1

Over-the-counter (OTC) financial derivatives and the

regulation of risk within complex markets

How do efforts to regulate over-the-counter derivatives in the E.U.

and U.S. engage with contemporary financial markets, and what

does this reveal about the nature of the relationship between

economic structures and political authority?

Oliver Biggs

MA Critical Global Politics

University of Exeter

Supervisor: Dr Matthew Eaglton-Pierce

Word Count: 16,279

2

Contents Page

Abstract 3

Introduction 5

Chapter 1 11

OTC Derivatives and their role in the

accumulation of Capital and Risk

Chapter 2 27

Economic Orthodoxy, Complex Markets,

and the Transnational Network: Regulation

prior to the GFC.

Chapter 3 46

Post Crisis Regulation: Change and Continuity

Conclusion 63

Bibliography 66

3

Abstract

This dissertation contends that over-the-counter (OTC) derivatives play a central role

within contemporary capitalism. Performing a number of valuable functions, these

instruments facilitate the accumulation of capital, deriving new value from existing

through the assumption of risk. Given the significance of OTC derivatives, an

exploration of the regulatory framework surrounding these markets provides a

valuable means of shedding light on the relationship between economic structures

(market) and political authority (state). Orthodox IPE interpretations have tended to

see the market and state as separate and homogenous entities that are connected

by a relationship of mutual antagonism. Through an exploration of the regulatory

framework prior to and following the Global Financial Crisis (GFC), this dissertation

offers a critique of this frame. I argue that the inter-relationship between state and

market is more complex than simply being demonstrative of regulatory capture by

the largest and most sophisticated private market institutions. Instead, drawing on

the importance of both economic ideas and elite narrative, I argue that the pre-crisis

regulatory framework, with its emphasis on self-regulation, was shaped by a public-

private elite who operated within a dominant free-market intellectual frame and

whose governance strategies operated in the context of stable narratives of

beneficial financial innovation and of the ʻgreat moderation.ʼ Thus, I argue that the

pre-GFC regulation can be characterised more by consensus than capture. The view

that the post-crisis regulatory framework, with financial regulation being brought back

4

under the control of national states, represents a ʻparadigm shiftʼ from what had

come before is also challenged. I underline the continuity with the pre-GFC regime

and argue that, despite increasing tensions appearing between elites as they seek to

create new and stable post-crisis narratives, they have retained considerable

influence over the shaping of regulation. Thus the impact of new regulation has been

watered down and little attempt has been made to introduce democratic

accountability into the system. I conclude by arguing that the regulation of OTC

derivative markets demonstrates the complexity of the state market relationship and

that this relationship is better theorized as an ensemble of governance than as an

antagonistic relationship between two separate entities.

5

Introduction

A little more than 40 years ago, financial derivatives, a form of financial instruments

whose value is derived from an underlying asset, played a relatively discrete role

within the global economy. Today, they represent by far the largest financial

transaction on the globe, with the total notional amounts outstanding on OTC

derivatives contracts amounting to around nine times global GDP by the end of June

2012. (BIS, 2012). Despite Warren Buffetʼs eerily prescient description of derivatives

as “financial weapons of mass destruction” (Buffet, 2002, p.14), they have remained

a mystery to the majority of those outside of the realm of finance, only emerging into

the broader public consciousness as a result of them being heavy implicated in the

ongoing GFC that began in 2007. The narrow avoidance of economic meltdown, and

the public outcry at the costs involved in doing so, led governments in the U.S. and

the E.U to introduce a broad raft of new legislative regulatory measures addressing

financial derivatives. With some authors having described the pre-GFC OTC

derivative markets as ʻunregulatedʼ (DʼSouza et al., 2010, p.476), this very public

intervention in the regulation of derivative markets has been hailed by some as a

ʻparadigm shiftʼ (European Commission, 2009) from what was in essence a “light-

touch” (Helleiner, Pagliari, 2009, p.285) pre-crisis regulatory framework.

In this dissertation I argue that OTC derivatives perform a variety of significant roles

within contemporary capitalism, but that despite their use as tools of risk

management, they have contributed to the growing instability of the global economy.

A regulatory regime has emerged in parallel with the growth of the OTC derivatives

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markets. This regime has been shaped by a cosy transnational policy community of

regulators, supervisors and private actors, who have combined a belief in market

efficiency with a desire to profit from ʻthe goose that lays the golden eggsʼ (Haldane,

2009). The GFC appears to have reversed the growing delegation of regulatory

authority to the private sector that took place before the crisis, and a number of

regulatory reforms are underway. However, these reforms represent a tuning rather

than a radical reform of the existing system. Any argument that a ʻtechnical fixʼ will

resolve the issues of systemic risk within the global financial system is deeply

flawed. The degree to which ʻexpertiseʼ continues to be heralded above all else

within the technocratic world of finance ensures that the same actors who led the

world into the GFC have remained at the heart of post-GFC reform debates. Despite

the turmoil caused by the GFC, the memory of it is slowly fading from the collective

public memory, and the “implicit and generous contract” (Tsingou, 2009, p.14)

between state and financial elites therefore remains largely in place.

In chapter one I demonstrate that OTC derivatives perform a variety of important and

interconnected functions within contemporary global capitalism. I start by examining

the orthodox view, which sees the primary function of financial derivatives as highly

effective tools of risk management, providing insurance against the potentially

adverse effects of – for example - future price movements. According to this view,

derivatives also perform a valuable arbitrage function, helping to restore prices to

their fundamental value and increasing market efficiency. I counterpoise this

interpretation against those of scholars such as Susan Strange who argue that the

speculative use of derivatives increases price volatility within financial markets,

7

contributing to increased levels of risk within the global economy. I explain that

focusing on derivatives either as benign risk management tools, or as pernicious

tools of speculation, ignores what Nasser Saber has described as their 'dual' nature,

which allows them to perform both of these functions simultaneously. Building from

this, I demonstrate that derivatives also perform a number of additional functions

within contemporary capitalism. Thus, I follow the work of scholars such as Costas

Lapavitsas to highlight the way in which financial institutions use derivatives to

realize future revenue streams as immediate profit through a process of

securitization. Drawing on the work of Dick Bryan and Michael Rafferty, I also

highlight the binding, and blending functions of derivatives, whereby they allow for

both the setting of future prices, and the commensuration of different forms of capital.

My position is that the nature of OTC derivatives allows them to perform a number of

important and interrelated functions within contemporary capitalism, that are linked

by the way in which they promote capital accumulation. (Norfield, 2012) However,

drawing on examples from the GFC, I argue that derivative use has also increased

levels of risk and volatility within the global financial system.

Having underlined the significance of OTC derivatives within contemporary

capitalism, in chapter two I ask what the regulation of these instruments prior to the

GFC tells us about the nature of contemporary financial markets and the market /

state relationship. Drawing on the work of Daniel Drezner and Kathleen McNamara,

who underline the importance of political power and economic ideas in shaping the

global economy, I examine the influence of orthodox economic theory on the pre-

GFC regulatory regime. I outline the way in which a belief in the efficiency of markets

8

and their ability to self-regulate led to the emergence of a ʻlight touchʼ regulatory

approach that placed an emphasis on standards aligned self-government. I argue

that as a result of the free-market frame in which it operated, the pre-GFC regulatory

regime was unable to take into account the complexity of OTC derivative markets,

whose informational asymmetries were exploited by private market actors. The pre-

crisis regulatory framework has been described as one in which regulatory capture

had occurred, with regulation increasingly served the vested interests of a small

number of large financial intermediaries. Whilst acknowledging the degree to which

actors within the financial markets gained a stake within the regulatory and

policymaking communities, I argue that the concept of regulatory capture is too

simplistic. Not only does it presuppose the unity of private sector interests, but it also

exists within an Orthodox IPE frame that tends to view the state and market as

neatly distinct, with a clear conflict of interests between the two (Underhill, 2000). I

seek to position my argument outside of this frame by drawing on the work of

Tsingou and others to argue that a transnational governance network of public and

private actors dominated the pre-crisis regulatory system. In combination with a

ʻrevolving doorʼ that existed between the public and private sectors, and a shared

economic ideology, I demonstrate how this led to a blurring of the boundaries

between state and market actors. Taking inspiration from the work of Rawl Abdelal

and others, who highlight the important role state actors played in the creation of the

contemporary financial system, I argue that a light-touch regulatory regime did not

just serve the interests of large financial intermediaries but also served the interests

of national governments. Thus, as a direct result of the extraordinary expansion of

the financial sector, largely driven by the growing use of OTC derivatives to

9

securitize house-hold debt, states were able to reap the benefits of “one of histories

great boom periods” (Guttman, Pilhon, p.3, 2010).

Following the GFC it has been argued that a paradigm shift occurred, with a re-

politicization of financial regulation occurring, and regulatory authority shifting back to

the public sector. Building on the analysis of the previous chapter, I compare the new

regulatory legislation regarding OTC financial derivatives in the U.S. and the E.U. I

acknowledge that post-GFC regulation is resulting in the gradual development of

new market infrastructure such as Central Counterparty Clearing Houses (CCPs)

and Trade Repositories (TRs) that have the potential to reduce complexity within

OTC derivative markets, and thus to help to counteract the pernicious impact of

derivative trading on the global financial system. However, following Eleni Tsingou, I

highlight how this new regulation is being implemented in an ad-hoc and fragmented

way. In doing so, I demonstrate that regulation is failing to adequately resolve the

regulatory challenges posed by OTC derivative markets. Despite the re-politicization

of regulation following the GFC, and despite the lack of a single unifying grand

narrative such as 'the great moderation', that defined the pre-GFC period, I conclude

that the “intellectual and institutional parameters” (Tsingou, 2009, p.14) of

international regulation are still being shaped by the same elite public and private

actors whose “hubristic misjudgment” (Engelen et al, 2011, p.21) during the build up

to the GFC created an increasingly ungovernable financial system.

Analyzing the regulation of OTC derivatives markets provides a valuable way of

shedding light on a key question that contemporary IPE seeks to address, namely

10

“What is the nature of the relationship between economic structures and political

authority” (Underhill, 2000). Despite a great deal of critical public attention being

drawn to the financial markets as a result of the GFC, it is evident that a close and

ongoing relationship exists between the state and market. Thus a 'revolving door' still

operates and the private sector retains an ongoing semi-formal policy making role.

These findings, and the nature of the state-market interaction that they describe,

differs significantly from the theorization of much mainstream IPE scholarship. Whilst

accepting that political authority and markets are interdependent and should not be

considered in isolation from one another, within mainstream IPE, the relationship

between the two tends to fit a general description of “interdependent antagonism,”

(Underhill, p.804) whereby the state and the market exist in direct antipathy to one

another. There is a great deal of value to conceptualizing states and markets as

clearly separate entities. However, even concepts such as regulatory capture, which

seek to explore the inter-relationship between the two, are prone to seeing this

relationship as a dichotomous tug-of-war. The exploration of the regulation of the

OTC derivatives markets that takes place in this dissertation therefore represents an

attempt at a more nuanced understanding of states and markets. A perspective

which can draw on the interplay between power and ideas, (Drezner and McNamara,

2013) the importance of elite narratives, (Froud et al, 2012) and that views the state

and market as part of the same complex “ensemble of governance” (Underhill, 2000,

p.807).

