\\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 1 30-APR-14 10:57 R A , EGULATORY RBITRAGE E J , XTRATERRITORIAL URISDICTION D -F : T AND ODD RANK HE I US G MPLICATIONS OF LOBAL OTC D R ERIVATIVE EGULATION Christian Johnson* INTRODUCTION A review of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and the multitude of Commodity Futures Trading Com- mission (“CFTC”) and Securities and Exchange Commission (“SEC”) rule- making projects suggests that the United States has entered into a “race to the top” of over-the-counter (“OTC”) derivative regulation. Pressing forward, Con- gress and the CFTC appear to be at least a year ahead of enacting OTC deriva- tive reforms in contrast with other foreign competing jurisdictions. In addition, many of the statutes and rules adopted by the United States go well beyond the relatively modest commitments that competing jurisdictions have agreed to meet with respect to reforming their own OTC derivative markets. The US race to regulate OTC derivatives creates a legal environment ripe for regulatory arbitrage and the isolation of US OTC derivative markets, leaving the United States still vulnerable to systemic trading losses suffered in less or non-regu- lated jurisdictions. US policymakers and regulators believe that losses stemming from unreg- ulated OTC derivative trading could result in systemically significant financial failures in the United States, potentially triggering the next financial crisis. To prevent these systemic failures, the CFTC is aggressively promulgating rules and regulations to implement the Dodd-Frank OTC derivative reforms that will minimize the risk of future losses. The United States is determined not only to regulate the swap trading activity between US persons, but also the global swap trading activity of non-US persons who trade with US persons.1 Given the probable costs and burdens of the US regulatory approach, it is likely that both non-US persons and US persons will try to trade OTC deriva- tives in less-regulated jurisdictions. Failure to control this regulatory arbitrage may result in trading, that was previously being done in the US, moving to darker corners of the already opaque global OTC derivatives market. To control * Associate Dean for Academic Affairs and Professor of Law, University of Utah College of Law. The author gratefully acknowledges that the paper was supported by a grant from CME Group Foundation, administered by The Federalist Society for Law and Public Policy Studies. The views expressed herein are solely the views of the author. 1 See infra Part I.C. 542 \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 2 30-APR-14 10:57 Spring 2014] REGULATORY ARBITRAGE 543 regulatory arbitrage, Dodd-Frank has endowed the CFTC and SEC with unprecedented extraterritorial jurisdiction to regulate the swap trading activities outside of the United States of non-US persons.2 A related concern of regulatory arbitrage, however, is the effect that it will have on the preeminence of the United States as one of the world’s most impor- tant and innovative OTC derivative markets. The United States, and the CFTC in particular, appear to feel ambivalent about this result; instead transfixed on eliminating any possibility that OTC derivative losses could contribute to sys- temic financial risks in the United States.3 The CFTC’s response to challenges that US derivative reforms (not in harmony with other jurisdictions) will make US firms and markets uncompeti- tive is threefold. First, the CFTC appears to believe that the resulting price transparency and increased safety of United States markets from Dodd-Frank reforms will make US markets even more attractive to non-US persons. Sec- ond, it appears that US regulators and policymakers believe that the size, importance, and profitability of US derivative markets will be more attractive to non-US swap dealers the regulatory costs being imposed by Dodd-Frank on both US and non-US participants. A lowly third on the totem pole appears to be compromising US rules to match those of less-regulated jurisdictions.4 Because of regulatory arbitrage, however, Dodd-Frank may instead turn the traditionally robust and innovative US OTC derivative market into an island, where the only participants are those that have no other options as to where and with whom they can trade. Even