The dismantling of the economy’s legal infrastructure III: Derivatives [Updated]

Derivatives are financial contracts that do not involve direct investment in productive activity, as stocks and bonds do, but instead reference such contracts (or other phenomena including stock market indexes and even the weather). In short, they are called derivatives, because their value is derivative from that of other assets. While derivatives contracts take many forms, for the purposes of this post it is enough to understand a specific derivative, a futures contact. A futures contract is a standardized contract to purchase/sell a specific amount of a specific asset at a specific price on a specific future date.

Consider an example, in which I agree in December 2018 to sell 100 shares of Apple stock at a price of $150 a share (the current market price) on May 15, 2019. I will call the person who takes the other side of this agreement, my counterparty. Whether the market price of Apple is $140 or $158 on May 15 does not affect the price at which our contract will settle, because the whole point of a futures contract is to fix the price of the contract on the future date. For the purposes of discussion let’s assume that the price on May 15 turns out to be $158. Since I sell my shares at $150, I have $800 less, that is $8 less per share, than I would have if I had simply waited to sell my shares. Similarly, my counterparty has $800 more than she would have if she had simply waited to buy the shares.

Why would I have chosen to enter into this contract? If I owned Apple shares maybe I knew in December that I would need the money on May 15, but didn’t want to sell in December for tax purposes and was worried that the price would fall in the meanwhile. Alternatively, maybe I don’t own Apple shares, but have reason to believe that the price is going to fall over the next six months and want to have the opportunity to sell shares that I will be able to purchase at low price (as I expect to be the case in May) while selling at high price. In the first case, I am protecting myself against risk of loss – or hedging, and in the second case I am speculating on the price of the shares.

Why would my counterparty have chosen to enter into this contract? Perhaps, she expects the price of Apple shares to go up over the next six months, but doesn’t have the money to buy them now and wants to lock in today’s price on a contract that can be paid for when her funds are available. In other words, she is speculating on the price of the shares, since she could simply wait and buy the shares when her funds are available. (A retail investor would not be hedging, since that would imply some kind of an obligation to possess shares in May that aren’t owned in December. By contrast, a financial professional might have such an obligation and be using such a position to hedge an exposure.)

Thus, a crucial aspect of a derivatives contract is that the same contract can be used either to hedge an exposure – i.e. to insure against an existing risk – or it can be used to speculate on a change in prices. The derivatives contract itself will not give any indication how it is being used. If the owner of shares enters into a contract to sell them in the future, that is a means of protecting the owner against the risk of loss, and it would not be considered a wagering contract under the traditional law governing derivatives. Traditional gambling law applied only to derivatives where no contract participant was hedging, but instead both were speculating (in opposite directions) on a price movement.

With this introduction let’s get into some details.

Britain’s Gaming Act of 1845 laid a cornerstone of Anglo-American securities regulation: wagers, including derivatives that could be characterized as wagers, were void and could not be enforced as contracts. The reasoning behind this approach was cost-benefit analysis. Because a wager, by definition, involved two parties who did not have a real economic interest or productive purpose at stake, the benefit of enforcement was necessarily small and deemed not to be worthy of the costly expense of judicial resources (H.C. 1844: v-vi; see also testimony of Daniel Whittle Harvey, Esq., Commissioner of the City Police Force, Honorable Mr. Justice Patteson, and John Bush, Esq., Attorney and Solicitor).

In Britain, as in the US, the real world implications of a law are often determined only after the courts have interpreted the text of the law and developed a legal test that will be used to apply the law. In 1851, Grizewood v. Blane, 138 Eng Rep 578, 584 (C.B.), interpreted the 1845 Act, establishing a seminal precedent that would undergird Anglo-American securities law for the better part of a century: if one of the parties genuinely intended to deliver/receive the underlying asset (typically a question of fact for the jury), the transaction was not a wager, but instead a valid contract. Over the next 50 years many US state legislatures adopted similar gaming laws and many US courts cited Grizewood v. Blane on the interpretation of such statutes with respect to financial transactions. The Supreme Court affirmed this interpretation in Irwin v. Williar, 110 US 499 (1884).[1]

Let us apply this legal test to the example given in the introductory paragraphs. If I am hedging my need to sell 100 shares of Apple in May, then the whole point of the transaction is that I expect to sell (and deliver) my shares. On the other hand, if I am speculating, then I don’t have any shares to sell, and it’s easiest to just pay the difference between the contract price and the actual price in May. In this example, I pay my counterparty $800 without a transfer of shares. The fact that I own shares and need to sell them in May would be strong evidence of my intent to deliver, and therefore that the contract is not a wager. By contrast, the absence of any such evidence together with the presence of a pattern of entering into futures contracts and settling differences without ever taking ownership of shares is likely to be viewed as evidence that I am speculating. If the same is also true of my counterparty, then the derivative is a wager. As noted, in practice the evidence on each party’s intent was typically submitted to the jury so the jury could make the factual determination with respect to each party.

