FFoorrddhhaamm LLaaww RReevviieeww Volume 67 Issue 6 Article 10 1999 HHaavvee YYoouu HHeeddggeedd TTooddaayy?? TThhee IInneevviittaabbllee AAddvveenntt ooff CCoonnssuummeerr DDeerriivvaattiivveess Carolyn H. Jackson Follow this and additional works at: https://ir.lawnet.fordham.edu/flr Part of the Law Commons RReeccoommmmeennddeedd CCiittaattiioonn Carolyn H. Jackson, Have You Hedged Today? The Inevitable Advent of Consumer Derivatives, 67 Fordham L. Rev. 3205 (1999). Available at: https://ir.lawnet.fordham.edu/flr/vol67/iss6/10 This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Law Review by an authorized editor of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact [email protected]. HHaavvee YYoouu HHeeddggeedd TTooddaayy?? TThhee IInneevviittaabbllee AAddvveenntt ooff CCoonnssuummeerr DDeerriivvaattiivveess CCoovveerr PPaaggee FFoooottnnoottee The author wishes to thank Kenneth Raisler, Partner, Sullivan & Cromwell, and Professor Donna Redel, Adjunct Professor, Fordham University School of Law, for their helpful guidance and comments. Any errors or omissions are exclusively those of the author. This Note is dedicated to Sanjay R. Sathe—thank you. This article is available in Fordham Law Review: https://ir.lawnet.fordham.edu/flr/vol67/iss6/10 HAVE YOU HEDGED TODAY? THE INEVITABLE ADVENT OF CONSUMER DERIVATIVES Carolyn H. Jackson* The long history of finance is cluttered with stories of fortunes lost on big bets. No one needed derivatives in order to go broke in a hurry. No one need go broke any faster just because derivatives have become a widely used financial instrument in our times. The instrument is the messenger; the investor is the message.' INTRODUCTION During your hectic rush-hour drive to work, you contemplate the good news-your daughter has been accepted to the college of her dreams. Simultaneously, you reflect on the down side, namely, the substantial tuition payments are going to dramatically increase your fixed monthly payments. Nagging at the back of your mind are the financial news reports cautioning that interest rates might rise to the double-digit levels of the 1970s and early 1980s due to the current over-heated inflationary economy. Given the considerable increase in your monthly fixed payments, you realize that your thirty-year variable rate mortgage is just too risky. A fixed rate mortgage would provide you wvith greater financial certainty and insulate you from any increase in interest rates. Pre- paying your existing mortgage and re-negotiating a new variable rate mortgage, however, could take months, and would inevitably be time consuming and stress inducing. As you take the exit off the highway that leads to your office, you pass an ATM facility of the bank that provided your mortgage. You recall that at the same time you had signed the mortgage agreement, you signed another agreement with the bank-a swap agreement. You stop at the ATM machine. After entering your card and pass- word, you touch the screen entitled "swap contract." You then select the mortgage screen. It tells you that you could currently convert your variable rate interest payments on your mortgage to a fixed rate of six percent. You punch, "YES." That's it-no bank meetings, no new mortgage agreements, no time delays, no missed market opportu- nities. In a matter of seconds, your swap agreement has allowed you * The author wishes to thank Kenneth Raisler, Partner, Sullivan & Cromwell, and Professor Donna Redel, Adjunct Professor, Fordham University School of Law, for their helpful guidance and comments. Any errors or omissions are exclusively those of the author. This Note is dedicated to Sanjay R. Sathe-thank you. 1. Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk 326 (1996). 3205 3206 FORDHAM LAW REVIEW [Vol. 67 to alter your mortgage interest payments to a structure that best suits your current financial needs. The above hypothetical is by no means far-fetched. Over the past two decades, privately negotiated derivatives (swaps) have revolution- ized how financial institutions and corporations evaluate, quantify, and manage risk.2 Access to new funding and investment markets, lower borrowing costs, increased investment yields, and low-cost, flex- ible asset liability management are among the myriad purported bene- fits of swaps.3 Everyone, it seems, is on the derivatives bandwagon. Everyone, that is, except for consumers. Despite the seemingly endless financial advantages of derivatives, to date only a very limited and sporadic retail derivatives market ex- ists.4 Some retail participation is direct, such as a consumer entering into a mortgage with a periodic cap.5 Most retail participation, how- ever, is indirect, such as a consumer investing in a hedge fund that utilizes derivatives to manage the portfolio or in the shares of a corpo- ration that engages in derivatives.6 Individuals are not utilizing deriv- atives in managing their financial activities on a daily basis. If derivatives are indeed invaluable as a risk management tool for corpo- rations,7 they should be equally invaluable for ordinary consumers. 