule, „Crisis Governance in the Administrative State: 9/11 and the Financial Meltdown of 2008‟ (2009) 76 University of Chicago Law Review 1613. 63

E.P. Rowady Jr., The Global Risk Transfer Market: Developments in OTC and Exchange-Traded Derivatives (Tabb Group, November 2010) p. 64 [http://www.world-exchanges.org/files/statistics/excel/V08-030%20Global%20Risk%20Transfer%20Market.pdf – Last accessed 4 July 2011]. 64

P. Latimer, „New Regulation of Derivatives Markets in Canada – an Australian Perspective‟ (2009) 24 Australian Journal of Corporate Law 55; „Regulation of Over-the-Counter Derivatives in Australia‟ (2009) 23 Australian Journal of Corporate Law 9. 65

See, Financial Stability Board, Implementing OTC Derivatives Market Reforms (October 2010) [http://www.financialstabilityboard.org/publications/r_101025.pdf - Last accessed 9th August 2011]; OTC Derivatives Regulators Forum, Framework for Information Sharing and Cooperation Among OTC Derivatives Regulators (September 2009) [http://www.otcdrf.org/documents/framework_sept2009.pdf - Last accessed 9th August 2011]; International Organization of Securities Commissions, IOSCO Forms Task Force on OTC Derivatives Regulation (October 2010) [http://www.iosco.org/news/pdf/IOSCONEWS191.pdf - Last accessed 9th August 2011]. 66

For discussion see, e.g., V.V. Acharya et al., „The Dodd-Frank Wall Street Reform and Consumer Protection Act: Accomplishments and Limitations‟ (2011) 23 Journal of Applied Corporate Finance 43. 67

European Commission, Proposal for a Regulation on OTC derivatives, central counterparties and trade repositories 2010/0250 (COD) [http://ec.europa.eu/internal_market/financial-markets/docs/derivatives/20100915_proposal_en.pdf - Last accessed 4 July 2011]; European Commission, Proposal for a Regulation on Short Selling and Certain Aspects of Credit Default Swaps Title VII Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 H.R. 4173 (111

th

Congress) [http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf - Last accessed 4 July 2011]. 68

Article 8 SSCDS. 69

For discussion of the CCP prescription see, e.g., D. Duffie and H. Zhu, Does a Central Clearing Counterparty Reduce Counterparty Risk? (Rock Centre for Corporate Governance and Stanford University Graduate School of Business Research Paper, April 2011) [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1348343 – Last accessed 8

th August 2011];

C.Pirrong, The Economics of Central Clearing: Theory and Practice (ISDA Discussion Papers No. 1, May 2011) [http://www2.isda.org/functional-areas/research/discussion-papers/ - Last accessed 8

th

August 2011]; J.K. Kress, „Credit Default Swap Clearinghouses and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity‟ (2011) 48 Harvard Journal on Legislation 49.

12

as well as mandatory reporting of almost all derivatives, whether cleared or OTC, to Trade Repositories (TR‟s). The US appears to have gone further in some key respects, particularly through the controversial „Volcker Rule‟70 which will prohibit proprietary trading by some regulated financial institutions and affiliates, as well as the equally controversial „swaps push out‟ rule which will demand that banks move certain derivatives activities to separately capitalised entities in order to continue to enjoy guarantees of public assistance.71 However, at time of writing the technical implementation of much of this reform remains ongoing. In the US, the competent agencies have recently been attempting to grapple with implementation challenges in the face of industry resistance,72 while in the EU many important technical questions similarly remain unelaborated.73 The analysis thus far has proceeded under the implicit assumption that public actors and measures are now the primary drivers of regulation in the OTCD markets, including CDS. It is clear that that this is patently not the case. It is thus necessary to examine the role of a particular transnational private regulator, the International Swaps and Derivatives Association (ISDA) and recent industry initiatives which indicate that attempts have been underway to preserve certain key gatekeeping functions in the private sphere. ISDA emerged in the OTCD markets in the 1980‟s, building on foundational work carried out by market participants seeking to standardise definitions and documentation for OTCD instruments. 74 This standardisation project began with swaps and later extended to most other instruments through the promulgation of the ISDA Master Agreements, the latest version appearing in 2003, reinforced by credit support documents, governing definitions and user‟s guides. ISDA has supplemented this with lobbying activities75 seeking to, inter alia, enshrine „netting‟ protections and bankruptcy „safe harbours‟ for OTCD creditors76 in individual jurisdictions, offering boilerplate legislation to aid the process.77 Belying the official technical demagoguery invoked by ISDA on this issue, public transposition of these norms seems to be a highly political process. 78 44

70

For discussion, see e.g., C.K. Whitehead, „The Volcker Rule and Evolving Financial Markets‟ (2011) 1 Harvard Business Law Review (forthcoming). 71

For discussion see, e.g., C.T. Fowler, „The Dodd-Frank Wall Street Reform and Consumer Protection Act: The Swaps Push out Rule: An Impact Assessment‟ (2011) 15 North Carolina Banking Institute 205. 72

See, e.g., M. Greenburger, Implementing Dodd-Frank: A Review of the CFTC‟s Rulemaking Process: Testimony Before the United States House of Representatives Committee on Agriculture (Washington: April 2011) (on file with author). 73

J. P. Braithwaite, „The Inherent Limits of “Legal Devices”: Lessons for the Public Sector‟s Central Clearing Prescription for the OTC Derivatives Markets‟ (2011) 12 European Business Organization Law Review 87. 74

For a good overview see, e.g., S.M. Flanagan, „The Rise of a Trade Association: Group Interactions within the International Swaps and Derivatives Association‟ (2001) 6 Harvard Negotiation Law Review 211. 75

See, e.g., ISDA, ISDA Calls for Reform of Netting and Collateral Legislation in Romania [http://www2.isda.org/search?keyword=netting – Last accessed 4 July 2011]. 76

For discussion of these concepts see, e.g., ISDA, The Importance of Close Out Netting (ISDA: Research Notes, No 1, 2010) [http://www2.isda.org/search?keyword=netting – Last accessed 30 April 2011]. 77

See, ISDA, 2006 Model Netting Act-Version 2 (ISDA: October 2007) [http://www2.isda.org/search?keyword=netting – Last accessed 30 April 2011]. 78

For discussion of the circumstances surrounding the transposition of the Japanese netting law for example, see, e.g., A. Riles, The Transnational Appeal of Formalism: The Case of Japan‟s Netting

13

countries had either adopted or were considering netting legislation as of February 2011.79 ISDA has also engaged in commissioning legal opinions from top law firms regarding the enforceability of netting safe harbours regulations across individual jurisdictions. It bears testimony to ISDA‟s effectiveness as an educational and lobbying organisation that as of February 2011, ISDA had received such legal opinions in 53 countries and had commissioned opinions in a further two.80 ISDA has also secured separate collateral opinions in 44 countries as of July 2011.81 Where disputes between counterparties cannot be resolved amicably through recourse to posted collateral, which appears, apart from its practical uses,82 to also act as a significant private regulatory mechanism, 83 ISDA Master Agreements are enforceable through the Southern District of New York (SDNY) or English public courts, rather than through any systematic arbitration mechanism. 84 Interestingly then, the ISDA private ordering regime thus does not appear to substantially depend upon trust and other non-legal interpersonal sanctions 85 observable in other industries as such. 86 Rather, collateral seems to help mitigate the possibility of disputes from the outset in the OTCD market, as well as acting as an effective contract based resolution instrument where disputes do arise.87 Accordingly, despite the very outwardly legalistic nature of the ISDA Master Agreements and regime generally,88 the paradox is that actually remarkably few OTCD cases seem to reach

Law (Stanford/Yale Junior Faculty Forum Research Paper 00-03, 2000) [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=162588 – Last accessed 4

th August 2011].

