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REGULATORY CAPITALISM AND

ASYMMETRIC INFORMATION

AN ANALYSIS OF THE U.S DERIVATIVES MARKET

Master Thesis International Political Economy By Maurits Boomars (1879731)

University of Groningen

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List of Abbreviations

CBOT Chicago Board of Trade

CCP Central Counterparty Clearing House

CDO Collateralized Debt Obligation

CDS Credit Default Swap

CFMA Commodity Futures Modernization Act of 2000

CFTC Commodity Futures Trading Commission

DOL Department of Labor

EU European Union

FCIC Financial Crisis Inquiry Commission

Fed. Federal Reserve System

FINRA Financial Industry Regulatory Authority

G16 Group of sixteen largest derivatives traders

IPE International Political Economy

IR International Relations

ISDA International Swaps and Derivatives Association

GFC Global Financial Crisis

LCTM Long-Term Capital Management

MNC Multinational Corporation

NASD National Association of Securities Dealers

(I)NGO (International) Non-Governmental Organization

ODSG OTC Derivatives Supervisors Group

OTC ‘Over-the-Counter’

PA Principal-Agent

PPP Public Private Partnership

SDNY Southern District of New York

SEC Securities and Exchange Commission

SRO Self-Regulatory Organization

TNC Transnational Corporation

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Table of Contents

Introduction ... 4

Regulatory capitalism, a theoretical conception ... 10

Asymmetric Information ... 17

Methodology ... 23

Derivatives regulation in the United States ... 25

Derivatives, their use, form and key-players ... 25

Derivatives and the Global Financial Crisis ... 28

Important players ... 29

Regulatory capitalism in the US: The ISDA and asymmetric information ... 31

Legitimacy and Asymmetric Information ... 39

Conclusion ... 48

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Introduction

In International Relations (IR), and International Political Economy (IPE) in particular, a lot of attention has been paid to the ever changing role of transnational actors and their effects on the formal international institutions, the distribution of power and wealth. In 1971, Robert Keohane and Joseph Nye, called for greater attention to the changing role of transnational actors within the discipline of IR (Keohane & Nye, 1971). In the following four decades after Keohane and Nye made their claim, scholars within IR have acknowledged this increasing role of these actors in a multitude of realms, such as in economics, environment studies and human rights (see e.g. Mosley, 2005). Furthermore, the process of globalization introduced a situation often referred to as a system of ‘complex interdependence’. Additionally, technological innovation has further increased the importance of transnational actors – ranging from multinational corporations (MNCs) to banks, institutional investors and non-governmental organizations (NGOs) (Mosley, 2005: 1). The importance of such transnational actors, is aptly exemplified by the growth of the structural power of business, as this form of power directly relates to the role transnational business actors have acquired. Accordingly, this power stems from three sources, being the importance of MNCs in creating welfare and economic growth, the possibility of MNCs to choose between jurisdictions and their marketing power creating a business friendly culture (Porter & Ronit, 2009: 23). This growing importance has led to increased regulation, and in effect increased private and/or self-regulation by transnational actors. As such, during the course of time, private regulation, whether national or transnational, has become one of the central elements in the regulatory architecture of the financial sector.

Consequently, before the 2007 financial crisis, financial governance reforms placed private, transnational, authority increasingly at the center of the governance of the global financial system. The question who governs finance has in effect become an increasingly difficult question to answer and occupies a significant number of academic studies. No longer can a clear division of roles between the ‘regulator’ on the one hand and the ‘regulatee’ on the other hand be distinguished (Pagliari, 2012: 44). As such, contrary to the belief that public authority has always had, and still maintains, the responsibility to oversee and regulate private authority, the balance between ‘regulator’ and ‘regulatee’ is not fixed but susceptible to changes across countries, history and sectors.

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future.1 As such, contrary to this popular belief, the derivatives market appears to be far from

deregulated, but subject to intensive governance and subsequent regulation by transnational private authority rather than the traditional governmental institutions. Essentially, this should not directly be a problem. But, whereas, Underhill and Zhang (2009; 117) note, financial governance always involved close cooperation between private and public institutions, the recent trend in global economic integration has eroded regulatory capacities of national governments, inherently strengthening the need for enhanced business involvement in financial governance. As such, private actors in the financial sector were increasingly able to align the public interests with their own interest (Underhill & Zhang, 2009: 119).

This prevailing regulatory situation appears to be closely related to what Levi-Faur named ‘Regulatory Capitalism’. Accordingly, he defines regulatory capitalism as a hybrid that includes both public governance and private governance. Civil regulation (also referred to as private regulation) is an important element in establishing regulation both at the global and the national level (Levi-Faur, 2009: 212). In order to avoid confusion in the remainder of this essay, regulation by government officials will be referred to as public regulation, whereas civil regulation will consist of both private regulation – being regulation introduced by corporate actors – and regulation based on input from society. Hence, this research adopts Levi-Faur’s (2009: 212) definition of civil regulation, who argues that “civil regulation refers to the institutionalization of global and national forms of regulation through the creation of private (non-state) forms of regulation to govern markets and society.” As such, civil regulation is in itself a hybrid consisting of societal input and business input. Furthermore, civil regulation can consist of either voluntary regulation or coercive regulation, which again can be split into either self-regulation and or third-party regulation (Levi-Faur; 215). Additionally, Levi-Faur (2009: 211), along these lines, attributes an important role to the state, arguing that modern states are effectively increasing the use of authority via their rule and standard setting power. Hence, regulation is in effect an expanding branch of governmental conduct rising the expanse of alternatives to regulation, such as (re-)distributive policies. Based on the strength of either public or civil regulation, several different forms of regulatory capitalism can eventually be distinguished, as will be discussed later on in this research.

Hence, Levi-Faur’s conceptualization of regulatory capitalism fits easily within the increasing attention for transnational actors within IR. Furthermore, another recurrent theme in IR, and more specifically within IPE, which is closely related to both Levi-Faur’s regulatory capitalism and transnational actor importance is the principal-agent (PA) problem. Within IR, such PA-approaches have been used in a multitude of domains, ranging from the economic domain – where PA-approaches originates from – to the domain of International Organizations (IOs) and humanitarian intervention (see e.g. Rauchhaus, 2009; Elsig, 201). Principle-agent

1 See for example the Financial Crisis Inquiry Report, drafted by the National Commission on the Causes of

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theory centers on the relationship between a principal which hires an agent to complete a certain task (Rauchhaus, 2009: 873). The dilemma of this situation arises from the discrepancy between the on the one hand the principal’s preferences and on the other hand the agent’s preferences. In other words, the preferences between both parties are not perfectly aligned, creating a situation where an asymmetry of information is present. Effectively, principle-agent theories distinguishes between two types of information problems, being moral hazard and adverse selection. Moral hazard occurs when insured parties knowingly engage in risky behavior which potentially can do harm to themselves, for they have established the fact that they are insured against such harm (Rauchhaus, 2009: 875). Adverse selection potentially wields out optimal outcomes due to differences in information between the parties entering into a contract (Rauchhaus, 2009: 876).