11

Chapter 1

Over-The-Counter Derivatives and their role in the accumulation of Capital and

Risk

Although derivatives are not broadly understood outside of the realm of finance, they

have a long history, with the first known instance of derivative trading dating back to

2000BC (Dodd, 2004). According to the definition provided by the U.S. Treasury

department, ʻA derivative is a financial contract whose value is derived from the

performance of an underlying asset - such as the price of a particular commodity - or

an underlying market factor - such as interest rates or currency exchange ratesʼ

(Office of the Comptroller of the Currency). All derivative products are made up of an

option, a future, or a combination of the two. Purchasing an option gives the buyer

the right to buy or sell a specific underlying asset at an agreed price at, or before an

agreed time without any obligation to do so. A future differs from an option in that it

represents a contractual obligation to buy or sell at an agreed price (Karol, 1995).

Futures are a reflection of the value that an underlying asset will have at a particular

future date, while the value of an option equates to the value of the right to buy or

sell the underlying asset at a certain price (Alessandrini, 2011).

Derivatives are separated into two categories: Exchange-traded derivatives (ETDs)

and over-the-counter (OTC) derivatives. ETDs are traded using a public exchange

whereas OTC derivatives are traded directly between two parties. Exchanges were

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set up originally for the trade of ʻfuturesʼ on agrarian commodities. (Clark et al, 2009)

ETDs are much more standardised contracts which tend to be based on the most

commonly traded assets. They also tend to include a number of pre-defined

variables. ETDs are settled through a clearinghouse, which requires a margin

(collateral) from both parties engaged in the exchange and acts as counterparty to

both the buyer and the seller. This reduces the risk of counterparty default – a

situation one of the two parties in the deal is unable to fulfill their commitments

(DʼSouza, Ellis, Fairchild, 2010). In contrast to ETDs, OTC derivative contracts do

not have to be traded through an exchange or settled through a clearinghouse. This

means that OTC derivatives do not need to be standardised but are instead highly

customizable, offering a much wider variety of underlying assets and a more tailored

set of terms and conditions (Nystedt, 2004). I am focusing solely on the regulation of

OTC derivative markets in this dissertation as their highly customisable nature

means they dominate the contemporary derivatives market (Hull, 2010), I am limiting

my attention to the regulation of OTC derivatives in the E.U. and U.S., as these are

by far the two largest players in the global OTC derivative market.

The volume of global derivatives trading has grown exponentially since the 1970s,

with trade shifting away from commodity based derivatives to financial derivatives,

defined by the fact that the underlying is another financial asset or relationship. In the

last decade alone - and despite relatively stagnant growth since the onset of the

GFC – the value of global OTC derivatives contracts has grown roughly six-fold (BIS

2012). This new phase of derivative trading can be traced back to the development

of the Black and Scholes options pricing model in 1973 and the opening of the new

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derivatives exchanges in Chicago in 1972 and 1973. These two developments

created the ideological and material underpinnings for the subsequent growth in

derivatives trading (Arnoldi, 2004). Other factors that have contributed to the growth

of derivatives trading include states turning to finance to avoid “a series of economic,

social, and political dilemmas” (Krippner, 2011) that confronted policymakers from

the late 1960s and into the 1970s. The growing volatility of the post-Breton Woods

financial System (BWS) is also considered to have significantly increased demand

for the hedging functions of derivatives.

A great deal of attention has been paid to the role played by OTC derivatives in the

GFC. OTC derivatives have been described both as the main cause of the crisis

(Stout, 2009) and as having played a very minimal role (Helwege, 2009, Stulz, 2010).

OTC derivatives have often been framed within a narrative of risk. Whilst I argue that

their trade has increased levels of volatility and risk within the global economy, OTC

derivatives are also an “integral part of the global financial system” (Arnoldi, 2004,

p.23) because of the multiple ways in which they have helped to spur capital

accumulation (Norfield, 2012). Thus, I seek to move beyond the traditional

assumptions regarding derivatives, whereby the speculative ʻexcessesʼ of

derivatives, representative of the unproductive realm of finance, need to be

controlled, so that their hedging functions can work to the benefit of an otherwise

healthy system of production (Bryan, 2006).

Neo-Classical Economic Orthodoxy has tended to understand the primary function of

OTC derivatives as insurance policies, tools for managing risk through hedging

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(Karol, 1995). Thus, a business exposed to an unwanted risk, may neutralise this

risk by offsetting it against a counterbalancing derivatives transaction (Partnoy,

2007). Derivatives provide a way for parties to take ʻoptimalʼ positions on the future

price movements of assets, providing a means of unbinding risk so that it can be re-

packaged into separate transactions with different risk profiles (Gibson, 2007). This

allows other parties to sell off or take on the risk of future price movements.

Derivatives are considered to be such powerful risk management tools because they

allow for the commodification of risk. They give exposure to risk without the need to

own any of the underlying asset from which the risk is derived, which in turn allows

for efficient ʻinter-temporal and inter-spatial resource allocationʼ (Karol, 1995).

From the Neo-Classical position, Arbitrage is the activity of market participants

whose activity is based on their capacity to discover inefficiencies within the market

(such as price differentials between markets) and who are able to profit in a risk free

manner from them (Varian, 1987). Derivatives are the ideal tool for doing this due to

their high levels of flexibility and customization, allowing arbitrageurs to exploit price

differentials between a wide-range of underlying assets. It is argued that

arbitrageurʼs participation in the market leads to higher levels of liquidity as they fill

the gap between the demand for, and offer of, hedging opportunities (Gemmill,

1986). Arbitrage is seen to lead to higher levels of market efficiency, (Shleifer, 2000;

Mackenzie, 2005) as the exploitation of price differentials serves to draw prices back

to a point of equilibrium, their so-called ʻfundamental valueʼ (Friedman, 1953). If

market inefficiencies prevent the effective distribution of resources then arbitrageurs

provide a valuable service to society. However, market inefficiencies do not always

15

lead to significant allocative inefficiencies (Stout, 1980, 1995). The benefits of

Arbitrage are brought into question by the suggestion that real-life arbitrage requires

capital and is not actually risk free (Schleifer, Vishny, 1997). The functionality of

derivatives as tools of arbitrage has also been brought into question by a series of

authors (Callon, 1998; McKenzie, 2007, Alessandri, 2011) who challenge the

concept of fundamental value within markets upon which the concept of arbitrage

depends. They argue that derivatives create major feedback effects (Lepinay, and

Callon, 2010, p.282) that give rise to a situation whereby derivatives do not merely

derive their value from their underlying asset(s) but instead from the trend of their

value on the market (Alessandri, 2011) which can in turn effect the value of the

underlying asset.

Although the neo-classical view of derivatives does include the concept of

speculation, it effectively absorbs it within the concept of arbitrage, and the primary

role of derivatives therefore remains as tools of risk management. However the neo-

classical understanding of markets, characterized by perfect information, the

absence of transaction costs and rational market participants, has increasingly come

under attack as a result of its own positivistic criteria. In reality, financial markets and

their participants rarely conform strictly to these inherent assumptions. If ʻarbitrageʼ

really did bring prices back to a point of equilibrium then thirty years of ongoing

exchange rate volatility can therefore only be explained by this theory as a distortion

(Bryan. Rafferty, 2008) .The concept of the self-equilibrating market and the value of

derivatives as tools of arbitrage and of risk management has, therefore, been

brought into doubt by ongoing market volatility and a series of crashes and financial

16

crises.

What neo-classicists have described as arbitrage is often viewed by Keynesian,

Marxist and other critical theorists as financial speculation. Whereas hedgers try to

mitigate unwanted risk, speculators take on risk in an attempt to earn large profits

(Engel, 2013). Derivative transactions allow investors to leverage capital, as the

price of a derivative is only a fraction of the price of the underlying asset, yet it gives

exposure to the underlying asset. The profit, or loss that may arise from a derivative

acquisition - as a result of the evolution of the value of the underlying asset - may

equal the profit or loss of speculating in the underlying asset itself, but without the

cost of having to buy it outright (Arnoldi, 2004). Thus derivatives allow an investor to

increase the potential for a much higher rate of return on their capital, but in doing so

they take on a much higher level of risk. Keynesian critics see the markets as being

driven not by rational behaviour and fundamental values but by a herd-like mentality

of following trends. Prices are thus created on the basis of actors "anticipating what

average opinion expects the average opinion to be" (Keynes, 1964). While average

opinion is seen as being typically stable for long periods and dominated by

convention (as opposed to neo-classical fundamentals), a sudden shift in average

opinion can overwhelm these 'seemingly true' models and lead to "potentially

catastrophic disruption in the operation of the… economy" (Eatwell, 1996, p.3). The

growth of highly leveraged derivative products is therefore considered to have

amplified the speculative dimension of the market. Speculative use of derivative is

seen as increasing systemic risk, creating a situation whereby market participants

fail to fully internalize the risks of their activities, and in doing so create negative

17

externalities that the rest of society is, eventually forced to absorb (Baker, 2010).

LiPuma and Lee describe the role played by derivatives in creating a 'circulation

economy' that is removed from the ʻrealʼ productive economy and that is fraught with

volatility and speculation. They argue, for example, that financial derivatives,

specifically designed to deal with short term fluctuations in the price of money,

actually "exaggerate the oscillations in exchange and interest rates." (LiPuma and

Lee, 2004, p.4)

While the neo-classical view focuses on the role of derivatives in terms of

competition and efficiency, critics focus on monopoly and market power (Bryan,

2006). The growth of financial derivatives is depicted as a form of gambling with

terms such as 'casino capitalism' (Strange, 1986) and 'hot money' (Bello et al, 2000)

. Although computer models may be created to support their use, the speculator

therefore remains "confronted by the uncertain and incalculable" (Hilferding, 2006).

Critics of the neo-classical model have also drawn on Marxist theory to highlight the

speculative nature of financial derivatives, drawing upon Marxian value theory to

argue that labour involved in the buying and selling of finance is unproductive,

involving the appropriation rather than the production of surplus value. This view

draws upon the concept of fictitious capital (Marx, 1996) to argue that derivatives are

the object of speculation because the market value of financial claims that exist only

in paper form can be driven up and inflated artificially, as a result of supply and

demand factors which can themselves be manipulated for profit (1996). Alternatively,

derivatives and finance are seen as an unproductive, but necessary, part of capital

accumulation. The driving force behind the exponential growth of financial

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transactions, they are considered speculative as their growth is completely out of

proportion to that of goods production (Dumenil & Levy, 2004). Finally finance has

also been interpreted as the dominant part of capital, ruling over the productive

sector. According to this view, finance seeks to use its own institutions to protect

itself from the risks that accompany investing in the productive sector. Derivatives in

this context represent not a means of managing risk but rather of imposing it on

others. This leads to the deepening of crises and can also create new crises

(Dumenil & Levy, 2004).