79 ISDA, Netting Legislation – Status [http://www2.isda.org/search?keyword=netting – Last accessed

30 April 2011]. For a detailed breakdown of implementing legislation the EU see, Allen & Overy LLP, Status of Close Out Netting in the EU Member States [http://ec.europa.eu/internal_market/financial-markets/docs/cesame2/presentations/20100408-guest_status_report_en.pdf - Last accessed 8 July 2011]. 80

Slovenia and Mauritius. See ISDA, Netting Opinions [http://www2.isda.org/search?keyword=netting – Last accessed 8 July 2011]. 81

ISDA, Collateral Opinions [http://www2.isda.org/functional-areas/legal-and-documentation/opinions - Last accessed 5th August 2011]. 82

C.A. Johnson, „Derivatives and Rehypothecation Failure: Its 3.00 P.M., Do You Know Where Your Collateral Is?‟ (1997) 39 Arizona Law Review 949. 83

For discussion on the significance of collateral as a regulatory mechanism in OTCD markets see, e.g., A. Riles, „The Anti-Network: Private Global Governance, Legal Knowledge, and the Legitimacy of the State‟ (2008) 56 American Journal of Comparative Law 605. 84

F. Partnoy, ISDA, NASD, CFMA and SDNY: The Four Horsemen of Derivatives Regulation? (Brookings-Wharton Papers on Financial Services, 2002). 85

Riles above n. 83, at 622. 86

L. Berstein, „Private Commercial Law in the Cotton Industry: Creating Cooperation Through Rules, Norms and Institutions‟ (2001) 99 Michigan Law Review 1724; L. Bernstein, „Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry‟ (1992) 21 Journal of Legal Studies 115; J. McMillan and C. Woodruff, „Private Order under Dysfunctional Public Order‟ (2000) 98 Michigan Law Review 2421; K. Clay, „Trade Without Law: Private-Order Institutions in Mexican California‟ (1997) 13 Journal of Law, Economics and Organizations 202; R.C. Ellickson, „Of Coase and Cattle: Dispute Resolution Among Neighbours in Shasta County‟ (1986) 38 Stanford Law Review 623. 87

Riles above n. 83, at 622. See also A. Riles, Collateral Knowledge: Legal Reasoning in the Global Financial Markets (Chicago: Chicago University Press 2010). 88

This may have something to do with the possibility that market participants may be more interested in what the ISDA Agreements signal, rather than necessarily what they do. On a similar theme see, e.g., A. Gelpern and M. Gulati, „Public Symbol in Private Contract: A Case Study‟ (2006) 84 Washington University Law Review 1627.

14

full trial,89 usually settling beforehand.90 ISDA acts as amicus in a select number of cases which do reach trial and where important policy questions for the OTCD markets are raised.91 The ISDA Master Agreements92 and ISDA‟s lobbying activities have introduced an undoubted degree of transactional certainty to the OTCD markets, particularly important throughout the late 1980‟s and 1990‟s in the midst of public regulatory floundering, especially in the US. ISDA officials were also involved93 in producing an influential Group of Thirty (G30)94 report in 199395 which heavily implied that OTCD markets should be self regulating, subject to prudent checks and balances implemented by industry and supported by a hospitable public legislative and regulatory environment.96 Today, ISDA‟s membership encompasses the large OTC derivatives dealers (primary members), end users such as hedge funds and large corporations, governments, servicing entities, and reputable law and accounting firms (associate and subscriber members). A cadre of derivatives dealer banks, the „primary members‟,97 the „Group of 14 (G14)‟98 or the „derivatives dealers club‟99 have unquestionably held the reins of power within ISDA since its formation. Today, ISDA boasts over 820 members on six continents and retains offices in New York, London, Brussels, Washington, Singapore, Tokyo and Hong Kong, 100 „key regulatory locations‟.101 Drawing on earlier successes, committees are central to ISDA policy making activity generally, comprising highly informed actors. 102 35 committees and subcommittees currently concern themselves with region specific issues covering, inter alia, Asia-Pacific, China, Australia, Latin America and Japan. A

89

For a flavour of notable cases which have reached trial see, e.g., S. K. Henderson, „Credit Derivatives and Operational Risk, or Why a Credit Default Swap is Not Like a Bond‟ (2007) 1 Law and Financial Markets Review 31. 90

A recent notable example of this was Lehman Brothers Inc. v J.P. Morgan Chase Bank NA, 10-03266, U.S. Bankruptcy Court (Southern District of New York (Manhattan), 2

nd February 2011).

91 A recent notable example was CSX Corporation v The Children‟s Investment Fund Management

(UK) LLP et al No. 08 Civ 2764 (LAK) (S.D.N.Y. June 11, 2008). For further discussion of the potential theoretical significance of the amicus role, as well as ISDA‟s role generally see, e.g., A. Gelpern, „Commentary: Public Promises and Organizational Agendas‟ (2009) 51 Arizona Law Review 57. 92

For discussion of the ISDA Master Agreements in this context see, e.g., S. Choi and G.M. Gulati, „Contract as Statute‟ (2006) 104 Michigan Law Review 1129. 93

G. Tett, Fools Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe (London: Little, Brown 2009) pp. 31-42. 94

Group of Thirty [http://www.group30.org/ - Last accessed 8th August 2011].

95 Working Group on Global Derivatives, Derivatives: Practices and Principles (G30: 1993)

96 For broader discussion of what this report may have represented see, e.g., E. Tsingou,

Transnational Policy Communities and Financial Governance: The Role of Private Actors in Derivatives Regulation (University of Warwick Centre for the Study of Globalisation and Regionalisation Working Paper, 2003) [http://wrap.warwick.ac.uk/2009/1/WRAP_Tsingou_wp11103.pdf - Last accessed 8th August 2011]. 97

The G14 currently consists of Bank of America-Merrill Lynch, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, Royal Bank of Scotland, Société Générale, UBS, and Wells Fargo. 98

D. Mengle, Concentration of OTC Derivatives Among Major Dealers (ISDA: Research Notes No. 4 2010) [http://www2.isda.org/search?keyword=concentration – Last accessed 4 July 2011]. 99

R.E. Litan, The Derivatives Dealers‟ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties (Initiative on Business and Public Policy, Brookings 7 April 2010) (on file with author). 100

[http://www2.isda.org/about-isda/executives-offices/ - Last accessed 30 April 2011]. 101

G. Morgan, „Market Formation and Governance in International Financial Markets: The Case of OTC Derivatives‟ (2008) 61 Human Relations 637, at 644. 102

Ibid., at 646 citing M. Callon (ed.), The Laws of the Market (Oxford: Blackwell and Sociological Review Press, 1998).

15

plethora of other committees concern themselves with the US and Europe. 103 A considerable range of committees and subcommittees are also dedicated to specific OTC derivative products, 104 functional matters in the OTC markets, such as accounting and taxation considerations, regulatory issues, revisions to ISDA documentation and so forth.105 There are also industry governance committees.106 In terms of membership and voting on these committees, it is widely accepted, confirmed in discussion with ISDA officials, that OTCD dealers dominate their membership, though it has also been pointed out that ISDA has recently been at pains to ensure that committees are comprised of at least one third of „buy side‟ members, such as hedge funds, as far as possible.107 Overall though, the dynamics driving the establishment and sustenance of ISDA as a transnational private regulatory regime, particularly the issue of producer dominance, appear to fit quite well into a predictive model offered by Daniel Mugge.108 The impending public regulatory reforms are clearly a significant challenge to the traditional modus operandi of ISDA, perhaps representing a gear change in terms of the near deference which public actors have displayed toward ISDA in the past.109 In the wake of the GFC, ISDA has thus recognised that adapting certain market practices will be necessary in order to shield the OTCD industry from further interference beyond the current public regulatory proposals, or, indeed, shield ISDA itself from public scrutiny. This objective is arguably most pressing in relation to the governance of the OTC CDS markets which have invoked special concerns, fostering a perception that these markets may be a potential sources of systemic instability. ISDA Credit Derivatives Determinations Committees In 2009, ISDA instituted procedural reforms in CDS markets through the so called „Big Bang‟ and „Small Bang‟ Protocols.110 The Protocols seek to engage in „hardwiring‟ of CDS contracts, amending provisions in the 2003 ISDA credit derivatives definitions under which most CDS have hitherto been documented. The measures basically aim to streamline the settlement of CDS upon the occurrence of certain events which trigger the contracts. Hitherto, settlement had been largely contingent on sometimes cumbersome and disruptive bilateral engagements

