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Regulating Financial Derivatives

Clearing and Central Counterparties

Alexandra G. Balmer

This book puts forward a holistic approach to post-crisis derivatives regulation, providing insight into how new regulation has dealt with the risk that OTC derivatives pose to financial stability. It discusses the implications that post crisis regulation has had on central counterparties and the risk associated with clearing of OTC derivatives. The author offers a novel solution to tackle the potential negative externalities from the failure of a central counterparty and identifies potential new risks arising from post crisis reforms.
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Alexandra G. Balmer

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Wei Shen

According to the report released by the Financial Stability Board (FSB) in November 2011, shadow banking is defined as ‘credit intermediation involving entities and activities outside the regular banking system’. Put differently but simply, shadow banking is the realm of lending that does not rely on deposit-taking banks using customer money to fund loans. The International Monetary Fund (IMF) defines the shadow banking system as ‘off-balance-sheet and non-bank financial intermediation’ including Internet finance, micro-lending, asset securitization and some wealth management products. ‘Shadow banks’ in the context of Western countries refer to buy-out firms, hedge funds, venture funds and ordinary corporations which are using their investors’ money and wholesale funding to hire disgruntled bank traders, engage in direct lending and escape traditional banking regulation. In more advanced economies, shadow banking remains a key channel of credit intermediation that complements the formal banking system.

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Harry McVea

This chapter sets out to explore the role of hedge funds in the context of sale and repurchase agreements (so-called ‘repos’) – an important and increasingly high-profile facet of the shadow banking universe. In this respect, the focus is on bilateral repos – that is, repo transactions which are negotiated and settled directly between two counterparties without the use of a ‘triparty agent’. Hedge funds are major players in such repos and these markets are widely regarded as being opaque. More pertinently, the chapter seeks to critically analyse the ways in which, within the context of repo transactions, hedge funds may trigger and, in turn, transmit ‘systemic risk’ by way of a so-called ‘repo run’ – either within the shadow banking system itself, or, in ways which adversely affect, directly or indirectly, the traditional banking sector.

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Iris H.-Y. Chiu

The interpretation of ‘shadow banking’ and the mapping of the shadow banking universe is the subject of much academic commentary and policy discussions. This is because ‘shadow banking’ is often used as a catch-all term to refer to financial activities and transactions that may not be subject to traditional realms of regulation, but the amorphous nature of the term is unsatisfactory for informing debates on regulatory perimeter and policy. Often, a ‘functional’ approach is suggested in order to understand the nature of financial activities and transactions that are lumped into the shadow banking category. The functional approach focuses on the economic function of the financial activity in question, regardless of the type of institution carrying it out. By looking at the economic function performed by the financial activity in question, one may better be able to ascertain the underlying demand and supply for such function and the risks that such functions give rise to, particularly whether systemic risk is implicated. The approach may also highlight the functional similarities and differences with already-regulated financial activity in order to form views as to the regulatory perimeter for shadow banking activities. The functional approach to shadow banking is therefore a prima facie useful approach to surveying the universe of shadow banking and informing the policy-making process in relation to shadow banking activities and transactions at national and international levels. This chapter however raises queries as to the limitations of the functional approach, and whether such limitations would ultimately hamper the development of regulatory policy. In particular, we question whether the functional approach is too embedded in market-liberal assumptions, and stymies imagination in regulatory design by converging upon ‘like-for-like’ analyses and applications. Further, we query whether the functional approach, though conceptually promising, is subject to the legal arbitrage that it seeks to overcome. Nevertheless, this chapter does not deny the achievements made by adopting the functional approach and suggests how it should be put to optimal use.

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Pauline Westerman

Chapter 2 analyses the threefold structure of the norms that are developed if regulation is outsourced. The characteristic format is discernible in the framework directive: it consists of an aspirational norm, indicating the goal that should be achieved, an implementation norm requiring the norm-addressee to take measures or to draft rules in order to achieve that goal and an accountability norm, demanding regular reports on the progress made. For a large part this threefold structure is reproduced at each level of the outsourcing chain. At each (lower) level of norm-addressees, goals are formulated, albeit in a more concrete form, accompanied by performance indicators which specify the targets to be reached. At each level, implementation and accountability are also concretised and specified. The result is a great number of rules which mainly prescribe the state of affairs that should be reached, and which leave underdetermined how and by whom this result should be obtained. Furthermore, the typical structure of norms invites to a regime of risk liability and effectively reverses the burden of proof.