When Levi-Faur’s conception of regulatory capitalism works flawlessly, there would be – at least theoretically – no direct principal-agent problem. That is, when regulation consists of a hybrid including public, private and societal regulation, the relation between a principal and an agent would be absent as the regulation represents the preferences of a wide range of agents. Nevertheless, such a principal-agent problem may arise if the relevant hybrid puts more emphasis on the preferences of a certain agent, in effect creating a discrepancy between other agents’ preferences which are to be taken into account in the regulatory processes. The emergence of such a principal-agent problem might have consequences for the way people perceive the appropriateness of the regulatory mechanisms. Effectively, the occurrence of a principal-agent problem has the potential to undermine the legitimacy of regulations. Again, within both the discipline of International Political Economy (IPE), and International Relations (IR) in general, legitimacy is a frequently used concept. Generally, the legitimacy of regulation is said to be established through several phases, being the input and output phases, possibly complemented by a third phase of accountability (Elsig, 2007). Effectively, in Levi-Faur’s conceptualization regulation on the national and international arena hinges on the input of a dispersed range of actors, the output would most likely be in accordance with generally accepted norms.

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authorities dependent on information provided by private authorities (Underhill & Zhang, 2009: 118). That is not to say that private involvement in regulation is inherently problematic. Historically, as mentioned above, involvement of private authority in regulation has been a common form of governance and has proven that it has the potential to provide the benefits stipulated by Levi-Faur (Underhill & Zhang, 2009; 119). Nevertheless, when the private interest becomes aligned with the public good, participation of the private sector in regulation can become problematic.

Within the derivatives market the most notable private regulator is the International Swaps and Derivatives Association (ISDA). The ISDA, established in 1985, is chiefly aimed at regulating the over-the-counter (OTC) derivatives market in the most efficient manner. As such, the ISDA mainly aims to establish private ex ante legal rules (Partnoy, 2002: 2). It includes over 800 member institutions, originating from 63 countries, and the ISDA has offices in important hubs in the financial sector, such as New York, London and Tokyo, accompanied by offices in important hubs in the regulatory process, such as Brussels and Washington. The ISDA tries to position itself as a source of trustworthy documentation and information, advancing an efficient infrastructure, advocating clearing and effective risk management and representing the derivatives industry through public policy (ISDA, n.d.). According to Biggins and Scott (2012: 322), the lobbying and standard-setting processes of the ISDA are a key defining feature in both the regulatory configuration before and after the crisis. As such, the ISDA has become increasingly effective in penetrating public legislative procedures, which is intensified by the receptivity of public actors to ISDA’s information and lobbying (Biggins & Scott, 2012: 322).

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asymmetry is present, the legitimacy of regulatory capitalism as proposed by Levi-Faur is significantly undermined. As such, underlying this research is the question to what extent

asymmetric information does have an impact on the legitimacy of the regulatory configuration of regulatory capitalism in the U.S. derivatives market.

A multitude of approaches have been proposed by numerous IR scholars in order to assess the legitimacy of regulations. This research will separate legitimacy in input legitimacy, output legitimacy and an accountability phase. Effectively, this separation of phases in legitimacy is especially instructive and important when related to regulatory capitalism. For these elements of legitimacy are also integral components of regulatory capitalism, as will be discussed later. In effect, separating legitimacy in these three phases allows taking into account all strong and weak elements of regulatory capitalism. According to Elsig (2007), input conceptions can be distinguished on whether they have a focus on either processes or structure. Important perspectives focusing on the process are deliberative models – which see an increase of legitimacy associated to an increase in deliberation – and pluralist models – which emphasize competition among interest groups as key to enhancing legitimacy (Elsig, 2007: 81-82). Structural perspectives on the other hand look at the optimal design of representation and the degree of representation, delegation and control (Elsig, 2007: 83). Within this perspective, centralists follow a functionalist approach, for they see legitimacy essentially as a problem-solving logic best attributed to higher levels of government, whereas subsidiarists view legitimacy being increased by empowering lower levels of governance (Elsig, 2007: 83). It is beyond the scope of this paper to assess the legitimacy of private regulation based on all these different perspectives. Hence, this research will adopt a pluralist perspective, as this best captures several elements present in the notion of regulatory capitalism. That is essentially due to the fact that both regulatory capitalism and pluralist conceptions of legitimacy emphasize a complex process of negotiation, conflict and compromise (Elsig, 2007: 82; Levi-Faur, 2009: 206).

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implies that private regulation inherently increases corporate welfare which needs to outweigh the negative welfare consequences of other individuals. That is not to say that inefficient regulatory situations are inherently illegitimate, as it can be offset by high input legitimacy and/or a high level of accountability. Hence, this research assumes a third phase in legitimacy, which is closely related to the output phase, being an accountability phase. Effectively, accountability has the possibility to correct the misuse of power, whether this misuse takes place in the ranks of government officials or is the result of faulty private conduct (Elsig, 2007: 85). Accountability occurs through the people which are situated outside and affected by the acting agent (Elsig, 2007: 85). As a result, the absence of effective accountability can seriously undermine legitimacy of the prevailing regulatory situation.

The importance of investigating this relation between the effects of asymmetric information in regulation and legitimacy originates from several observations. First, transnational private regulation continuous to occupy a central position in contemporary regulatory governance across a wide range of sectors. Despite a degree of skepticism expressed since the global financial crisis, private authority remains to be actively involved in self-regulation and the setting of nationally and/or internationally accepted standards. Subsequently, as mentioned above, as legitimacy is obscured by a lack of transparency and participation during the formation of regulation several key characteristics of democratic decision making are obscured in the process. Finally, this research complements other research conducted on regulation in the financial sector. Most of the research conducted on regulation in the financial sector assesses the economic effects, efficiency and soundness of the regulations. Without going into detail about the effects of asymmetric information on the economic efficiency of such regulations, assessing the legitimacy of these very regulations provides new insights in the desirability of these regulations.

This research will proceed in several sections. These sections will comprise of the necessary steps in order to reach the answer on the main question posed above. As such, these sections will effectively all correspond to certain implicit sub-questions. In the first section, Levi-Faur’s proposed regulatory architecture will be examined, for this examination is necessary to uncover the link to legitimacy and asymmetric information. Levi-Faur (2009) provides an attentive view of the expansion of rule-based governance. Accordingly, governance of the national, transnational and global level occurs to innumerable regimes, which are hardly ever entirely private or public (Levi-Faur, 2009: 205). Civil regulation in this sense reinforces state regulation rather than strictly replacing public regulation and in effect offers an opportunity for effective transnational governance. Nevertheless, in this regulatory approach, Levi-Faur takes no account of a potential information asymmetry between or within public and private interests. As such, this section will serve as the first step in the analysis, uncovering the important elements of regulatory capitalism, how it relates to legitimacy and how it is to be applied to real-world examples.

