Assessment of post-GFC derivative regulations and impact of new processes and technologies in the financial derivatives sector

Table of Contents

Executive Summary

Introduction

Section 1: Overview of the Post-GFC Financial Derivatives Market
Part 1: Financial Derivatives Market Observations and Trends
Part 2: A Comparative Assessment of Regulatory Convergence Initiatives (EU- US Framework) and Global Harmonization Attempts in Financial Derivatives Market Regulations

Section 2: Smart Derivative Contracts and Derivative Security Tokens– An Analysis of Selected New Processes and Technologies in the Financial Derivatives Market
Part 1: Smart Derivative Contracts- the Legal Considerations and the
Regulatory Governance Framework
Part 2: Derivative Security Tokens- the Legal Considerations and the Regulatory Governance Framework

Conclusion

Executive Summary

The reforming process in the global derivatives market is not an entirely new development. The global financial markets have experienced a series of important changes following the 2008 global financial crisis (GFC), posing a number of regulatory challenges. These changes have illustrated several important pitfalls of regulatory design and oversight mechanisms prevalent prior and during the GFC. With the help of new technologies and processes, regulators have set goals to address systemic risk creation and therefore provide a more effective supervisory oversight for derivative market participants, especially in the face of increasingly interconnected capital markets.

Several concerns have been raised with the new regulatory framework. This framework has been considered complicated by some, especially considering the emergence of highly technical aspects of EU and US regulations. In this paper, fragmentation tendencies in national derivative regulations across EU jurisdictions and disagreements between EU Member States and on a broader level, among EU and US regulators will be addressed. Other relevant regulatory issues addressed include lessening the asymmetric impact of regulations across Member States and balancing competing interests among EU and US regulators, in spite of differing legislative mandates and legal powers in the regulatory origins of states. Overall, a more stringent regulatory regime has been welcomed following the GFC. However, this is changing with the new US administration’s outlook which favours a lessened regulatory grip on derivatives markets that exhibit liberalization tendencies.

Similarly, regulatory harmonization efforts have in the past decade increased the importance of having a centralized supervision function across the EU landscape and finding an optimum level of intervention on the market. To this end, the introduction of new EU supervisory bodies has been supportive of the goal to achieve the mission of ‘Single Europe’ across EU derivative trading activities. The ‘Single Europe’ approach by EU institutions, as well as the stance of the US regulatory bodies have majorly reflected a granular approach to design regulatory goals following the GFC. However, the landscape for US regulations is expected to change. The new US administration’s policy design reflects a shift from maintaining global harmonization goals towards prioritizing a national agenda.

This paper addresses these recent developments and seeks to find out the current state of regulatory convergence and seeks to understand the optimum level of regulatory convergence in the derivatives market. It also evaluates the developments in the global derivatives markets with a comparative approach by looking at how regulations differ across various jurisdictions. Hence, the primary focus is not on critically evaluating the highly technical aspects of regulatory developments but rather on assessing the practical outcomes derived from such changes. In addition, this paper also seeks to find an answer to achieve transformative changes by setting effective policies across the EU and the US derivatives landscape. The comparison of policies and regulatory design reveals that increased harmonization and supervision must be sustained as important policy goals across the EU and the US and for this reason tighter regulations and requirements for derivatives trading are necessary tools to avoid systemic risks in the future.

This paper in its second part is focused on the more recent technological advancements which have a direct impact on derivatives trading activities. Taking into consideration that innovation has tended to outpace regulation throughout history, it attempts to answer the question of regulating two selected innovations; smart derivative contracts and derivative security tokens. The findings reveal that both innovations disrupt the traditional way of regulating derivative trading and post-trading activities through adopting streamlined, simplified techniques whilst transforming the existing multi-tiered structure of modern financial market infrastructures.

The relevant observations are also in support that these novel processes hold great promise for financial services through supporting product and process innovation and eliminating inefficiencies in the market.

Introduction

The year 2008 marks one of the worst financial crisis since the Great Depression of the 1930s. This crisis of the markets has caused a paradigm shift in the global financial and capital markets.¹ During the period covering 2008 to 2012 a number of complications were seen in the markets, ultimately leading to a collapse of many institutions. Credit risk and complex securitized products were priced incorrectly, and equally importantly, insufficient risk management functions provided by numerous parties dealing with financial derivatives (derivatives) amplified the scale of risks transmitted within multiple channels across the global markets.