small regulatory differences between the United States and competing jurisdictions may be enough to move OTC derivative trading offshore. Instead of US dealers, exchanges, and clear- inghouses leading the industry, the US market may become a safe, although smaller, backwater harbor. But such safety may be illusory if swap activity moves to unregulated markets that may, in the long run, have a systemic effect on the United States if such trading results in outsized losses. The simplified analysis of the US approach to derivative reform is that the United States can protect itself from the potential systemic effects of losses from OTC derivative transactions through two ways. First, the Dodd-Frank reforms subject any OTC derivative transaction to US regulation that is exe- cuted with a US person. That would include trades not only between a US person and a US person but also trades between a US person and a non-US person. Under this scenario, the US financial system will not be subject to the risks of a US person entering into systemically dangerous trading since all trades will be subject to Dodd-Frank, regardless of where the swap is executed.5 Second, the United States protects itself from the risks of non-US swap activities of non-US persons (who trade with US persons) by exercising extra- territorial jurisdiction. The CFTC will subject the swap activity of a non-US person (that is classified as a swap dealer or major swap participant under Dodd-Frank) to the Dodd-Frank rules or to the rules of a foreign jurisdiction 2 See infra Part II–III. 3 See infra Part II. 4 See infra Part I.B. 5 See infra Part III.C.3. \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 3 30-APR-14 10:57 544 NEVADA LAW JOURNAL [Vol.14:542 that has rules comparable to Dodd-Frank, regardless of where in the world such trades are executed. The only true escape from the extraterritorial reach of the CFTC would be for swap activity to be done between two non-US parties, neither of whom is subject to either Dodd-Frank registration requirements or to comparable rules from another jurisdiction.6 A key factor in the potential success of the CFTC’s approach is that the major global swap dealers, often referred to as the G14, control the vast major- ity of the global OTC derivative market. Each of the G14 also has significant trading operations in the United States. The United States has made it clear that if these dealers want to continue doing business in the United States, they will not only need to comply with Dodd-Frank with respect to their US customers, but they will also need to demonstrate that they are subject to comparable “Dodd-Frank” regulation of their derivative activities outside of the United States with non-US persons (or comply with US rules). The United States is gambling that this extraterritorial approach to regulation will result in Dodd- Frank effectively serving as a global floor of acceptable OTC derivative regulation.7 The United States is not alone, however, in trying to reform OTC deriva- tive markets. In 2009, the leaders of the individual G20 countries, which include the United States, agreed to require by 2012 that standardized OTC derivatives be traded on exchanges, cleared through central counterparties, and reported to trade repositories, with non-cleared bilateral trades subject to higher capital requirements and margin requirements as well (the “G20 Commit- ments”). Although the respective G20 countries have agreed to the commit- ments, the devil is always in the details. It is inevitable that regulatory differences will emerge between the United States and competing jurisdictions. By enacting rules and regulations that are stricter (or go beyond) those enacted by the other G20 countries, the United States risks pushing non-US persons away from US markets, and motivates US persons to devise ways to avoid US regulation.8 Given the uncertainty, complexity, business disruption, and cost of Dodd- Frank, there is concern that dealers and other market participants alike will attempt to structure their trading activities away from United States dealers, exchanges, and clearinghouses and into jurisdictions that are less restrictive and more flexible. Although this movement may initially be to other G20 jurisdic- tions, there is concern that there may develop OTC derivative markets