Legal Research On The Regulation Of OTC Derivatives Market

The 2008 Financial Crisis raised the world attention to the regulation of OTC derivatives market.The large financial institutions deeply involved in trading credit default swaps,such as Lehman Brothers,Merrill Lynch,AIG,etc.,got into trouble,which created a panic in the financial market.As the famous investor-Warren Buffett once mentioned OTC derivatives as weapons of mass destruction,it was regarded as the trigger of this financial crisis.And those famous Wall Street investment banks continued to trade and lost money in OTC derivatives market nowadays.In May 2012,JP Morgan suffered a great loss in complex derivatives trading,which led to the Volcker Rule in the new financial regulation in the United States.As for China,large corporations,such as China National Aviation Fuel,Citic Pacific,Air China,etc.,also suffered great losses during the period of 2008-2009.After the crisis the nominal volume of OTC derivatives trading fell much more greatly than exchange-traded market.However,with the global economic resurgence,the volume of OTC derivatives trading went up again and reached its historical highest level of 706.88 trillion USD.And in December of 2012 the nominal amount of the world OTC derivatives market was more than eight times larger than the world GDP.The rapid development and huge amount of trading volume reflects that there is a great need on the market.And now it is not a question of whether or not to regulation the OTC derivatives market,but worth to discuss how to regulate it.And the dissertation composed of five chapters will focus on this topic.Chapter One studies the needs of regulation of OTC derivatives market.The author traces the history of creation and development of OTC derivatives and finds it always a flexible tool of risk management and it has been developed into a relatively independent market.In recent years,OTC derivatives have a trend of standardization.OTC derivative is characterized of its high risks such as credit risk,market risk,liquidity risk,legal risk and systematic risk.Default issues frequently happen on the OTC derivatives market all over the world because of lack of regulation.As for the Chinese market,we have a relatively late start of development and there are problems in the current laws and regulations.The second chapter studies the relevant fundamental theories.According to the economic theories,OTC derivatives market has the problem of incomplete competition,information asymmetry and negative externality according to Public Utility Theory,which may result in market inefficiency.From legal perspectives,an OTC derivative is a contract and its regulation reflects both the principles of contract freedom and government coercion.The regulation is a mix of public and private laws.Based on these theories and the nature of OTC derivatives,four general principles of the regulation of OTC derivatives market can be proposed-regulation at an appropriate degree,regulatory coordination and cooperation,systematic risk control and investor protection.Based on the economic and legal theories and with reference to the regulation of five developed market(US,UK,EU,Singapore and Hong Kong SAR),Chapter Three,Four and Five research and analyze the regulation model and regulators of the OTC derivatives market,and design the regulatory structure and mechanism from both behavioral and institutional perspectives.Chapter Three analyzes the regulation model of financial market and regulatory framework of OTC derivatives market in United States,United Kingdom,Singapore and Hong Kong SAR.After a horizontally and vertically comparative study,the author finds that government regulation in these four countries and regions all play a more important role while regulation by self-regulatory organizations still function.There is a tendency of mixed use of institutional and functional supervision and most of the mature financial markets have a trend to use Twin Peak theory but at different degrees.However,the situations and development of OTC derivatives market in China is different from the foregoing countries and regions.The Chinese OTC derivatives market grew slowly until 2005.The market lacks of innovations and inventions due to the policy of “research on one kind of derivatives,promulgating a new rule and introducing the new product into the market”.We should choose and design our regulation model not only according to our own current situations but also follow the rules of development of OTC derivatives market,gradually reinforce the current government regulation while establishing self-regulatory system at the same time,transform from institutional regulation to functional-dominant regulation model and enhance the coordination of other countries?regions?.Chapter Four discusses behavioral regulation of the OTC derivatives market from four perspectives.First,central counterparty(hereinafter CCP)clearing.Countries?Regions? made agreement on CCP clearing on G20 Pittsburgh Summit in 2009.CCP clearing can manage risks on one single platform and greatly reduce the nominal volume of OTC derivatives trading,but CCPs will also gather the risks together because CCPs become the counterparty for all the other parties of the OTC derivatives contracts.There should be measures to control risks and for prudential regulation such as membership,default rules,margin and reserves requirements and so on.Second,the legal mechanism of ensuring performance of OTC derivatives contracts.The legal mechanism of ensuring performance is created to prevent credit risks from counterparties of the OTC derivatives contracts.It is of key importance for those products which cannot be cleared by CCP.Presently,the ISDA Master Agreement and Credit Support Annex is most widely used to ensure performance all over the world.The National Association of Financial Market Institutional Investors have issued the master agreement and relevant documents of ensuring performance for OTC derivatives as well in 2007,but these documents have some conflicts with the current PRC Guarantee Law and Enterprise Bankruptcy Law.Third,reporting requirements and trade repository(hereinafter TR).Another tendency in OTC derivatives market is to build TR in order to promote market transparency.During the subprime crisis,DTCC released the information of Lehman Brothers' derivatives trading,which calmed down the market immediately.Countries?Regions? also made agreement on reporting and building TRs in the G20 summit.And afterwards FSB,CPSS,IOSCO and other international organizations have made proposals related to this issue.Last,Suitability Rules of OTC derivatives trading.Reporting cannot solve all the problems of information asymmetry between financial institution and investors,which makes it important to apply Suitability Rules into derivatives trading especially for those public investors.The sellers need to know their customers and know about the products they sell and provide different level of protection to different investors.Risk disclosure has higher requirement of than reporting in terms of the content,forms,standards of effectiveness and civil liabilities.Chapter Five discusses institutional regulation on OTC derivatives market.It studies the regulation on two categories of institutions.One is dealers and major participants on the OTC derivatives market.The author takes the 2010 Dodd-Frank Act as an example and introduces the new laws and regulations on the regulatory framework of different market players,such as swap(or security-based swap)dealer and major participants,as well as the various measures in order to control the systematic risks of swap(or security-based swap)dealer and major participants.Another kind of institutions which should be under regulation is CCP.At present there is no special rule on CCPs so they have to comply with the laws or regulations of exchanges or clearing houses.However,CCPs of OTC derivatives trading are different from exchanges and clearing houses.CCPs should be regulated at two different levels: government regulation from the outside of CCPs and internal control of the CCPs themselves.In conclusion,the OTC derivatives market always develops in the way of “regulation-deregualtion-reregulation-deregulation” approach.Market players have the intentions of maximizing their profits and relieving their liabilities as much as possible.As a result,there would be more risks on the financial market.and the government has to play the role of Night Watch.Practices and experiences show that every attempt of innovation of OTC derivatives aims at evading responsibilities and that the innovation itself not only makes the market more active but also puts more risks on it so that the government is obliged to review and examine the loops and holes of regulation and modify it all the time.