During this time of hardship, regulators globally have become interested in the derivatives markets primarily owing to their benefits, as well as the costs. The derivatives world has undergone a massive growth in the past two decades. To quantify, in 2016, the notional value of derivatives has risen to USD 605 trillion, which amounts to approximately 10 times world GDP in 2010.² In the year 1998, the notional value of derivatives was USD 81 trillion, which represented only 3 times world GDP.³

A critical question regulators ask specifically after the GFC is, “How large and how systemically important are derivatives?” It is clear that derivatives will remain the foundation blocks of financial innovation. Over-the-counter (OTC) derivatives market represents 96% of all derivatives traded with the remaining traded on exchanges – a figure of USD 28 trillion.⁴ These financial instruments’ functionality serves the needs of financial market players, and having already penetrated through the traditional borders established in between banking, insurance and securities sectors, the answer to the prior question should be “extremely important.” With reference to this, the growth in the derivatives market has drawn increased attention. As US chairman Turner has called in a speech, “All financial innovation is useful to be challenged, and for consideration to be given to the optimal size of the wholesale financial services, particularly of trading activities.”⁵

In this speech, Turner rightly observes that the trading activities of credit enhancement derivatives as a financial innovation instrument has resulted in the mispricing of risk and the building of leverage by many market participants. Many scholars have labelled derivatives as the chief villain in relation to the financial crisis. According to Buffett, derivatives are the “financial weapons of mass destruction.”⁶ Some other academics share the view that derivatives have not caused the financial crisis directly, but have contributed to the building up of systemic risk. These observations point out to two distinct qualities of derivative instruments.

Firstly, derivatives could be used for harm.⁷ Secondly and equally importantly, the economic utility coming from derivatives benefits many parties in the market. They offer qualities which help market participants to spread the risk in the allocation of capital through matching investors with individual risk appetites. In today’s market-based finance, derivatives offer important functionalities and flexibilities to market players. For this reason, one must also take into account the risks inherent in the derivatives market while appreciating its virtues. Globalization and increased competition in capital markets have made it easier for numerous parties to engage in riskier transactions by the use of derivatives. In light of this, strong capital standards for financial institutions and the international harmonization of the derivatives market have become important policy goals for regulators.

Potential challenges regulators face in policy harmonization attempts are two- fold. Firstly, the absence of a standard law for derivatives and secondly, the absence of a single-body governing the regulation and supervision of derivatives across the globe. In such a heterogeneous legal landscape, while it is still considerably early to define the specifics of the new global regulatory perimeter to be set for derivatives, the overall trend and development for protection against systemic risk urgently and systematically calls for a worldwide greater financial integration based on new reforms.

This paper hopes to answer why the derivatives market has to be regulated more intensively and effectively, in spite of the various theories advocating the risks arising out of overregulation in this market. The framework of investigation is eclectic and is therefore based on various academic articles, journals and papers. In the first section, Part 1 will observe the trends in the derivatives market, and assess the initiatives of several important agencies involved in the global regulatory decision-making process. Part 1 also aims to emphasize the deepening of the financial market and presents the urgency for implementing an effective framework for the regulation and supervision of the derivatives market across different jurisdictions, with a post-GFC perspective. The oligopolistic market structure of OTC derivative markets, which comprise 96% of all derivatives traded by Globally Systematically Important Financial Institutions (GSIFIs) and its influence on preserving financial market stability are also analysed in this section. In such a structure, market share is dominated by the largest banks and is therefore highly concentrated which has significant implications on the regulation of specific market participants.⁸

The current level of regulatory convergence in the derivatives market with particular focus on the time period post-GFC will be examined in Part 2 of Section 1. The focus here is on identifying effective global harmonization attempts with an eye on the recent developments in the United States and Europe. This section aims to compare the level of convergence across jurisdictions by observing the differing level of implementations of bilateral/multilateral agreements across different settings.

Following this, Section 2 will present an analysis of selected new technologies and processes in the financial derivatives market. Specifically, the application of blockchain financial networks and the distributed ledger technology (DLT) have collectively allowed for new forms of innovation in the market. These changes promise to simplify certain complex processes inherent in the financial derivatives market. Part 1 of Section 2 analyses a new technological application; smart derivative contracts and further evaluates the underlying regulatory and legal governance framework for such contracts. Part 2 analyses the introduction of derivative security tokens as an extension of the DLT which is bound to replace typical forms of collateralisation techniques commonly used in derivative contracts. Furthermore, Part 2 of Section 2 will present the legal and regulatory considerations surrounding derivative security tokens.