in non- regulated jurisdictions that allow a party to trade OTC derivatives free (or on more liberal terms) of the rules, standards, and regulations developed in the United States and other G20 countries.9 The incentives to avoid US regulation through regulatory arbitrage are on their face compelling. Dodd-Frank regulation and the G20 Commitments effec- tively require market participants to completely change how they trade, settle, and clear OTC derivatives, demanding large amounts of additional margin, new relationships, documentation, and business practices. Many view the regula- 6 See infra Part III. 7 See infra Part III.B. 8 See infra Part I.C. 9 See infra Part II. \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 4 30-APR-14 10:57 Spring 2014] REGULATORY ARBITRAGE 545 tions as burdensome, costly, and excessive. The Dodd-Frank OTC derivative statutory provisions exceed 300 pages and the proposed and final rules and regulations issued by the CFTC already exceed 4,200 pages in the Federal Register.10 The flip side of regulatory arbitrage, and the hope of the CFTC and US policymakers, is that these regulations and reforms will make OTC derivatives markets more transparent, safe, and efficient, and create incentives to trade and clear them in the United States as opposed to fleeing to less-regulated jurisdic- tions. Chairman Gary Gensler of the CFTC has highlighted the important advantages of transparency in the OTC derivative market. In fact, in spite of the enormous obstacles to clearing OTC derivatives, the volume of cleared OTC derivatives continues to increase even with Dodd-Frank regulations looming in the background. It remains unclear, however, whether these gains will incen- tivize market participants to continue using United States dealers, exchanges, and clearinghouses as the Dodd-Frank rules and regulations become effective in the United States.11 One regulatory approach that may contribute to the isolation of US mar- kets is the potential unwillingness of the United States to allow a non-US per- son, (whether a swap dealer or not) to comply with its own comparable regulations (as opposed to Dodd-Frank Rules) when it is transacting swap activity in the United States. Although such non-US person would be allowed to comply with what is referred to as “substituted compliance” (i.e., its own jurisdiction’s regulations) when it is transacting swap activity outside the United States, it could end up being subject to its own jurisdiction’s regula- tions, as well as Dodd-Frank when it does business in the US. There are already indications that non-US persons may decide that such a situation makes US markets that much more unpalatable.12 The US approach, however, could eventually backfire. Confronted with what many believe to be costly and burdensome US regulations, many partici- pants that do not have operations in the United States may now be reluctant to trade there. Those that do have operations in the United States may still try to trade elsewhere, attempting to exploit even tiny regulatory differences in other regulated jurisdictions or perhaps even shuttering their US activities in order to avoid more complex and costly regulation. It remains to be seen whether the United States and the other G20 countries will be able to completely harmonize their regulatory regimes, eliminating the possibility of regulatory arbitrage. New dealers (not subject to US or G20 jurisdiction) may also spring up to meet the demand of customers that do not want to be subject to US or even lesser G20 regulations. Effecting the OTC derivative reforms envisioned by the United States and the G20 countries will require great attention and effort to avoid regulatory arbitrage. The reduction of Dodd-Frank and the G20 commitments to regula- tory details will be difficult and still remains to be done for many G20 jurisdic- tions. Particularly contentious issues include margin (i.e., collateral) issues, 10 See infra Part II. 11 See infra Part I.B. 12 See infra Part III.C.2. \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 5 30-APR-14 10:57 546 NEVADA LAW JOURNAL [Vol.14:542 exemptions and safe harbors from mandatory clearing and trading, and business conduct standards. Using these G20 objectives as a baseline, the United States has gone well beyond what many jurisdictions may have understood as