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private regulation within Levi-Faur’s regulatory architecture. An especially important consequence in such an asymmetry of information is adverse selection, where eventually sub-optimal – seen from the perspective of the general public – regulation will arise due to a lack of transparency and information on the public side. This section will thus proceed the theoretical examination of regulatory capitalism while taking into account an important factor – asymmetric information – originally not included in the framework. As such, the combination of these two elements – asymmetric information and regulatory capitalism – is not only crucial as a second step for answering the question posed above, rather the consequences of this relation also has important implications for the usage of regulatory capitalism as a framework of analysis.

After the theoretical framework has been laid out in the preceding sections, attention will be given to the actual regulatory situation in the derivatives market. After shortly laying down the methodology in the third section, the fourth and fifth section will provide an overview of the derivatives market, with a focus on the derivatives market in the United States. As such, by doing so the latter part of this research will serve as a most-likely case-study (e.g. Odell, 2001) aimed at supporting the theoretical considerations of the preceding sections. Attention will be given to the important position derivatives occupy in the financial sector and the development of the derivatives market. Effectively, in the fourth section, the regulatory architecture of the derivatives market in general and in the United States will be examined in more detail. The focal point will be the influence of private – transnational – authority, especially the ISDA, on the regulation of the sector. Hence, this examination will closely resemble the framework of regulatory capitalism – and in effect also the three steps of legitimacy – in which multiple actors from various backgrounds are important to the regulatory process and outcome. As such, the fifth section will shed light on the extent to which regulatory capitalism and asymmetric information are applicable to the U.S. derivatives sectors.

The final section will serve as a conclusion where the findings in the preceding section and the discussion of these findings will be summarized. Subsequently, the conclusion will return to the importance of this research in relation to International Relations and IPE in general. Eventually, the combination of these sections will shed light on the effects of asymmetric information on the legitimacy of private regulation in the derivatives market. While acknowledging that the conclusions drawn from assessing the influence of the ISDA on regulation in the US derivatives market might not be representable for every derivatives market across the globe, the likelihood of correlations remains high due to the transnational character the ISDA possesses. That is, as the ISDA exerts influence in a multitude of countries, they will likely penetrate regulatory processes in these countries with largely similar effects as in the United States.

Regulatory capitalism, a theoretical conception

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been much debated upon (e.g. Pagliari, 2012; Porter and Ronit, 2009; Mosley, 2005). Increasingly, such governance occurs through innumerable regimes, which are almost never entirely private or entirely public (Levi-Faur, 2009: 205). As such, public and private elements within these regimes are thought to be competing with one another, while simultaneously mutually adjusting and cooperating (Levi-Faur, 2009: 206). Although influence of non-public actors in the regulatory process has been present throughout history on countless occasions, such civil regulation – being voluntary regulation, purely private regulation or non-state industry or cross-industry codes – the influence of non-public actors has become highly visible during the last couple of decades (Vogel, 2010: 68). Regulation, nowadays, draws heavily on the influence of non-public actors and covers a wide array of issue-areas, ranging from the establishment of labor and production standards, human rights policies and environmental performance. Effectively, this means that not only the regulation we witness stems from a hybrid of public and private regulatory bodies, but also the provision of services, production processes and even the environment are shaped by regulatory mechanisms which are not directly attributable to national parliaments, executives or judiciaries, but extent beyond these in both scope as well as territorially (Braithwaite and Drahos, 2000).

Many of these hybrids consists of influential business actors, trade associations or nonprofit advocacy groups, with either material or non-material motives, alongside the relevant public actors. In other words, the distance between regulators and regulatees have diminished as noted by Pagliari (2012). Hence, these private regulatory regimes do not exist in a vacuum (Levi-Faur, 2009: 206). As such, it appears to be wrong to argue that globalization and liberalization implies deregulation on behalf of the state, which is replaced by civil and voluntary regulation. In such a view, the demand for and supply of accountability, and in effect the scope of public control, would be inherently limited and declining (Levi-Faur, 2009: 206). A more optimistic view on the other hand would argue that increased globalization is not inherently causing deregulation, and that the global is not simultaneously falling in the hands of the privileged domain of business. That is, rather than deregulation liberalization entails reregulation, in which corporate actors witness an increase in regulatory influence, which is conversely not inherently decreasing the regulatory capacities of public actors. Effectively, this means that civil regulation co-expands traditional state regulation, rather than replacing it (Levi-Faur, 2009: 207). As such, this more positive view would see the scope of public control increased, along with a bigger demand and supply for accountability. This interplay between public and private actors is important, as it not only relates to legitimacy, but also to potential principal-agent problems and asymmetric information.

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regulatory capitalism denotes the fact that a privileged position of private actors is not a reason to adopt a pessimistic view. Rather, there should be recognition of the fact that the establishment of such hybrids of regulation increase the difficulty of forming unified regulatory solutions, given the highly fragmented policy arenas (Levi-Faur, 2009: 208). This in fact results in the fact that panoptic forms of transparency are needed, alongside more punitive forms of accountability, in order to assure that no misuse is made of an actor’s position in the regulatory process. In other words, if regulatory capitalism is working flawlessly, the accountability phase of legitimacy is inherently satisfied – given the presence of punitive forms of accountability.

The way modern capitalism is changing in effect forms a major factor underlying the formation of these hybrids of regulation – i.e. regulatory capitalism. According to Levi-Faur (2009: 209), this contributes to the creation of a new global order, where there is a proliferation of various mechanisms of control – being regulation – at either the national or global level. As a result, Levi-Faur defines regulatory capitalisms as

“a political, economic, and social order where it is regulation, rather than the direct provision of public and private services, that is the expanding part of government, and where legal forms of domination are increasingly organized around functional roles and problem solving rather than national demarcation lines. The distribution of power and the corresponding form of interest intermediation in each issue arena and functional arena are shaped by the particular interaction of civil and state forms of regulation” (Levi-Faur,

2009: 210).

As such, it resembles more traditional forms of regulatory mechanisms, as regulation formed within an order of regulatory capitalism naturally has the potential to generate as well positive as negative results. The fact that regulatory capitalism entails a political, economic and social order directly relates to the composition of regulatory capitalism. As such, it is required to examine this composition and the individual parts in more detail, in order to get a clear grip on the totality of the framework. Subsequently, an examination of these constituent parts creates a direct relation to both legitimacy and potential principal-agent problems or instances of asymmetric information to be discussed thereafter.