Both parts of Section 2 encourage regulatory rethinking in light of recent technological advancements and developments in the global financial landscape.

Section 1

Part 1: Financial Derivatives Market Observations and Trends

Today’s market-based finance favours complex financial instruments where firms are increasingly engaged in flexible financing techniques owing to the process of financial innovation. Derivatives are powerful tools to either hedge risks, arbitrage prices for speculative purposes or to reduce regulatory and agency costs.⁹ By definition, a derivative is a type of financial contract which is derived from at least one underlying asset. The value of the derivative directly depends on the value on the underlying asset(s). A derivative contract effectively looks at monetizing a right or obligation or payment flows between two parties. The two parties engaging in a derivatives transaction may have an interest in speculating or transacting in order to monetize or mitigate their financial risk. In its purest form, derivatives represents a transfer of wealth. This financial instrument can be classified broadly into two categories:

i) Exchange-traded derivatives (ETDs) of which equity derivatives and commodity derivatives dominate the spectrum.
ii) Over-the-counter (OTC) derivatives such as fixed income, exchange rate derivatives, currency derivatives and interest rate derivatives. Interest rate derivatives have an approximate 68% market share and comprise nearly 75% of the entire derivatives market with a total market share of USD 452 trillion, followed by exchange rate derivatives with a market share of USD 53 trillion.¹⁰

Derivatives have experienced lowered transaction cost pioneered by the power of technology, allowing this market to enjoy an unprecedented scale and depth of liquidity in the past two decades. This development has amplified the complexity of derivatives to a new scale. A prime example of the scale of growth can be seen from the credit default swap (CDS) market, an OTC derivative market which reached a nominal aggregate value of $61 trillion in 2007.¹¹

Following the crisis, increased regulations and tighter rules in the CDS market prevented the possible transmission of risks originating from risky CDS activities across different markets. This was accomplished by an increased effort in trying to quantify the exposure levels of parties entering into these derivative transactions. Consequently, the CDS segment declined to a value of USD 30 trillion in 2017.¹²

The following years after the GFC has seen a global trend in monitoring financial innovation, which was originally cultivated prior to 2008. For example, The Basel II capital accord, an international agreement published initially in 2004, came into force prior to the GFC and advocated the efficient market theory and the OTC marketplace. In the meanwhile, concerns have been raised by regulators towards the increased use of derivatives by GSIFIs and other market actors particularly for speculative trading activities. Having understood Basel II’s insufficient monitoring of GSIFIs’ derivatives exposures, regulators have emphasized the importance of implementing more stringent regulations. Proof of this can be found in an OECD Report: “Basel II left the financial system with not nearly enough capital to deal with massive losses and has necessitated the implementation of a more stringent regulatory framework.”¹³

The huge financial losses of the universal banks such as JP Morgan, Credit Suisse, UBS have encompassed the global derivative business, owing to their trading of complex derivatives under the provisions of Basel II. These banks were trading OTC contracts which are by nature not traded on exchanges and are prone to transmit unaccountable magnitudes of risk across markets. The internal measures for risk capital such banks used remained conducive of unaccountability, owing to the banks’ individual Risk-Based Approach (IRB) models. During the GFC of 2008, the European legislators were equally concerned of the risk transmitted through the anti-competitive behaviour of GSIFIs particularly in the OTC market. In fact, the activities of these global banks have resembled an oligopolistic derivative market, in which CDS’s took a huge part in the generation and subsequent transmission of risk. In parallel to this development, the European Commission Progress Report rightly observes that the trend in regulatory practices prior to 2008 pointed towards maintaining an “open, inclusive, competitive, and economically efficient EU financial market.”¹⁴ The unconstrained leverage such GSIFIs were taking were largely overlooked by this regulatory agenda.