the reach of these proposed reforms.13 If the United States persists in insisting on other jurisdictions conforming to US regulation or risk extraterritorial jurisdiction, the United States may find itself on the receiving end of the same medicine. Non-US jurisdictions may decide to impose their own extraterritorial jurisdiction on US swap dealers. Swap dealers such as Goldman Sachs and JPMorgan Chase may find them- selves not only complying with Dodd-Frank in the United States, but also sub- ject to inconsistent and perhaps contradictory G20 regulation imposed because of the US swap dealer’s activities with non-US persons in a G20 jurisdiction. Part I will discuss the rise of the global OTC derivative markets and the fears of regulators and policymakers that systemic risks to the US financial markets will stem from losses suffered from OTC derivatives. Part I continues to describe US and the G20’s reform efforts to tame global OTC derivative markets. Part II will focus on the nature and causes of regulatory arbitrage. In par- ticular, Part II will discuss the unique characteristics and peculiarities of OTC derivative trades and markets that may trigger an exodus of trading and partici- pants from US markets into less-regulated environments. It will also discuss examples of regulatory arbitrage in the OTC derivative markets and whether the resulting price transparency and safety of US derivative markets offset the high regulatory costs that motivate regulatory arbitrage. Part III will discuss the CFTC’s and other jurisdictions’ efforts to deal with regulatory arbitrage through extraterritorial regulation, assessing whether these very efforts may affect the vitality and viability of US markets for trading OTC derivatives. If US regulation proves to be overly aggressive and possibly enacted earlier than that of other jurisdictions, the consequences could be severe. First, such regulation could discourage the use of the US OTC deriva- tive markets if such regulation proves to be too costly or burdensome. The paradox of stricter regulation is that it could drive trading out of US markets into darker corners of the derivative markets where latent systemic risks to the US and global financial system could ferment. Second, extraterritorial applica- tion of Dodd-Frank could generate substantial legal uncertainty and confusion as parties attempt to cope with determining which jurisdiction’s rules govern certain transactions. Finally, the effort to avoid US regulation could end up fragmenting global derivative markets and increasing trading and hedging costs for all participants. Lastly, Part IV provides recommendations and ideas that the United States should consider to avoid the possible loss of OTC trading activity in US mar- kets. Part IV will offer a way to analyze the trade-offs between increased regu- lation and regulatory arbitrage. It will also discuss how the United States should consider compromising its level of regulation with that of other jurisdic- tions, such as the other G20 countries. Finally, the paper will offer specific 13 See infra Part II.B. \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 6 30-APR-14 10:57 Spring 2014] REGULATORY ARBITRAGE 547 technical suggestions to the CFTC’s final interpretive guidance that may help minimize regulatory arbitrage issues. I. DRIVE TO REGULATE OTC DERIVATIVES To understand the current drive to create a uniform global regulatory structure of the regulation of OTC derivatives, it is important to understand the size and global nature of OTC derivatives. As regulators were confronted with the financial carnage from the Great Financial Crisis, policy makers and regula- tors feared that future systemic losses suffered in OTC derivative markets could ignite the next financial panic. A. Understanding OTC Derivatives Although OTC derivatives have been characterized as weapons of mass destruction by the great Omaha financial sage Warren Buffet,14 derivatives have always played an important role in commerce. They can provide a critical means for parties to hedge business risks and to speculate with respect to the future movement of prices and indexes. Historically, the most common types of derivatives were options and forward transactions. The derivatives market vastly expanded as parties used organized exchanges to trade futures and