103

[http://www2.isda.org/committees/region-specific-committees/ - Last accessed 30 April 2011]. 104

[http://www2.isda.org/committees/product-committees/ - Last accessed 30 April 2011]. 105

[http://www2.isda.org/committees/functional-committees/ - Last accessed 30 April 2011]. 106

[http://www2.isda.org/committees/IIGC-committees/ - Last accessed 30 April 2011]. 107

Interview with two senior ISDA officials (30 November 2010). See also, R.G. Pickel, „Navigating the Financial Crisis: Choosing the Right Path for the Derivatives Industry‟ (2009) 4 Capital Market 108

D. Mügge, „Private-Public Puzzles: Inter-firm Competition and Transnational Private Regulation‟ (2006) 11 New Political Economy 177. 109

See, e.g., the circumstances surrounding the rescue of Long Term Credit Bank, H. Nakaso, The Financial Crisis in Japan in the 1990‟s: How the Bank of Japan Responded and the Lessons Learnt (Bank for International Settlements Papers No. 6, October 2001) [http://www.bis.org/publ/bppdf/bispap06.pdf?noframes=1/ - Last accessed 21

st July 2011].

110 ISDA, ISDA Announces Successful Implementation of „Big Bang‟ CDS Protocol; Determinations

Committees and Auction Settlement Changes Take Effect (ISDA News Release, 8th April 2009)

[http://www.isda.org/press/press040809.html - Last accessed 5th August 2011]; ISDA, ISDA Launches „Small Bang Protocol‟ and Restructuring Supplement (ISDA News Release, 14

th July 2009)

[http://www.isda.org/press/press071409.html - Last accessed 5th August 2011].

16

between counterparties.111 The changes are automatically applied to certain CDS contracts written after the promulgation of the Protocols while parties also had the option of depositing an Adherence Letter with ISDA, incorporating the reforms, including in relation to already existing CDS agreements. Most importantly from a practical and normative perspective, the Protocols establish Credit Derivatives Determinations Committees (ISDA DC‟s or DC‟s). The rules drawn up by ISDA governing the DC‟s are couched in complex jargon and are certainly not conducive to casual perusal.112 What has been observed is that there exist five regional DC‟s.113 ISDA acts as a non-voting secretary to all of them. The DC‟s are composed of ten voting „sell side‟ derivatives dealer banks and five voting „buy side‟ hedge funds serving on rotation, as well as two non-voting consultative dealer banks. CCP‟s have also recently been afforded „observer‟ status on the DC‟s. Voting membership is seemingly largely determined by OTCD trading volumes registered with Depository Trust Clearing Corporation (DTCC),114 as well as other requirements, particularly active participation in derivatives auctions.115 Fundamentally, the ISDA DC‟s are charged with voting, ad hoc, upon questions submitted to them by CDS market participants (who need not be ISDA members and need not disclose their identity)116 on events in the financial markets. Votes are taken on the basis of publicly available information as to whether a particular credit or restructuring event has occurred in accordance with the relevant ISDA Definitions, thereby exerting effects on relevant CDS contracts. They are also empowered to decide upon questions relating to general contractual issues pertaining to the overall CDS market.117 The DC is required to reach an 80 per cent supermajority with regard to most decisions; if the DC members fail to reach such a majority, or if they voluntarily elect on certain matters, a question may be referred to a panel of three external reviewers, drawn from a pool of lawyers and retired judges, who issue legally binding determinations118 unless new information comes to light which may be referable back to the DC. The extent of the majority required at the review panel depends upon the level of the majority at the original DC sitting. It does not appear that the DC‟s are required to accompany their „Yes‟ or „No‟ decisions with any reasoning per se, though reasoning is not precluded either,119 nor do the DC Rules

111

111

J. Williams and V. Aravind, „Credit Default Swaps: Lessons on the Role of Private Ordering in Mitigating Systemic Risk‟ (2010) 5 Capital Markets Law Journal 267 112

ISDA, DC Rules (July 11, 2011) [http://www.isda.org/credit/revisedcrules.html - Last accessed 4th August 2011]. 113

Americas, Asia excluding Japan, Australia-New Zealand, Europe and Japan. 114

[http://www.dtcc.com/ - Last accessed 4th August 2011].

115 Williams and Aravind above n. 111, at 273.

116 A market participant can submit a „General Interest Question‟ which will shield their identity. It also

appears that the „Eligible Market Participant‟ submitting a given question theoretically need not necessarily be party to the specific CDS contract referencing the third party/instrument in question. 117

[http://www.isda.org/credit/ - Last accessed 4th August 2011].

118A.W. Glass, „The Regulatory Drive Towards Central Counterparty Clearing of OTC Credit

Derivatives and the Necessary Limits on This‟ (2009) 4 Capital Markets Law Journal S79, at S91. 119

For sample decisions illustrating instances where reasoning was and was not employed see, e.g., Determinations Committee Decision as to Whether a Restructuring Event Has Occurred with Respect to the Governor and Company of the Bank of Ireland (11

th July 2011)

[http://www.isda.org/dc/docs/BoI_EMEA_Determinations_Committee_Decision.pdf - Last accessed 7th August 2011]; Determinations Committee Decision as to Whether a Restructuring Event Has Occurred With Respect to Republic of Ireland (15

th March 2011)

[http://www.isda.org/dc/docs/EMEA_Determinations_Committee_Decision_15032011.pdf - Last accessed 7th August 2011].

17

appear to mention anything about potential conflicts of interest arising on the DC when deciding upon a particular event. However, in contrast, the external review panel does appear to be subject to an explicit requirement to provide reasoning and conflicts of interests are also taken into consideration when selecting an external reviewer.120 In any event, where a CDS event is determined in the affirmative, the DC can be responsible for arranging, inter alia, auctions which determine the settlement values of outstanding CDS contracts, though for the time being this is actually carried out by other private organisations, Markit and Creditex.121 Although announced by ISDA as a market initiative, these Protocols were reportedly the by-products of a long period of consultation between the major derivatives dealers and public regulators.122 The reforms were substantially motivated by an acceptance on the part of ISDA and the industry that further standardisation of CDS documentation was necessary in order to enhance efficiency in the market, but particularly to facilitate standardised CDS instruments for CCP clearing under the public reforms.123 Although the analysis thus far may appear a little mundane, this has set the scene for arguably more interesting theoretical and normative questions which will be explored. It is obvious that these DC‟s potentially wield considerable power and will very likely exert third party effects in financial markets well beyond immediate individual determinations.124 Accordingly, a question which may arise, related to an ongoing question on the broader activities of ISDA,125 is as to what the DC‟s specifically represent in theoretical and normative terms. At first blush they appear to be doing something similar in spirit to the verification functions of credit ratings agencies and, therefore, the question arises as to whether this body can thus be conceptualised as a financial market gatekeeper in some way similar to the position of the credit ratings agencies or something different again. Either way, prima facie this would appear to potentially raise important considerations, particularly in relation to issues such as liability for decision-making and incentives arising from „regulatory licenses‟, a debate which has raged regarding the credit ratings agencies. Moreover, even if the DC‟s do not neatly fit into the financial market gatekeeper paradigm, the structure and activities of the DC‟s may nonetheless raise some pressing normative challenges, especially in the wake of public regulatory reforms in OTCD markets. Gatekeeping, Credit Ratings Agencies and the ISDA DC’s: Comfortable Theoretical Bedfellows?

120

DC Rules above n. . 121

The results of which are published at [http://www.creditfixings.com/CreditEventAuctions/fixings.jsp - Last accessed 5th August 2011]. 122

Glass above n. 118, at S89. 123

M. Bullock, M. Mackenzie and G. Tett, „Big Bang Arrives for Credit Default Swaps Industry‟, Financial Times (8

th April 2009); A. Chander and R. Costa, „Clearing Credit Default Swaps: A Case

Study in Global Legal Convergence‟ (2010) 10 Chicago Journal of International Law 639, at 679. 124

See, e.g., L. Story, „Derivatives Cloud the Possible Fallout from a Greek Default‟, New York Times (22

nd June 2011) [http://www.nytimes.com/2011/06/23/business/global/23swaps.html?pagewanted=all

= Last accessed 7th August 2011].