From the outset, the US regulatory practices were even more engaged, if not more than in Europe, in maintaining such an open, neo-liberal agenda which favoured financial innovation, minimum regulation and openness. Prior to the 2008 era the regulatory landscape was generally facilitative and had narrow regulatory clutches to entirely reach into the wholesale markets. The derivative business, as observed by a study, enjoyed “exponential global growth vs. global GDP”, in sharp contrast to the primary securities on which such derivatives were based.”¹⁵

The same EU Progress Report pinpoints that today in Europe, and also elsewhere, financial services regulation is majorly concerned with improving safety and soundness.¹⁶ This is due to the opacity of the products in the OTC markets in the GFC era and the combined effect of having a tight regulatory framework. In effect, this has fueled the emergence of a disastrous situation which is hoped would not be repeated again. The Progress Report further states that “much has already been achieved in pursuit of this goal and there are many newer regulatory initiatives in the pipeline.”¹⁷ Hence, the priority in today’s regulatory perimeter is focusing on safety and soundness as a key principle, as well as maintaining the objective to preserve financial stability and market integrity. To this end, “stand-alone policy goals” have proven to be ineffective to maintain the goals highlighted in the Progress Report.¹⁸

If the decade following the GFC marks the era of financial market integration then international regulatory cooperation has become ever more important. It is observable that trans-governmental networks of financial regulators and treaty- based organizations such as the G-20, IMF, WTO will increasingly push for a cooperative regulatory model to achieve financial market integration. This is illustrated by robust supranational institutions with their wide-reaching delegated powers in the rule-making, monitoring and enforcement mechanisms.¹⁹

The post-GFC European regulatory agenda is observed to rely even more on increasing levels of intervention in Member States’ regulatory regimes. The introduction of the three new European Supervisory Authorities (ESA); namely the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Systemic Risk Board (ESRB) has improved the consistent enforcement of rules and a systemic oversight within the EU. In the meantime, European authorities are also facing internal market challenges. For example, European authorities are now facing a wider regulatory perimeter with a risk of an asymmetric impact across the Member States.²⁰ This is due to the potential risk of concentration of financial market segments in selected national markets. There are challenges relating to accurately balancing competing national interests whilst attempting to achieve harmonization across markets. In light of this obstacle, the European regulator reiterates its calls for a proposal for a regulation on derivatives as follows: “…There is a real likelihood of a potential need for fiscal support that Member States supervision is necessary. Some seeds to this effect are already being planted.”²¹

The European Supervisory Authority (ESA) is to effectively implement change with a tight grip on convergence efforts, and to align European financial services supervision in accordance with a centralization principle. In this framework, central EU authorities are expected to gain full control over financial services supervision, which includes the European derivatives markets.²² Certain developments in the derivatives market may have incentivized ESA to take a centralization initiative. For example, the unprecedented levels of the use of OTC derivatives during the GFC have increased the leverage on the capital important players in the market i.e. GSIFIs and non-bank dealers assumed.²³ This has triggered the building up of systemic risk, leading to the collapse of the financial markets in 2008. Hence, ESA’s supervisory centralization efforts have peaked as a response to regulate the market participants more intensively and effectively in the post-GFC setting.

In order to understand the building up of systemic risk in the derivatives market, one has to examine the role OTC derivatives have played in the financial markets. OTC derivatives are opaque by nature, making it difficult to quantify the risk they expose counterparties holding them, and this risk can persist for several years which could turn into systemic risk as a consequence.²⁴ Systemic risk refers to the collapse of the entire financial market as a result of the risks imposed by interlinkages and interdependencies in a system. The OTC derivatives exposures of market participants during the GFC were largely unaccountable and subsequently this has contributed to the building-up of systemic risk. Moreover, the leverage put on by lightly-regulated banks, with their own internal risk measures have enabled GSIFIs to mostly dismiss the total risk-adjusted measures to include derivative exposures as part of their balance sheet checks²⁵. GSIFIs ‘Too Big to Fail’ (TBTF) status allowed such banks to assume inappropriate risks in derivative trading activities. Coupled with their frequent inconsistent measures and tests of solvency, a post-crisis urgent reform in the EU addressed the issue of monitoring GSIFIs.²⁶ In the meantime, similar reforms have also been implemented by the US regulator to increase the systemic oversight of GSIFIs derivative trading activities. ²⁷

In light of these developments in the markets, centralized supervision of authorities in Europe is likely to improve cross-border cooperation. The expanding powers of the European authorities to work in closer proximity with the National Competent Authorities (NCAs) of Member States to regulate and supervise the derivatives markets within the European Union are likely to result in a greater degree of standardization throughout all EU jurisdictions. The centralized framework of authorities has given aggregate powers to ESA to take decisions directly applicable to individual financial institutions of derivative activities “in cases of manifest breach or non-application of law.”²⁸