During this period derivatives contracts, particularly those that were typically settled by paying price differences, were at risk of being deemed unenforceable in court. Because settling by paying price difference was common on the Exchanges, they had to develop their own mechanism by which they could enforce the claims of parties to these contracts.[2] That mechanism was margin, which is a synonym for collateral.[3] Upon entering into a derivatives contract a trader was asked to post to the exchange margin that would cover a portion of the value that the trader might end up owing on it. And on a regular basis the exchange would reevaluate the contract and change the amount of margin that must be posted to reflect how the contract had changed value over time. In this way, if the trader went bankrupt the exchange had the means to make sure payment was still made on the contract.

In short, the system of margining derivatives contracts was designed for an environment where legal enforcement of contracts was not likely to be available to traders. This alternate system for ensuring payment on derivatives conflicted with the bankruptcy code which sought to catalog all of a bankrupt’s assets and distribute them fairly across creditors. The Supreme Court in 1876 created a carve-out for exchanges, allowing them to process transactions according to their rules and indeed even allowing them to use the proceeds from the sale of the bankrupt’s seat on the exchange to settle any remaining debts on the exchange – all outside the reach of the bankruptcy court (Hyde v. Woods, 94 US 523, 1876). This special status was preserved for commodities exchanges when the Bankruptcy Code was revised in 1978 by allowing commodities brokers to foreclose on margin despite a bankruptcy. In 1982 the contractual rights set forth by the rules of securities exchanges were also exempted from bankruptcy (Pub. L. No. 97-222).

In the early 20th c. the invention of the telegraph posed an existential crisis for the Exchanges as their prices were instantly transmitted for off-exchange trading, threatening not just members’ income, but the price discovery process itself (Levy 2006). This led in 1905 to a Supreme Court determination that exchange-traded contracts were a special category due to the important role they play in setting prices for the business world, CBOT v. Christie Grain, 198 US 236 (1905). This decision distinguished exchange-traded contracts from off-exchange contracts and deemed only the former legally enforceable. The wagering laws that had been enacted at the state level continued to apply to derivatives contracts that were not traded on an exchange.

The Commodities Exchange Act of 1936 was therefore building on existing law when it prohibited trade in derivatives referencing commodities with two exceptions: exchange-traded contracts and contracts where the intent was to deliver the underlying.[4] In 1974 when the CFTC was created and tasked with enforcing the Act, the definition of a commodity was deliberately amended to cover not just virtually all goods, but also “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in … .” In short, the CFTC was granted jurisdiction over derivatives referencing virtually anything, except for categories that would be explicitly excluded, including currencies, government bonds and mortgages that were considered the domain of banks, and options on securities that were removed to the sole jurisdiction of the SEC.[5]

As a result, during the 1980s there were two tiers of regulation governing derivatives. At the Federal level the CFTC Act made derivatives presumptively illegal, unless they were traded on an exchange, the intent was to deliver the underlying, or they were explicitly excluded from the CFTC’s jurisdiction. And at the state level derivatives contracts were void unless they either served to insure one party from an existing risk or the intent was to deliver the underlying.[6]

At the same time, subsequent to the Savings and Loan crisis there were growing markets in new categories of derivatives, interest rates swaps which reference Treasuries, and foreign exchange swaps. The 1974 Treasury Amendment’s exemption of commercial banking activities excluded some such derivatives from the CFTC’s jurisdiction. By 1985, however, products outside the exemption were being developed, and US investment banks were prominent dealers in this market alongside three major commercial banks. These dealers formed the International Swaps Dealers Association (ISDA) with the explicit goals of standardizing the unregulated contracts to facilitate trade, and addressing accounting and regulatory issues. Effectively the ISDA was acting as a Self-Regulatory Organization (SRO) like the National Association of Securities Dealers, but without any supervising regulator. The market grew rapidly and increased tenfold from 1986 to 1990. (Sissoko 2017).