options on futures.15 Since the early 1980s, the OTC derivatives market has provided parties with endless possibilities of hedging and speculating using OTC derivative transactions. The general term “derivative” encompasses a wide variety of financial instruments. The classic definition of a derivative is “a financial contract whose value depends on the values of one or more underlying assets or indexes of asset values.”16 Derivatives can be divided into several categories. The most common and simplest division is between derivatives that are traded over organized exchanges (“exchange-traded derivatives”) and those that are traded in the OTC market. Both of these markets are measured in the trillions of dol- lars and continue to grow in size and importance. The exchange-traded derivatives industry is a mature and active financial market. The Bank for International Settlements (the “BIS”) estimated that there were over 86.9 million open futures contracts as of June 2013, of which 27.6 million were entered into in North America.17 The outstanding notional amount 14 WARREN E. BUFFETT, BERKSHIRE HATHAWAY INC., 2002 ANNUAL REPORT 15 (2003). 15 The exchange-traded derivatives market is credited with beginning with the Chicago Board of Trade in Chicago in 1848. History of the CFTC: US Futures Trading and Regula- tion Before the Creation of the CFTC, U.S. COMMODITY FUTURES TRADING COMMISSION, http://www.cftc.gov/About/HistoryoftheCFTC/history_precftc (last visited Feb. 19, 2014). 16 BD. OF GOVERNORS OF THE FED. RESERVE SYS., FED. DEPOSIT INS. CORP. & OFFICE OF THE COMPTROLLER OF THE CURRENCY, DERIVATIVE PRODUCT ACTIVITIES OF COMMERCIAL BANKS: JOINT STUDY CONDUCTED IN RESPONSE TO QUESTIONS POSED BY SENATOR RIEGLE ON DERIVATIVE PRODUCTS 2 (1993); see also U.S. GEN. ACCOUNTING OFFICE, GAO/GGD- 94-133, FINANCIAL DERIVATIVES: ACTIONS NEEDEDTO PROTECTTHE FINANCIAL SYSTEM 24 (1994). 17 BANKFOR INT’L SETTLEMENTS,BIS QUARTERLY REVIEWapp. A, at 147 (2013), available at http://www.bis.org/publ/qtrpdf/r_qt1306.htm. \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 7 30-APR-14 10:57 548 NEVADA LAW JOURNAL [Vol.14:542 of those trades is estimated by the BIS at $25.188 trillion as of June 2013.18 The BIS further estimated that there were 144 million option contracts open, 45.6 million of which were entered into in North America.19 In the United States, futures and options on futures (and the accompanying exchanges and clearinghouses) are regulated by the CFTC.20 Currently there are eighteen exchanges (referred to as “Designated Contract Markets” by the CFTC) operating in the United States.21 Further, there are thirteen clearing- houses (referred to as “Derivatives Clearing Organizations” by the CFTC) in the United States that clear futures and options trades.22 Proponents of the proposed OTC derivative reforms believe that the reduc- tions in credit risk, increased transparency, and price discovery in the exchange-traded market can be exported wholesale into the OTC derivative markets. Clearinghouses act as the intermediary between the buyer and seller.23 A clearinghouse greatly increases the usefulness of futures and options on futures by permitting parties to enter into trades without having to worry about the creditworthiness of their counterparty. Of course, the party is still subject to the credit risk that the clearinghouse may not perform. While there is an actual buyer and seller for each contract sold, the clearinghouse acts as an intermedi- ary between the two parties, and actually steps into the shoes of the counterparty to the respective buyer or seller.24 Since the early 1980s, the OTC derivative market has developed outside of the exchange/clearinghouse environment. This market is dominated by large commercial banks, investment banks, and similar financial institutions that act as swap dealers for the other participants. Parties in this area trade a wide vari- ety of different OTC derivative products.25 The growth and development of the 18 Id. at app. A, at 146. 19 Id. at app. A, at 147. 20 See Mission and Responsibilities, U.S. COMMODITY FUTURES TRADING COMMISSION, http://www.cftc.gov/About/MissionResponsibilities/index.htm (last visited Feb. 20, 2014). 21 See Trading Organizations – Designated Contract Markets (DCM), U.S. COMMODITY FUTURES TRADING COMMISSION, http://sirt.cftc.gov/SIRT/SIRT.aspx?Topic=TradingOrgani zations&implicit=true&type=DCM&CustomColumnDisplay=TTTTTTTT (last visited Feb. 20, 2014). 