125 This will be explored in a separate paper J. Biggins and C. Scott, Legitimacy, Efficiency, ISDA and

the OTC Derivatives Markets (Working Paper 2011, forthcoming).

18

Within legal scholarship, a gatekeeper in the commercial context has been broadly defined by John Coffee as possessing:

„significant reputational capital, acquired over many years and many clients, which it pledges to assure the accuracy of statements or recommendations that it either makes or verifies...the gatekeeper receives a far smaller benefit or payoff for its role, as an agent, in approving, certifying or verifying information than does the principal from the transaction that the gatekeeper facilitates or enables‟.126

Thus, gatekeepers are fundamentally „reputational‟127 or „informational‟ intermediaries,128 most significant where information asymmetries may exist. The costs associated with loss of reputational capital should serve to motivate gatekeepers to perform their functions as competently as possible. Coffee‟s writings on gatekeepers primarily seek address the roles of auditors, lawyers, securities analysts and CRA‟s in verifying signals sent by corporate issuers.129 However, Frank Partnoy has offered the intriguing caveat that the CRA‟s, in particular, „might not be like other gatekeepers‟.130 CRA‟s are probably recognisable to most due to their controversial roles the lead up to the GFC131 and in the current international sovereign debt crisis.132 But a brief outline of what a CRA does is warranted. In short, a „credit rating represents a rating agency‟s opinion regarding the creditworthiness of a borrower, either with respect to a particular debt obligation (an issue rating) or in general (an issuer rating)‟.133 CRA‟s are thus performing a verification function within the meaning of Coffee‟s definition. Traditionally, Moody‟s134 and Standard and Poor‟s135 have arguably been most influential in this industry. The role of the CRA‟s as market gatekeepers has attracted attention as potentially paradoxical in some respects and normatively challenging on other respects. It may be useful to briefly survey this debate before moving to consider whether or to what extent some parallels might be drawn with the ISDA DC‟s.

126

J.C. Coffee Jnr., „Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms‟ (2004) 84 Boston University Law Review 301, at 308. 127

J.C. Coffee Jnr., Gatekeepers: The Professions and Corporate Governance (New York: OUP 2006) p. 287. 128

F. Partnoy, Overdependence on Credit Ratings Was a Primary Cause of the Crisis (University of San Diego Legal Studies Research Paper Series No. 09-015, July 2009) p. 2 [hereinafter Partnoy 2009] [http://ssrn.com/abstract=1430653 – Last accessed 5

th August 2011].

129 J.C. Coffee Jnr., „What Caused Enron? A Capsule Social and Economic History of the 1990‟s‟

(2004) 89 Cornell Law Review 269; J.C. Coffee Jnr., “Understanding Enron: Its About the Gatekeepers Stupid‟ (2002) 57 Business Lawyer 1403; Although a distinction could be made between „reputational intermediaries‟ and „corporate gatekeepers‟ based upon what is being done rather than necessarily who is doing it. See, e.g., P.B. Oh, „Gatekeeping‟ (2004) 29 Journal of Corporation Law 735. 130

F. Partnoy, How and Why Credit Rating Agencies Are Not Like Other Gatekeepers (University of San Diego Legal Studies Research Paper Series No. 07-46, May 2006) p. 59 [hereinafter Partnoy 2006] http://ssrn.com/abstract=900257 – Last accessed 4

th August 2011].

131 For discussion see, e.g, K. Dennis, „The Ratings Game: Explaining Rating Agency Failures in the

Build Up to the Financial Crisis‟ (2009) 63 University of Miami Law Review 1111. 132

See, e.g., M. Gartner, B. Griesbach and F. Jung, „PIGS or Lambs? The European Sovereign Debt Crisis and the Role of Rating Agencies‟ (2011) 17 International Advances in Economic Research 288. 133

C.M. Bruner, „States, Markets and Gatekeepers: Public-Private Regulatory Regimes in An Era of Economic Globalization‟ (2008) 30 Michigan Journal of International Law 125, at 133. 134

[http://www.moodys.com/ - Last accessed 5th August 2011].

135 [http://www.standardandpoors.com/home/en/eu - Last accessed 5th August 2011].

19

Leaving aside the debate regarding the actual quality of credit ratings and the robustness of the modelling used by the agencies for a moment,136 it has been argued in a more general sense, particularly by Partnoy, that CRA‟s represent a paradox insofar as they inhabit a pivotal position in the financial markets, yet the informational value of what they do appears to be somewhat limited137 when compared to other sources of market information.138 This is coupled with indications that the CRA‟s are generally not held in particularly high esteem by sophisticated market participants, though nonetheless the ratings themselves are pivotal to the functioning of the markets. This suggests that a reputational capital model alone likely does not offer a complete explanation as to why CRA‟s may be so important.139 In the US context, Partnoy has traced this peculiar situation at least partly to the implicit granting of a „regulatory license‟ to market participants by CRA‟s, by reason of ratings dependent public regulation, particularly through the designation of CRA‟s as „Nationally Recognised Statistical Rating Organizations‟ (NRSRO‟s) under federal securities law. Essentially, this has enshrined certain public regulatory benefits for market participants who invest in financial instruments rated by the CRA‟s.140 Accordingly, this may have permitted CRA‟s to successfully generate rents from their ability to grant regulatory licenses in spite of incompetence they may display in actually carrying out their functions, illustrated by their seeming inability to grapple with ever more complex products including derivatives.141 Partnoy has dubbed this „behavioural and regulatory overdependence‟ and has observed that once „regulation is passed that incorporates ratings, rating agencies will begin to sell not only information but also the valuable property rights associated with it‟.142 The reputation of a CRA may thus be a less useful explanatory tool in relation to their usage as well as its capacity to act as an accountability mechanism. The US situation is intended as an example but it is conceivable that similar regulatory schemes exist in other jurisdictions. In a nutshell, therefore, it has been suggested that a reputational capital model fails to fully capture as to why CRA‟s may be so pivotal in financial markets, including as to why they are so profitable,143 and this may amplify the implications of other challenges which CRA‟s present to the gatekeeper model. Examples of this include concerns over conflicts of interest, exemplified in the GFC,144 given that CRA‟s are rating the debt securities of firms which are paying them huge fees to do so, constituting the bulk of CRA revenue. This opens up the prospect of capture in an oligopolistic market and thus the risk that CRA‟s will issue suspect or inaccurate

136

On this point, see e.g., T.E. Lynch, „Deeply and Persistently Conflicted: Credit Rating Agencies in the Current Regulatory Environment‟ (2009) 59 Case Western Reserve Law Review 227. 137

Although there may be more informational value associated with an initial rating, the quality of rating changes thereafter may be a more open question, C. A. Hill, „Regulating the Rating Agencies‟ (2004) 82 Washington University Law Quarterly 43. 138

For example, credit spreads. See, e.g., F. Partnoy, „The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies‟ (1999) 77 Washington University Law Quarterly 619. 139

Partnoy (2006) above n. 130, p. 61. 140

For discussion see Coffee (2006) above n. 127, pp. 287-292. 141

F. Partnoy, „Historical Perspectives on the Financial Crisis: Ivar Kreuger, the Credit Rating Agencies and Two Theories About the Function, and Dysfunction, of Markets‟ (2009) 26 Yale Journal on Regulation 431, at 441-442. 142

Partnoy (2006) above n. 130, p. 82. 143

Ibid., pp. 62-68. 144

See, e.g., M. Lewis, The Big Short: Inside the Doomsday Machine (New York: W.W. Norton 2010).