It is evident that strong capital standards following the GFC are necessary to discourage the extreme proliferation of OTC derivatives inside banks. It is also largely accepted that the post-GFC regulatory regime should limit the use of derivatives for large banks which have previously relied on these to appear nominally more profitable during the GFC. The US central bank Federal Reserve System (the Fed) in this respect, compared to that of the EU’s has been arguably more reluctant to unveil measures to prevent large banks to take more leverage through the use of derivatives following the GFC. The Fed’s stance is more inclined towards promoting the use of derivatives for their embedded leverage, thereby allowing the banks to get leveraged exposure of the underlying asset for a fraction of the cost of holding or funding the asset itself.²⁹ Some economists have identified the Fed’s ideological openness as a barrier towards global harmonization attempts.³⁰ The Fed’s support for the growth of these OTC instruments even post-GFC points to a fragmented approach across different jurisdictions. On the other hand, the European Commission’s stance remains relatively safer and sounder for the most part, taken as a comprehensive regulatory model. Similarly, this model will be scrutinized in Part 2 of Section 1.

The reform movement in the derivatives market is set to address systemic risk creation. International reform movement has focused on preventing systemic instability which could result from trading positions in derivatives. Proof of this is found in the G-20 agenda.³¹ Insufficient risk management practices by banks and sovereigns’ financial institutions, particularly in the OTC credit derivatives segment have initiated supranational regulatory reform initiatives.

Particular challenges to managing CDS exposures still remain, as disagreements between Member States over the position of naked sovereign CDS’s are yet to be resolved.³² CDS is a form of derivative which protects its buyer paying an annual premium to the seller. The buyer of CDS is covered from the risk of credit default of the reference entity that owns the sovereign or corporate bond. Specifically, a naked sovereign CDS allows the buyer of the CDS, having a long position³³ in the sovereign debt of the issuer to have no exposures which is to be hedged to the sovereign debt. A deeper dive into the regulation of credit derivatives, in particular CDS derivatives and derivatives trading will be provided in Part 2 of Section 1.

On the other hand, deep and rapid changes are occurring in commodity market conditions over the past decade. This market has been influenced by a process of regulatory innovation through the framework of MiFID II (Markets in Financial Instruments and Directive II) and MiFIR (Markets in Financial Instruments Regulation) reviews which now apply stringent rules on the trading of commodity derivatives. These derivatives are now subject to specific provisions included by EU policy-makers to tackle turbulences affecting commodity markets post-GFC. Several international organizations, such as the likes of G-20³⁴, IOSCO³⁵ have pointed the finger at the scarce regulation of the sector and have highlighted the need for a tight regulatory framework. The new and important features of the regulatory regime and major innovations of commodity derivatives in the past few years will be carefully examined in Part 2 of Section 1.

A summary of the nature of regulatory innovation based on these preliminary observations and general trends in the global derivatives market will be carried out in conjunction with an OECD study to finalize this section. An OECD report titled “Global SIFIs, Derivatives and Financial Stability” authors’ observations, based on calculations from BIS³⁶, Datastream³⁷ and WFSE³⁸ data have identified a similar trend across all derivatives markets, pointing out to the oligopolistic nature inherent in the market. The concentration trends of the derivatives market, as measured by the Herfindahl Index³⁹ have shown an increase post-GFC. This is an indication of GSIFIs, which are ‘stronger’ players of the market forcing new (and late) entrants to exit from derivative-trading activities. Ultimately the new entrants, facing decreasing margins and increasing leverage and enduring the pressure from the oligopolistic power of GSIFIs experience huge losses and are forced out of the market. In this particular case, banks with smaller scale of operations which had entered the market late in 2007 were forced to exit the market. These smaller-players exit from the industry ultimately led to a more oligopolistic structure and increased the concentration of the market in which only the ‘winners’- GSIFIs, with improved margins were able to dominate OTC derivatives trading activity. Interestingly, this pointed out that stronger regulations and increased barriers lead to higher concentration rates.⁴⁰

In light of the findings of this very interesting study, two observations are made,

i. Increased regulation post-GFC in the entire derivatives market is a barrier for new and more inexperienced market players to enter. This phenomenon has the potential to render the derivatives market less competitive in the long-run, and less efficient particularly with the threat of having ineffective rules in the market. The oligopolistic structure is also conducive of market inefficiencies, as bid-ask spreads and lack of price competition prevail in such a structure which has to be carefully examined by regulators.
ii. While GSIFIs are being heavily impacted by increasing regulation and a tighter regulatory framework, it is for this same reason that they are likely to remain the only ones enjoying returns in a more concentrated market. Less players and fewer entrants will lead to higher abnormal profits given there is no formation of cartels among a few of the players. Therefore, their regulation and supervision is critical to reduce systemic risk and support financial stability in the long-run.

