Substituted Compliance and Systemic Risk: How to Make a Global Market in Derivatives Regulation

Abstract

The conventional wisdom is that the global financial crisis of 2007-2008 revealed faults in the ability of international financial regulation to contain the problem of systemic risk. Further conventional wisdom suggests that the failure to regulate complex financial instruments, especially derivatives, contributed significantly to the crisis. As a result, an international consensus quickly formed around tightening global financial regulation generally and derivatives regulation in particular. Moreover, the preferred approach to containing systemic risk in the context of derivatives quickly converged on mandatory central counterparty clearing.

An obstacle to implementing the consensus solution, however, is the absence of a system of global financial regulation. While there are international organizations through which national actors can meet to deliberate, discuss, and even decide on financial regulatory policy, ultimately any such decisions must be implemented by national actors with potentially divergent incentives. This creates the prospect of “regulatory arbitrage” — that is, the risk that jurisdictions will reduce regulation to win business from regulated entities, leading to a race to the bottom among regulatory authorities and the ultimate failure to achieve the regulatory goal. In the context of derivatives, if U.S. authorities impose a harsh clearing regime, banks may shift their derivatives operations to London or, if European and American regulation converge, to Hong Kong or Singapore or some less highly regulated jurisdiction. The result of this process, many argue, is the degradation of regulatory standards and the concomitant failure to reduce systemic risk.

Alert to the possibility of regulatory arbitrage, policymakers have sought to impose regulatory uniformity through either multilateral efforts at harmonization or unilateral assertions of extraterritorial jurisdiction. In a harmonized regulatory regime, national actors work together to arrive at a shared regulatory goal, such as, in this context, mandatory clearing of over-the-counter (OTC) derivatives transactions. In an assertion of extraterritorial jurisdiction, national actors seek to impose their regulatory requirements on entities and transactions outside of their borders. Either way of achieving regulatory uniformity, however, may compromise the ultimate goal of containing systemic risk.

Regulatory uniformity, in general, is a highly suspect means of addressing systemic risk. Uniformity, by definition, means all jurisdictions regulate in the same way, but if financial market crises have taught us anything, it is that regulators often do not anticipate the next crisis. Thus, if all jurisdictions regulate in the same way, and if, as has often been the case in the past, their chosen regulatory approach fails to account for an emergent crisis, then world financial markets will be more exposed to systemic risk than they might have been had some jurisdictions regulated differently. More specifically, recent scholarship shows that mandatory clearing is no panacea for systemic risk, and once it is imposed on a globally uniform basis, its flaws will be unchecked, rendering the global financial system uniformly vulnerable.

This Article argues that a better approach to derivatives regulation would be to adopt a more supple regulatory super-structure that encourages a diversity of approaches to achieve the objective of minimizing systemic risk. Encouraging a diversity of regulatory approaches, all aimed at containing systemic risk, provides a number of benefits. These include the promotion of innovation and the adoption of efficient regulatory structures as well as the production of information about successful and unsuccessful approaches to the problem. Perhaps most importantly, however, regulatory diversity creates fire-breaks in the event of contagion so that the failure of one regulatory regime will not necessarily lead to the failure of the world financial system. This Article advocates the adoption of a regime of regulatory diversity in the context of derivatives regulation, providing several proposals for achieving such a regime at both the national and international levels.

From this introduction, the Article proceeds as follows: Part I provides background on derivatives and the problem of systemic risk, reviewing the ways in which derivatives were and were not implicated in the global financial crisis of 2007-2008. Part II describes the global regulatory response to the systemic risk of derivatives transactions, examining both the international regulatory agenda and differences between different national actors in implementing it. Part III introduces the problem of regulatory arbitrage and highlights attempts to combat it by achieving regulatory uniformity, either through harmonization or exercises of extraterritorial jurisdiction. Part IV critiques regulatory uniformity, detailing both general objections to uniformity as a means of containing systemic risk and specific problems with the clearing mandate in the context of derivatives regulation. Part V offers a regulatory alternative, aimed at reducing systemic risk by encouraging the proliferation of regulatory alternatives rather than imposing a uniform approach. Part V provides a package of reforms that could be implemented at either or both the national and international levels. The Article closes, finally, with a brief summary and conclusion.