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As such, regulatory capitalism both complements and challenges the concept of the regulatory state as envisioned by Moran (2002: 391). It complements the regulatory state as regulatory capitalism argues that the provisions of regulation is an expanding part of public authorities (Levi-Faur, 2009: 211). Accordingly, modern states are increasingly emphasizing rules and standard-setting practices, while using their authority within these fields. This rise in regulatory activities within the scope of government is aptly characterized by the increase in the creation of law-backed specialized agencies, rather than through direct public-ownership (Moran, 2002: 392). Moran (2002: 392) points to the United States as virtually inventing the regulatory state, arguing that the US has been incredibly effective in establishing such regulatory agencies, becoming a pioneer in this respect. Accordingly, the creation of these agencies was largely spurred by two events, being the Progressive Movement – the period of social activism between the 1890s and 1920s – and Roosevelt’s New Deal in the 1930s (Moran, 2002: 392). Globally, a survey (see Jordana, Levi-Faur and Fernandez i Martin, 2008) examining 63 countries found that the rate of establishment of new regulatory agencies increased drastically, to more than an average of twenty agencies annually in the period between 1990 and 2002. Simultaneously, with the rise of the regulatory state, the alternatives to regulation – i.e. distributive and redistributive strategies – are stagnating or even declining (Levi-Faur, 2009: 211). This is captured most adequately by Giandemonico Majone’s work on regulation within the European Union (EU) (see Majone, 1996; 1999) who argues that the state has three major functions – redistribution, stabilization and regulation. The rise of the regulatory state effectively causes the latter function to rise at the expense of the other functions. As such, regulatory capitalism at least partially shies away from Susan Strange’s (1996) influential work on the retreat of the state. Essentially, it implies that the regulatory state changes the fate of the state, rather than decreasing the overall importance of the state.

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regulation through the creation of private (non-state)2 forms of regulation to govern markets

and societies” (Levi-Faur, 2009: 212).

Effectively, the number of non-public groups who advocate civil regulation belonging to the regulatory society is considerable. Traditionally one might think of non-governmental organization (NGOs) – either national or international non-governmental organizations (INGOs) – and other informal or formal networks of professional actors (Levi-Faur, 2009: 213). Nevertheless, increasingly other groups have also started to exert influence in civil regulation, such as national or transnational corporations, industry associations, lobby groups and even terrorist groups and criminals (Levi-Faur, 2009: 213). Each of these civil organizations has increasingly gained a degree of significance in the regulatory process – e.g. occurring deliberately through instances of lobbying or unintentionally through criminal networks – and have a significant degree of autonomy in this very process (Levi-Faur, 2009: 213). Despite the fact that the boundaries between the regulatory state and the regulatory society can become blurred, there is a notable difference in output of both. That is, whereas state regulation most of the time takes the form of hard law, civil regulation operates around such hard law and is best qualified as soft law where violators are not facing legal penalties but rather market or other civil penalties (Vogel, 2006: 2-3). Such penalties can take a number of forms, ranging from direct influence on the economic outcomes of the violator, but also affecting the reputation of the violator. This means that within the regulatory society, a wide range of actors have the possibility of influencing regulation and have several distinct possibilities of backing these regulations.

At this point, it is worth noting that the sole co-existence of both regulatory society and state is not sufficient for an order of regulatory capitalism to be present. That is, mutual acceptance vis-à-vis one another is a necessary condition for such an order to be present. That is, the absence of some form of approval or interaction inherently opposes the creation of an order simultaneously incorporating the political, economic and social realm (Levi-Faur, 2009). Or as Levi-Faur argues:

“the consolidation of the regulatory state and regulatory society, and the more general

expansion in the number of rules, order, bylaws, administrative guidelines, statutory instruments, and the like, are the preconditions for the emergence of regulatory capitalism. This order is defined, sustained and legitimized by the expansion in the number and scope of rules, rule making, rule monitoring, and rule enforcement. The dynamics and content of such rule activity is shaped by the interaction of varying degrees of civil and state regulation.” (Levi-Faur, 2009: 217).

Essentially, regulatory capitalism can take a strong or weak form. Coupled with the varying degrees of both civil and state regulation, four different varieties of regulatory capitalism can be distinguished. In other words, these varieties are distinguished by their composition of

2 Recall the difference in terminology mentioned in the introduction. Hence, Levi-Faur’s conception of private

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respectively weak or strong civil or state regulation. These four varieties will inherently and directly have a different impact on legitimacy, given the differences in input within these varieties. As such, after introducing these four varieties below, this direct link to legitimacy will be elaborated upon.

The first situation, laissez-faire regulatory capitalism, signifies a situation in which there is only a limited amount of official regulation. In such an order, both civil and state regulation are inherently weak, and form only rudimentary elements of this order (Levi-Faur, 2009: 218). As such, this form of regulatory capitalism is closely related to the neo-liberal paradigm, where sanctions and the like directly relate to workings of the market rather than to separate state or civil forms of regulation. As such, laissez-faire regulatory capitalism embodies the contraction of all forms of political mechanisms of control, leaving a void which is filled by market mechanisms of control (Levi-Faur, 2009: 218). In general, this order is characterized by an importance of principles, instead of rules, within governance dynamics (Levi-Faur, 2009: 218).

The second form of regulatory capitalism is étatist regulatory capitalism. Such an étatist form denotes an order where there is weak civil regulation accompanied by strong state regulation (Levi-Faur, 2009: 217). Whereas laissez-faire regulatory capitalism is representative of the neo-liberal paradigm, étatist system clearly represents the traditional Westphalian order in the regulatory arena and affiliated governance instances (Levi-Faur, 2009: 217). The fact that public authorities are the main initiators of regulation does not necessarily oppose supranational or intergovernmental forms of rule-making, as long as public authorities remain at the heart of the policy process. Furthermore, within étatist forms of regulatory capitalism, prescriptive rules are the most common form of regulations, for these have the potential to be highly capable of specifying obligatory actions and standards (Levi-Faur, 2009: 217). These prescriptive regulations are thought to be easily backed by sanctioning mechanisms, alongside clear demarcations of responsibility and accountability, all in order to ensure the endurance of the order.

The opposite of an étatist order is a system of pluralist regulatory capitalism. Such an order stands for strong civil regulation alongside weak forms of state regulation. Pluralist orders are characterized by an absence of clear public regulation and sanctioning and a situation where it is group competition and contestation that establishes regulation (Levi-Faur, 2009: 218). The absence of public authority in the regulatory process creates a potential for a dependence on short-termism, given the absence of public authorities guarding the long-term interest. That means that an order of pluralist regulatory capitalism is subject to frequent changes in the regulatory regime, high potential of regime demise and adversarialism (Levi-Faur, 2009: 218). Additionally, the absence of regulation and sanctioning on behalf of public authority means that regulation will likely be process-based or performance based, as these will avoid high monitoring and enforcement costs (Levi-Faur, 2009: 218).