20

ratings145 as the „potential gains from inaccurate ratings‟146 increase. Developments in the GFC would lend credence to this possibility. As a result, transparency in CRA activity is a pressing concern and, while public regulatory reform in this area has recently been proposed and adopted in the US and EU, implementation issues remain unclear at present.147 Other concerns surround the potentially deleterious effects of „unsolicited‟ ratings.148 But perhaps one of the most unique aspects of CRA‟s, as distinct from other gatekeepers, has been their ability to usually sidestep civil liability,149 in the absence of fraud, arising from their ratings, particularly in the US. There, ratings agencies have been rendered explicitly immune from liability under elements of the securities legislation, as well as escaping many common law negligence suits through reliance upon First Amendment protections.150 Accordingly, the CRA‟s have asserted that their ratings are merely „opinions‟ normally based on publicly available information and part of the family of financial publishing, analogous to journalistic motivations such as those pursued by the Financial Times or Wall Street Journal.151 However, it has been argued that substantively the CRA‟s are clearly exerting effects and engaging in actions not consistent with mere speech.152 Consequently, if reputation appears not to be acting as a significant accountability mechanism in the case of the CRA‟s153 and where civil liability is also restricted, this presents normative challenges in and of itself especially given the risk of negative externalities arising from CRA activity, somewhat at variance with the position of other gatekeepers such as accountants and lawyers. Arising from these considerations, it may be fruitful to probe whether the ISDA DC‟s also fit into gatekeeper theory and/or whether they may differ from other gatekeepers, perhaps including CRA‟s. Implications arising from this will then be discussed. Placing the ISDA DC‟s in the context of the CRA‟s: Similar but Different? The ISDA DC‟s are arguably, at the very least, performing a verification function within the meaning of Coffee‟s definition and probably also performing a de facto independent regulatory role. The ISDA DC‟s are charged with verifying, upon request, as to whether a credit event or restructuring event has occurred with respect to

145

Lynch above n. 46, at 256. 146

Partnoy (2009) above n. 128, p. 3. 147

See, e.g., J.P. Hunt, „Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, The Insufficiency of Reform, and a Proposal for Improvement‟ (2009) Columbia Business Law Review 109; T.M.J. Mollers, „Regulating Credit Rating Agencies: The New US and EU Law – Important Steps or Much Ado about Nothing? (2009) 4 Capital Markets Law Journal 477. 148

Hill above n. 137, at 51-52. 149

On the issue of gatekeeper liability generally see, e.g., A. Tuch, „Multiple Gatekeepers‟ (2010) 96 Virginia Law Review 101; A.B. Laby, „Differentiating Gatekeepers‟ (2006) 1 Brooklyn Journal of Corporate, Financial and Commercial Law 119; Coffee (2004) above n. 126; F. Partnoy, „Strict Liability for Gatekeepers: A Reply to Professor Coffee‟ (2004) 84 Boston University Law Review 365; F. Partnoy, „Barbarians at the Gatekeepers?: A Proposal for a Modified Strict Liability Regime‟ (2001) 79 Washington University Law Quarterly 491; R.H. Kraakman, „Gatekeepers: The Anatomy of a Third Party Enforcement Strategy‟ (1986) 2 Journal of Law, Economics and Organization 53. 150

K.C. Kettering, „Securitization and Its Discontents: The Dynamics of Financial Product Development‟ (2008) 29 Cardozo Law Review 1553, at 1691. 151

Partnoy (2006) above n. 130, pp. 83-88. 152

Partnoy (2009) above n. 128, pp. 13-14. 153

Seemingly contrary to earlier views, S.L. Schwartz, „Private Ordering of Public Markets: The Rating Agency Paradox‟ (2002) 1 University of Illinois Law Review 1, at 15.

21

particular reference entities. In similar spirit to the CRA‟s, this activity serves essentially to verify the debt obligations of third party issuers referenced in CDS contracts. But how credible is this nascent process from the perspective of market participants? The ISDA DC‟s, as fiefdoms within ISDA itself, are relatively recent creations and thus would not yet appear, strictly speaking, to embody reputational capital acquired over many years and clients in and of themselves, as such. However, this perspective would betray the reality that the individual participants actually comprising the ISDA DC‟s arguably do embody pre-existing reputational capital through prevailing experience and dominance in the OTCD market, cemented over a number of years. Given that the ISDA DC‟s reach decisions through majority voting this would implicate that the reputational capital of individual members is an important consideration in underpinning the credibility of any particular decision, feeding into the collective credibility of a DC. Thus, while the decision-making structure of the ISDA DC‟s appear to differ from other private financial market gatekeepers, including the CRA‟s, the substantive reputational capital test might appear, on the face of it, to be satisfied. However, it will be illustrated that, similar to the CRA‟s, reputational capital may not necessarily be a prerequisite for the ISDA DC‟s to maintain their position either. At first glance, it would also appear that the ISDA DC‟s in principle satisfy the proposition that the payoffs for the gatekeeper in acting as such is less than the payoff accruing to third party investors/parties to a transaction from determinations arising from the ISDA DC‟s. But, looked at more closely this notion is contestable or, at least, may be more complicated and thus may diverge from the position of other gatekeepers, including the CRA‟s. The payoff for CRA‟s as gatekeepers has undoubtedly been significant in recent years, for example measured in terms of fees, profitability and share price.154 Nevertheless, it might be expected that these benefits might still remain less than the magnitude of the expected benefits/payoff for market participants actually relying upon the credit ratings, though this hunch would obviously be a matter for further empirical investigation outside the scope of this paper. In the case of the ISDA DC‟s, however, the issue is more convoluted. This might be substantially because determinations forthcoming from ISDA DC‟s might actually serve to benefit members of the DC‟s, given that it is entirely plausible that one or more of the individual members of an ISDA DC could actually profit from a particular decision of their DC pertaining to a CDS contract in which they are perhaps party or an intermediary. It is conceivable to suggest that benefits accruing to a particular DC member or members arising from a particular determination might outweigh benefits to other CDS market participants which ISDA DC‟s are charged with verifying. Therefore, the incentives faced by ISDA DC‟s may be even less transparent than in the case of CRA‟s, thereby arguably raising, in principle at least, pressing conflict of interest considerations. Although, in contrast to CRA‟s, ISDA DC‟s are not paid by market participants to issue determinations, this does not negate conflict of interest issues. Given that the ISDA DC‟s are populated by ten permanent voting OTCD dealers in the various regions, conflicts of interest and accountability could potentially become problematic. The ISDA DC Rules do not appear to mention anything about conflicts of interest amongst voting members on a particular determination nor a requirement for certain

154

Partnoy (2006) above n. 130, p. 67.

22

members to necessarily excuse themselves from certain votes, though it is possible for individual members to abstain or not attend. But this does not appear to be connected in the Rules to conflict of interest issues.155 However, this could be countered with the contention that the requirement for an 80 per cent supermajority on most votes taken by an ISDA DC might mitigate the risk of conflicts of interest interfering with the integrity of actual outcomes given that no particular member alone would likely be in a position to influence a given determination. At the same time, the risk remains that the interests of the vast majority of DC members might align in a particular vote, thereby possibly interfering with objective decision-making. In the absence of mandated reasoning, however, detection of any such tendency would appear near impossible. What is observable is that the ISDA DC‟s have already begun come under fire on precisely this transparency issue,156 though some market participants have balanced this against the contention that the ISDA DC‟s have also imbued the CDS markets with greater standardisation and certainty.157 In any event, the mechanisms for external review theoretically do at least appear to enshrine the requirement for reasoning and conflict of interest considerations, though, in reality, such external reviews will constitute a slim proportion of the decision-making forthcoming from the DC‟s. Aside from this, there might also potentially be a risk that ISDA DC‟s may come to issue unsolicited determinations not dissimilar in spirit to the CRA‟s. This could materialise where a „General Interest Question‟ is submitted by an eligible market participant As has been illustrated, CRA‟s have traditionally invoked journalistic free speech type protections in order to immunise themselves from civil liability in common law negligence for their decisions. This has also arguably undermined the accountability of CRA‟s. Similar, and perhaps even more pressing, considerations potentially arise in relation to the ISDA DC‟s. The author is not aware of any legal action having being taken against the ISDA DC‟s as of yet, or as to exactly how in practical terms an aggrieved party might try and go about suing these bodies. It is apparent that the ISDA DC‟s have enshrined certain provisions in their rules which might be invoked in an attempt to ward off tort based claims. This seems evident given the emphasis on the requirement for the DC‟s to base their decisions upon publicly available information or on information which could be rendered publicly available without consequence to the DC members.158 It is thus foreseeable that if a negligence based claim were taken against an ISDA DC on foot of a determination, the DC in question might attempt to rely upon the stock CRA defence that it was merely engaging in a form of interpretative speech based upon publicly available information. Arguably, however, compared to the CRA‟s, it may be even more questionable in the case of the ISDA DC‟s as to how free speech type defences could succeed. Given that ISDA DC determinations will exert actual legally binding effects on swathes of CDS contracts in the market, this activity seems substantively much closer in form to the effects rendered by, for example, decisions of public administrative bodies or even

