Law and Finance Workshop
June 16-17, 2014
The Federal Reserve Bank of Chicago will host a workshop on Legal Arrangements for Cross-border Resolution and Liquidity in OTC Derivative Markets: Theoretical Insights from “A Legal Theory of Finance” and Other Contemporary Perspectives, in conjunction with the following co-sponsors:
- University of Notre Dame, School of Law, Mendoza College of Business, Department of Economics and College of Arts and Letters
- Columbia Law School, Center on Global Legal Transformation
- Oxford University, Faculty of Law
- Wharton Financial Institutions Center
The workshop is intended to bring together academics, legal practitioners, industry professionals and policymakers to discuss issues of common interest. In particular, the workshop is designed to facilitate multidisciplinary interaction among workshop participants relating to: 1.) cross-border resolution of systemically important financial institutions (SIFIs) and financial market infrastructures; and 2.) legal aspects of global liquidity challenges in OTC derivative market infrastructures and other nonbank financial infrastructures.
The initial session is designed to provide a foundation for a discussion of contemporary theories of law and finance. In the first session, we will introduce Professor Katharina Pistor’s A Legal Theory of Finance (LTF). We propose to employ LTF to examine the importance of legal arrangements in the over-the-counter derivative (OTCD) markets, particularly with regard to issues of resolution and liquidity.
LTF asserts that the contemporary global financial system is legally constructed. A detailed analysis of the legal structure of financial instruments, their interplay with rules and regulations in different jurisdictions, and how they are used to allocate the costs of future uncertainty and liquidity volatility are of critical importance for our understanding of global finance and its governance.
This session will demonstrate the explanatory powers of LTF for global OTCD markets by highlighting the legal and institutional links between monetary systems and finance, the contribution of national regulatory frameworks to the rise of these markets, and the role of national backstops in the crisis.
OTC derivatives are cleared and settled within two distinct institutional environments. While these environments vary in a great many respects, they share the common feature that they are designed to respond to problems stemming from the fact that OTC derivatives contemplate the performance of, often contingent, contractual obligations by the counterparties over time. It is the performance of obligations over time, in turn, which introduces the liquidity and counterparty credit risks at the heart of the contemporary policy debate surrounding the regulation of these markets.
Within bilaterally cleared markets, market participants have historically managed these risks through contractual provisions such as payment and closeout netting, along with the use of credit support agreements. Market participants may also actively monitor the creditworthiness of their counterparties. Within centrally cleared markets, CCPs manage these risks through the use of multilateral netting, the collateralization of residual net exposures, and the mutualization of losses amongst clearing members via default waterfalls and other mechanisms.
In theory, then, the institutions at the heart of both bilaterally and centrally cleared OTCD markets can be understood as effective substitutes for one another. To understand whether and to what extent these institutions are substitutes in practice, however, necessitates closer examination. To date, such an examination has been problematic due to a lack of publicly available data regarding, for example, the amount and quality of collateral being posted within bilateral markets, the re-hypothecation and re-use of collateral, and collateral triggers. Simultaneously, the regulatory regimes governing centrally cleared markets vary from jurisdiction to jurisdiction and, in the wake of the global finance crisis,
have been in a more or less constant state of flux. (For example, important potential differences exist in terms of central bank liquidity provision and resolution. Subsequent sessions will explore these themes.) Compounding matters, even within centrally cleared markets, there is often significant opacity in terms of the detailed risk management practices of CCPs.
The purpose of this session is to drill down into this institutional detail as far as possible, identifying areas of functional similarity and difference, and where further information is required. Such an examination is necessary if we are to understand how market participants view the costs and benefits of these institutional structures, how these views are likely to influence their behavior and, ultimately, how this behavior may contribute to the build-up or amelioration of risk within the financial system.
The global character of OTCD markets increases the complexity of the attendant issues. Systemic risk concerns, liquidity challenges, and resolution planning for OTCD markets are global in scope, but the legal structures and institutions designed to manage these concerns retain a national focus.
For example, CCPs for exchange-traded and OTC derivatives offer clearing services for contracts denominated in foreign currencies. CME’s International Monetary Market (IMM) clears futures and options in 14 currencies. London’s LCH Clearnet also clears OTC interest rate swaps in 14 currencies through its SwapClear service. These multicurrency settlement arrangements require extensive, complex banking (and central banking) relationships and time sensitive, globally seamless liquidity provision. Such structures have become necessary to the efficient management of risk. Yet while financial markets increasingly demand globally seamless liquidity provision, the predominant global liquidity arrangements remain nationally centered.
This session is designed to employ LTF to examine the legal aspects of these global liquidity challenges in OTCD market infrastructures and other non-bank financial infrastructures. It will begin with an introduction to and exploration of the traditional role of central banks such as the Federal Reserve in relation to non-bank financial institutions, such as central counterparty clearinghouses (CCPs), and the markets they serve including, in particular, derivatives markets. The discussion will focus on the differences, if any, in the role of the central bank as provider of liquidity to banks and non- bank financial institutions, such as the “financial market utilities” which have been designated by the U.S. Financial Stability Oversight Council as “systemically important.”
Among other things, we will consider the role of central banks as lenders of “last resort” – a role that has changed in a number of ways in the years since it became enshrined in Bagehot’s Lombard Street. In particular, we will briefly compare central bank policies relating to liquidity provision (e.g., noting recent policy statements by the Bank of England) and highlight the restrictions on Federal Reserve credit to non-bank FMUs that were enacted as part of Dodd- Frank.
Helpful questions to explore the themes of this session include:
• How can the legal arrangements surrounding global liquidity needs in OTCD and related markets be made more explicit?
• How should we think about private versus public liquidity provision in financial crises and the role of the modern central bank? In particular, how should we address questions about the interaction between central banks as the ultimate provider of liquidity, given that they primarily operate as single currency silos (FX swaps excepted) and what does this suggest in terms of the need for robust multicurrency liquidity support for the operations of financial market infrastructure such as CCPs on a global scale?
• How to meet and support the multicurrency liquidity needs of global CCPs and other financial market infrastructures
Closely linked to the challenge of global liquidity provision in a world of nationally-centered legal institutions is the harmonization of global resolution regimes. This session is designed to examine the challenges involved in cross-border resolution of systemically important financial institutions (SIFIs) and financial market infrastructures (FMIs) such as CCPs.
OTCD markets intensify global interconnections among financial market participants and institutions, making the resolution of such institutions especially complex. We will focus on the cross-border operations of both SIFIs and FMIs (CCPs, CSDs and Payment Systems) with particular attention to systemically significant CCPs for OTC derivatives (note that strong similarities exist between the issues of private international law and cross-border resolution relevant to CCPs and those relevant in these domains to other FMIs). To ground our discussion in current policy debate, we will consider materials such as the FDIC and Bank of England’s White Paper on SIFI resolution and white papers on CCP resolution and employ LTF and competing theories to critique them.
The fifth session is designed to be a concluding session to: 1) to summarize and reflect upon our discussions, and 2) to identify and to suggest paths for future research.
Hotel and Area Information
Reservations: Please call the club and mention the Chicago Fed Law and Finance Workshop when making your reservation.
Cut-off Date: 03/20/2014
Private club located two blocks 3ast of the Chicago Fed. The club features a premiere gym including a regulation size basketball court and lap pool, several restaurants and a pub. All sleeping rooms are newey renovated.
Documents that provide additional reference information.