Finally, a situation in which both civil and state regulation are strong denotes an order of

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of state and civil regulators which do not directly threaten each other’s autonomy (Levi-Faur, 2009: 219). Regulatory corporatism can give rise to a multitude of possible forms of regulation (Levi-Faur, 2009). Co-regulation, for example, denotes a situation in which the responsibility for designing and enforcing the regulation is shared between society and the state. Another possibility is enforced self-regulation, where civic groups interact with state authorities in establishing and maintaining self-regulating principles. Closely related to instances of enforced self-regulation is meta-regulation, denoting a situation in which the regulatee can choose its own form of regulation, without any influence of public authorities (Levi-Faur, 2009: 219). In such a situation, the role of public authorities is confined to establishing certain institutions supporting such meta-regulation. Effectively, meta-regulation is increasingly becoming seen as any form of regulation which directly regulates some other regulatory solutions (Levi-Faur, 2009: 219; Parker, 2002). As such, it includes as well non-legal methods of regulation as legal regulations concerning self-regulation, whether these are national or transnational. A fourth form of regulatory corporatism denotes an order where regulatory authority is allocated to multiple levels, such as the national, regional or supranational level (Levi-Faur, 2009: 220). Regulation in this order can be allocated to the regulation on multiple bases, such as functionality, hierarchy or other alternatives.

In Levi-Faur’s (2009) account of regulatory capitalism, there is no direct mention of legitimacy in these four different orders. Nevertheless, based on the parameters of input legitimacy, a clear and important distinction can be observed in these four varieties. As pluralist conceptions of legitimacy emphasize processes of competition, negotiation and cooperation, regulatory corporatism appears be the most legitimate order concerning input, whereas an order of laissez-faire regulatory capitalism is relatively illegitimate input-wise due to the absence of such processes. Subsequently, a pluralist order of regulatory capitalism appears to be more legitimate input-wise than an étatist order, given the fact that regulation stems from multiple societal actors. In other words, an order of regulatory corporatism is most legitimate input-wise, respectively followed by pluralist regulatory capitalism, étatist regulatory capitalism and laissez-faire regulatory capitalism. Note that this does not mean that these latter forms get more illegitimate in total, as the regulation in these systems, or even the absence of such regulation, can be highly legitimate output- and accountability wise.

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civil regulation. Effectively, this means that, even though such an étatist order has more regulation in place than a laissez-faire order, accountability might be more obstructed in such an order.

Having set out the basics of regulatory capitalism, it appears that the legitimacy of the regulatory order is dependent on the context-specific circumstances of the given order, as for example the presence of institutionalized mechanisms of accountability and transparency. This entails that in order to assess this legitimacy first several steps should be undertaken to examine the exact composition of the regulatory order. That is, for both the regulatory state and the regulatory society, it should be made clear what the exact role of actors within the regulatory situation, how they relate to one another, and how they compete, cooperate and interact in the regulatory process. But before going into detail in how the theory of regulatory capitalism applies to the derivatives market, and the legitimacy thereof, the next section will first go into the problems of asymmetric information and the consequences of such information asymmetries.

Asymmetric Information

The presence of a wide variety of agents in the regulatory process of regulatory capitalism implies that information is valuable for each of these agents. That is, when each agent has the same information available, regulatory outcomes would only differ due to discrepancy in interests rather than the (in)ability to assess the best possible regulatory outcome. Furthermore, the absence of the necessary information to assess the required regulatory outcomes could easily induce ineffective or even unnecessary regulation for all or some parties involved. That is not to say that information is the sole decisive factor in the regulatory process, as the agent’s power is also important, irrespective whether this power stems from legitimacy, judicial elements, structural factors or other forms of power-enhancing elements at the disposal of regulatory agents.

Effectively, regulatory capitalism deals with the importance of information in a contradictory way. That is, regulatory capitalism assumes that hybrids of regulation occur as regulation is best processed through a wide variety of agents who are best suited for the situation at hand. As such, this implies that these relevant agents will have better information to assess the situation and hence create the required regulation. Nevertheless, while this basic underlying assumption assumes that regulatory capitalism values the importance of information, there is no direct mention of the importance of information regulatory agents possess and the effects of incomplete information – or the misuse of information – in Levi-Faur’s (2009) account on regulatory capitalism.

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informational problems and economics are an integral part of every economic theory, while simultaneously being most aligned with contract theory and principal-agent models (Schwalbe, 1999: 2). Nevertheless, how information is characterized in these theories, can vary in two considerable ways. An exemplification of both theories will indicate the underlying characteristics of an asymmetry in information. As such, even though an extensive discussion between both studies will be beyond the scope of this paper, a short reflection on both theories is indicative of asymmetric information.

First, some scholars, of which Beth Allen (1986, 1990) is the most notable, treat information as a commodity. Accordingly, information is an initial endowment which is attributable to an agent in the same way an agent has an initial set of physical commodities (Schwalbe, 1999: 4). An agent is interested in information only as better informational endowments allows him to choose a better consumption plan. This implies that an agent has a satisfied demand for a certain set of information, for an agent’s consumption plan, and in effect his course of action, can and does not change due to two or more pieces of equivalent information (Schwalbe, 1999: 5). Treating information as an initial indivisible endowment to a certain agent raises a number of significant question. How is an agent able to sell a certain information commodity and how does this affect the information of the seller? Does the agent who sells his information maintain a copy of his sold information? It appears to be that personal information is only possible when there is some kind of mechanism which assures that the seller loses the information when sold (Schwalbe, 1999: 5). Furthermore, in such a transaction of information, the buyer is by no means sure that the information he obtains is the correct information, as he is inherently unable to check the correctness of this information (Schwalbe, 1999: 6). Finally, the idea that information is a tradable commodity also suffers from some weaknesses. That is, you can never know in advance what exactly compromises the information and what you will be learning (Hirshleifer & Riley, 1992: 168). Effectively, Hirshleifer & Riley (1992, 168) argue that an agent can never purchase a certain set of information, but only an information service, being a set of potential alternative information.