155

DC Rules above n. 112. 156

C. Whittall, „Dealers Defend ISDA Committee‟s Record, As Restructuring Event Put in Play‟, International Financing Review (6

th – 12

th August 2011) [http://www.ifre.com/dealers-defend-isda-

committees-record-as-restructuring-event-put-in-play/648036.article - Last accessed 7th August 2011]. 157

C. Whittall, „ISDA Determinations Committee Under Scrutiny‟ International Financing Review (5th

August 2011) [http://www.ifre.com/isda-determinations-committee-under-scrutiny/647984.article - Last accessed 7th August 2011]. 158

DC Rules above n. 112.

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courts. It is difficult to see how the ISDA DC‟s could be considered arbitral type bodies in that their determinations exert wide ranging third party legal (and economic) effects in the financial markets well beyond the confines of any particular bilateral dispute. ISDA effectively recognises this quasi-adjudicative role and relates it back to the desirability of building up a customary industry precedent in this area, given the supposed inherent uncertainties associated with OTCD disputes reaching the public courts.159 Overall, it would thus arguably appear that the ISDA DC‟s are indeed performing a gatekeeping role within the definitions set out by Coffee and Partnoy. The ISDA DC‟s are fulfilling, at the very minimum, a verification type function in similar fashion to the CRA‟s. Furthermore, there do appear to be conflict of interest and accountability challenges associated with the ISDA DC‟s which appear somewhat analogous to those traditionally attaching to the CRA‟s. Having said that, there are obviously dynamics associated with the ISDA DC‟s, particularly on the open question of liability, which could be differentiated from the CRA‟s. It appears to be much less clear as to whether an ISDA DC could plausibly rely upon journalistic free speech protections to shield itself from legal suits, given the seemingly more formal legalistic sort of adjudicative processes adopted by the DC‟s. It appears that ISDA has been sensitive to some of the issues raised regarding the DC‟s. In a Q&A on the Greek and US sovereign debt crises and their potential to trigger CDS contracts, ISDA took the opportunity to contend, inter alia: „This process is fair, transparent and well tested, and was developed working closely with global regulators‟.160 Parallels may thus also be found between the CRA‟s and the ISDA DC‟s in terms of the „regulatory license‟ narrative. The reference to the input of regulators might be significant here and can also be connected to provisions in the public regulatory reforms in the US and EU. It appears that the ISDA DC‟s have may have been granted the authority to issue „regulatory licenses‟ by public policy makers but perhaps in a more subtle sense than has been the case with the CRA‟s. This warrants further elaboration and consideration of some potential practical and normative implications. ISDA DC‟s and the „Regulatory License‟

It is plausible to suggest that the ISDA DC‟s, as CDS market gatekeepers, do enjoy the requisite reputational capital in order to fulfil their role with credibility. But, like the CRA‟s, it appears that reputational capital alone might not necessarily be a sufficient explanatory reason as to why the ISDA DC‟s can expect to remain as influential gatekeepers. Here, the „regulatory license‟ analysis may also be helpful. While the substance of recent public regulatory reform proposals in the OTCD markets is challenging to decipher,161 one thing has been apparent from the outset. There will

159

Whittall above n. 156. For further discussion of the potential significance of this point see, e.g., Gelpern above n. 91. 160

CDS on US Sovereign Debt Q&A (27th July 2011) [http://www2.isda.org/news/cds-on-us-

sovereign-debt-qampa - Last accessed 7th August 2011]; CDS on Greek Debt Q&A 161

For a readable comparison between the US and EU proposals see, e.g., Sherman & Sterling LLP, Proposed US and EU Derivatives Regulations: How They Compare (Financial Institutions Advisory and Financial Regulatory and Derivatives Groups, 10

th November 2010)

[http://www.shearman.com/files/Publication/84c83ccc-2a2d-4e20-880c-45c31c6059ea/Presentation/PublicationAttachment/a13fc03b-2189-413c-9ce1-0b066c5d27f1/FIA-111010-Proposed-US-and-EU-Derivatives-Regulations.pdf - Last accessed 8th August 2011].

24

be segments of the markets which will likely not be suitable for CCP clearing and associated requirements,162 due to market liquidity and risk considerations. This logic will prevail regardless of whether certain instruments are standardised or not.163 Accordingly, it is obvious that while most OTCD market activity will be generally subject to deeper direct public regulatory intervention as a general matter, especially in terms of notification and margin requirements, the reality is that certain instruments will still be bilaterally concluded and usually documented under ISDA Master Agreements. Insofar as this remains the case in segments of the CDS market, particularly the presumably considerable segment governed by the ISDA Big and Small Bang Protocols, transnational private regulation through ISDA generally and the ISDA DC‟s in particular, will seemingly remain pervasive. In sum therefore, the OTCD public regulatory proposals on both sides of the Atlantic could be conceptualised as arguably ceding a subliminal authority to the ISDA DC‟s to grant a sort of „regulatory license‟ to market participants to those CDS transactions which might not be eligible for CCP clearing either presently or in the future. This subliminal regulatory license may differ in substance from the more overt license granted to CRA‟s, for example in the US, but nonetheless may be symbolically analogous. In both cases, verification control over a significant and risky segment of the financial markets has effectively been delegated by public policy makers to transnational private actors or regulators. As illustrated, in the case of the ISDA DC‟s, its role in granting regulatory licenses may actually go well beyond a mere verification function in terms of its effects. Therefore, in adapting Partnoy‟s analysis, while there are parallels with the gatekeeping position occupied by CRA‟s, in some important ways the ISDA DC‟s might also represent something new and therefore „might not be like other gatekeepers, including the CRA‟s‟. Moreover, it is thus quite apparent that public regulatory reforms in OTCD markets may operate to „lock in‟ the role of the ISDA DC‟s rather than „lock out‟ these bodies or the pre-existing dominant form of transnational private regulation generally, as well as its associated normative challenges. If this is the case, it begs the question as to what normative challenges this retention of considerable influence within the realm of the ISDA DC‟s may present. The ISDA DC’s: Private Governance, Public Implications?

As has been illustrated in Part I, developments in OTC CDS markets have a penchant for either creating or amplifying risk with consequent negative externalities for society as a whole. Accordingly, the likelihood that OTCD industry actors will in all probability maintain considerable control over the „uncleared‟ CDS markets in accordance with the „regulatory license‟ reasoning may present potential practical benefits certainly, but also some pressing normative challenges. Colleen Baker has recently illustrated aspects of this challenge with specific reference to the ISDA

162

H.T.C. Hu, Credit Default Swaps and the Financial Crisis: “Interconnectedness” and Beyond (Washington: Hearing on the Role of Credit Derivatives in the US Economy, US House Committee on Agriculture, 13

th October 2008) [http://agriculture.house.gov/testimony/110/h81015/Hu.pdf - Last

accessed 9th August 2011]. 163

See, e.g., UK House of Lords European Union Committee, The Future Regulation of Derivatives Markets: Is the EU on the Right Track? (10

th Report of Session 2009-10, 31

st March 2010)

[http://www.publications.parliament.uk/pa/ld200910/ldselect/ldeucom/93/93.pdf - Last accessed 8th August 2011].