In 1990 at the request of the ISDA the Bankruptcy Code was amended to exempt interest rate and currency swaps as well as “any other similar agreement” from provisions of the Code (Pub. L. No. 101-311). Observe that, whereas the original Bankruptcy Code exemptions had only been granted to the contractual rights created by the rules of the regulated Exchanges (and related SROs), in 1990 these exemptions were granted to unregulated financial contracts and to contractual rights founded in common law; in short, this new exemption was much broader than the 1982 exemption. Having opened this breach in the financial regulatory structure, industry lobbyists spent the next decade and half forcing the gap open as wide as possible.

A 1992 law granted the CFTC the power to exempt any contract from its oversight and by doing so to preempt the application to the exempt contract “of any State or local law that prohibits or regulates gaming or the operation of ‘bucket shops’” (Futures Trading Practices Act, Pub. L. No. 102-546). The structure of this exemption power was unwise, and set a dangerous precedent. In order for the CFTC to exempt a contract from its own oversight, it also had to exempt the contract from one aspect of the traditional State law regulating securities contracts. In short, instead of treating the law that had supported economic activity for more than a century as valuable infrastructure, the 1992 law treated it as disposable. As a result, even the subject experts who staffed the CFTC were not given the choice of exempting a contract from CFTC oversight while at the same time leaving in place traditional state-based restrictions on wagering-type contracts.

In 1993 the CFTC exempted interest rate and currency swaps as well as “any other similar agreement” with the qualifications that they could not be standardized, fungible contracts and that they not be traded through a multilateral execution facility (58 FR 5587 at 5589 (Jan. 22, 1993)). By 1998 the swaps market had evolved such that it was no longer evident that the contracts complied with the qualifications on the exemption, and scandals that had led to litigation indicated that unwitting participants had in some cases been defrauded. When the CFTC proposed to revisit the question of regulating of the swaps market, stating explicitly that any such regulation would only be prospective (63 FR 26, May 12, 1998), industry lobbyists has sufficient influence at the Federal Reserve and Treasury to successfully pressure Congress to enact a six-month moratorium on the CFTC release (Greenberger 2018: 21-23).

The final outcome of the full-bore industry response to the CFTC’s proposal to evaluate the need for regulation of swaps was the enactment of the Commodities Futures Modernization Act of 2000 (CFMA; Pub. L. No. 106-554), which excluded not just interest rate and currency swaps, but financial derivatives more generally from the Commodity Exchange Act – as long as they were traded by “eligible contract participants,” roughly speaking entities with more than $10 million in assets. By excluding these derivatives from the Act itself, they were not just removed from the jurisdiction of the CFTC, but also from the CEA’s anti-fraud and anti-manipulation provisions. Furthermore, when it came to the application of State law excluded contracts were treated like contracts that had been exempted as per the 1992 FTPA; in other words, the CFMA explicitly preempted any application of state gambling law to excluded contracts (Greenberger 2018: 27-28).[7]

Pause for a moment to consider the hubris embedded in the CFMA. At least the 1992 FTPA had left the discretion to the subject experts at the CFTC to determine whether or not to exempt contracts from both oversight and state law. In the CFMA Congress assumed that it had the ability to judge not just whether the excluded contracts should be subject to the CFTC’s oversight but also whether they should be exempt from the State law and common law that had served the economy well for more than a century. And this decision was taken without even commissioning a study of the reasoning behind the use of the traditional wagering law to restrain securities markets. (One is reminded of Chesterton’s fence: “If you don’t see the use of something. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”)

Although the CFMA established over-the-counter derivatives as an entirely unregulated market and allowed to the ISDA to organize that market unsupervised and without the constraints on anti-competitive practices that had been adopted throughout the financial system in the 1930s, this was not, however, enough.

The margining system that had been developed to enable the earliest exchanges to enforce their contracts without relying on the legal system could be used to create leverage that was invisible to the Federal Reserve, which was still using theoretic frameworks appropriate to unsecured interbank lending, and had not yet mastered the implications of the growing use of margin by the biggest financial participants. With the Fed blind not just to the risks of the derivatives margining system but also to the extent of its growth, commercial and investment banks could take on an unregulated form of leverage.

It seems unlikely that many of the financial industry lobbyists saw the big picture of what they were doing when they lobbied for the 2005 bankruptcy act. Most likely they simply saw an opportunity to shift the rules in a way that would be profitable for them and went for it, without a thought for the broader economy at all.