Views highlighting the largely speculative nature of derivatives are supported by the

fact that only a small share of trading is undertaken by non-financial companies, who

might have a legitimate need to hedge commercial price-risks. However, the fact that

financial companies undertake most derivatives trading does not mean that

derivatives exist "only to satisfy the demands of speculators." (Norfield, 2012) Banks

and financial companies are also exposed to risk in the form of changing interest and

exchange rates, and may also use derivatives to hedge risk. Tony Norfield argues,

therefore, that although the majority of trading volumes appear to be dominated by

speculators, the core-demand for derivatives comes from economic agents who wish

to hedge risk. The higher volume of 'speculative' trading is therefore simply a result

of the fact that, while the volume of trading undertaken by a hedger is limited to the

size of their business operations, the speculator can always chose to seek higher

profits by engaging in a higher volumes of trading (Norfield, 2012).

The views outlined so far tend to emphasise the power of derivatives, either as

19

effective risk management tools, or as dangerous "financial weapons of mass

destruction" (Buffet, 2002). However, these views appear to be an over-simplification

in that they respectively focus on one half of the 'dual natureʼ of derivatives, as

highlighted by Nasser Saber - "On the one hand, it is a cushion limiting the losses

that arise from changes in the prices of financial assets and liabilities. On the other

hand we have a betting chip that serves and bolsters speculative behaviour." (Saber,

1999, p.9) This is a view shared by Alexander Engel, who argues that 'at best'

hedging represents "the intent to decrease exposure to a specific market risk, as part

of a constant process of readjusting principally ʻspeculativeʼ market positions by all

market participants" (Engelen, 2013, p.1). The interrelationship between the

speculative and hedging dimensions of derivative use is highlighted by scholars who

argue that it is important for speculators to be present in the market as they take up

opposite positions to counterparties, thus adding liquidity to the market and allowing

those seeking to hedge risk to do so effectively (Norfield, 2012, Deuskar and

Johnson, 2010). However, Engelen argues that the need to hedge has in turn driven

a need to respond to speculative activity; whilst McKenzie points out that rather than

adding to liquidity to the market, it is the speculative element that leaves at the first

'whiff' of instability, leading to a loss of liquidity and the potential for crisis (McKenzie,

2010).

The use of Credit Default Swaps (CDSs) in the GFC, provide an excellent example of

the dual nature of derivatives. CDSs are a form of derivative contract whereby in

exchange for an ongoing fee the seller of the contract agrees to compensate the

buyer for any losses generated by a specific credit event – such as a default –

20

occurring with regards to an underlying asset such as a Mortgage Backed Security

(MBS) or a Collateralized Debt Obligation (CDO) (Cont, 2010) They perform a risk

management function in that they allow debt holders to insure themselves against

the likelihood of default. However, whilst many market actors used CDSs as a means

of hedging risk, others lacking any insurable interest in the underlying asset,

purchased CDSs for speculative purposes. As rumours about problems at Lehman

Brothers spread during the GFC, the number of CDS contracts on Lehman therefore

increased dramatically as speculators ʻbetʼ on the firm going bankrupt (Morgan,

2010). The traditional ʻhedgingʼ interpretation of derivatives argues that they manage

risk by spreading it more broadly and amongst those willing to take it on. However, in

the case of the GFC, CDSs became highly concentrated amongst a small number of

institutions, which served to concentrate rather than distribute risk. In quarter four of

2008, just five large US banks, held a 92% share of the $34 trillion global gross

notional CDS market (Markose et al. 2012, p. 6). The trade of CDSs during the GFC

demonstrates how the same derivative product can be used to hedge the risk

associated with specific underlying assets whilst also being traded speculatively in a

way that increases levels of systemic risk.

The use of CDSs in the GFC also supports McKenzieʼs claim that whilst speculation

may increase liquidity within markets, it can also lead to a loss of liquidity in financial

markets during times of economic uncertainty. As an OTC derivative product, CDSs

include mark-to-market conditions under which the levels of collateral required move

with the change in value of the derivative and its underlying asset. Most contracts

linked the level of collateral to be posted with the credit rating of the CDS seller. As

21

conditions in the financial markets declined and the credit-rating of the underlying

assets (including sub-prime mortgages) were downgraded, companies - such as AIG

- who were selling CDS contracts were forced to post more collateral. As a result of

the declining value of the underlying asset, the needs to post more collateral came at

exactly the point when it was most difficult to do so (Morgan, 2010). As the

derivatives products such as MBSs and CDOs that formed the underlying assets of

CDS had become increasingly complex, their value also became increasingly hard to

predict during periods of market volatility. This in turn made it increasingly difficult to

calculate the sellersʼ collateral requirements.

The Opacity of the collateral system within the CDS market and OTC markets as a

whole created a systemic problem whereby it was impossible for market participants

to assess the stability, and risk exposure of the counterparties to their OTC

derivative contracts. This resulted in a seizing up of the credit markets, which in turn

brought the financial institutions with the highest dependency on short term lending

to the point of crisis. (Tett, 2009) When Lehman Brothers declared bankruptcy for

lack of funds to cover its debts, the possibility arose that the same thing could

happen to many other large financial institutions, with the interdependencies of the

system making the possibility of systemic contagion and collapse increasingly

possible (Morgan, 2010). Attempts to conceptualise derivatives either as an effective

risk management tool or as dangerous financial weapon are therefore far too

simplistic. The use of OTC derivatives can in-fact display aspects of both of these

positions, with the risk amplifying aspects of their use coming to the fore during

periods of economic uncertainty. (McKenzie, 2010)

22

Daniel Mügge has highlighted the way in which financial institutions use derivatives

to realise future profits in the present through a process of securitization; the slicing

and repackaging of debt, whether it be mortgages, infrastructure payments, student

loans, car loans or household insurance, into derivative products with different risk

profiles that can be sold on to investors around the world (Mügge, 2009). The

significance of securitization is highlighted by Andrew Leyshon and Neil Thrift who

argue that the collateralization of asset streams using OTC derivative products such

as MBSs and CDOs represents the ʻbedrockʼ of contemporary financial capitalism,

providing the necessary ʻfeedstockʼ for financial innovation and speculation (Leyshon

and Thrift, 2007). The bursting of the U.S. housing bubble has been widely been

cited as the trigger for the GFC (Martin, 2010, Shiller, 2008, Baker, 2008). The

dramatic expansion of lending which preceded the crisis would not have been

possible without the emergence of a new ʻoriginate-and-distributeʼ banking model.

(Lapavitsas, 2009) Under this model, banks were making money not from the

interest payments on lending (which would accrue to the securities holders, who also

bore the risk of default or non-payment) but through the marketing of derivative

products such as MBSs and CDOs - from which they banks could earn origination

fees (Purnanandam, 2010). Securitization allowed banks to divorce their success

from that of the mortgages themselves and to 'churn' their capital, generating

additional mortgages that helped to drive the expansion of the housing bubble (Keys

et al, 2009, Martin, 2010).

Robert Shiller has argued that securitization, in allowing for the broadening of the

23

asset base of financial capital also serves to spread risk, as financial speculation is

not forced to continually feed on only a few classes of assets (Shiller, 2003).

However, the outcome of securitization, or ʻfinancial appropriationʼ, (Lapavitsas,

2009) is that hidden layers of debt increasingly built up on-top of ʻmundaneʼ forms of

income reliant on an unproblematic unfolding of the everyday economy (Leyshon

and Thrift, 2007). Although seemingly ordinary, this everyday economy is in-fact

highly complex and securitization has therefore served to increase the level of

financial risk borne by individual families, with the International Monetary Fund

declaring in 2005 that households had become the financial systemʼs “shock

absorbers of last resort” (IMF, 2005, p.89). Therefore, although securitization

allowed banks to supply new loans (European Central Bank, 2007) and contributed

to economic growth in the U.S. and several other industrial countries, (Shadow

Financial Regulatory Committees Joint statement, 2009) it also played a key role in

triggering the GFC.

Dick Bryan and Michael Rafferty have highlighted the binding and blending functions

of derivatives. These functions enable derivatives to 'nail' the present to the future

(through agreed prices set at future dates) and to measure the 'value' of the different

capitals that are often blended into a single derivative product. This is particularly the

case with OTC derivatives given the ʻsyntheticʼ nature of many of these products -

their value is based on a combination of different underlying assets (Arnoldi, 2004); a

derivative product creates value from the pre-existing value of underlying assets.

However, it also derives its value from the lack of any prior integration between the

underlying assets and the value of a derivative product therefore also comes from

24

“the existence of gaps and discontinuities between underlying assets, and its ability

to bridge these gaps” (Lepinay and Callon, 2009, p.264).

Networks of derivatives help to provide continuity in the value of capital by "trading a

diverse range of contracts designed to specify or delimit the rate of conversion of one

'bit' of capital value (whether it be money or commodity and whatever its currency

denomination and time specification) into another" (Bryan and Rafferty, 2008, p.132).

Critics of derivatives have often argued that derivatives are in some way detached

from the real productive economy. Bryan and Rafferty however, argue that financial

derivatives represent capitalʼs way of drawing national monies - whose prices vary

as result of interest rates and exchange rates - into coherent global money. As such,

they represent a form of 'meta-commodity' that exists only in the sphere of circulation

but allows for the commensuration of different assets. This makes derivatives

'productive' because they permit the conceptual presumption of a stable monetary

standard, embodying commodified risk management within abstract money (Bryan

and Rafferty, 2006). In this interpretation derivatives merge the categories of capital

and money, breaking down the differentiation between the spheres of production and

the money economy. Whilst Norfield questions the 'money-ness' of derivatives

pointing out that there is no 'derivative-currency' unit of account, he agrees that they

represent "an integral expression of capitalism" (Norfield, 2012) and this re-

conceptualisation of derivatives allows us to move beyond the standard hedging /

risk and productive / non-productive frames.

OTC Derivatives are used in ways that have both a speculative and a hedging

25

dimension. They perform valuable binding and blending functions and play a key role

in collaterising new asset streams. What unites these multiple functions is the way in

which they help to promote capital accumulation (Norfield, 2012). OTC Derivatives

can promote accumulation by reducing the transaction-costs that companies face, by

appearing to lower levels of risk - and therefore allowing for higher levels of

borrowing and/or lending - and by generating profits based on speculative price

rises. Alexander Engel explores the way in which futures markets ultimately increase

the average exposure to risk whilst also making this exposure potentially

manageable. He argues that the economic process therefore increasingly develops

by "expressing expectations about the future through taking market positions"

(Engel, 2013) i.e. by creating risk. The process of ʻderivingʼ means creating new and

accepted economic value using pre-existing economic value (Lepinay and Callon,

p.267, 2010). Whilst Lepinay and Callon argue that the underlying economic values

will be strengthened if the derivation is successful, the danger implicit in this

methodology of capital accumulation is that a problem with the underlying asset(s)

upon which the derivatives are constructed can undermine the assumptions upon

which the value of these transactions depends (Norfield, 2012, p.117). Following the

collapse of the BWS, and the ongoing financialisation1 of an increasingly volatile

global economy, derivatives have assumed an increasingly essential role within the

process of capitalist accumulation. However, the nature of derivatives, and the role

they played in both the build up to the GFC, and the crisis itself, indicate that the

growing trade in OTC derivatives has also contributed to higher levels of risk within

1 Financialisation has been described as the “increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein, 2005, p.1)

26

the global economy, and have increased the likelihood and severity of financial

crisis. OTC derivatives therefore allow for the accumulation of both capital and risk

as a consequence of the way in which they derive their value from pre-existing

assets. Given the significance of these OTC derivatives, in the next two chapters I

will explore how they have been regulated, and what this reveals about the nature of

contemporary financial markets and their relationship with political authority.