25

DC‟s.164 For example, Baker points to the case of Bradford & Bingley (B&B), nationalised in 2009, where the UK Treasury had authorised B&B to defer meeting obligations on subordinated bonds and that such a move would not be considered a „credit event‟ as far as the UK Treasury was concerned. However, Morgan Stanley sought the opinion of the relevant ISDA DC as to whether a credit event had actually occurred for the purposes of CDS contracts referencing B&B (insuring the bonds).The ISDA DC responded that this was indeed a credit event, thereby contradicting and serving to effectively override the UK Treasury view. Furthermore, it is clear from a little further investigation that Morgan Stanley also seemingly participated in the vote at the relevant ISDA DC deciding this issue and predictably voted in favour of the resolution.165 Baker thus suggests, inter alia, that this signifies a „powerful example of the development of global private governance mechanisms and their potential to impact on government actors‟.166 Consequently, turning to normative considerations, this activity firstly raises questions regarding the legitimacy of this type of transnational private regulation, though such general questions are of course obviously not necessarily unique to the ISDA DC‟s, as such. But, as has been highlighted herein and elsewhere, it is clear that ISDA, but particularly the ISDA DC‟s, are doing things which significantly deviate from the traditional dispute resolution activities adopted by other transnational private trade associations. As such, the ISDA DC‟s have been suggested to represent an „important step beyond international commercial arbitration‟ due to the significant, direct, legally significant third party effects exerted by individual determinations. It has been postulated that the ISDA DC‟s could expand their scope in the OTCD markets over time and thus possibly morph into „the nascent beginnings of cross border specialist financial courts‟.167 However, the potential challenge at the moment is that these young bodies, while wielding considerable power, simultaneously appear to lack the degree of transparency which might be typically associated with a public commercial court. For example, it has been highlighted by Adam Glass that „there is no explicit requirement that votes cast...be based on the belief that the interpretation supported is legally correct (in the sense of what a court is most likely to decide)‟.168 In this line of reasoning, it has been postulated that this should be seen as efficient for the market insofar as it „eliminates the need for the DC to make strained interpretations to reach the result it wants; it can, with perfect legitimacy and formal sanction, simply decide on the basis of what it believes to be the practical result‟.169 However, if the ISDA DC‟s resemble courts in some respects in accordance with Baker‟s contention but simultaneously do not comfortably fit that paradigm in other key respects, as Glass has illustrated, to suggest that these bodies enjoy „perfect legitimacy‟ seems a slightly precocious venture at this point.

164

C.M. Baker, „Regulating the Invisible: The Case of Over-the-Counter Derivatives‟ (2010) 85 Notre Dame Law Review 1287, at 1361. 165

Determinations Committee Decision as to Whether a Failure to Pay Credit Event Has Occurred with Respect to Bradford & Bingley plc (9

th July 2009)

[http://www.isda.org/dc/docs/EMEA_Determinations_Committee_DecisionA_09072009.pdf - Last accessed 8th August 2011]. 166

Baker above n. 164, at 1363. 167

Ibid., at 1362; On a similar theme see, J.B. Golden, „The Courts, the Financial Crisis and Systemic Risk‟ (2009) 4 Capital Markets Law Journal S141. 168

Glass above n. 118, at S93. 169

Ibid.

26

Legitimacy is a multifaceted and potentially slippery concept in a globalising world,170 especially when attempting to apply it to the activities of private actors operating within a transnational regulatory regime. It necessitates a more holistic approach which may or may not include traditional statist measures of legitimacy.171 A helpful opening definition has been set forth by Colin Scott who has suggested that legitimacy is ultimately concerned „with the nature and extent of acceptance that institutional arrangements and normative choices, from among the possible configurations, are more or less right for the time being‟.172 Accordingly, the question arising here is whether the arrangements described are more or less right for all stakeholders affected by the determinations of the ISDA DC‟s. It is conceivable that the legitimacy transnational private regulatory bodies, such as the ISDA DC‟s, may „evolve over time‟ depending upon the perspective adopted.173 For the time being it does appear that the ISDA DC‟s may be satisfying a test of „pragmatic legitimacy‟. This could be largely measured in terms of the certainty wrought by ISDA DC determinations for participants directly involved in the OTC CDS markets, in conformity with a „neo-organizational‟ theory of effectiveness.174 Whether the ISDA DC‟s satisfy a test of „moral legitimacy‟, with reference to a broader range of stakeholders indirectly affected by developments,175 particularly negative developments, in the OTC CDS markets appears to be far more of an open question and might be considered from a number of perspectives. Financial instability arising in the CDS markets may be considered a „public bad‟.176 Therefore, perhaps the legitimacy of the ISDA DC‟s from the perspective of society writ large might at least partly be predicated on the achievement of certain outcomes, particularly financial stability.177 However, cultivating broader moral legitimacy, outcome based or otherwise, for this type of transnational private regulation may be challenging in the wake of the GFC, unless, perhaps, the ISDA DC‟s can set the terms of reference of the legitimacy debate from the outset. There are indications that ISDA, as a general matter, has indeed been engaging in „manipulating for moral legitimacy‟ of the type elaborated by Benjamin Cashore.178 Glenn Morgan has alluded to this in describing how ISDA, through the media and other activities, has attempted to set the terms of reference of the debate on OTC derivatives public regulatory reforms by trying to divert attention away from narratives which have questioned the overall legitimacy of

170

See, e.g., J. Brassett and E. Tsingou, „The Politics of Legitimate Global Governance‟ (2011) 18 Review of International Political Economy 1. 171

J.A. Scholte, „Towards Greater Legitimacy in Global Governance‟ (2011) 18 Review of International Political Economy 110, at 12. 172

C. Scott, Regulating in Global Regimes (UCD Working Papers in Law, Criminology & Socio-Legal Studies Research Paper No. 25/2010) p. 10 to appear in Handbook on Regulation (Edward Elgar 2011, forthcoming). 173

S. Bernstein, „Legitimacy in Intergovernmental and Non-State Global Governance‟ (2011) 18 Review of International Political Economy 17, at 42. 174

As elaborated by D. Kerwer, „Rules That Many Use: Standards and Global Regulation‟ (2005) 18 Governance 611, at 617-619 175

B. Cashore, „Legitimacy and the Privatization of Environmental Governance: How Non-State Market-Driven (NSMD) Governance Systems Gain Rule Making Authority‟ (2002) 15 Governance 503, at 511-512; M.C. Suchman, „Managing Legitimacy: Strategic and Institutional Approaches‟ (1995) 20 Academy of Management Review 571 176

Tsingou above n. 96. 177

For further discussion of this outcome based measure see, e.g, D. Mugge, „Limits of Legitimacy and the Primacy of Politics in Financial Governance‟ (2011) 18 Review of International Political Economy 52. 178

Cashore above n. 175, at 512.

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CDS markets.179 The creation of the ISDA DC‟s may also have precisely been intended to manipulate for moral legitimacy as part of this project, through construction of a new „cognitive and political community, taking the role of the creator of the rules of the game‟.180 However, the success of this endeavour in the case of the ISDA DC‟s is unclear, perhaps, because even the creation of „new rules of the game‟ in a technical market such as CDS still might not „be expected to favour the adhesion of other actors who feel technically handicapped and uncertain about the potential opportunism of a small group of active promoters‟.181 Accordingly, whether the ISDA DC‟s have been successful in manipulating for moral legitimacy might still remain an open question at present. There may also be other ways of looking at the legitimacy issue. For example, Robert Keohane has expounded six criteria for legitimacy. Keohane draws upon liberal democratic precepts and admittedly primarily intends the criteria to apply to global governance institutions such as the World Trade Organisation and United Nations Security Council. Consequently, it might be an even more precarious endeavour to try and apply Keohane‟s principles to transnational private regulatory regimes such as the ISDA DC‟s. The „thresholds of acceptability‟182 that democratic theory is appropriate to use may vary wildly depending upon the nature of the particular regime. Nonetheless Keohane‟s criteria may arguably be wide enough to capture the activities of a broad range of global governance institutions, including the private variety, and thus could further inform the present discussion. Keohane outlines: a necessity for „minimal moral acceptability‟ insofar as any global governance institution should not persist in committing serious injustices; „inclusiveness‟ insofar as to have a claim to make rules on a global basis, institutions need to display a willingness to open up to all peoples willing to attain goals established by the institution; „epistemic quality‟ referring to a twin requirement for the institution to display institutional integrity or an acceptance of certain truths and realities, as well as a sufficient degree of transparency as to how the institution operates; „accountability‟ assessed in terms of standards for accountable bodies, the degree of information available to accountability holders and the ability of accountability holders to impose sanctions; compatibility with democratic governance; and „comparative benefit‟ or that the institution produces results that are better than those under alternative feasible arrangements.183 In accordance with these criteria, the ISDA DC‟s might be thought to perform reasonably well on some of these legitimacy measurements. The DC‟s probably do display at least a minimum moral acceptability and at least a limited degree of epistemic quality, especially given that the rules of the institution are at least publicly available (though not particularly easy to decipher). Furthermore, the ISDA DC‟s probably do confer a comparative benefit on market participants at least, insofar as the previous bilateral regime for settling credit events in CDS markets may have been cumbersome and intolerably risky. Nonetheless, the ISDA DC‟s may not perform particularly well on the