These observations point out to the pivotal role derivative regulations have, especially given the prevailing influence and power of GSIFIs. A market without improved and revised regulations may satisfy the short-term appetite of GSIFIs given that they would be less likely to face regulatory burdens and costs with less stringent capital and risk position requirements. Nevertheless, in the long run, as supported by the OECD Journal study, GSIFIs are the ones to persist and stay on in the market. ⁴¹ These are the institutions to enjoy higher margins owing to the concentrated oligopolistic structure of the market and the effect of tight regulatory requirements. GSIFIs effectively need to be regulated in such a manner that would not jeopardize market stability by giving them too much power, but also with the principle to give them the necessary ‘playing field’ among themselves and with non-bank entities to fully functionalize flexibilities derivatives offer. An optimum level of intervention must be sought which will be analysed in part 2 of Section 1.

In deciding this level, the task should focus on improving the information flow between GSIFIs and regulators to be as accurate as possible to guarantee the preservation of sufficient margins for GSIFIs. The objective here is to get regulation ‘right’, which is detailed in the next part of this section. As such, it is clear that if reforms are implemented weakly this will have a regulatory burden on GSIFIs who would suffer the biggest blow and in turn, the effects are likely to be amplified on the larger global financial market with a negative spillover effect. Additional policy measures for GSIFI banks are favoured as their interconnectedness may give rise to systemic risks.⁴²

Section 1

Part 2: A Comparative Assessment of the Regulatory Framework and the Global Harmonization Attempts in the Financial Derivatives Market Regulations

The post-GFC regulatory agenda has the mission to eliminate systemic risk which was prevalent during the GFC. A critical policy goal of regulators in the post-crisis setting has been to regulate the excessive risk-taking activities of GSIFIs, along with other financial institutions and governments. Additionally, the scale and complexity of derivative instruments have led many participants engaging in derivative transactions to become increasingly difficult to be distinguished from each other; “a hedge fund on one side of a financial derivative contract can be indistinguishable from an insurance firm- except for the manner in which they are regulated.”⁴³ This redirects attention to the importance of identifying parties correctly in derivative trades and designing effective policies that outline specific obligations of different market actors from one another. The developments in the EU and US regulatory agenda after 2008 have been to this end promising as policy redesign has not necessarily suppressed the risk-taking activities of market actors.⁴⁴

A pertinent question to ask here is, ‘How could regulators ensure they get regulation ‘right’, in its purest form?’ It seems challenging to have a single answer to this question. In the absence of a harmonized legal landscape for the for the regulation of derivatives, any attempt to set effective policies should include measures to achieve transformative changes as an end-goal. A potential route to take is to implement “third-level” changes, that are designed to take place in the “cognitive or normative nature of regulation.”⁴⁵ The reform movement therefore requires a classification of a series of changes in accordance with their intended impacts across institutions, market actors and the broader regulatory framework encompassing the organizations which govern the derivatives market. Hence, a didactic approach will reveal three changes that occur that come along with regulation. These are;

i. “First-level changes that affect the settings of the regulation, which comprise technical changes to rules and practices. These have no impact on the regulatory status-quo and are not necessarily related to financial innovation
ii. Second-level changes which relate to institutional models and the intervention itself, which may comprise a combination of changes to hard and soft law implemented by regulators
iii. Third-level changes which encompass cognitive and or normative nature of regulation. These reforms may call for a modification in policy goals of regulation and consists practices leading to transformative changes.” ⁴⁶

It is observed that various regulatory strategies have been adopted following the GFC by regulators with an end-goal of producing transformative change across derivatives markets. Proposals adopted in the European legislation are accurate reflections of “first-level” changes which comprise changes to technical standards and “second-level” changes that relate to the nature of intervention with a “decreasing reliance on self-regulation.”⁴⁷ When the impact of such changes is analysed, the first and second-tier changes are holistic drivers supporting the creation of transformative changes. Transformative changes in this framework require an evaluation of the cognitive and normative aspects of derivative regulations to reveal how regulatory bodies have taken measures with an end purpose to increase liquidity, innovation and market-efficiency following the crisis.⁴⁸ In parallel with this observation, cognitive and normative frames have the effect of shaping the practices and behaviours of public and private market actors and therefore are important contributors to design public policies.⁴⁹ Hence, a more comprehensive orientation and guidance to market actors is maintained through an improvement of prudential rules, in accordance with the cognitive frames of regulation⁵⁰. These improvements are likely to result in achieving transformative changes across derivative markets. On the other hand, normative frames of regulation⁵¹ could be pivotal to assist the post- GFC revised regulatory framework to provide clear and accurate direction to market participants in their dealings with derivative transactions. Consequently, transformative third-level changes are reflected by an interplay of these two frames which have the capacity to determine the practices, behaviours and the scope of the potential instruments that regulators can use to implement more effective and harmonized policies.

