The Regulatory Dialectic

by: Craig Pirrong

The Commodity Futures Modernization Act has been demonized as a major contributor to the financial crisis-unfairly in my view. This view is ahistorical, and fails to understand what led up to its passage. In brief, the evolution of derivatives markets, and particularly the growth of the swaps market in the 1980s and 1990s created legal and economic challenges that the Commodity Exchange Act, dating from 1922 with a major modification in 1936, was completely unable to handle.

The CEA was passed at a time where “off exchange” transactions meant $10 bets at bucket shops, not huge deals between major banks and corporations. The categories of market participants and the kinds of derivatives traded that Congress had in mind when drafting this legislation were vastly different from those developed during the wave of financial innovation that began in earnest in the early-1970s. As a result, by the mid-1980s, and certainly by the 1990s, the regulatory framework in place was completely ill-adapted to market conditions.

In particular, the exchange trading requirement of the CEA constrained the ability of market participants to undertake mutually beneficial transactions. Those entering into perfectly sensible OTC deals risked running afoul of the requirement, which put their transactions at considerable legal risk. The CFTC responded to this situation by issuing a variety of interpretative statements and no action letters and exemptions that were intended to give relief to these transactions. Soon a confusing thicket of ambiguous and often contradictory rulings, exemptions, no action letters and interpretations grew up around OTC derivatives trades. The legal, logical, and linguistic contortions became increasingly absurd. Although these permitted certain transactions to go forward, they did not address the very serious risk that someone could challenge whole categories of OTC trades and instruments in court, and that a judge would find them in violation of the CEA.

This was the genesis of the CFMA. The “modernization” was intended to create a legal framework that reflected modern market reality, and which gave legal certainty to economically beneficial transactions. It was an effort to clear the thicket, to replace an often absurd and contradictory set of ad hoc improvisations with a coherent structure.

The fundamental problem that CFMA was intended to address was that legal and legislative categories did not correspond to market reality. The CFTC reacted by crafting ad hoc fixes. But in the face of rapid innovation, the bolting of one ad hoc fix onto another created a vast Rube Goldberg contraption that was an accident waiting to happen.

Move forward 10 years from CFMA to Frankendodd. Frankendodd creates numerous categories of instruments and market participants-swap, securities swap, swap dealer, major swap market participant, and on and on. It then delegates to multiple regulators the task of establishing detailed criteria describing these categories. Frankendodd itself weighs in at 2400+ pages, and the myriad regulations thereunder will run to many thousands of additional pages.

And that will just be the beginning. The proliferation of categories that do not correspond to market realities today, let alone market realities in the future that develop in response to fundamental economic changes, financial innovations, and the regulations themselves, will lead to serious contradictions between what makes commercial and policy sense, and the letter of the law and the regulations. The regulators will inevitably respond today the way they did in the 1980s and 1990s-with ad hoc responses intended to address the specific transactions and transactors at issue, with only passing regard for the coherence of the overall set of rulings and interpretations. A Talmudic mind will be required to sort through it all.

Lawyers will rejoice and prosper-hence the rejoicing-because the most important design consideration for a transaction or a new structure will be how it can be jiggered to satisfy the regulations and interpretations, rather than the most efficient way to achieve a particular economic objective. And even then there will be considerable uncertainty given the inevitable contradictions in the regulations, interpretations, judicial rulings, and on and on.

In due course, the whole edifice will become utterly unworkable and incoherent, and create a real systemic risk-a risk arising from the serious legal uncertainty that is inevitable. And the problems arising out of Frankendodd will be all the worse than those arising out of CEA because it is more sweeping, the markets are more complicated and international, and the categories and distinctions and requirements it creates are vastly more numerous.

The ink on some regulations arising out of Frankendodd is barely dry and this regulatory dialectic is already beginning. The regulators are already making ad hoc adjustments. From the FT:

US regulators are exploring ways to give large foreign banks and overseas subsidiaries of US lenders a reprieve from stringent new derivatives rules, potentially alleviating one of the biggest concerns facing global financial institutions.

The US Commodity Futures Trading Commission is looking to grant a temporary exemption to swap dealers that may fall under the jurisdiction of foreign financial authorities from complying with a host of post-financial crisis regulations governing derivatives transactions, people familiar with the matter said.

If you think this exception is the exception, you have another thing coming. This is just the beginning of the dialectic. Moreover, the international nature of the derivatives industry and the creation of laws, rules, and regulations in different jurisdictions around the world will just accelerate it.

Within a period of a few years, derivatives regulations will be another absurd Rube Goldberg contraption. And in its inimitable fashion, Congress (and the EU-if it still exists) will feel compelled to pass The Derivatives Modernization Act of 2020 (to choose a realistic round number). Mark my words.