The outcome was legal reform of the Bankruptcy Code as it affected financial institutions that was just as stunning in its implications as the CFMA had been with respect to derivatives regulation: In an early paper I dubbed this legislation “The No Derivative Left Behind Act of 2005” (Sissoko 2010). The goal of the reform was to make it possible for the broker-dealer banks to manage collateral, not contract by contract, but in a way that would make the collateral as mobile as possible. The banks wanted to be able to aggregate all the margin posted by a certain counterparty on all of its contracts and deal with it as a whole. Since the broker-dealers (but for the most part not their clients) could reuse – or rehypothecate – the margin that was posted to them, the ability to aggregate collateral positions would free up more collateral for the broker-dealers to reuse. Reusing margin is a way for a bank to leverage its balance sheet.

The ability to aggregate collateral positions was created by, first, granting exemption from the Bankruptcy Code to master agreements that were designed to bring a wide variety of different contracts under a single netting agreement, and, second, by revising the specific terms of the bankruptcy exemptions granted to the different types of contract so that they would be uniform – and thus amenable to aggregation. Unsurprisingly the way the various terms were made uniform was by taking the broadest grant of exemption from the Bankruptcy Code and applying it to the various contracts (Sissoko 2010).

For example, exemption from the Bankruptcy Code for options on securities had been limited as was noted above to contractual rights established by the rules of a securities exchange. This was expanded to include the terms that applied to swaps and thus to the more general contractual rights that exist under common law. This was a vast change in the applicability of the Bankruptcy Code exemptions.

Other revisions in the 2005 Act also broadened its reach: to allow for new products to be developed, each type of exempt contract was defined to include similar contracts. One practitioner’s comment on the new definition of a swap was: “Read literally this language cedes the content of the definition to the players in the market.” Kettering (2008: 1712). In addition, before the 2005 Act exempt repurchase agreements had been limited for the most part to those referencing Treasuries and Agencies. After the Act, repurchase agreements on securities and mortgages had been included in the definition of securities, and were therefore exempt.

Like the CFMA, the hubris implied by this law boggles the mind. The bankruptcy exemptions had been created to facilitate the operation of Exchanges because they could not rely on the courts to enforce their speculative contracts. The whole logic of this financial structure was turned on its head by applying the exemptions to off-exchange contracts, that had already been exempted from the state and common law governing speculative contracts. Not only this, but this brand-new, ill-considered financial structure was not applied to some very narrow set of contracts, but it was applied to a vast range of contracts and was designed to make it easy for the interested parties who had lobbied for the law to expand the range of contracts at will.

Just three years after the law was passed, the implications of establishing a vast unregulated financial market with extraordinary privileges under the Bankruptcy Code were realized. The repurchase agreement market which was a core part of the margining system for this unregulated market experienced a massive run and came close to bringing down the financial system entirely. The margining system was saved only by the Federal Reserve’s unprecedented measures.

With the Dodd-Frank Act supervision has been extended over these instruments, and many have been forced to trade on exchanges. The basic incoherence of this new financial structure remains, however. Off-exchange contracts are still exempt from provisions of the Bankruptcy Code and from state wagering laws. The central banks are struggling to develop a theoretic framework that can allow them to manage the new system of margin-based interbank lending successfully. It remains to be seen if the growth rates achieved under the old system can be attained under the new one.

[1] Note that Kreitner (2000)’s discussion of the intersection between securities regulation and wagering law starts with Williar, and this case apparently does not offer the best explanation of the logic underlying this form of securities regulation. Kreitner (2000) argues that moral rather than economic considerations drove this form of securities regulation.

[2] As Levy (2006) observes, while there are many cases arguing that exchange-traded contracts were void as wagers in the late 19th century, not one of them is brought by a member of the exchange. That is, they are all brought by the clients of exchange members.

[3] In 1865 the Chicago Board of Trade introduced the first standardized futures contract together with the requirement that a “performance bond,” which serves the same function as margin, be posted by futures traders.

[4] Derivatives were covered by the term “contracts for future delivery,” but the law was careful to state that “The term ‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery,” thus creating what was known as the “forward contract exclusion.” (as currently encoded, 7 U.S.C. 1(a)(27))

[5] The bank contracts were exempted in the 1974 Treasury Amendment to the CEA and securities with the 1982 enactment of the Shad Johnson Accord (GAO 2000).

[6] Because the era of federal common law had ended in 1938, the exchange trading exemption to state wagering laws was unsettled.

[7] In current law this exclusion is found in 7 USC s. 16(e)(2).

Note: Updated January 14 2019 to add more explanatory text regarding derivatives.

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