22 Derivatives Clearing Organizations (DCO), U.S.COMMODITY FUTURES TRADING COM- MISSION, http://sirt.cftc.gov/SIRT/SIRT.aspx?Topic=ClearingOrganizations&implicit=true& type=DCO&CustomColumnDisplay=TTTTTTTT (last visited Feb. 20, 2014). 23 Clearing Organizations: Derivatives Clearing Organizations, U.S. COMMODITY FUTURES TRADING COMMISSION, http://www.cftc.gov/IndustryOversight/ClearingOrganizations/index .htm (last visited Feb. 20, 2014). 24 CHATHAM FIN., THE END-USER GUIDES TO DERIVATIVES REGULATION: OVERVIEW OF CENTRAL CLEARING 2 (2012), available at http://www.chathamfinancial.com/wp-content /uploads/2012/08/Chatham-Financial-Overview-of-Central-Clearing.pdf. 25 COMPTROLLER OF THE CURRENCY, OCC’S QUARTERLY REPORT ON BANK TRADING AND DERIVATIVES ACTIVITIES FIRST QUARTER 2012 1 (2012), available at http://www.occ.gov /news-issuances/news-releases/2012/2012-96a.pdf. In soliciting legal opinions regarding the enforceability of OTC derivative transactions, the International Swaps and Derivatives Asso- ciation (“ISDA”) has developed the following comprehensive list (with definitions) of the various OTC derivative transactions that opining counsel is required to address. This list is generally considered to be comprehensive of the types of various transactions in the deriva- tives markets: basis swap; bond option; bullion option; bullion swap; bullion trade; cap transaction; collar transaction; commodity forward; commodity option; commodity swap; \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 8 30-APR-14 10:57 Spring 2014] REGULATORY ARBITRAGE 549 OTC derivative industry has been aided and fostered by the market’s principal trade group, the International Swaps and Derivatives Association (“ISDA”).26 As the “buy side” (customers of the swap dealers) was demanding custom- ized derivative products from dealers to meet hedging requirements and other needs, dealers became concerned that, under the Commodity Exchange Act, such products could be classified as illegal off-exchange future products.27 In an effort to enhance legal certainty and to determine regulatory jurisdiction over the nascent OTC derivatives market, political pressure was placed on the CFTC to exempt OTC derivatives from their regulatory jurisdiction. Through regulatory and larger Congressional action, OTC derivatives were exempted from CFTC regulation.28 As Gary Gensler, Chairman of the CFTC, noted, “[l]eading up to the financial crisis, swaps were basically not regulated in Asia, Europe or the United States.”29 US banks, however, were at least subject to prudential regulation.30 credit spread transaction; cross currency rate swap; currency option; currency swap; equity forward; equity index option; equity option; equity swap; floor transaction; foreign exchange transaction; forward rate transaction; interest rate option; interest rate swap; physical com- modity transaction; swap option; total return swap; weather index transaction. Memorandum from Mayer Brown Law Firm on the Enforceability of the Termination, Close-Out and Mul- tibranch Netting Provisions of the 1987, 1992 and 2002 Editions of ISDA Master Agree- ments for the Int’l Swaps and Derivatives Ass’n, app. A, at 1–5 (Mar. 13, 2012) (on file with author). 26 About ISDA, ISDA, http://www2.isda.org/about-isda (last visited Feb. 20, 2014); see also John Biggins & Colin Scott, Public-Private Relations in a Transnational Private Regulatory Regime: ISDA, the State and OTC Derivatives Market Reform, 13 EUR. BUS. ORG. L. REV. 309, 309 (2012); Sean M. Flanagan, The Rise of a Trade Association: Group Interactions Within the International Swaps and Derivatives Association, 6 HARV. NEGOT. L. REV. 211, 240–41 (2001). 27 See Steven Lofchie et al., What Is a “Swap” and Other Jurisdictional Questions?, CAD- WALADER CABINET (April 3, 2012), http://www.cadwalader.com/thecabinet/page.php?page _id=33#What%20the%20CFTC%20has%20Jurisdiction%20Over%20and%20Why%20It% 20Matters. 