Split Derivatives: Inside the World's Most Misunderstood Contract

72 Pages Posted: 23 Aug 2018 Last revised: 29 May 2020

See all articles by Dan Awrey

Dan Awrey

Cornell Law School; European Corporate Governance Institute

Date Written: August 13, 2018


Derivatives are the ‘bad boys’ of modern finance: exciting, dangerous, and fundamentally misunderstood. These misunderstandings stem from the failure of scholars and policymakers to fully appreciate the unique legal and economic structure of derivative contracts, along with the important differences between these contracts and conventional equity and debt securities. This paper seeks to correct these misunderstandings by splitting derivative contracts open, identifying their constituent elements, and observing how these elements interact with one another. These elements include some of the world’s most sophisticated state-contingent contracting, the allocation of property and decision-making rights, and relational mechanisms such as reputation and the expectation of future dealings. The resulting hybridity essentially splits every derivative into two separate contracts: one that governs under normal market conditions, another that governs under conditions of fundamental uncertainty. In good times, derivative contracts contemplate the almost automatic determination and performance of each counterparty’s obligations. In bad times, these contracts include various mechanisms designed to provide counterparties with the flexibility to incorporate new information, fill contractual gaps, and promote efficient renegotiation.

The process of splitting derivative contracts open yields a number of important policy insights. First, the bundling of contract, property, decision-making rights, and relational mechanisms makes derivatives look far more like commercial loans than publicly-traded shares or bonds. The regulatory treatment of derivatives as ‘securities’ — and the resulting emphasis on market transparency — thus serves to distract attention from the significant prudential risks posed by the widespread use of derivatives. Second, the flexibility associated with the relational mechanisms embedded within many derivative contracts can play a useful role in promoting both institutional and broader financial stability. This has important implications in terms of the desirability of the recent push toward mandatory central clearing of derivative contracts. It also exposes the potential perils of recent proposals to use distributed ledger technology and smart contracts to execute, clear, and settle these contracts. Finally, the widespread breakdown of these relational mechanisms can be a source of financial instability. This provides a compelling rationale for authorizing central banks to act as ‘dealers of last resort’ during periods of fundamental uncertainty.

Keywords: derivatives, swaps, incomplete contracting, contractual governance, collateral, securities law, Dodd-Frank Act, clearinghouses, distributed ledger technology, smart contracts, dealer of last resort

JEL Classification: D23, D81, D82, D86, G1, G18, G23

Suggested Citation

Awrey, Dan, Split Derivatives: Inside the World's Most Misunderstood Contract (August 13, 2018). Yale Journal on Regulation, Forthcoming, Oxford Legal Studies Research Paper No. 6/2019, European Corporate Governance Institute - Law Working Paper No. 520/2020, Available at SSRN: https://ssrn.com/abstract=3229916

Dan Awrey (Contact Author)

Cornell Law School ( email )

Myron Taylor Hall
Cornell University
Ithaca, NY 14853-4901
United States

European Corporate Governance Institute ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels

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