Opposite to the approach of Allen, is Radner’s (1968) approach which denotes information as a characteristic of an agent, rather than a commodity. Accordingly, different actors can have different information sets, aimed at qualifying a certain situation (Schwalbe, 1999: 7). When an agent is incompletely informed about the given situation, in Radner’s (1968) model a state of nature, he can only act according to that course of action prescribed by his information (Schwalbe, 1999: 7). Subsequently, an agent cannot act in a certain way as a reaction to an event without having information on their occurrence (Schwalbe, 1999: 7). This implies that all agents have the same information at their disposal, as information is not a personally tied commodity. In other words, information in these approaches refers to the fact that

“each agent has access only to a vague measuring instrument which he uses to observe the

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state of nature. Therefore, his information about the states of nature will be imperfect.”

(Schwalbe, 1999: 14)

The rest of this research will adopt information as a characteristic of an agent, as this is most instructive to regulatory capitalism. That is, the required information in financial regulation is a public good, being non-rival and non-excludable, as all regulatory agents have the theoretical possibility to obtain the relevant information without diminishing the availability of this information to others.

Following from both definitions derives the fact that the information an agent possesses has direct impact on his decisions, as being incompletely informed restricts an agent’s possibility to choose between different courses of action (Schwalbe, 1999: 18). Possible courses of action have to be identifiable and measurable by an agent and his information set (Schwalbe, 1999: 18). This implies that in a situation where an agent’s course of action is also dependent on the information of another agent, or directly related to another agent’s data, an asymmetry of information might occur. Whether this information set is a commodity possessed by an agent or a characteristic of this agent does not change this situation, as long as the essence of a difference in information between actors remains. The implications of such an asymmetry of information can result in second-best situations, as the first-best solution appears to infeasible (Schwalbe, 1999: 24; Milgrom & Roberts, 1992: 141). This process is often attributed to a situation of adverse selection or moral hazard, which in effect affect the legitimacy of any output given it to be second-best.

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an insurance against theft or damage of these is a regularly used example (Rauchhaus, 2009: 874).

Another effect of asymmetric information is adverse selection. An adverse selection problem is aptly described by the influential work of Akerlof (1970) in his explanation of the market for used cars. In his account, Akerlof (1970: 489) argues that there are four types of cars, good and bad – which he refers to as ‘lemons’ – new cars and good and bad used cars. The buyer will only know the probability of the car being a lemon, as the buyer will know the total proportion of good cars produced (q) and in effect the proportion of lemons produced

(1-q) (Akerlof, 1970: 489). Following from this, Akerlof (1970: 489) notes that the price of a

second-hand car, whether this is a good car or a lemon, should be the same, given the fact that a buyer of a second hand car has, upfront, no information on whether the car he will be buying is actually a good car. It is obvious that such a situation is unsustainable, as it would be possible to trade a lemon for another car with the probability of q for being a good car (Akerlof, 1970: 489). This means that, as the seller knows his car is worth more than the prevailing price of second-hand cars, his car will be pushed out of the market by lower priced cars. That is because buyers would assume that the car they will be buying is potentially a lemon, inclining them to only buy cars for a low price. As a seller cannot get the appropriate price for his car, he would be inclined to sell his car only when it has become a lemon after a certain period of time. The same analogy can be applied to, for example, health insurances (see Akerlof, 1970). Those persons taking high risks, are assumed to end up in the hospital on a more regular basis than non-risk taking actors. This means that the high risk group will be more likely to purchase high amounts of insurance, while simultaneously also actually needing this insurance. In effect, this gives insurers an incentive to increase the price of insurances – either for the sake of increasing profits or for the need to balance higher costs – which reduces the amount of insurance bought by a low-risk group. For this low-risk group has only limited use of their insurance given the higher fee.

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Recall that regulatory capitalism, as expressed by Levi-Faur (2009), requires some form of interaction between public and civic actors – irrespective whether these are strong or weak forms of input. Moral hazard can in this respect penetrate the regulatory mechanisms. Suppose a situation in which there are only two important actors interacting, contesting and cooperating with one another, being a purely public and a purely civil regulator. Despite the fact that in such a situation there is no direct division between a buyer and seller of certain services such as insurances, there is a situation in which both actors enter in a contract with one another – be it explicitly or implicitly by accepting the prevailing regulatory solutions. This could theoretically lead to a situation in which one actor is in a position in which it is advantageous to deceive the counter-party. This would mean that either the civil or the public regulator would enter into a certain contract – i.e. it would accept and stimulate the proposed regulation by the counter party or initiated by itself – while simultaneously having more information about how this regulation protects their disadvantageous3 behavior vis-à-vis the other party. As such, this would entail that it is advantageous for a contracting party to undertake faulty behavior given his knowledge that the regulation in place protects it from retaliation. Note that his also entails that the monitoring party has not enough information to uncover the faulty behavior of the opposing party, nor the information to assess the negative impact of the regulation during the regulatory process.

In addition to the application of moral hazard to regulatory capitalism, adverse selection also has an important implication for a hybrid of regulation. Adverse selection – as envisaged by Akerlof (1970) – within the regulatory process would imply that the eventual regulation would not be the optimal outcome resulting from intensive cooperation, consultation and contestation between a wide range of actors. Rather regulation would be the result from a lopsided input within this range of actors. Suppose again that the situation at hand would be characterized by only two agents, one civil and one public. Suppose that in this situation, the civil actor has more and better information on the effects of different regulatory outcomes and could in effect determine which of this regulation is most suitable to their preferences – without this necessarily meaning that this regulation is also suitable for the public actor. Given the fact that the public actor does not have the information to assess the outcome, he has to rely on the civil actor for information, or has only the information to partly assess the implications, he has no possibility to determine whether the by the civil actor proposed regulation is any good. This would imply that the optimal regulation – seen from an overall perspective – has only little chance to arise, given the absence of effective monitoring mechanisms solving the asymmetry of information. Note that such adverse selection can also be present within the regulatory state or the regulatory society, meaning that, for example, private and societal inputs are unable to create optimal regulatory inputs given an asymmetry in information between them.

3 Note that the label ‘disadvantageous’ is attached to the behavior from the point of view of the damaged

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As both adverse selection and moral hazard have implications for regulatory capitalism, it inherently also affects legitimacy, given the close resemblance of the elements within both. Effectively, these negatives effects of asymmetric information can have implications for the legitimacy of the regulatory process, mechanisms and outcomes within a given society. As has been mentioned above, an order of regulatory capitalism is likely to be the most legitimate as input in the regulatory process stems from numerous actors. This best resembles Elsig’s (2007: 82) account of pluralist forms of input legitimacy, viewing negotiation, conflict and compromise to be central to such input legitimacy. Effectively, asymmetric information upsets this regulatory process, as the input of certain actors will have only a limited effect. Despite the fact that it is a natural phenomenon that certain actors will have less influence than others (Elsig, 2007) asymmetric information can aggravate this situation, limiting the input according to a pluralist conception. Hence, asymmetric information is not the only factor potentially limiting input legitimacy, rather it is a factor among other determining variables.