Following this point, third-level transformative changes in the derivatives regulation should allow for “social exchanges and disagreements rather than simply supporting an unlikely consensus.”⁵² In hindsight, the post-GFC derivatives regulation landscape have seen various tensions and disagreements to exist among market participants, i.e. in between Member States competent NCAs, national and supranational authorities within EU and the US. These tensions have also sometimes resulted in regulatory fragmentations across cross- jurisdictions. However, the intense dialogues, discussions and debates among all market actors have therefore been the building blocks of transformative changes in the derivatives markets. The overarching goal to regulation ‘right’ and implementing effective policies for the purposes of regulatory convergence is more possible as a result of these valuable social exchanges.

Derivative Regulation Regimes in Europe and the United States

The comprehensive regulatory framework for OTC derivatives in the US is governed under the Dodd-Frank Act Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and in the EU, it is governed by the European Market Infrastructure Regulation (EMIR) and the second review of the Markets in Financial Instruments Directive (MiFID II). The Dodd-Frank Act, originally passed in 2010 by the guidance of the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) underwent recent changes in regards to the derivatives rule-making processes by the US President Donald Trump on May 2018.⁵³

The requirements of the European Market Infrastructure Regulation (EMIR) which came into force in 2012 by the EU legislature comprise transformative changes to the OTC derivative contracts and implementation of risk management standards, which include reporting, central clearing and bilateral risk- management obligations.⁵⁴ EMIR is one of several initiatives the EU has taken in multiple jurisdictions. EMIR’s transformative changes are a by-product of broad structural changes in the OTC derivatives landscape derived from first and second level change. For example, a series of Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS) have been adopted by the European Commission (EC) pursuant to delegated legislations and are an accurate reflection of first-level changes. The reduction of counterparty risk is being monitored by ESMA, which now mandates that relevant class of derivatives should be subject to clearing obligation, including all OTC derivatives to be cleared by CCPs. On the other hand, the clearing obligation is a reflection of a second-level change as it requires modifications in a number of hard and soft laws relating to central counterparties dealings with derivative activities in Europe. Currently, there are proposals in regards to the supervision of central counterparties to clear derivative transactions which cover amendments to the EMIR, and will be elaborated in Part 2 of Section 1.

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¹ Baker, Filbeck, Paradigm Shifts in Finance, Some Lessons from the Financial Crisis, The European Financial Review, April 30 2013, Accessible from: http://www.europeanfinancialreview.com/?p=879

² Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p.3, Accessible from: https://www.oecd.org/daf/fin/financial-markets/48299884.pdf

³ ibid, p.3

⁴ ibid, p.4

⁵ Ferran, Moloney, Hill, Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, 2012, p.132

⁶ Sorkin, Derivatives, As Accused by Buffett, 15 March 2011, Accessible from: https://www.cnbc.com/id/42088700

⁷ ibid, Accessible from: https://www.cnbc.com/id/42088700

⁸ Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p.20, Accessible from: https://www.oecd.org/daf/fin/financial-markets/48299884.pdf

¹⁰ Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p.4, Accessible from: https://www.oecd.org/daf/fin/financial-markets/48299884.pdf

¹¹ Aldasoro, Ehlers, The credit default swap market: what a difference a decade makes, BIS Quarterly Review, June 2018, https://www.bis.org/publ/qtrpdf/r_qt1806b.htm

¹² Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p4, https://www.oecd.org/daf/fin/financial- markets/48299884.pdf

¹³ ibid, p.15

¹⁴ Charlie McCreevy, European Commissioner for Internal Market and Services, Speech/06/314 titled Financial Markets Integration in Europe, Accessible from: http://europa.eu/rapid/press- release_SPEECH-06-314_en.htm

¹⁵ Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p3, Accessible from: https://www.oecd.org/daf/fin/financial-markets/48299884.pdf