28 See CFTC Policy Statement Concerning Swap Transactions, 54 Fed. Reg. 30,694 (July 21, 1989). The CFTC distinguished OTC derivatives from futures based partly on the fact that OTC trades are individually tailored, are not marketed to the general public, and lack exchange derivative characteristics such as exchange-style offset and clearing. In 1993, the CFTC further confirmed the regulatory division between OTC derivatives and exchange- traded derivatives when it promulgated regulations that exempted OTC derivatives from CFTC jurisdiction, provided again that the OTC transactions were substantively different from exchanged-traded transactions that the Commodity Exchange Act was designed to cover. Id. at 30,695. One important difference was that the transactions were not “standard- ized as to their material . . . terms . . . .” Commodity Options and Agricultural Swaps, 76 Fed. Reg. 6,095, 6,097 n.23 (Feb. 3, 2011) (emphasis added). 29 Gary Gensler, Chairman, U.S. Commodity Futures Trading Comm’n, Keynote Address on the Cross-Border Application of Dodd-Frank Swaps Market Reforms before the 2012 FINRA Annual Conference (May 21, 2012), available at http://www.cftc.gov/PressRoom /SpeechesTestimony/opagensler-113. 30 See Memorandum from the Comptroller of the Currency, Adm’r of Nat’l Banks, on the Risk Management of Financial Derivatives to the Chief Exec. Officers of Nat’l Banks, Gen. Managers of Fed. Branches and Agencies, Deputy Comptrollers, Dep’t and Div. Heads, and Examining Pers. 1 (Oct. 27, 1993) (on file with author), issued by the OCC in 1993, for an example of the requirements that banks acting as dealers are required to meet. \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 9 30-APR-14 10:57 550 NEVADA LAW JOURNAL [Vol.14:542 The OTC derivatives market has experienced nothing short of explosive growth since the early 1980s.31 The total notional amount outstanding as of the end of 2012 (the most recent data) for OTC derivatives was estimated by the BIS to be approximately $633 trillion.32 The gross market value of these trades was estimated at $24.7 trillion with the gross credit exposure calculated to be $3.6 trillion.33 To understand the current OTC derivative reforms, it is important to understand that the key reforms of exchange trading and clearing through clear- inghouses find their root and motivations in the exchange-traded derivative world. There, collateral is king and the trading of futures, options on futures, and options is only done through regulated exchanges and cleared through clearinghouses. In the great debate over OTC derivative regulation, politicians, regulators, and pundits regularly bolster their cases for regulation by trumpeting the size as measured by the notional amount of the global OTC derivative market. By citing to the $633 trillion notional amount statistic, however, they render any rational discussion about the true risks of the OTC derivative industry almost meaningless, the number is simply too large to grasp.34 It is important to under- stand that the notional amount does not provide a direct indication of the amount that can be lost in these markets. The notional amount instead refers to the reference amount that payments in a derivative transactions are based upon.35 For example, an interest rate swap payment would be calculated by multiplying the relevant rate by the notional amount (which typically would reference the amount of the liability that was being hedged). Gross market value instead represents the mark-to-market value of all of the outstanding transactions as of the end of 2012.36 This is typically explained as the amount that would be paid by one party to another party at a particular point in time if the OTC derivatives were to be terminated prior to maturity. Although $24.7 trillion is an extraordinarily large number as well, it does not take into account the effect of close-out netting.37 31 Henry T. C. Hu, Keynote Address: The SEC, Dodd-Frank, and Modern Capital Markets, 7 N.Y.U. J.L. & BUS. 427, 427 (2011). For a general description and discussion of the derivatives market, see 6 CHRISTIAN A. JOHNSON, LEARNING CURVES: A GUIDE TO USING AND NEGOTIATING OTC DERIVATIVES DOCUMENTATION 1–18 (2005). 32 MONETARY AND ECON. DEP’T, BANK FOR INT’L SETTLEMENTS, STATISTICAL RELEASE: OTC DERIVATIVES STATISTICS AT END-DECEMBER 2012, at 1 (2013), available at http:// www.bis.org/publ/otc_hy1305.pdf. These statistics represent the size of the OTC derivative market in the G10 countries (in addition to Switzerland). 