2. See Robert M. McLaughlin, Over-the-Counter Derivative Products: A Guide to Business and Legal Risk Management and Documentation 1 (1998) (commenting on the forces that moved derivatives markets to the "forefront of the world economic scene"); Willa E. Gibson, Investors, Look Before You Leap: The Suitability Doctrine Is Not Suitable for OTC Derivatives Dealers,2 9 Loy. Chi. L.J. 527, 530 (1998) (discuss- ing derivatives, "predominant role in the financial markets"). Derivative transactions fall broadly into three segments: (1) privately negotiated derivatives between two arms-length participants; (2) derivatives traded on an organized exchange, i.e., fu- tures; and (3) derivatives that are embedded in a capital raising security. The scope of this Note is limited to privately negotiated derivatives. For an overview of the seg- mentation of derivatives transactions into these three broad categories, see Christo- pher L. Culp Competitive Enter. Inst., A Primer on Derivatives: Their Mechanics, Uses, Risks, and Regulation, 3-30 (1995) [hereinafter Culp, Primer on Derivatives]. See also infra notes 41-84 and accompanying text (discussing the various derivative products within the three categories). 3. See Culp, Primer on Derivatives, supra note 2, at 40-42. 4. See id. at 81-82 (discussing the absence of "widows and orphans" in what is generally regarded as a wholesale market); Ronald H. Filler, 7vo-Tiered Regulation, Futures Industry, Feb./Mar. 1999, at 1, 21 (stating that retail comprises a "very small part" of the industry); Gibson, supra note 2, at 539 (categorizing derivatives players as either dealers, consisting of banks, securities firms and other financial institutions, and end-users, consisting of sophisticated institutions such as corporations and govern- ment entities). 5. See George Crawford & Bidyut Sen, Derivatives for Decision Makers 197-98 (1996). 6. See id. 7. See Culp, Primer on Derivatives, supra note 2, at 41. Derivatives enable firms to manage the risks of anticipated expansion by increasing the certainty of the firm's net cash flow. See id. Derivatives provide an efficient method for corporations to manage their interest rate and currency risk. See id. 1999] RETAIL DERIVATIVES 3207 The primary reason for the current amount of retail swap activity is low is regulatory, i.e., the regulatory uncertainty concerning privately negotiated derivatives has led to a stalemate between United States regulators and derivative dealers.8 Regulatory authorities such as the Securities and Exchange Commission ("SEC") and the Commodity Futures Trading Commission ("CFTC") have insinuated that their ju- risdictional authority to regulate consumer activity in securities and futures may extend to any consumer activity in privately negotiated derivatives.9 Swap dealers, to maintain their current favorable regula- tory environment, are willing to at least entertain the idea that the SEC and CFTC do have such authority.1" Retail derivative activity is inevitable. Just as swaps have evolved across different currency markets and different underlying indexes, such as commodity and equity," so too will the product evolve from an almost exclusive institutional activity to include retail activity. Cost is no longer a prohibitive factor due to the acceptance and advance- ment of electronic funds transfers and the Internet.12 The risk man- agement benefits of derivatives are too substantial to be kept from consumers. The question that underscores the future of retail derivative activity is how, if at all, it should be regulated. One possible answer is that the current regulatory structure that focuses on institutional regulation is adequate. Another response is that a product regulator such as the SEC, CFTC, or even a yet-to-be-formed derivatives agency may be necessary to protect consumers from fraud and other deceptive mar- 8. See generally Christopher L. Culp, Functional and Institutional Interaction, Regulatory Uncertainty, and the Economics of Derivatives Regulation, in Derivatives Handbook: Risk Management and Control 458, 486-87 (Robert J. Schwartz & Clif- ford W. Smith, Jr. eds., 1997) [hereinafter Culp, Functionala nd InstitutionalI nterac- tion] (discussing the regulatory uncertainty for privately negotiated derivatives, as no bright line exclusions exist to definitively place the transactions outside of the regula- tory jurisdiction of the securities or commodities laws). Culp asserts that both the regulators and even swap dealers themselves due to their own self-interest, actually promote this uncertainty. See id. at 486-87. 9. See id. at 481-86. 10. See infra Part III.B.2. 