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Anna P. Donovan

In 2008 Satoshi Nakamoto released a White Paper introducing the cryptocurrency ‘bitcoin’ to the public. Intended to revolutionise the payments process, bitcoin is a peer-to-peer (and therefore distributed) ‘electronic cash system’ that facilitates relatively fast online payments with low transaction costs and ‘without going through a financial institution’. As a currency, it is perhaps not surprising that bitcoin has been met with both scepticism from the public and resistance from traditional financial institutions. In contrast, as a platform, the distributed ledger technology (DLT) that underpins bitcoin (known as the blockchain) is now witnessing mainstream adoption by major financial institutions. This transition comes as banks and other financial institutions are recognising the blockchain’s significant potential to ‘radically transform’ the financial services industry, resulting in what some are calling the ‘fourth industrial revolution’. As a consequence, it is becoming increasingly clear that DLTs have the potential to similarly disrupt the shadow banking sector as they enable innovative business models to be adopted by both banks (acting outside of the traditional regulated realm) and non-bank institutions (to conduct financial services activities).

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Christian Hofmann

For a better understanding of the shadow banking issue in Singapore and its financial landscape in general, we must start with the role of the banks. Banks are the key financial institutions and are placed at the top of the financial sector hierarchy in Singapore. Their prominent role results from two factors. First, banks are the most strictly regulated financial institutions, and Singapore complies with (and selectively surpasses) the latest Basel standards. These strict regulatory requirements for banks result in the benefit that a banking licence replaces the need for other financial licences. For example, s 99(1) of the Securities and Futures Act (SFA) provides that banks licensed under the Banking Act do not need a capital markets services licence. Once licensed as banks, these institutions are permitted to engage in the full range of financial services including the typical activities of deposit-taking, lending and payment services that generally define a bank. Also, banks are permitted to manage their customers’ wealth, offer typical investment activities and insurance brokerage.

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Edmond J. Curtin and Joseph Tanega

In this chapter, we consider the substance of the legal relationship between a dealer and its client when transacting in derivatives, taking into account both the contractual relationship between the parties and the regulatory relationship arising under the Markets in Financial Instruments Directive (MiFID). We refer to these respective relationships as the contractual model and the regulatory model. The contractual model is derived from a privately negotiated legal framework premised on the idea that the parties are allocating risk inter se and doing so as principals and at arm’s length. Under the contractual model, the parties retain the freedom to allocate risk inter se based on a careful circumscription of respective rights, duties, privileges, powers and immunities. The regulatory model is derived from a legal framework premised on the idea that the dealer is providing the client with a service. Under the regulatory model, where a client interest may be implicated by a decision of the dealer, the dealer should take into account that client interest. These respective models and their combination are discussed further below. The chapter is not a critique of the regulatory model as such. Rather, it is a meditation on the substance of the derivatives contract as the quintessential shadow banking instrument. This quintessence is the acceptance of the investment risk associated with one’s bargain. This chapter is in five parts. The first is a circumscription of the phenomenon of derivatives and its place in shadow banking. The second is a description of the MiFID legal framework and the place of derivatives within that legal framework. The third is a description of the contractual model. The fourth is a description of the regulatory model. The fifth is a reconciliation of the regulatory model with the contractual model. ‘a transaction under which the future obligations of one or more of the parties are linked in some specified way to another asset or index, whether involving the delivery of the asset or the payment of an amount calculated by reference to its value or the value of the index. The transaction is therefore treated as having a value which is separate (although derived) from the values of the underlying asset or index. As a result, the parties’ rights and obligations under the transaction can be treated as if they constituted a separate asset and are typically traded accordingly.’2 We suggest that four further ideas may assist one in understanding derivatives. These are as follows.

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Pierre de Gioia Carabellese

Securitizations affect the way a credit institution operates. Alongside structured finance, they allow a bank to free capital and transform risk management. Securitizations allow lenders to refinance a set of loans or assets via their conversion into securities. As the lender organizes a portfolio of its loans in different categories of risk also according to the risk appetite of each investor, the cash flows of the underlying loans represent the returns to the investors. However, structured finance transactions have been identified among the main culprits for the 2008 financial crisis. As such, these transactions may pose a considerable threat to the stability of financial markets. Thus, securitizations, the stereotypical transactions of this kind, have challenged the supervisory authorities, given the dearth of regulation in this area until a decennium ago. Nevertheless, securitization markets are still believed to provide operators with unique opportunities to raise finance through alternative funding and diversified funding sources.