33 Id. 34 Id. 35 DEUTSCHE BO¨RSE GRP., THE GLOBAL DERIVATIVES MARKET: AN INTRODUCTION 38 (2008), available at http://www.math.nyu.edu/faculty/avellane/global_derivatives_market .pdf. 36 BANK FOR INT’L SETTLEMENTS, BIS QUARTERLY REVIEW: INTERNATIONAL BANKINGAND FINANCIAL MARKET DEVELOPMENTS 24 (2007), available at http://www.bis.org/publ/qtrpdf /r_qt0712.pdf. 37 INT’L SWAPSAND DERIVATIVES ASS’N, OTC DERIVATIVES MARKET ANALYSIS YEAR-END 2012, at 3, 9 (2013), available at http://assets.isda.org/media/467fbf64/438d9f0f.pdf/. \\jciprod01\productn\N\NVJ\14-2\NVJ213.txt unknown Seq: 10 30-APR-14 10:57 Spring 2014] REGULATORY ARBITRAGE 551 Finally, the gross credit exposure of $3.6 trillion represents the net amount that would be payable, after taking into account close-out netting.38 This is the amount of net exposure that participants in the OTC markets have to each other, that could be lost in the event that parties (and the global OTC derivative financial markets) are at risk, and that is typically collateralized.39 B. Global OTC Derivatives Markets and Systemic Risk OTC derivatives were initially developed to help parties manage various business risks. For example, one of the first publicly-reported swaps was used to help the World Bank and IBM manage foreign exchange risk through a for- eign exchange swap.40 Although, given the size of the OTC derivative market, it could be argued that the industry has an exemplary record, there are numer- ous historical examples of failures to which critics continue to call attention. As the recent Great Financial Crisis continued to drag on, regulators and policy makers began to focus on eliminating the perceived dangers of OTC derivatives. Commissioner Gensler41 has been consistent is his rallying cry to regulate: “And we must not forget the lessons of the 2008 crisis and earlier. Swaps exe- cuted offshore by U.S. financial institutions can send risk straight back to our 38 Id. 39 ISDA estimates that “collateral in circulation in the uncleared OTC Derivatives Market” was $3.6 trillion at end of 2011. INT’L SWAPS AND DERIVATIVES ASS’N, ISDA MARGIN SURVEY 2012, at 3 (2012), available at http://www2.isda.org/functional-areas/research /surveys/margin-surveys/. 40 World Bank: The IBM Deal that Opens a Cash Source, BUS. WK., Sept. 7, 1981, at 48; World Bank Arranges Borrowing in Europe Totaling $290 Million, WALL ST. J., Aug. 12, 1981, at 34; I.B.M. in Deal on Currency, N.Y. TIMES, Aug. 18, 1981, at D10; Swapping Currencies with the World Bank, INSTITUTIONAL INVESTOR, Dec. 1981, at 133. 41 Gary Gensler’s term as Commissioner of the CFTC technically ended in April, but “Fed- eral rules permit Gensler, a Democrat, to remain as chairman of the commission until the end of 2013.” Silla Brush, CFTC’s Gensler Interested in Second-Term as Derivatives Overseer, BLOOMBERG BUSINESSWEEK (Oct. 12, 2012), http://www.businessweek.com/news/2012-10 -12/cftc-s-gensler-interested-in-second-term-as-derivatives-overseer. Gary Gensler in many ways was a peculiar choice to lead the charge in reforming OTC derivative markets. Having made partner at age 30 at Goldman Sachs, many might worry that he would become a pawn of Wall Street, putting his considerable talents to watering down reform. Ironically now, Chairman Gensler “worked alongside Robert E. Rubin, then the Treasury secretary under President Clinton, and Alan Greenspan, then the chairman of the Federal Reserve, to block proposals by the commission to regulate the new [derivative] instruments.” Edmund L. Andrews, Obama Names Insider to Commodities Post, N.Y. TIMES, Dec. 19, 2008, at B3, available at http://www.nytimes.com/2008/12/19/business/19gensler.html?_r=0. His collec- tive experience over time, however, with investment banks and swap dealers, appears to have instead turned him into a crusader for reform, sensitizing him to the risks of gutting regulation through exceptions and safe harbors. The various regulations written by the CFTC appear to have become longer and more complicated in an effort to avoid evasion by sophis- ticated and experienced investment bankers. Although universally recognizable by everyone in the derivative industry, the New Republic still listed him as one of Washington’s Most Powerful, Least Famous People. Editorial, Washington’s Most Powerful, Least Famous Peo- ple, NEW REPUBLIC (Oct. 12, 2011), http://www.newrepublic.com//article/politics/96131 /washingtons-most-powerful-least-famous-people.