27

Chapter 2

Economic Orthodoxy, Complex Markets, and the Transnational Network:

Regulation prior to the GFC.

In chapter one I explored the significance of OTC derivatives within contemporary

capitalism and highlighted the way in which their use has increased risk levels within

the global economy. In this chapter I will explore the pre-crisis regulatory framework

of OTC derivatives in the U.S. and E.U. I argue that the pre-GFC regulatory

framework was dominated by the presuppositions of neo-classical economic

orthodoxy. I explore how the dominance of this intellectual frame on both sides of the

Atlantic led to the emergence of a club style transnational regulatory network or

public and private actors. This transnational network oversaw the emergence of a

ʻlight touchʼ regulatory regime that encouraged the delegation of a significant degree

of regulatory authority to the private sector. I explain how this ʻlight touchʼ regime,

driven by the ideology of efficient markets, failed to address the complexity of real

financial markets and the financial innovation occurring within them. Following the

GFC, the shift in regulatory authority towards private sector actors and its failure to

address financial market complexity and innovation, resulted in claims that the pre-

crisis regulatory regime had fallen prey to multi-level regulatory capture. However, I

argue that the concept of regulatory capture remains an orthodox IPE frame that

sees the market and state as engaging in a perpetual tug-of-war. Instead, I

counterpoise the lack of unity amongst private sector interests with the degree to

which public and private actors shared both an intellectual common ground, and a

28

desire to benefit from the ʻgolden gooseʼ of finance. Thus, I argue that the pre-GFC

regulatory regime reveals a more nuanced market-state relationship that is defined

more by consensus than capture.

Prior to the GFC, the OTC derivatives market in the U.S. had become increasingly

unregulated (DʼSouza et al., 2010, p.476). The Commodity exchange act (CEA) of

1936 had served as a regulatory framework for two overlapping bodies, the

Commodities Futures Trading Commission (CFTC) and the Securities and Exchange

Commission (SEC) (Cardozo, 2012). The Commodities Futures Modernisation Act

(CMFA) of 2000 however, had completely exempted OTC derivatives from regulation

by the CFTC whilst limited their regulation by the SEC (DʼSouza et al., 2010). Only if

a derivative contract was classified as a security was it subject to the securities laws.

However, even the definition of a security had been amended by the CMFA so that it

no longer included certain qualifying ʻswap agreementsʼ, a category that contains a

variety of options, forwards, and other derivative products (Baker, 2010). Since their

creation, the SEC and CFTC had waged an almost constant turf war over the

boundaries of their regulatory jurisdiction (Benson, 1991). The deregulation

introduced as part of the CMFA, in combination with the lack of a single unified

regulatory body, had created a situation whereby regulators were completely unable

to establish a “comprehensive regulatory oversight” (Cardozo, 2012, p.480) over

OTC derivatives in the U.S.

Prior to the GFC, a similar picture appears within the E.U. European pre-crisis

regulation was largely based on national authorities with the Financial Services

29

Authority (FSA) responsible for regulating derivatives trading in the U.K., the largest

single player in the global derivatives market. Here, the Financial Services and

Markets Act (FSMA) of 2000 had removed most derivatives in the U.K. from

regulatory oversight although restrictions did exist regarding which parties were able

to trade in derivatives. Across Europe, efforts had been made to harmonise financial

regulations, with the European Commission using the Markets in Financial

Instruments Directive (MiFID) in 2004 to create common rules for the securities and

derivatives markets. However, the directive adopted a market-making competition-

friendly approach and was “excessively convoluted” (Quaglia, 2010, p.1020), with

national authorities demanding the right to national discretion and/or the gold plating

of specific aspects of the directive (Quaglia, 2010). Similarly, although a push had

been made within Europe for the introduction of central counterparty clearing (CCP)

this had not been put in place prior to the GFC (Cardozo, 2012).

The pre-crisis regulatory framework in the U.S. and the E.U. was dominated by the

pre-suppositions of neo-classical economic theory, with the “pervasive belief in the

social desirability of unfettered markets” (Awrey, 2012, p.2) driving the programme of

de-regulation outlined above. In general, the pre-requisite for entering the financial

policymaking community, prior to the GFC was the ownership of a postgraduate

qualification from a top Anglo-American university where the economic orthodoxy

would be taught (Sitlitz, 2009). This meant that the promotion of the concept of self-

regulating markets by members of the financial community often chimed with the

thinking of regulators and policy makers, as it was largely compatible with the formal

training that they had received (Baker, 2010, Tsingou, 2003, Helleiner and Pagliari,

30

2011). This shared intellectual common ground meant that the private sector was

able to exert influence over financial policy, a process that was facilitated by the rate

of innovation within financial markets and the concentration of financial expertise

within the private sector. Poorly resourced regulators were often several steps

behind with regards to technical knowledge and the emergence of complex new

financial instruments. This led to the emergence of an “epistemic gap” (Weber, 2012,

p.657) between what regulators knew and the level of information necessary for

effectively carrying out their regulatory responsibilities. The private sector was

therefore able to gain a degree of authority, legitimacy and acceptance, with the

public sector tacitly accepting that it could not match and therefore must draw upon

the valuable knowledge and expertise within the private sector (Underhill, Zhang,

2008).

The growing legitimacy of the private sector allowed it to assume a key role within

the transnational policy community, the space where the structure, regulation and

supervision of financial activities and institutions takes place (Baker, 2010). The

transnational policy community had a number of core organizations that brought

public officials and senior financiers together to discuss the structuring of the global

financial architecture. These organisations facilitated the interaction of a group of

elites whose similar educational, social and ideological upbringings (Van der Pijl,

1998, Robinson & Harris, 2000) allowed for the creation of a ʻprofessional financial

ecologyʼ where the boundaries between private and public were increasingly

'blurred,' (Tsingou, 2009) and that cut across the “formal structures of states” (Porter,

2005, p.53). Within a professional ecology such as this, influence over policymaking

31

was gained through expertise and specialist knowledge (Griffith-Jones and Persaud,

2008, Tsingou, 2009). Given the epistemic gap already discussed, this technocratic

framework increasingly allowed private sector ʻexpertsʼ to decide what should and

should not fall within the frame of regulation and policy-making (Strange, 1994).

Financial policymaking was increasingly becoming a technical exercise, with

organizations such as the Basel Committee providing the institutional framework for

coordinated standard-setting. Institutions such as this lacked the formal decision-

making structure, resources or strong enforcement mechanisms of other

international organizations such as the IMF the World Bank and the WTO (Pagliari,

2012) whilst suffering from the same democratic deficit (Porter, 2001). The degree of

influence that market participants had prior to the GFC is clearly demonstrated by

Basel 2, the second accord held by the Basel Committee. The core elements of the

accord, covering minimum capital requirements, supervisory review and market

discipline, were all highly suited to the needs of the largest and most sophisticated

financial intermediaries, and allowed them to ascertain their own exposure to risk

and necessary levels of reserve capital (Pagliari, 2012, p.50). The small, club-like

settings of international financial fora, also made it relatively easy for the US and the

UK to dominate (Drezner, 2007). Encouraging a highly consensual form of

ʻgroupthinkʼ, these fora allowed the interests of the leading banks to play a key role

in the production of regulatory and supervisory standards (Baker, 2010, Tsingou,

2009). Many of the standards and best practice guidelines produced in the pre-GFC

period were the product of private organizations such as the International Swaps and

Dealers Association (ISDA), the Futures Industry Association and the Derivatives

32

Policy Group. The dominant mode of pre-crisis governance in the OTC derivatives

market on both sides of the Atlantic can be best described as ʻstandards aligned self

governmentʼ (Tsingou, 2009).

The dominance of the scientific theories of financial economics within the pre-crisis

regulatory regime meant that it was ill-suited to address the complexity of

contemporary financial markets. Theories such as the Efficient Market Hypothesis

and Modern Portfolio theory, share a number of underlying assumptions; perfect

information, the absence of transaction costs and rational market participants.

According to these assumptions all market participants have perfect knowledge

about the price, utility and quality of goods, buyers and sellers do not incur any costs

in making an exchange of goods, and all actors always make the optimal decision

when buying and selling (Shiller, 2003). However, these theories “cannot be

maintained as accurate descriptors of the world.” (Shiller, 2003, p.102) Instead,

within OTC derivative markets, information is costly and unevenly spread,

transaction costs are widespread, and market participants regularly demonstrate

cognitive biases and bounded rationality2 (Awrey, 2012).

Complexity and Innovation within Financial Markets

In this section, I will build on the work of Dan Awrey to outline the six sources of

complexity within OTC derivative markets, explore the relationship between

2 Bounded rationality describes a situation whereby the ability of an individual to make an optimal decision is determined by the availability of information.

33

complexity and financial innovation, and argue that private financial actors have a

vested interest in maintaining the complexity of financial markets.

Technology has played a significant role in the growth of financial markets.

Developments in telecommunications have facilitated the creation and

communication of information (Langley, 2002, Hauswald, 2003). This has lowered

information costs and allowed the development of sophisticated methods for

calculating the value of financial assets. However, technological advances have also

created information costs, which have contributed to market complexity. Developing

the necessary in-depth understanding of financial theory required to understand

these models requires a large investment in ʻhuman-capitalʼ as does developing the

technical expertise and experience to use them effectively (Awrey, 2012). Advances

in the ability to process information increases the informational advantage of

sophisticated financial intermediaries that can afford these costs, creating the scope

for informational rent-seeking and an increase in the cost of information (Hauswald,

2003).

Opacity also contributes to the complexity of financial markets. The OTC derivatives

markets are particularly opaque with regards to pricing information and identifying

counterparties. Because OTC derivatives are effectively bespoke and individualised,

there is no large secondary market from which market valuations might be ʻderivedʼ,

and the pricing of derivatives is therefore overly reliant on the valuation models used

by the same institutions that create them (Engelen et al, 2012). Many financial

institutions also demonstrate opacity as the number of positions held, the

34

sophistication of the financial instruments and the complex and sometimes

contradictory nature of the market makes it extremely difficult to determine the

overall value / risk of a counterparties loan-book (Awrey, 2012). The dense

“information thicket” of vast volumes of data within modern financial markets, also

makes specific information extremely expensive to obtain, filter, and analyze.

The growing integration of financial markets and institutions has created complex yet

fragile net of counterparty arrangements between a small number of systemically

important financial institutions (Awrey, 2012). By 2009 out of a total world derivative

market valued at $614,673 billion, the top 5 US banks held approximately a one third

share (Engelen et al, 2012). The balance sheet of each of these institutions are

connected to the markets and then via the markets back to the balance sheets of

other financial institutions through the use of mark to market accounting methods.

These linkages create system wide feedback effects between asset values, leverage

and liquidity, making it difficult and expensive to identify and monitor potential

sources of risk within the financial system (Awrey, 2012).