179

G. Morgan, „Legitimacy in Financial Markets: Credit Default Swaps in the Current Crisis‟ (2010) 8 Socio-Economic Review 17, at 39. 180

I. Huault and H. Rainelli-Le Montagner, „Market Shaping as an Answer to Ambiguities: The Case of Credit Derivatives‟ (2009) 30 Organization Studies 549, at 567. 181

Ibid. 182

R.O. Keohane, „Global Governance and Legitimacy‟ (2011) 18 Review of International Political Economy 99, at 100. See also, A. Buchanan and R.O. Keohane, „The Legitimacy of Global Governance Institutions‟ (2006) 20 Ethics and International Affairs 405. 183

Ibid., at 101-103.

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inclusiveness and accountability standards. If the stated objective of the ISDA DC‟s is to standardise the settlement of CDS trades with a view to minimising market risks, then surely a broader constituency of stakeholders which might be interested in this objective should, in principle, participate in the determinations process. In terms of accountability, as outlined above the lines of accountability of the ISDA DC‟s are as yet unclear and it does not appear obvious as to whether these bodies are particularly accountable to members within the regulatory regime or to others outside the regime. However, as will be demonstrated, attempting to extrapolate accountability issues in transnational private regulation can be something akin to opening a Pandora‟s Box. Accountability184 is a relevant consideration in the case of the ISDA DC‟s. These activities arguably do impinge on international capital mobility with potential social welfare implications and therefore questions of accountability, at least prime facie, arise. Accountability and legitimacy can be linked but, depending on the prism of analysis, they may not always necessarily be mutually reinforcing.185 Nonetheless, accountability will often be a measure of legitimacy. Instituting a form of enhanced accountability on the ISDA DC‟s may be especially challenging precisely because their expertise and activities at present seem prima facie credible from an industry perspective.186 The challenge could be illustrated thus. For example, the ISDA DC‟s could seek to „enrol‟ other, possibly public actors,187 with a view to enhancing their moral legitimacy. While this may serve to satisfy certain moral legitimacy claims on the ISDA DC‟s, at least theoretically it also opens up potentially new demands on the accountability of these bodies to other stakeholders. Exactly how such accountability could be operationalised188 and what form this could take is highly debateable.189 But the ISDA DC‟s might then be in danger of simultaneously being rendered subject to certain accountability demands from within and without the organisation, thereby impinging on both their „input‟ and „output‟ legitimacy.190 Some of these demands may turn out to be mutually exclusive. For example, demands for greater inclusiveness, democracy and transparency in decision-making within the ISDA DC‟s may impact upon the DC‟s ability to produce effective determinations and/or impede the DC‟s from reacting nimbly to systemically significant market events, affecting pragmatic legitimacy.191 Overall the situation the ISDA DC‟s could face, especially in the face of the GFC and the reforms envisaged in market infrastructure, might

184

See, e.g., M. Bovens, „Analyzing and Assessing Accountability: A Conceptual Framework‟ (2007) 13 European Law Journal 447; R. Mulgan, „Accountability: An Ever Expanding Concept?‟ (2000) 78 Public Administration 555. 185

J. Black, „Constructing and Contesting Legitimacy in Polycentric Regulatory Regimes (2008) 2 Regulation and Governance 137. 186

Kerwer above n. 174, at 620. 187

J. Black, „Enrolling Actors in Regulatory Systems: Examples from UK Financial Services Regulation‟ (2003) Public Law 63. 188

For discussion see, e.g, D. Curtin & L. Senden, „Public Accountability of Transnational Private Regulation: Chimera or Reality?‟ (2011) 38 Journal of Law and Society 163. 189

Global Administrative Law scholarship has begun to attempt to address such questions. See, e.g., B. Kingsbury, N. Krisch and R.B. Stewart, „The Emergence of Global Administrative Law‟ (2005) 65 Law & Contemporary Problems 15. 190

G.R.D. Underhill and X. Zhang, „Setting the Rules: Private Power, Political Underpinnings and Legitimacy in Global Monetary and Financial Governance‟ (2008) 84 International Affairs 535, at 539. 191

J. Black and D. Rouch, „The Development of the Global Markets as Rule-Makers: Engagement and Legitimacy‟ (2008) 2 Law and Financial Markets Review 218, at 228.

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conform to what Julia Black has termed a „legitimacy dilemma‟192 and/or „multiple accountability disorder‟.193 Such challenges arising in the regulation of OTCD have been recognised elsewhere and a way through has been sought. Colleen Baker has exemplified the potential benefits of adopting less subtle and more explicit „public-private „negotiated governance‟194 relationships for the OTCD markets, underpinned by an informal international accord and the creation of new public-private oversight bodies, such as a Global OTC Derivatives Supervisory Board. The structures envisaged would oversee regulation in these markets in a more open, effective and transparent way, harnessing the benefits associated with private expertise and public involvement.195 It is conceivable that the ISDA DC‟s could come to play a useful role in such an arrangement. Meanwhile, Kristin Johnson has separately suggested the desirability of creating of a new CDS SRO. 196 Illustrating that the fallout from CDS market failures could indeed be portrayed as a „tragedy of the commons‟, Johnson draws upon a „community governance‟ model. It is postulated that such a measure would be preferable to the currently proposed regulatory schemes insofar as a CDS SRO would explicitly engage both public and private interests, including ISDA. This could thereby encourage effectiveness through collaborative rule making, as well as public accountability and transparency guarantees. Again it is plausible to imagine that the ISDA DC‟s could mutate into such an SRO, perhaps enjoying enhanced legitimacy and effectiveness. Conclusions This paper has aimed to illustrate that recently established bodies, the ISDA DC‟s, appear to be performing a new gatekekeeping function in OTC CDS markets, though different in some crucial respects from other gatekeepers. It can also be argued that the ISDA DC‟s have been afforded the authority, by virtue of the content of recent public regulatory reforms, to grant „regulatory licenses‟ in similar spirit to CRA‟s, to CDS market participants operating under the Big Bang and Small Bang Protocols. The ISDA DC‟s have thus been implicitly „locked in‟ by public actors to OTCD regulation for the foreseeable future. This has established a subtle recalibration of the public-private balance in these markets. It has crucially ensured that industry actors will continue to exert regulatory control over some of the riskiest segments of the OTCD markets into the foreseeable future, as unsuitability for CCP will inevitably imply that many OTC CDS will reside under the auspices of the ISDA regulatory regime, including the DC‟s. It has been suggested that while these arrangements may be comparatively more desirable for direct market participants than the previous settlement procedures, pertinent practical and normative challenges may nevertheless potentially arise from this recalibration which should warrant further exposition.

192

Black (2008) above n. 185, at 153. 193

J. Koppel, „Pathologies of Accountability: ICANN and the Challenge of “Multiple Accountability Disorder”‟ (2005) 65 Public Administration Review 94. 194

Drawing on J. Freeman, „The Private Role in Public Governance‟ (2000) 75 New York University Law Review 543 195

Baker above n. 164, at 1371 196

Johnson above n. 28, at 244-256.