11. See Kenneth R. Kapner & John F. Marshall, The Swaps Handbook: Swaps and Related Risk Management Instruments 288-89 (1990). Commodity swaps are similar in structure to interest rate swaps. One counterparty to the swap makes pay- ments at a fixed price for a commodity, in return for receiving payments at a variable price of the commodity. The transaction is cash settled, i.e., there is no exchange of the physical commodity. The Chase Manhattan Bank pioneered the first commodity swap in 1986. See id.; see also Tanya Styblo Beder, Equity Derivativesf or Investors, in Advanced Strategies in Financial Risk Management 223, 223-39 (Robert J. Schwartz & Clifford W. Smith, Jr. eds., 1993) (discussing the evolution and applications of eq- uity swaps). In a common form of an equity swap, one counterparty makes future payments based on an equity index in exchange for receiving future payments in ref- erence to another index, such as a fixed interest rate. See id. at 236-38. 12. See Crawford & Sen, supra note 5, at 198. 3208 FORDHAM LAW REVIEW [Vol. 67 ket practices. Increased regulation, however, could increase transac- tion costs, perhaps driving the derivatives market offshore. This Note addresses the need for regulation of the evolving retail derivatives market. Part I presents the mechanics of swap transac- tions. Part II discusses the regulatory jurisdictions of the SEC and the CFTC. Part III analyzes the reasons for the current lack of retail swap activity. Part IV discusses the applicability of the securities and com- modities laws to retail swaps. Part V presents arguments against in- creased regulation of swaps, even if swaps do indeed extend to retail. This Note concludes that further regulation of retail derivatives is un- necessary. The existing regulatory structure has led to the United States' premiere market position.13 I. THE MECHANICS OF SWAPS The fundamental principle of exchange behind swap transactions is quite simple. Even young children on the playground, as they swap items in their lunchbox for those of a friend, demonstrate they under- stand the principle of exchange. A swap, in its most basic form, is simply an exchange of cashflows.14 Unfortunately, the press, in their zealousness to portray swaps as "a kind of financial cyberspace" based on "calculations designed and monitored by computer wizards using abstruse mathematical formulas that even their bosses at major trad- ing houses do not really understand," have obscured this simplicity. 5 As one scholar puts it, swaps are frequently viewed as "science run amok,... a financial Jurassic Park."' 6 A swap is a bilateral contract between two parties (counterpar- ties)17 to exchange or swap defined cashflows at specified intervals, The cashflows can be determined in reference to an interest rate, for- eign currency, equity or an equity index, commodity, etc. The most frequently transacted swap is the interest rate swap, in which cash- 13. See Philip McBride Johnson, Relying on Consumer Protection Laws, Futures Industry, Feb./Mar. 1999, at 18,20 (stating that, "The United States cannot risk losing its pre-eminence as a financial center simply to make work for the CFTC."). 14. See Satyajit Das, Swap Financing-Interest Rate and Currency Swaps, LTFX, FRAs, Caps, Floors and Collars: Structures, Pricing, Applications and Markets 17 (1989) [hereinafter Das, Swap Financing]. 15. John Greenwald, The Secret Money Machine, Time, Apr. 11, 1994, at 28, 30. One reporter has admitted that a financial product, "if it's complex,... [is] apt to get the name [derivative]." Carol J. Loomis, Untangling the Derivatives Mess, Fortune, Mar. 20, 1995, at 50, 54. 16. Henry T.C. Hu, Hedging Expectations: "Derivative Reality" and the Law and Finance of the CorporateO bjective, 73 Tex. L. Rev. 985, 989 (1995) [hereinafter Hedg- ing Expectations]. 17. See Ravi E. Dattatreya et al., Interest Rate & Currency Swaps: The Markets, Products and Applications 12 (1994). 18. See id. at 1. 1999] RETAIL DERIVATIVES 3209 flows are determined in reference to two different interest rates.19 The most simple of these, a "plain vanilla" or "fixed-for-floating" swap,2° involves the exchange of cashflows determined in reference to a fixed rate of interest for cashflows determined in reference to a 21 floating rate of interest. A specific application of an interest rate swap provides the best in- sight into its mechanics. Corporation A has a loan at a fixed rate of interest. The firm believes interest rates will fall, and would rather have the interest payments on its loan pegged to a floating interest rate. The floating interest rate payments will enable Corporation A to reduce its future borrowing costs if indeed it is correct and interest rates fall over the life of the loan. Corporation B has a loan at a float- ing rate of interest. This corporation, in contrast to Corporation A, believes future floating interest rates will rise, and thus would rather lock in its future interest payments at a known fixed rate.22 Corporation A could achieve its interest rate objectives by first pre- paying its existing fixed rate loan and then entering into a new floating rate loan agreement. Similarly, Corporation B could achieve its inter- est rate objectives by first prepaying its existing floating rate loan and then entering into a new fixed rate loan