Securitization is the perfect example of how the fragmentation of economic interests

takes place alongside market integration. Securitization transforms what was often

initially simply a bilateral relationship - for example between a bank and the holder of

a mortgage – into a complex web involving many counterparties. Each time assets

are repackaged through securitization, the relationship between counterparties and

the underlying assets in which they have invested becomes increasingly abstract.

This process of abstraction not only increases the information and coordination costs

35

for counterparties but it also dilutes the incentives for counterparties to coordinate

their activities or invest in the acquisition of information. Fragmentation thus also

represents a significant driver of complexity within modern financial markets (Awrey,

2012).

The complexity of modern financial markets can also be exacerbated by the

complexity of the regulatory regimes created to govern them. This can be caused by

the tangle of complex rules that have put in place by a number of different and

sometimes overlapping regulatory bodies (Awrey, 2012). Additionally, in requiring

additional information be disclosed, regulation can also contribute to the ʻdata

thicket.ʼ The growing gap between increasingly globalised and integrated financial

markets and institutions and national / regional regulatory regimes can also result in

higher information costs for market participants who have to try and understand and

comply with different regulations in different territories. Higher information costs

increase the likelihood of informational asymmetries and the opportunities for market

abuse that come with this and can also create opportunities for regulatory arbitrage

whereby market participants are able to profit by exploiting opportunities created by

“differential regulations or laws” (Partnoy, 1997, p.227).

The reflexive nature of financial markets is a final additional source of complexity. An

example of this reflexive nature would be the way in which economists develop

theories about market behaviour that in turn influence the actions of the very market

participants that they sought to understand. Mackenzieʼs examination of the

development of the Black-Scholes options pricing model provides a clear example of

36

the entwined nature of theory and practice (MacKenzie, 2006). When first

formulated, the Black-Scholes model did not fit reality and there was a systematic

difference between it and actual prices. However, over time there was a growing fit

between model and market as the model came to shape the way market participants

thought and talked about options and increasing use of the model reduced the

discrepancies between it and real prices (Mackenzie and Millo 2003). Although the

theory of the ʻperformativityʼ or reflexivity of economics is still considered to be ʻunder

constructionʼ (MacKenzie et al, 2007), it is clear that the practices of finance do not

exist completely independently from the ideas and beliefs about them (De Goede,

2002). The interactions between the perceptions of market participants and

regulators, their subsequent actions based upon those perceptions and the impact of

these actions within the markets themselves can generate complex and sometimes

self-reinforcing feedback loops (Awrey, 2012) that add to levels of market

complexity. Technology, opacity, interconnectedness, fragmentation, regulation and

reflexivity together create a degree of complexity within OTC derivative markets that

creates significant information costs and leads markets to function in very different

ways from those posited by the models of conventional financial theory that

dominated the pre-GFC regulatory regime.

Having ascertained the complexity of these markets, exploring the relationship

between this complexity and financial innovation casts some light on the incentives

of market participants with regards to financial regulation. Financial innovation has

conventionally been seen as a rational demand side response to market

imperfections that limit the ability of market participants to maximize their “utility

37

functions” (Miller, 1986). In bypassing these imperfections, financial innovation is

seen to yield “economic benefits that are no less real than improvements in physical

technology” (Silber, 1983, p.94). However, in seeking to understand financial

innovation from a supply side perspective Dan Awrey argues that financial

intermediaries possess additional incentives to innovate, including the desire to

mitigate the potentially negative impact of regulation on the profitability of their own

operations, or to use their informational advantage to procure the ongoing extraction

of rents (Awrey, 2012). This view of financial innovation, chimes with the work of

Engelen et al who borrow the concept of 'Bricolage' from Levi Strauss to describe

financial innovation as "contingent, resourceful and context-dependent." (Engelen et

al., 2013, p.54). Derivative products are the most profitable part of the worldsʼ

financial markets (Tett, 2008). It is impossible to protect the ʻintellectual propertyʼ of

these financial innovations however, and the quick turnaround of new instruments

leads to rapidly falling profit-rates (Engelen in Clark et al, 2009). This creates an

enormous driver for innovation (Augar, 2005), not only to create new products

differing from those of rival companies, but also that differ from previous versions of

the same product. This can lead to financial intermediaries creating products, whose

benefits have been described by Lord Adair Turner, former chairman of the Financial

Services Authority (FSA) as being "at best marginal" (Turner, 2009) yet which

contribute further to the overall complexity of the system.

The supply side incentives for financial innovation demonstrate the way in which

financial intermediaries actually benefit from the complexity of the financial system.

Sophisticated financial intermediaries enjoy a higher tolerance for complexity relative

38

to other market participants. In markets such as the OTC derivatives market, that are

opaque and illiquid, and where financial intermediaries play an important market

making role (Duffie, Garleanu, Pederson, 2004), these organizations can exploit

information asymmetries to extract rents by miss-selling products and services that

their clients may not fully understand (Polato, Floreani, 2011). The interrelationship

between innovation and complexity is a mutually reinforcing one. Financial

intermediaries use the complexity of the financial system to their benefit, creating

new complex financial products that have high information costs, are traded in

opaque markets and that generate new interconnections and additional complexity.

These products create the possibility of misuse, miss-selling, or over-leveraging, all

of which can increase the level of risk within the system (Dorn, 2011). The SECʼs 22-

page lawsuit against Goldman Sachs provides a perfect example of this, highlighting

the way in which a company exploited information asymmetries to defraud investors

out of more than $1bn (Securities and Exchange Commission, Litigation Release No.

21489).

Regulatory Capture?

As well as increasing the level of risk within the global economy - and providing

avenues for the transmission of contagion during periods of market stress, (Pritsker,

2000), the growing complexity of financial markets makes it increasingly difficult for

regulatory agencies to monitor and police incidents of excessive risk taking or market

abuse. Financial innovation allows sophisticated market participants such as the

largest banks to exploit informational asymmetries that arise as a result of the

39

complexity of markets, providing an incentive for maintaining the complexity of the

system (Dorn, 2011). The growing influence of a small number of private market

players within the pre-GFC regulatory system, and the failure of this regulatory

system to resolve the issues of complexity and innovation within these markets, has

led to scholars such as Andrew Baker to argue that a form of “multilevel regulatory

capture” had taken place prior to the GFC (Baker, 2010, p.86). Regulatory capture

describes a process whereby the content of financial regulation was being actively

designed by, and in the interests of, the regulated industry itself. (Bo, 2006, Stigler,

19771) Thus, it is claimed that the regulation of the OTC derivatives markets

increasingly served the interests of the very financial institutions that it was supposed

to be regulating. The Basel Committee on Banking Supervision has been held up as

the perfect example of financial regulatory capture, with Basel II signifying the point

at which large multinational banks were considered to have 'captured' control of the

regulatory process (Goldin and Vogel, 2010, Helleiner and Porter, 2009, Ocampo,

2009, Tsingou, 2004, Underhill and Zhang, 2008).

The phenomenon of ʻrevolving doorsʼ has played a key component of the regulatory

capture argument. Revolving doors describes a phenomenon whereby there is a

two-way flow of people between the public and private sector. This flow of people

can lead to the ʻcolonizationʼ of regulatory agencies (Baker, 2010, p.652) and the

creation of perverse incentives that encourage regulators to comply with the

demands of the financial industry in anticipation of well-paid future careers within the

industry (Makkai, Braithwaite, 1992). There is significant evidence for the existence

of the revolving door phenomenon as demonstrated by two examples from the U.K.

40

Between January 2000 and July 2009, there were 36 different members of the FSA

board. Of those 36 members, 26 had connections at board or senior level with the

banking and finance industry either before or after their term or office with nine of

these members also continuing to hold appointments in financial corporations whilst

they were at the FSA (Miller, Dinan, 2009). During the period between 2004 and

2006 – a period that coincides with the very height of the pre-crisis financial boom -

James Crosby, the then CEO of HBOS, was also on the board of the FSA (Prat,

2009). A situation had therefore emerged whereby senior members of regulated

financial institutions were simultaneously also overseeing the body responsible for

regulating these same institutions.

The degree of direct lobbying that was undertaken by the financial sector prior to the

GFC has also been used to make the case for regulatory capture. During the 1990s

and 2000s the vast wealth within the financial sector gave bankers considerable

political clout, allowing them to back electoral campaigns and to lobby for regulatory

reform (Baker, 2010). The scale of wealth available for this purpose should not be

underestimated, with the repeal of the Glass-Steagall act in 1999 being described by

Ed Yingling, chief lobbyist for the American Bankers Assocation as “probably the

most heavily lobbied, most expensive issue to come before Congress in a

generation” (Miller, Dinan, 2009). In just one year, the banking, insurance and

securities industries gave $58 million to Federal political candidates. They also

donated $87 million in ʻsoft moneyʼ to the political parties, and they reported

spending $163 million in additional lobbying expenses (Centre for Responsive

Politics). While it is difficult to prove that because parties access money from specific

41

sources, this shapes the policies that they then pursue, the general trajectory of

reform prior to the GFC has been described as being “entirely congruent” with the

banking industryʼs wishes (Baker, 2010) .

There appears to be a strong case for the argument that a form of multi-level

regulatory capture had occurred prior to the GFC, with direct lobbying, the revolving

door and what Lord Adair has described as “regulatory capture through the

intellectual zeitgeist” (Turner, 2009) resulting in the growing delegation of regulatory

authority to the private sector. This process of regulatory capture has been linked

with a failure to address the complexity of the OTC derivative markets and the

associated information asymmetries from which the major financial players - using

financial innovation - have been able to profit. The degree of influence that the

private sector has exerted over the pre-crisis regulatory framework certainly should

not be underestimated. Confidence in market-based practices, close relationships

between regulators and banks and the supremacy of technocratic thinking were all

characteristics of the pre-crisis regulatory regime (Young, 2012). However, the

ongoing heterogeneity of even the largest banks, alongside the persistence of

business conflict with regards to issues of financial regulation, means that private

sector influence was not always as consistent or as systematic as some have stated,

with private sector influence not always leading to the weakening of regulatory

standards. (Young, 2012, p.666)

42

Orthodox IPE and The State / Market Relationship

Although Young underlines the ability of public agencies to resist private sector

demands, he does not seek to challenge the “hard dividing line” (Young, 2012,

p.682) between the public and private spheres that defines the orthodox IPE frame.

Both the concept of regulatory capture and Youngʼs critique therefore remain

bounded within a frame that depoliticises the economic sphere by perceiving the

state and market as separate domains. Whilst acknowledging that there is an

interrelationship between these two, this tends to be defined in terms of a

dichotomous tug-of-war (Underhill, 2010). Within this frame, the postwar BWS era is

described as a period when the state was able to ʻcontrolʼ finance through the use of

capital controls (Helleiner, 1994). In contrast, the collapse of the BWS is viewed as

the ʻunshacklingʼ of an abstract all-powerful global capital that undermines the

capacities of the nation state (Cerny, 1994 Cohen, 1996). The concept of regulatory

capture fits within this frame as it draws a clear line between state and market actors

and reproduces the conceptualisation of the state-market relationship as being an

antagonistic one. However, the state-market divide has been challenged by scholars

who have argued that financial market evolution should be seen as "a political animal

not just in its effects but also in its origins" (Mugge, 2009 p.525). Thus, only by

considering the two together as a state market ʻensembleʼ or condominium (Underhill

and Zhang, 2005) can the true nature of the two be more fully understood.