Next to the crucial fact that asymmetric information affects the legitimacy of the input of regulatory capitalism, it can also undermine output legitimacy. As well as in instances where there is adverse selection present, as where regulation is subjected to occurrences of moral hazard, the prevailing regulation – or the absence of such regulation4 – can impede the optimal outcomes. When assessed in a simple cost-benefit analysis, in the two-player illustrations mentioned above, the gains of the agent exploiting his advantage of better information will need to outweigh the negative consequences for the other player. In a situation where there is a multitude of act actors which are affected by the regulation – either positively or negatively – for an increase in desirability of regulation to be present, the gains of a certain group will need to be larger than the negative consequences of the disadvantaged. In other words, if the asymmetry in information were to cease to exist and new regulation would replace the faulty old regulation, there is a probability that the gains will be redistributed in a more favorable way. That is not to say that the outcome is the worst possible outcome or that with an absence of asymmetric information output is inherently legitimate (e.g. Elsig, 2007). Nevertheless, it seems accurate to assert that both adverse selection and moral hazard have some sort of implications for output legitimacy, as output is inherently flawed under asymmetric information.

Finally, an asymmetry in information can easily impede accountability as a source of legitimacy. That is, given the inability of certain actors to assess the soundness and appropriateness of regulation – due to a lack of information – there is innately less possibility for holding the regulators accountable. In other words, as long as there is no information that the prevailing regulatory situation is unacceptable, there is no reason for stakeholders to hold

4 Effectively, there is no difference in the creation of regulation which is aligned to the interests of a certain

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the regulators accountable – despite the possible presence of institutions supporting such accountability. This implies that, overall, asymmetric information can have a negative impact on the legitimacy of regulatory capitalism. Essentially, following from the above, regulatory capitalism, legitimacy and asymmetric information form a closely related group of elements, where changes within a certain element directly affect the other elements. Whether this also holds on a practical level will be seen in the following sections, where the theory of regulatory capitalism and its relation to asymmetric information will be projected on the derivatives sectors in the United States.

Methodology

Applying regulatory capitalism, as a framework of analysis, to a specific industry is in effect rather straightforward. That is, it requires that the different components having set out by Levi-Faur (2009) have to be present. Regarding the regulatory state, it has to be discovered whether in fact regulation is the expanding part of government, or in fact is present to such an extent, that it is safe to classify the state as a strong or weak regulatory state.5 This will be done by assessing the amount of public involvement in the regulatory process. Public involvement covers a wide range of possible actors. The most important actors that will be taken into account are regulatory agencies such as the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). Additionally, public courts also fall under the heading of public regulators as initiators of ex post regulation. This requires an analysis of the outcomes of the most important court litigations. The civil side of regulatory capitalism will take into account the input of a multitude of actors. Nevertheless, the focus will be on the ISDA, as this allows the assessment to be linked to a potential of asymmetric information. Subsequently, given the technically difficult nature of derivatives, societal regulation will most likely be limited given a lack of information and interest in the derivatives market.

Testing asymmetric information and the subsequent problems of adverse selection and moral hazard often occurs through complex economic models, such as presented in Schwalbe’s book (1999) or as in Stiglitz’ (1977) analysis of adverse selection. Doing so would be beyond the scope of this paper. As such, this research will focus on examining and proving the presence of conditions conducive to a presence of asymmetric information. In other words, given the presence of the five conditions discussed below, asymmetric information will likely be present.

The first of these instances is a situation in which the interests of private actors become aligned with the interests of public authority and civil society (e.g. Underhill & Zhang, 2009). This alignment of interests is notable in respect of asymmetric information as it implies accepting a certain information set at the expense of a different information set. Effectively,

5 Note that the state is only assumed a regulatory state in relation to the specific industry at hand. Hence, this

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given this alignment, public authorities are dependent on the provision of private information and expertise when determining their interests (Underhill & Zhang, 2009: 118).

Secondly, asymmetric information can plausibly be present when by the industry agreed upon standards – whether this is through tacit or explicit approval – are not universally accessible to actors outside or within this industry. As such, the information employed in and by these standards are restricted to a confined group of actors. Effectively, this opposes the concept of information as a characteristic of an agent where the particular information is at the disposal of all relevant agents.

Furthermore, situations in which public ex ante and ex post regulation is created through legislation and judicial decisions which are based on guidelines and/or information of private actors also likely indicates asymmetric information. For the public authority is directly dependent on the information of a private agent, without developing the necessary information itself. This also includes lobbying, as such a process of interaction between private and public actors will upset the informational imbalance – or balance – as private agents potentially alter the information characteristics of the public agent in their favor. Whereas this condition closely relates to the first condition, the actual result of it is presumably different. Whereas the first condition refers to intangible interests, this third condition directly results in tangible outcomes.

Subsequently, Patel et al. (2002) demonstrate that transparency and disclosure both are an indispensable element of corporate governance. As such, better disclosure and related higher transparency significantly reduce asymmetric information (Patel et al., 2002: 326). Hence, as a fourth condition, this research will assume that in circumstances where transparency is hindered by some form of secrecy – effectively also increasing the inefficiency of monitoring – asymmetric information will likely be present. Again, this can also be linked to lobbying, as a the contents of lobbying are generally undisclosed by the parties involved.

Finally, and relatedly, a lack of accountability can also be inductive to asymmetric information, as those actors to be holding others accountable do not possess the correct information to do so. Whereas accountability – or a lack thereof – is often associated with output, it can also point at a potential asymmetry in information. That is, a lack of accountability either stems from approval of agents external to the legislative process, or from the inability to judge the actual effects of the regulation. In other words, in this latter situation the general public and other regulatory agents mistakenly perceive lemons to be good cars, removing the direct need for accountability. Only after a certain period of time will these agents have acquired the information necessary to assess the favorability of the outcome.

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of these instances plausibly show that asymmetric information is in fact occurring, the likelihood that this is attributable to coincidence is considerably reduced.

Derivatives regulation in the United States

Having set out the theoretical confinements in the previous sections, this section and the following will apply these theoretical considerations to a real-world perspective. It tries to do so by applying them to the derivatives industry, as part of the financial sector, in the United States. In doing so, this section will turn to derivatives themselves, their form and use, history and important players within the derivatives sector. As such, first the basics of derivatives trading will be examined, respectively followed by an analysis of the role of derivatives to the global financial crisis and the most important players in derivatives trading. Effectively, the following three sub-sections will demonstrate the complexity, importance and characteristics of the derivatives market. In effect, it also shows the utility of using regulatory capitalism as a framework of analysis, given this high complexity, importance and multiplicity of interests.