agreement. The prepayment of debt and the negotiation of a new loan agreement, however, can involve substantial transaction costs and take considerable time, at which point the market may have moved unfavorably against the cor- porations. On the other hand, an interest rate swap allows each cor- poration to achieve its financial objectives while leaving the existing loan agreements in place.23 Under the terms of the swap contract, Corporation A agrees to pay to Corporation B interest at the floating rate that exists on B's floating rate loan. In return, Corporation B agrees to pay to Corporation A interest at the fixed rate of interest that exists on A's fixed rate loan. The swap agreement, through a separate legal contract, transforms each corporation's net interest pay- ments, leaving the initial loan agreements intact, thereby lowering transaction costs and execution time.24 19. See Edward S. Adams & David E. Runkle, The Easy Case for Derivatives Use: Advocating a CorporateF iduciary Duty to Use Derivatives, 41 Wm. & Mary L. Rev. (forthcoming 1999) (manuscript at 12, on file with the' Fordham Law Review). 20. See id. (manuscript at 12). 21. See id. (manuscript at 12). 22. See Das, Swap Financing, supra note 14, at 31-32. 23. See id. at 216-21. 24. See id. at 33. The swap is a legal contract completely independent of the un- derlying borrowing agreements of Corporations A and B. The institutions that pro- vided the original loans to Corporations A and B are not parties to the swap. Corporations A and B, despite entering into the swap agreement, continue to be obli- gated to their distinct institutional lender for the payment of the principal and inter- est. The lenders may even be unaware of the swap contract between Corporations A and B. See id. 3210 FORDHAM LAW REVIEW [Vol. 67 In the same manner that an interest rate swap can transform inter- est payments from fixed to variable payments or vice versa, a currency swap transforms currency payments from one currency to another.' Although the volume of outstanding interest rate swaps dwarfs the volume of currency swaps,26 the currency swap actually evolved first.27 The concept of currency swaps originated from the sterling and United States dollar parallel loans arranged between British and American entities in the 1970s.2 The loans evolved as a method of 1 avoiding the United Kingdom's foreign exchange controls that had been implemented to deter the outflow of capital.29 These parallel loans required that a United States parent corporation have a subsidi- ary in the United Kingdom in need of local funds and, simultaneously, that a United Kingdom parent corporation also have a subsidiary in the United States in need of local funds.30 Two loans were actually involved in the parallel loan.3' Under the terms of the first loan, the United States parent corporation would lend the funds it has raised in the United States dollar market to the United Kingdom subsidiary.32 Under the terms of the second loan, the United Kingdom parent firm would lend an equivalent amount of pound sterling it has raised in its domestic market to the United States subsidiary.3 As a result of this arrangement, the British and American parent corporations were able to indirectly access the other country's capital market to fund their overseas subsidiaries, circumventing the foreign exchange controls.34 Currency swaps are similar in structure to parallel loans,35 with one exception-the counterparties do not lend currencies to each other.36 Under a currency swap, the two currencies are not loaned, but are exchanged with a simultaneous commitment to reverse the exchange of currencies at the maturity date of the transaction.37 The currency amounts to be exchanged, both at inception and maturity, are deter- mined by the spot-exchange rate set at the time of execution of the 25. See Dattatreya, supra note 17, at 47. 26. See International Swaps and Derivatives Association, Inc., Summary of Mar- ket Survey Statistics: 1997 Year End. The survey reports that at the end of 1997, the notional principal amount of interest rate swaps outstanding was approximately $22 billion, in contrast to $1.8 billion of currency swaps. See id. 27. See Das, Swap Financing, supra note 14, at 5-6. 28. See id. 29. See Kapner & Marshall, supra note 11, at 6. 30. See Roberta Romano, A Thumbnail Sketch of Derivative Securities and Their Regulation, 55 Md. L. Rev. 1, 49 (1996). 31. See id. 32. See id. 33. See id. 34. See id. 35. See 1 Satyajit Das, Swaps & Financial Derivatives: The Global Reference to Products, Pricing, Applications and Markets 66 (2d ed. 1994) [hereinafter Das, Global Reference]. 