Whilst Young challenges the regulatory capture argument by underlining the lack of

43

unity amongst private sector actors and emphasising the ability of public regulators

to resist regulatory capture, it should be emphasised that a light touch regulatory

approach was also being actively pursued by national governments (Engelen, 2012).

Operating within the same free-market intellectual frame as their private sector

counterparts, the discipline imposed by regulators was increasingly seen as ʻrule-

based, bureaucratic, episodic and slow to changeʼ in comparison with the ʻflexible,

forward-looking, continuous and non-bureaucraticʼ nature of market discipline

(Herring, 2004). With an increasingly integrated global economy having weakened

the capacity of individual nations to effectively regulate and monitor markets, the

shifting of some of this responsibility onto the very same private market actors was

seen as a way of "enabling public authorities to pursue their tasks more efficiently"

(Underhill and Zhang, 2008, p.536), a means of preserving financial stability without

“stifling innovation or posing unnecessary costs” (Pagliari, 2012, p.48). Encouraged

by the success of the short-lived boom of the mid-2000s, public officials such as

Gordon Brown in the U.K., also saw the promotion and encouragement of ʻlight

touchʼ regulation as the most effective model for achieving sustained economic

growth (Engelen et al, 2012).

The pre-crisis regulatory framework can be characterised by a growing emphasis on

transnational standard setting through small, semi-formal and informal institutions

and networks. This 'cosy' network facilitated an ongoing process of 'elite integration',

a process that has been facilitated by a revolving door between senior positions

within private and public financial institutions (Chari and Bernhagen, 2011). As a

result of what has been referred to as the “hubristic detachment” (Engelen et al,

44

2012) of political elites, the revolving door helped to create an environment in which

the interests of private financial sector actors had become an integral part of a policy

making process increasingly viewed as a technical and apolitical affair (Tsingou,

2009). The largest most sophisticated market players were able to use financial

innovation to exploit and profit from the information asymmetries that arise from the

complexity of financial markets such as the OTC derivatives markets (Dorn, 2011,

p.443). Whilst a number of scholars have argued that the pre-GFC regulatory regime

in the U.S. and E.U. represents an excellent example of regulatory capture, I argue

that the influence of private sector actors was not as systematic or continuous as has

been presumed, and did not always lead to de-regulation. In drawing a clear divide

between private and public sector actors, the regulatory capture argument also falls

within an Orthodox IPE framework that misses the nuances of the relationship

between state and market by failing to see them as an deeply interconnected whole.

Whilst acknowledging the degree to which regulatory efforts such as the Basel II

Accord appeared to serve private sector interests, I argue instead that the pre-GFC

regulatory regime was shaped by the emergence of a professional financial ecology

involving both public and private actors. This professional ecology was characterised

by a shared intellectual common ground, which, in combination with an ongoing

revolving door between the two sectors, led to a blurring of the boundaries between

the two. The emergence of a light-touch regulatory regime with an emphasis on self-

regulation occurred not simply because the policy-making agenda had been

ʻcapturedʼ by the private sector. Its emergence can instead be understood in the

context of the fact that it chimed with an intellectual free-market zeitgeist that crossed

45

the public/private dividing line. At the heart of this was a conviction that the

innovative nature of markets was in itself a powerful defence against market failure

and that the complexity of instruments such as OTC derivatives allowed them to

function as powerful tools of risk management (Froud, et al, 2012). The pre-GFC

regulatory regime represented not only the interests of large financial conglomerates,

but also of national governments, whose ʻhubristic detachmentʼ from the policy-

making process is a result of the extraordinary expansion of the financial sector

allowing them to reap the benefits of “one of histories great boom periods” (Guttman,

Pilhon, p.3, 2010). This detachment arose as shared stories of 'the Great

Moderation', of the end of boom and bust, and - to quote Ben Bernake, then

chairman of the Federal Reserve - the "enormous economic benefits that flow from a

healthy and innovative financial sector" (Bernake, 2007) increasingly narrowed the

governing agenda, operating in a frame of interests and ideologies that undermined

any political questioning of finance (Froud, et al. 2012). Having outlined this more

nuanced view of state-market relations prior to the GFC, in which growing private

sector involvement in financial regulation was “often encouraged by states

themselves” (Underhill and Zhang, 2008, p.536), in the next chapter I will seek to

explore whether, following the shock of the GFC, the new regulatory frameworks that

have emerged represent change or continuity with regards to this relationship.

46

Chapter 3

Post Crisis Regulation: Change and Continuity

In Chapter two, I argue that the pre-crisis regulatory framework was characterised by

an increasingly cosy relationship between the public and private sector, with a

growing amount of regulatory authority being delegated to the private sector. This

process, which has seen private market agents significantly enhanced their influence

over international policy making processes has been described as "one of the most

salient changes in the global financial system in recent decades" (Underhill and

Zhang, 2008, p.535). In this chapter I explore the development of post-GFC

regulation with regards to the OTC derivatives market. In doing so, I acknowledge

the degree to which a re-politicization of financial regulation has occurred. I also

recognise the efforts have been made to develop market infrastructure, including

Central Counterparty Clearing Houses (CCPs) and Trade Repositories (TRs),

changes that have the potential to reduce the complexity of the OTC derivative

markets. However, arguing against claims that a 'paradigm shift' from pre-GFC

financial regulation has occurred, I demonstrate the degree of continuity between the

pre-crisis and post-crisis regulatory frameworks by emphasising the resilience of

'private–public' regulation (Savage and Williams, 2008). Although efforts have been

made to resolve some of the issues of complexity within global financial markets, a

simple technocratic fix will not rectify the pernicious affects of OTC derivatives

because it fails to take into account the complex interrelationship between state and

market. I draw on the work of Froud et al, to take into account the importance of

47

narrative or 'elite storytelling.' I outline how the old, familiar stories that had provided

the ideological foundations for the pre-GFC framework - such as that of the 'great

moderation - were increasingly replaced by competing stories from bankers,

politicians and regulators. The post-GFC regime does not demonstrate the same

level of consensus amongst different actors as the pre-GFC regime did. However, I

argue that the slow and fragmented way in which regulation in the U.S. and E.U. has

been implemented is demonstrative of the fact that that the “intellectual and

institutional parameters” (Tsingou, 2009, p.14) of international regulation are still

being shaped by the same elite state and private market actors. It is these actors

who shaped the pre-GFC regulatory regime, and whose “hubristic misjudgment”

(Engelen et al, 2011, p.21) during the build up to the GFC created a financial system

that has in many ways become ungovernable.

The impact of the GFC of 2007-10 should not be underestimated, with "every big

capitalist democracy being forced to take a large chunk of its financial system into

public ownership" (Haldane, 2010). The use of public money to bail out and support

financial institutions led to an “unprecedented politicisation of financial regulatory

politics” (Pagliari, 2011, p.52). Within the context of OTC derivatives, it quickly

became apparent that the operational infrastructure that had been developed under

a system of self-regulation prior to the crisis had been unable to keep up with the

exponential growth in volume of derivatives trading (Presidentʼs Working Group on

Financial Markets, 2008, pp.7-8; Awrey, 2012; Duffie, Li, Lubke, 2010). However, the

initial regulatory response to the crisis bore a significant resemblance to pre-crisis

strategies. Regulatory bodies from the U.S. met with their main European

48

counterparts and the main derivative market players in a series of behind closed

doors meetings. In these meetings the derivative market participants were presented

with a series of requests from the regulators that were to be met through an ongoing

process of self-regulation (Pagliari, 2011). These meetings resulted in the major

private actors in the derivative market committing to a number of actions that

included increasing the standardisation of OTC derivatives, reporting all credit

derivatives to a central ʻtrade repositoryʼ, reducing the volume of outstanding credit

derivatives trades3 and adopting central clearing parties (CCPs) as a way of

counteracting counterparty risk4 in derivatives transactions.

The initial regulatory response therefore bears a striking resemblance to the pre-

GFC frame with regulators largely relying on market discipline and self-regulation.

However, a shift appears to have occurred, when, following the collapse of Lehman

Brothers and the bailout of AIG, key regulatory technocrats - such as Lord Turner,

new chair of the FSA - on both sides of the Atlantic increasingly began to use

adversarial language, describing much financial innovation as "socially useless", and

began calling for a more "intrusive" regulatory style involving tougher regulatory

restrictions and structural reform (Turner, 2009). Both the U.S. and the E.U. began

to work on comprehensive plans for the regulation and supervision of the OTC

derivative markets under the oversight of public regulatory bodies, a change that has

been described as a “paradigm shift” (European Commission, 2009). In September

2009, therefore, the heads of state of the G-20 met at the Pittsburgh conference to

3 By tearing up contracts that take opposite positions on the same risk 4 Counterparty risk occurs when market participants do not know the extent or stability of their counterpartiesʼ exposure to risk.

49

discuss how to restore long-term stability to the global financial markets. The main

common objectives that were agreed at the conference with regards to the regulation

of OTC derivatives were:

1. All standardised OTC derivative contracts should be traded on exchanges or

electronic trading platforms, where appropriate, and cleared through central

counterparties (CCPs) by end-2012 at the latest.

Clearing OTC derivatives through CCPs is an attempt to reduce counterparty risk. A

CCP takes up a position between the buyer and seller whereby it becomes the buyer

to the seller and the seller to the buyer. In the case of default of any one of its

members, the CCP is the only party affected. CCPs also allow for multilateral netting

– whereby instead of there being one buyer to a seller, CCPs can take offsetting

positions with multiple members of the CCP, diversifying away risk (Aroskar, 2013).

With the use of CCPs, bilateral risk (the danger of a counterparty being unable to

meet its commitments) is reduced but the risk of the operational failure of the CCP

itself remains (Weistroffer, 2009). Pushing the trade in standardised OTC derivatives

onto exchanges and electronic trading platforms represents an attempt to increase

the efficiency and transparency of these markets and “foster greater market integrity

through transparent and enforceable participation and conduct requirements.” (FSB,

2013, p.27)

2. That OTC derivative contracts should be reported to trade repositories.

50

The reporting of derivative contracts to trade repositories represents an attempt to

reduce the level of opacity in financial markets by making information publicly

available. It also assists in the mitigation of systemic risk and in protecting against

market abuses by making information available to regulators. (FSB, 2010, 2013)

3. That Non-centrally cleared contracts should be subject to higher capital

requirements.

Increasing the capital requirements on OTC derivatives contracts is a way of

internalizing the systemic risk costs of derivatives, increasing the resilience of

market participants and encouraging central clearing. (FSB, 2010, 2013)

This new international objective placed the mandate for regulating OTC derivatives

"squarely on the shoulders of public officials" (Helleiner and Pagliari, 2009, p.123).