Derivatives, their use, form and key-players

Derivatives are a complicated financial instrument. The payoffs of derivatives are dependent on the price fluctuations of a multitude of other underlying financial products, instruments or indexes (Biggins & Scott, 2012: 312). In other words, derivatives derive their value from some underlying asset (Flanagan, 2001: 214). Such underlying products can take a variety of forms, such as commodities, securities, interest rates and currencies. This means that derivatives can best be described as fortuitous contracts which are dependent on a single event, or a multitude of events, or a form of metrics (Lynch, 2011: 14). These contracts reallocate risks, meaning that they isolate certain risks and move them from a single agent to another (Awrey, 2010: 160; Feder, 2002: 682). That is, as a contract reflects the value of an underlying reference – or the change in value of this underlying asset – the agents involved can shift the exposure-risk to these very assets which are specifically chosen to untangle risk (Feder, 2002: 682). Hence, derivatives provide end-users a possibility to manage the risk encountered in their business activities (Feder, 2002: 682). Additionally, derivatives trading may be pursued due to regulatory arbitrage – i.e. transactions which are made to exploit the difference between certain regulatory regimes – or for enhanced leverage – meaning that derivatives are used for increasing profits while simultaneously not being tied to harsh capital requirements (Awrey, 2010: 160).

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metals (Awrey, 2010: 158). Early derivatives markets were, for example, the Liverpool Cotton Exchange and the Chicago Board of Trade (CBOT) which were relatively sophisticated and achieved a high degree of formal regulation and organization (Awrey, 2010: 158). Nevertheless, these markets had a largely unchanged structure and nature extending well into the 20th century (Awrey, 2010: 158). Hence, the array of possible ways in which derivatives were to be structured, in combination with the amount of deployment, has evolved over time and especially since the 1980s, making them indispensable to modern forms of capitalism (Biggins & Scott, 2012: 312).

The rise of modern derivatives markets were, as argued by Awrey (2010: 158), for a large part encouraged by breakthroughs in financial theory, rapid technological innovations, bank deregulation, the collapse of the prevailing Bretton Woods exchange rate system, monetary policies and forces of globalization. Accordingly, modern derivatives vary from their traditional counterparts in four ways (Awrey, 2010: 159). First, whereas traditional derivatives were largely relating to physical endowments, present-day derivatives are mainly based on certain intangible assets, such as interest rates, equity, currencies or debt. Subsequently, modern derivatives have become almost incomprehensible relative to their predecessors, since the potential uses of these derivatives appear to be theoretically limitless (Awrey, 2010: 159). Third, whereas traditional derivatives often required a physical location for the transaction purposes, modern derivatives markets are – due to high technological innovation and globalization – effectively without both jurisdictional and physical boundaries (Awrey, 2010: 159). Finally, whereas traditional derivatives often involved a long time-span – e.g. given the long-term developments of harvests – and had little influence in financial markets as such, modern derivatives have become an indispensable and influential force of these financial markets (Awrey, 2010: 159).

Derivative contracts can take a variety of forms and can also have a variety of positive and negative effects. According to Biggins and Scott (2012: 312), the most used derivatives products are swaps, forwards and options6. That is, other more complicated forms of derivatives, such as synthetic derivatives, are based upon such swaps, forwards or options – or upon a combination of these. Furthermore, a derivative position ensures that a market participant is able to trade on leverage – also known as gearing. In other words, a certain derivative position can ensure that the trader gains or loses an amount of money, which is in excess of the leverage and the margin in the contract aimed at securing the contract (Biggins & Scott, 2012: 313). Given the profitability of derivatives contracts, whether it is between hedgers,

6 Biggins and Scott (2012: 312) define an option as a right – not an obligation – to buy or sell certain

underlying reference, such as currencies, commodities or securities; a forward contract entails both the right and the obligation to buy or sell a predetermined quantity of an underlying reference; and finally a swap as involving a number of payment exchanges, with the end result ultimately depending on the underlying reference (Biggins & Scott, 2012: 312). For an extensive overview of the exact workings of forwards, swaps, options and futures, see Flanagan (2001), The Rise of a Trade Association: Group Interactions Within the International Swaps and

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hedgers and speculators or solely between speculators, such contracts are considered adept of producing positive effects for firms and, in effect, social welfare (Bartram et al., 2011: 967). Note that with certain actors willing to incur large amounts of speculative risk, or when risk is not efficiently allocated, these welfare benefits can easily diminish (Biggins & Scott, 2012: 313-314). Hence, the form the derivative contract takes has significant effect on the eventual social welfare impact.

As well as in legal terms, as operationally, derivatives are distinguished between so called ‘exchange-traded’ derivatives and ‘over-the-counter’ (OTC) derivatives. Such exchange-traded derivatives occur through specially created central platforms or venues, referred to as ‘derivatives exchanges’, which are normally self-regulatory organizations (SRO) and easily subject to some form of public regulatory inspection (Biggins & Scott, 2012: 315; Mahoney, 1997: 453). Effectively, within such derivatives exchanges, dealers of derivatives take and place orders directly on behalf of their clients (Awrey, 2010: 159). The derivative instruments which are guided through these derivatives exchanges are more standardized – ‘vanilla’ in derivative jargon – than OTC derivatives, making them relatively more accessible to retail investors (Biggins & Scott, 2012: 315). Effectively, derivatives exchanges channel derivative transactions through what is called a central clearing house, or counterparty (CCP) (Biggins & Scott, 2012: 315). Such a CCP posits itself as an intermediate between every transaction, and is thereby a seller vis-à-vis every purchaser and a purchaser vis-à-vis every seller. This entails that these CCPs have the capacity to streamline all the payment and settlement mechanisms, on top of its ability to take into account the failure of either of its counterparties (Biggins & Scott, 2012: 315). Essentially, this latter function causes the attraction of public authority for such CCPs, as dampening risk – especially systemic risk – in the derivatives market potentially terminates negative externalities beyond the derivatives market (Duffie & Zhu, 2011: 74; Biggins & Scott, 2012: 315).

Whereas public regulators favor exchange-traded derivatives due to these CCPs and their relation to risk, OTC derivatives have a somewhat more complicated reputation. This reputation often frustrates public authorities, given the fact that the OTC market is considerably larger than the exchange-traded derivatives market. Simultaneously, OTC derivatives have emerged as a major factor in the global financial market (Awrey, 2010: 156). Essentially, OTC derivatives are traded bilaterally and off-exchange – hence, without direct involvement of any third parties (Biggins & Scott, 2012: 316). It’s mixed reputation stems from the fact that OTC derivatives trading is all together relatively more risky than simple exchange trading, while simultaneously also being capable of offering highly innovative – and even socially beneficial – risk and investment strategies (Stulz, 2004: 182; Biggins & Scott, 2012: 316). Biggins and Scott (2012: 316) note that these risks originate from

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