Friday, October 16, 2009

Regulating Derivatives

According to one school of thought, the excessive use of derivatives, particularly credit default swaps (CDSs) was a key cause of the global financial crisis. Related to this is the argument that progressive liberalisation of rules governing derivatives accelerated their downfall. In an interesting debate titled Regulate OTC Derivatives by Deregulating Them, Professor Lynn Stout traces the history of derivatives regulation:

… In the United States and the United Kingdom, derivatives traditionally were subject to a common-law rule known as the “rule against difference contracts.” … [The rule] allowed you to wager on anything you liked, from sporting contests, to wheat prices, to interest rates. But – here is the catch – the rule did require that if you wanted a court to enforce your wager, you had to demonstrate to the judge’s satisfaction that at least one of the parties to the wager either held title to the underlying thing bet on, or was legally obligated to take title to the underlying. … In other words, the rule against difference contracts required that, in order for a derivative contract to be lgally enforceable, one of the parties to the contract had to be using the contract to hedge against a pre-existing economic risk.
The logic of the common-law courts allowed parties to enter into derivative transactions as hedging mechanisms. Hence, a question arises whether derivatives can be used purely for speculative purposes. Stout argues that this is possible, but only through specific mechanisms:

This didn’t mean derivatives couldn’t be used to speculate. But the rule against difference contracts forced speculators to think about how to make sure their fellow gamblers paid their bets. The answer was for the speculators to set up private exchanges, like the Chicago Mercantile …

In the process, the private exchanges kept derivatives speculation within reasonable limits and under controlled conditions. … But off the exchanges, the old common-law rule against difference contracts served as the primary check against speculation in “over the counter” (OTC) derivatives.
Professor Stout argues that the common-law rule prohibiting speculation through OTC derivatives was gradually dismantled through statute both in the U.K. (through the Financial Services Act of 1986) and in the U.S. (through the Commodities Futures Modernization Act of 2000), which made OTC derivatives legal, whether they were entered into for hedging or speculative purposes. She then goes on to posit that such deregulation gave rise to massive speculation through derivatives such as CDSs causing systemic risk that in turn resulted in the crisis. What is the solution to this problem? Stout suggests that the law should revert to the previous position:

The answer seems obvious: go back to what worked well before. By refusing to devote public resources to enforcing an OTC derivatives contract unless at least one of the parties to the contract either owned or was legally obligated to take ownership of the asset underlying the contract, the common-law rule against difference contracts created an elegant legal sieve the separate socially useful hedging contracts from risk-increasing, purely speculative wagers.
Stout’s position received objections from three finance professors, who make several arguments, including that: (i) the financial crisis was not caused by derivatives, (ii) it is difficult to distinguish hedging from speculation (and, in any event, judges may not be adequately equipped to undertake this task); (iii) speculation may not necessarily be undesirable as it enhances liquidity and price discovery (a market-efficiency based argument). An element of oddity to this debate is that the response to a largely legal question came from three finance professors, which stopped short of considering the legal issues governing derivatives in their entirety.

As far as India is concerned, the common-law position detailed by Stout continues to be the law. In a sense, the common-law has been codified in the form of Section 30 of the Contract Act, which makes contracts of wager void. OTC derivatives, therefore, run the risk of being unenforceable unless at least one of the parties to it has a genuine interest in the underlying. In other words, derivatives for hedging are allowed, while derivatives for pure speculation are not given effect to by courts. At the same time, pure speculation is possible, but only through stock exchanges, and not on an OTC basis. For instance, where derivatives in securities are involved, they can be entered into for speculative purposes on stock exchange, as they are allowed under Section 18A of the Securities Contracts (Regulation) Act, 1956.

The enforceability of OTC derivatives (that were ‘exotic’ in nature) had invoked significant attention of the Indian courts last year, but the final outcome has not disturbed the basic legal principles noted above. For a discussion of this issue in the context of a judgment of the Madras High Court, see this previous post. The cases largely involved a determination of whether given contracts were for hedging or speculative purposes, and the courts were required to apply well-established principles to emerging complex derivatives transactions.

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