In creating the financial stability board (FSB), the G-20 were seeking to create the

ʻfourth pillarʼ of the global economic architecture alongside the IMF, the World Bank

and the World Trade Organisation. (Helleiner, 2010) The FSB was tasked with

regularly assessing the implementation of the objectives outlined above. It was also

tasked with assessing if said objectives are “sufficient to improve transparency in the

derivatives markets, mitigate systemic risk, and protect against market abuse” (G-20

Leaders Statement: The Pittsburgh Summit, 2009). The objectives that were agreed

by the national leaders of the G-20 at Pittsburgh represented an attempt to trace the

outline of global policy guidelines but it was left to national governments to build the

regulation that would articulate and enforce these commitments. This has led to

51

Helleiner and Pagliari arguing that the key change that has arisen as a result of the

GFC is therefore that it has "reinforced the role of domestic politics in leading states

as a key driver of international regulatory change" (2009, p.124). I will now focus on

how the U.S. and the E.U. have sought to implement these guidelines to explore

whether such a post-crisis 'paradigm shift' has really occurred.

In the U.S., The Dodd-Frank Act was signed into law in 2010. Title VII of the act

aimed to improve the transparency and stability of the financial markets by imposing

more stringent requirements and rules on the traders of OTC derivatives. These

requirements include improved record keeping, modified business rules and

standards and increased capital requirements and margins. The act requires that an

eligible OTC derivatives contracts be cleared through a CCP and requires that all

standardised derivatives should be traded on an exchange. Under the Dodd-Frank

Act all derivatives that are not exchange traded or traded through a CCP require

putting up collateral or margin to protect the counterparty in the case of default. The

Dodd-Frank Act also includes the ʻpush-outʼ provision forcing banks to spin-off some

of their derivatives related activities and gave the regulatory bodies significant

oversight and supervisory power over market actors and financial contracts.

However, it is worth noting that these supervisory powers exclude commercial

derivatives end-users who are deemed to use derivatives for hedging purposes

(Ariail, 2011).

In September 2010 the EC proposed its “Regulation on OTC Derivatives, Central

Counterparties and Trade Repositories” which is commonly referred to as European

52

market infrastructure regulation (EMIR). Title II of EMIR requires that all standardised

derivatives should be cleared through CCPs. For those derivatives that are not

standardised and therefore centrally cleared, EMIR instructs market participants to

adopt a number of techniques to minimize risk and monitor the value of outstanding

contracts (EMIR, supra n.154, Title II, article 8.1). Article 6 of the EMIR makes the

reporting of OTC derivative contracts to trade repositories mandatory and also

provides standards that the repositories should follow (EMIR, supra n.154, Article 6).

While the EC usually uses directives that leave member states with a degree of

choice as to how to implement them into legislation, in the case of EMIR, regulation,

being legally binding from the point it is passed and on a par with national laws, was

used so as to ensure continuity amongst the member states (European Commission,

2012).

There are broad similarities between the Dodd-Frank act and EMIR, as result of their

goals being defined within the context of the Pittsburgh G20 conference (Janda and

Rausser, 2011). The Dodd-Frank Act and EMIR both also have essentially the same

scope although the scope of EMIR is arguably slightly wider, as it integrates all

eligible derivatives whereas the Dodd-Frank only includes standardised derivatives

(De Meijer, Wilson, 2010). Under EMIR, derivative trading will continue to be

regulated by national regulators. CCPs sited within the E.U. will also fall under their

supervision whilst the European Securities and Market Authority (ESMA) will focus

on developing technical standards and overseeing CCPs outside of the E.U. (Janda

and Rausser, 2011). In the U.S., the Dodd-Frank Act allows for the continued

distribution of regulatory responsibilities between the CFTC and the SEC. While the

53

U.S. and E.U. approaches are similar, there are some important differences, which

emerge in the detail of the regulation. Thus, in the E.U., the difference between

standardised and CCP-eligible derivatives is ignored, with all standardised OTC

contracts being pushed onto CCPs. In the U.S., on the other hand, only eligible

contracts will be centrally cleared. They cannot be cleared without the approval of

both SEC and CFTC, and can only be cleared if both parties are dealers and/or

major swap participants. (Lannoo, 2010). With regards to CCP clearing, there are

more exceptions in the U.S. legislation, whilst the E.U. approach is more thorough

and prescriptive, requiring the use of a mutualised CCPS5 (Aroskar, 2013). Unlike

the EMIR, The Dodd-Frank Act requires that transactions that are subject to the

clearing requirement are also subject to the mandatory exchange-trading

requirement. (Janda and Rausser, 2011, p.6) For contracts that are not centrally

cleared, legislators on both sides of the Atlantic will impose higher capital charges

and margin requirements. The E.U. exempts any user not subject to central clearing

(Aroskar, 2013, p.50) whereas the US, exempts all non-financial end users (Lannoo,

2010) Data repositories will be mandatory for all transactions in the EU but only for

non-centrally cleared transactions in the US. The U.S. regulation is more stringent

with regards to maintaining confidentiality, which means less post-trade transparency

(Aroskar, 2013). Overall the E.U. regulation will provide greater levels of

transparency than its U.S. counterpart. The Frank-Dodd act does however call for

limiting the stake that frequent users of derivatives can hold in central clearing

houses at below 20% in an attempt to contain conflicts of interest when these

clearing houses have to determine whether or not a derivative transaction must pass

5 Whereby all members would share the costs of a clearing members default.

54

through central clearing (Lannoo, 2010). The E.U. Legislation lacks a similar

measure about the ownership of clearing houses and does not have an equivalent to

the ʻpush outʼ rule of the Dodd-Frank act6, or of the Volcker rule7 (Janda, Rausser,

2011)

While the approaches of the Frank-Dodd Act and EMIR are similar there are

therefore a number of differences between the two pieces of legislation, perhaps the

most significant being the dual jurisdiction of the CFTC and SEC in the U.S.

(Cardozo, 2012, p.497). These differences are important, as they may lead to the

possibility of regulatory arbitrage,8 which would have a significantly adverse effect on

the effectiveness of both pieces of legislation (Partnoy, 1997). The final shape of the

new OTC derivatives markets and the effectiveness of this regulation depends on its

successful implementation. In general, the Dodd-Frank Act gives regulators both the

scope and the authority to interpret key provisions of the underlying legislation and

would appear to allow private market actors to exert more influence. The EU

Regulation, in contrast, provides a much narrower role for regulatory agencies that is

primarily concerned with enforcing the appropriate acts and technical standards.

(Cardozo, 2012, p.490) Whilst this might appear less open to influence from private

market interests, as previously discussed, it was the viewing of financial regulation

and policy-making as a technocratic and largely apolitical process, that allowed

private market actors to establish so much influence on these processes prior to the

6 Which restricts the derivatives trading activities of banks. 7 Which restricts the proprietary trading operations of banks. 8 Regulatory arbitrage described the process whereby private market actors can increases profitability by exploiting the differences between different laws and regulations

55

GFC.

At the Pittsburgh conference of 2009, G20 leaders agreed that all standardized OTC

derivative contracts should be traded on exchanges or electronic trading platforms,

where appropriate, and cleared through central counterparties by end-2012 at the

latest (FSB Progress report, 2013). Most provisions of the Dodd-Frank Act and

relevant rules were due to take effect by July 2011. The EU regulation was intended

to be in force by 2012, and EU technical standards were due to be completed by the

end of June 2012 (Janda and Rausser, 2011). Both the U.S. and E.U. have

implemented legislation requiring all standardized OTC derivatives to be cleared

through CCPs. However, within the E.U., further technical standards determining

which products are subject to the clearing obligation have not yet been adopted (due

Q4 2013) and no products are currently required to be cleared (FSB, 2013). In the

U.S. although Swap funds and private dealers began clearing in March 2013,

clearing for other market participants has yet to be phased in and additional

implementing regulations establishing clearing requirements have still to be

implemented. The US remains the most advanced jurisdiction with respect to trade

execution requirements, with certain requirements for sufficiently standardized and

liquid OTC derivatives becoming operative over the course of 2013. The EU is

lagging behind here with legislation introducing a mandatory trading framework still

in the final stages of negotiation. Progress in the implementation of this objective

therefore lags behind other areas. Legislation requiring the reporting of information

to trade repositories is in place in the E.U. Mandatory reporting for IRS and CDS

transactions is due in Q.3 of 2013 with mandatory reporting for FX, Commodities and

56

Equities due in Q.1 of 2014. In the U.S. as of August 2013 all market participants in

all asset classes for OTC derivatives that fall within CFTC rules will be required to be

reported to data repositories (FSB, 2013, p.19). The Basel III framework, coming into

effect from the start of 2013 sets out capital requirements for prudentially regulated

banks. Transactions that are centrally cleared: these will receive a 2% risk weighting

(subject to certain conditions being met), while transactions that remain bilateral will

attract a higher capital charge (FSB, 2013, p.43). Regulatory frameworks allowing for

the setting of margin requirements of non-centrally cleared transactions have been

set in the EU and US, although both jurisdictions are still working on the final

requirements. Although the E.U. and the U.S. are amongst the most advanced of the

G-20 members in terms of implementing reform, it has been far from comprehensive

and according to the latest FSB progress report, “the timeline for applying the full

spectrum for reforms to implement the G-20 commitments still stretches way beyond

2013” (FSB, 2013).

U.S. and E.U. regulatory responses to the GFC do go some way towards addressing

the risks to the financial market that arise as a result of its complexity, although as

highlighted above, the fragmented way in which this regulation is being implemented

as it becomes entangled in turf battles struggles between different regulatory bodies,

(Froud, et al, 2012) means that the effectiveness of much of what has been put in

place can be brought into question. Whilst attempts have been made to reduce

levels of complexity within the OTC derivatives markets however, there remains little

sign of any effort having been made to resolve the issue of financial innovation. In-

fact, the way in which the new regulation differentiates between centrally cleared and

57

non-centrally cleared OTC derivative products through margin requirements, could

actually drive innovation, as market participants seek to avoid these higher costs.

A re-politicization of financial regulation does appear to have occurred, with

politicians seeking to seize back much of this authority (Helleiner, Pagliari, 2011) and

moving to strengthen regulatory institutions. This politicization, created a window of

opportunity for advocates of more stringent financial regulation to put their priorities

back onto the regulatory agenda (Pagliari, 2012). However, the greater role played

by elected regulators and the re-nationalization of financial regulation has meant that

many regulatory institutions such as IOSCO, which previously worked on informing

the content of domestic policies, have increasingly had to take on the role of seeking

to address the growing fragmentation of regulatory responses (Pagliari, 2012). At the

same time, regulatory developments have continued to take place "against a strong

transnational governance background" retaining many of its pre-GFC characteristics

(Tsingou, 2009, p.14). Throughout international, transatlantic, regional, and national

networks, the same players and ideas remain in circulation. The high level group on

financial supervision was established by the EU to report on the issue of financial

regulation. Otmar Issing, former chief economist of the European Central Bank, and

currently an International Advisor to Goldman Sachs, is one member of the The High

Level Group on Financial Supervision. Issing is typical of this group in holding or

having held senior private and public positions within the financial sector. The high

level group, therefore, provides a perfect example of how the same actors have

coordinated themselves ever more tightly since the GFC, retaining regulatory and

policymaking influence (Dorn, 2011).

