Considering the Transformation of the OTC Derivatives Market, 1984-2015

In my recent paper, “Private and Public Controls in the Over-the-Counter Derivatives Market, 1984-2015”, I study how private and public controls operated jointly in OTC derivatives over the period. A main conclusion is that private incentives especially shaped developments in the OTC markets, including after Dodd-Frank in 2010.

The over-the-counter (OTC) market in financial derivatives evolved from the 1980s to 2010 mainly under private controls designed by market participants, particularly the International Swaps and Derivatives Association (ISDA). Banking and other regulators frequently pushed market participants, informally, to remedy emerging problems. ISDA and others responded to these interventions to preserve their legitimacy as controllers. The Derivatives Policy Group and The Principles and Practices for Wholesale Financial Market Transactions (prompted by the SEC/CFTC and NY Federal Reserve, respectively, in 1994 and 1995); three reports by the Counterparty Risk Management Policy Group in 1999, 2005, and 2008; and firms’ reduction of backlogs in the processing of derivatives transactions from 2003 to 2006 were examples of this relationship between public and private controls.

The CFTC challenged private regulation of OTC derivatives in 1998. Chairperson Brooksley Born, through a CFTC concept release, argued that the OTC market was beginning to function like the regulated futures market and called for possible federal regulation. Other federal regulators and industry participants rejected this claim, and Congress formally deregulated OTC derivatives in 2000 through the Commodity Futures Modernization Act. One view of this incident cites it as a catastrophic disregard of a warning of the dangers of unregulated OTC derivatives. This view says that the financial crisis beginning in 2008 might have been avoided if Federal Reserve Chair Alan Greenspan, Treasury Secretary Robert Rubin, Assistant Treasury Secretary Lawrence Summers, and SEC Chair Arthur Levitt had not suppressed Brooksley Born’s effort to regulate OTC derivatives in 1998. However, contemporaneous documents show that most academics, and virtually all market participants and agencies outside the CFTC’s chair’s office, with the notable exception of the General Accounting Office, supported exempting OTC derivatives from federal regulation because the area’s private regulatory and market controls operated reasonably effectively.

Control failures in segments of the OTC derivatives market—mainly credit derivatives—contributed to the financial crisis beginning in 2008, and in 2009 the G20 national leaders called for public regulation of OTC derivatives. The United States legislated controls through the 2010 Dodd-Frank Act, but the initiative for public regulation occurred globally. In this new regulatory system government uses rules and incentives, including trading requirements and stricter capital and margin requirements for OTC transactions, to shift OTC activity to regulated exchanges or new non-exchange regulated trading facilities, called swap execution facilities (SEFs) in the United States. Regulation requires that many standardized swap transactions be centrally cleared where feasible, and requires post-trade reporting of transactions’ volume and pricing.

Supporters of these changes cited the ways in which cleared, exchange-executed futures markets have functioned effectively for decades under diverse economic conditions. They maintained that conducting swap transactions in a futures-like regulatory system would prevent the types of failures that had occurred leading up to 2008. In turn, critics of these changes argued that swap-related problems were only part of broader failures in both publicly regulated and unregulated markets, and that swap regulation would not have prevented the crisis. Reasonable arguments support both sides, but the trauma of the financial crisis tipped legislation in favor of a new regulatory system. As preeminent derivatives attorney John Williams, now of Milbank, observed in a forum in 2012: “The credibility of the major players in the financial markets to actually work with the regulators and explain what was going on was somewhat damaged through this process and so that’s one of the reasons why some people really felt that they needed to get control of the market away from the dealers—not just transparency, but actually needed to go in and tear the business away from the major dealers and put it in the hands of a completely different set of economic actors.”[1]

Dodd-Frank’s consequences depended on how agencies wrote rules implementing its broad directives. The CFTC under Gary Gensler, from 2009-2013, issued controls more aggressively than expected. Timothy Massad, Gensler’s successor, has not changed the CFTC’s overall policies dramatically, but other regulators and market participants acknowledge that the agency’s leadership since 2014 is less aggressive and more flexible.

By mid-2015, regulatory changes in the OTC derivatives markets have occurred unevenly and more slowly than expected. Central clearing of OTC derivatives transactions and stricter capital and margin requirements are forming most quickly, although serious problems, such as differences among nations’ requirements in a global market, remain. Reporting requirements are in place, but inconsistencies in reporting systems within and across nations diminish the usefulness of the data. New systems of trading, like SEFs in the United States, are more like regulation-induced adaptations of the systems used prior to Dodd-Frank than the transformations of OTC trading advocated by Dodd-Frank supporters.

One explanation of this uneven progress is that the major derivatives dealers resisted changes to a market they dominate. An alternative explanation is that market participants broadly have been satisfied with how the OTC derivatives market has operated for them. Market participants beyond the major derivatives dealers—exchanges, commercial end-users, and institutional investors, among others—have supported aspects of new rules when the changes favored their business models. However, while trying to get the best deal they can on specific issues, no major market participant group welcomed the effort to transform the OTC market through public regulation. New rules and incentives favoring exchange trading and central clearing of derivatives transactions would drive more business to existing exchanges and clearing firms like the CME and ICE, but the exchanges and clearinghouses pushed for as much discretion as possible in dealing with new requirements, saying that prescriptive rules potentially forced them to handle contracts under terms jeopardizing their operations. End-users of derivatives, particularly non-financial businesses and pension funds, resisted rules requiring them to incur additional margin and clearing costs for their derivatives business or otherwise restricting their transactions.

Strong backing from some private interests is usually important in implementing regulation. For example, public health organizations and organized labor are indispensable supporters of health and safety regulation. We do not see such support from any major group of market participants in the effort to transform the OTC derivatives markets. In contrast, the speed with which equity markets changed after the mid-1990s, and particularly after Regulation NMS in 2005, demonstrates how private interests benefiting from regulatory change can drive market transformation.

Thus, one lesson from studying the development of the OTC derivatives market over the past thirty years is that it is critical to look closely at how regulatory changes will help or hinder market participants’ day-to-day business processes. Change is exceptionally difficult when no key group of market participants backs regulation-induced reform of financial systems. In contrast, as we see in the changes in equity market structures over the past twenty years, market incentives can strongly reinforce regulatory actions. It is important to consider how market incentives and regulation align as agencies try to implement laws effectively.


[1] Fordham Law School, 2012: Minutes 56-57 Regulation of Over the Counter Derivatives: Part 1 of 2. February 13. New York.

The preceding post comes to us from David P. McCaffrey, Distinguished Teaching Professor at the University at Albany, and co-director of its Institute for Financial Market Regulation. The post is based on his article, which is entitled “Private and Public Controls in the Over-the-Counter Derivatives Market, 1984-2015” and available here.