36. See id. 37. See id. 1999] RETAIL DERIVATIVES 3211 swap.8 In addition to the initial and final exchanges of principal, the currency swap involves interest payments.39 The interest payments can be based on a floating or fixed rate basis.40 Interest rate and currency swaps fall under the broader umbrella term "derivative."'" A derivative is conventionally defined as a finan- cial instrument or bilateral contract that "derives" its value from the changes in value of other financial instruments or underlying refer- ence price, rate, or index.42 Derivatives can be classified into three broad categories: derivative securities, exchange-traded derivatives, and over-the-counter ("OTC") privately negotiated derivatives.43 A particular derivative transaction, depending upon which category it falls, will be labeled as either a security, future, or privately negotiated contract." The label is tremendously important because it ultimately determines what regulatory regime governs the derivative transaction.45 Derivatives, whether a security with an embedded derivative, fu- tures contract, or privately negotiated contract, are actually either a forward contract, option contract, or a combination of both.46 Deriva- tive transactions that are constructed from forwards include forward contracts themselves, swap contracts, exchange-traded futures, and se- curities with embedded forwards.47 Derivative transactions that are constructed from options include privately negotiated option con- tracts, exchange-traded options, and securities with embedded 4s options. Under the terms of a forward contract, the counterparties deter- mine a set price, amount, and date in the future at which one counterparty will buy, and the other will sell, a specific underlying as- set.49 The forward contract requires actual delivery of the underlying asset by the seller to the buyer.50 Forward contracts exist for agricul- tural and physical commodities, currencies (foreign exchange for- wards), and interest rates.5 A forward contract changes in value as 38. See Kapner & Marshall, supra note 11, at 281. 39. See Das, Global Reference, supra note 35, at 67. 40. See iUL 41. See Martin Mayer, The Bankers: The Next Generation 289 (1997). 42. See Global Derivatives Study Group, Group of Thirty, Derivatives Practices and Principles 28 (1993); Adams & Runkle, supra note 19, at 4. 43. See Saul S. Cohen, The Challenge of Derivatives, 63 Fordham L Rev. 1993, 2000-01 (1995); supra note 2. 44. See Global Derivatives Study Group, supra note 42, at 29. 45. See Cohen, supra note 43, at 1994. 46. See Global Derivatives Study Group, supra note 42, at 29-30. 47. See id at 29. 48. See id at 29-30. 49. See id at 30. 50. See Adams & Runkle, supra note 19, (manuscript at 6). 51. See Global Derivatives Study Group, supra note 42, at 30. 3212 FORDHAM LAW REVIEW [Vol. 67 the underlying asset changes in value.52 The terms of a forward con- tact are not standardized, but are customized to meet a couterparty's financial and/or business objectives. 3 The other fundamental derivatives contact, the option contract, grants its holder the right, but does not obligate him, to buy or sell the underlying asset (or cash settle) at a specified price, either over a de- fined time period or on a set date.54 The option purchaser can forego his right of exercise and let the option expire.55 The buyer of an op- tion benefits as the price of the underlying asset increases, but does not incur a loss if the price of the underlying asset falls. 6 In contrast to the buyer of the option, the seller of the option has the obligation to perform, that is, buy or sell the underlying asset if the option holder exercises the option.57 Derivative securities can embed forwards, options, or a combina- tion of the two. 8 An example of a derivative security that contains a series of foreign exchange forwards is a dual currency bond. 9 A dual currency bond is a bond that pays interest in one currency and princi- pal in another.6° For example, a United States dollar/Swiss franc dual currency bond would pay interest in Swiss francs, but principal in United States dollars.61 Implicit in this security is a series of Swiss franc/United States dollar forward foreign exchange contracts.62 Ex- amples of derivative securities that contain options are "callable" and "putable" bonds.63 A callable bond gives the issuer the right to buy back the bond from the holder at specific times in the future at a set price.' 4 The issuer in effect has purchased a call option from the holder of the bond.65 In contrast, the holder of a putable bond has purchased a put option from the issuer.6 This put gives the holder the right to sell the bond back to the issuer at specific times in the future at a set price.67 52. See id. 53. See id. 54. See id. at 32. 55. See id. 56. See id. 57. See Charles W. Smithson, A Building Block Approach to FinancialE ngineer- ing: An Introduction to Forwards,F utures, Swaps and Options 6 (CIBC Wood Gundy School of Financial Products, reprinted from Midland Corporate Finance Journal, Winter 1987). 58. See Global Derivatives Study Group, supra note 42, at 29. 59. See id. 60. See 1 Das, Global Reference, supra note 35, at 453. 61. See id. 62. See id. 63. See Global Derivatives Study Group, supra note 42, at 29. 64. See John Hull, Introduction to Futures and Options Markets 342 (1991). 65. See id. 66. See id. 67. See id.