58

Rather than bringing about wholesale change to the financial system, the majority of

reform proposals are more about tinkering with, and preserving it. The ʻenduring

powerʼ of transnational interests is demonstrates further by the incremental and

fragmented nature of much of the regulatory reform. In providing opportunities for

regulatory arbitrage, and in failing to effectively address issues such as complexity

and financial innovation, the current reform programme ensures that the

opportunities for sophisticated private market actors to profit from informational

asymmetries remain plentiful. This has led scholars such as Nicholas Dorn to argue

that "In the architecture and functioning of financial market regulation, information

asymmetries are not only strongly present but also institutionalized" (Dorn, 2011,

p.443). The fragmented way in which financial regulation has been implemented by

states at the national level also suggests that the incentive to free-ride9 remains

(Simmons, 2001), although elected policymakers are also much more susceptible to

the pressures of their domestic constituencies, and are therefore less likely to be

concerned with the need to maintain international regulatory consistency (Pagliari,

2012). Dorn has explored the way in which concepts such as fraud and conflict of

interest have been framed following the GFC, to explore the changing nature of the

private-public regulatory architecture. During the first stage of the GFC response,

states bailed out banks and only took action against the most undeniable financial

market criminals. During the second stage, as states increasingly re-politicised

regulatory bodies and came under strain from their electorates, they started to take a

stronger line against the markets. (Dorn, 2011) While electoral pressure has led to

59

states taking a stronger line against markets, the ongoing suspicion of governmentsʼ

ability to run banks or shape financial regulation effectively, in combination with a

continuing public sector 'inferiority complex' has meant that the ʻgrand old menʼ of

finance are playing a significant role in the response to the crisis (Tsingou, 2009),

and actively seeking to 'reconstruct' public policy making structures.

The way in which private market actors moved away from supporting self-regulation

of the OTC derivatives market, with actors such as Alan Greenspan acknowledging

that he had been 'partially' wrong to oppose CDS regulation (Das, 2009), highlights

the way in which these actors recognised the momentum in favour of regulatory

change and instead sought to proactively shape its direction (Labaton, Calmes,

2009; Helleiner, Pagliari, 2009). An example of the way in which private market

actors sought to shape policymaking is demonstrated by the chairman of the

Alternative Investment Management Association,10 who criticised the G20 process in

2010, calling for it to be overhauled. This example also demonstrates the way in

which organised private interests sought to turn the spotlight of 'regulatory reform'

away from themselves and back onto states (Bó, 2006), just as states have sought

to mitigate public anger by appearing to take a harder line with market actors (Dorn,

2011). The position of private market actors has not always been defensive however,

with some arguing that many of the changes being implemented by policymakers

will, in the long run, benefit the derivatives industry.

9 Free riding - To seek a competitive economic advantage, by implementing less stringent standards. 10 An interest group representing hedge funds.

60

It is important to note the heterogenous nature of industry preferences in and around

the financial markets, whereby private market actors may share anything from

common interest to outright hostility (Helleiner, Pagliari, 2009). However, Dorn and

Levi, in exploring the outcome of the civil charges laid against Goldman Sachs by the

SEC, argue that when shaken by an event such as the GFC, financial elites "seek to

build capacity for collective action" (Dorn, Levi, 2004), and it is worth noting how

quickly the financial industry as a whole, moved to restate both the social and

economic benefits of innovative financial markets. In the U.K. for example, the

Wigley and Bischoff reports both hailed the success of the British financial services

industry, virtually ignoring the GFC and emphasising instead the industriesʼ ability to

create jobs and generate tax revenues (Wigley, 2008, Bischoff and Darling, 2009).

The derivatives industry has generally moved towards favouring 'official' regulation,

however in doing so it has been largely successful in avoiding more "heavy handed,

and detailed" forms of regulation (Helleiner and Pagliari, 2009, p.145). It appears that

as the memory of the crisis fades, and public anger diminishes, a return to business

as usual "appears not only possible but also all-nigh inevitable" (Dorn, 2011, p.442).

Although the GFC has changed the way in which financial regulators have operated,

continuity with the pre-GFC regulatory regime remains, with private actors

influencing regulatory rule making and colluding with public authorities to create so-

called 'public' regulation (Dorn, 2011).

Whilst some important regulatory changes are occurring, the "intellectual and

institutional parameters of international regulatory change are [still] being defined by

the protagonists of the pre-crisis governance arrangements” (Tsingou, 2009, p.14).

61

The effects of the GFC threatened the legitimacy and authority of private sector

actors within the transnational policy community. However, the degree to which the

same intellectual frames have remained in place is demonstrated by the fact that In

2010 the Committee of European Securities Regulators recommended risk

assessment methodologies using measures including historical data, and value at

risk, that had been completely discredited by the GFC (Aboulian, 2010). Despite the

fact that the crisis has made it harder to claim that regulation of financial markets

should be left to experts, does not concern citizens, and is better left to private–

public interests (Dorn, 2011), these ʻexpertsʼ have not been fully discredited and the

same interests retain influence in institutions such as the Basel Committee and the

FSB. It is possible therefore, to trace a resurgence of confidence among public-

private elites, who are well positioned to shape its response (Bernhagen, 2010). This

chimes with the work of David Harvey who argues that the disruption caused by

economic crisis actually provides an opportunity for elites to reassert their power

(Harvey, 2006).

In this chapter I have acknowledged the "unprecedented politicization of financial

regulatory politics" (Helleiner and Pagliari, 2009, p.150) and a shift away from self-

regulation of the financial sector. However, whilst domestic financial regulatory

issues have become increasingly politicised, I argue that the ongoing authority of the

transnational policy community has limited the impact of this development (Tsingou,

2010). The Frank Dodd Act and EMIR demonstrate the ad-hoc way in which OTC

derivative regulation is being implemented, allowing opportunities for both state free-

riding and regulatory arbitrage. I argue that this technocratic approach to derivative

62

regulation cannot succeed, not only because it fails to address issues such as

financial innovation, but because it plays back into the hands of a public-private elite

who, as the memory of the GFC slowly fades from the public consciousness, remain

in the position to shape regulation in a way that suits their interests. The 'groupthink'

of the pre-GFC reflected “a stable frame and immediate cross group acceptance of

the liturgy about financial innovation" (Froud et al, 2012). This stable frame no longer

remains, and the post-2008 world is divided, with the main actors still trying to create

new narratives. However, whilst tensions have emerged between regulators and

private market actors that were much less in evidence prior to the GFC, the

ʻrevolving-door still operates and the state-market ʻboundaryʼ, remains highly

permeable (Froud et al, 2012). The process of re-regulation following the GFC has

focused primarily on the problem of financial risk, largely ignoring the chronic

socioeconomic insecurity of those - not only the poorest in society but the working

and middle classes too - who have borne the brunt of the crisis most heavily. (Peck,

2010). Thus, although financial regulation has been re-politicised, it is yet to be

democratised. Despite the enormous impact of the GFC on the global economy,

despite all of the rhetoric, the fact remains that "fundamental change is… by no

means assured” (OʼBrien, 2013) and it appears increasingly that the opportunity for a

real 'paradigm shift' in financial regulation has been missed.

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Conclusion

At the beginning of this dissertation I set out to explore the significance of OTC

derivatives within contemporary capitalism. In doing so, I have sought to understand

what efforts to regulate their trade in the U.S. and E.U. reveal about the nature of

contemporary financial markets and the changing relationship between the market

and political authority. Although OTC derivatives have tended to be understood

within a risk-based framework that has often been viewed in terms of a dualistic

hedging v.s speculation dichotomy, I have argued that this conceptualisation is too

simplistic. Instead, I have demonstrated the variety of valuable functions that OTC

derivatives can perform, and the way in which these functions are not just linked by

the concept of risk, but also by the ways in which they facilitate the accumulation of

capital. Derivatives facilitate the accumulation of both capital and risk because of the

way in which they derive new value from pre-existing value. Thus, derivatives allow

for the creation of new value that is derived from existing value through a process of

seeking to take on and manage additional risk, a process that explains the

paradoxical way in which derivative use can appear to simultaneously reduce

(manage) and increase (systemic) risk.

OTC derivatives play a significant role within contemporary capitalism, facilitating the

accumulation of capital whilst also generating additional risk within the global

economy. Exploration of the regulatory frameworks surrounding the OTC derivative

markets has shed light not only on the nature of these markets but more importantly

on the classic IPE question regarding the nature of the relationship between

64

economic structures (market) and political authority (state). In exploring the pre and

post-GFC regulatory regimes I have demonstrated the importance of both economic

ideas, and what Froud et al have referred to as “elite storytelling” (Froud et al, 2011)

in shaping regulation. I have argued that the pre-GFC regulatory regime was shaped

by a trans-national network of state and private actors that emerged within the

context of a dominant free-market zeitgeist, blurring the state / market divide. The

ʻlight-touchʼ regulatory regime, which delegated an increasing degree of regulatory

responsibility to private market actors, should not simply be seen as being

representative of the capture of the regulation-setting framework by the largest

financial conglomerates.

Although the failure of this regulatory framework to address issues such as

complexity and financial innovation was undeniably in the interest of the financial

institutions that it was supposedly regulating, a simple diagnosis of regulatory

capture fails to take into account the degree to which these measures were not

simply a reaction to private sector lobbying – although this too played a role. Instead,

these measures were also actively pursued by national governments, who sought to

benefit from securitization driven economic growth, believed in the effectiveness of

private regulation, and had bought into the narratives of beneficial financial

innovation, and of the ʻgreat moderation.ʼ In chapter three I argue that despite a re-

politicisation of financial regulation and an end to the cosy consensus amongst

private and regulatory elites that defined the pre-GFC regime, the revolving door

between the two has continued to turn, the influence of the same transnational

public-private elites remains intact. Hence, despite the sweeping consequences of

65

the GFC, the regulation of markets such as the OTC derivatives market has not been

democratised.

In exploring the development of the regulatory framework around the OTC

derivatives market, I have succeeding in challenging the orthodox IPE

conceptualization of the state-market dichotomy. Despite the heterogenous nature of

both private and public interests, and despite the disruption caused by the GFC to

the pre-crisis narrative around which consensus was built, a public-private elite has

and continues to shape the agenda of financial market regulation. If the term

regulatory capture were to be applied to the regulation of global financial markets, it

would not be in the context of private sector interests capturing the regulatory

framework prior to the GFC, nor would it be applied in the context of nation states

seeking to seize regulatory authority back from private sector actors through a

process of re-politicization. Instead regulatory capture would refer to the way in

which, despite the growing financialisation of personal income through securitization,

public-private elites have caught and maintained control over the intellectual and

institutional parameters of financial governance. This is no more clearly

demonstrated by the way in which the costs of the GFC have been socialized and by

the fact that six years on from the beginnings of the crisis, there has been no

success in fundamentally reforming a financial system whereby the accumulation of

capital seems to be increasingly tied to the accumulation of risk. Thus although

scholars such as Randall Germain have argued that debates about the norms and

rules of finance are displaying more “publicness”, (Germain, 2007,p.498) financial

regulation remains a long way from becoming democratically accountable.

66

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