¹⁶ Opinion of the European Economic and Social Committee on the ‘Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the European Central Bank — Regulating financial services for sustainable growth’, Official Journal of the European Union (OJ C 107), 2.2 6.4.2011, p. 21, Accessible from: https://eur-lex.europa.eu/legal- content/EN/TXT/PDF/?uri=CELEX:52011AE0347&from=EN

¹⁷ Ferran, Moloney, Hill, Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, 2012, p.81

¹⁸ Ferran, Moloney, Hill, Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, 2012, p.82

¹⁹ ibid, p.228

²⁰ Moloney, EU Securities and Financial Markets Regulation, Oxford University Press, 2014, p.38

²¹ Ferran, Moloney, Hill, Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, 2012, p.51

²² ibid, p.52

²³ Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p20, https://www.oecd.org/daf/fin/financial- markets/48299884.pdf

²⁴ ibid, p.13

²⁵ ibid, p.2

²⁶ ibid, p.2

²⁷ Acharya, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, Wiley 2010, p. 126

²⁸ Mayntz, Crisis and Control Institutional Change in Financial Market Regulation, Max Planck Institute for the Study of Societies, Cologne, Germany, Volume 75, p.186

²⁹ Vartanian, Harris, Ledig, Oringer, Financial Services Regulation Reform: What to Look for in 2018, Published: Feb 20, 2018, https://www.youtube.com/watch?v=vhUTBaPn5iQ

³⁰ ibid, https://www.youtube.com/watch?v=vhUTBaPn5iQ

³¹ Financial Stability Board Report, Implementation and Effects of the G20 Financial Regulatory Reforms, , 3 July 2017 3rd Annual Report, p.2, Accessible from: http://www.fsb.org/wp-content/uploads/P030717-2.pdf

³² European Commission, Regulation on Short Selling and Credit Default Swaps - Frequently asked questions, MEMO/11/713, 19 October 2011

³³ Long Position: Having a “long” position in a security means that the investor owns the security. Investors maintain “long” security positions in the expectation that the stock will rise in value in the future. (https://www.investor.gov/introduction-investing/basics/how-market- works/stock-purchases-sales-long-short)

³⁴ G20: The Group of Twenty (G20) is the premier forum for the governments and central bank governors from 19 countries and the European Union established for international economic cooperation and decision-making. (http://g20.org.tr/about-g20/)

³⁵ IOSCO: The International Organization of Securities Commissions (IOSCO) is the international body that brings together the world's securities regulators and is recognized as the global standard setter for the securities sector. (https://www.iosco.org/about/?subsection=about_iosco)

³⁶ BIS: Bank for International Settlements’ mission is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks. (https://www.bis.org/about/index.htm)

³⁷ Datastream: A global financial and macroeconomic data platform providing data on equities, stock market indices, currencies, company fundamentals, fixed income securities and key economic indicators for 175 countries and 60 markets. (https://www.eui.eu/Research/Library/ResearchGuides/Economics/Statistics/DataPortal/datastr eam)

³⁸ WFSE: The World Federation of Stock Exchanges is an international trade group that supports the interests of regulated securities exchanges around the world. (https://www.investopedia.com/terms/w/world_federation_of_exchanges.asp)

³⁹ Herfindahl Index: The Herfindahl-Hirschman index (HHI) is a commonly accepted measure of market concentration. (https://www.investopedia.com/terms/h/hhi.asp)

⁴⁰ Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p.7-11

⁴¹ Blundel-Wignall, Atkinson, Global SIFIs, Derivatives and Financial Stability, OECD Journal- Financial Market Trends, Volume 2011 Issue 1, p.32

⁴² ibid, p.2

⁴³ Ferran, Moloney, Hill, Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, 2012, p.18

⁴⁴ ibid, p.12

⁴⁵ Black, Julia, Lodge, Martin and Thatcher, Mark, eds. Edwar Elgar Publishing, 2005, p.9-11

⁴⁶ Ferran, Moloney, Hill, Coffee, The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press, 2012, p.116

⁴⁷ ibid, p.157

⁴⁸ ibid, p.116

⁴⁹ Surel, The Role of Cognitive and Normative Frames in Policy-Making, Journal of European Public Policy 7 (4), 2000, p.501, https://www.tandfonline.com/doi/abs/10.1080/13501760050165334

⁵⁰ Cognitive frames of regulation: As a policy paradigm, refers to the schemes through which actors view and interpret the world. (Caramani, Comparative Politics (2nd Publication), Oxford University Press, p.382

⁵¹ Normative frames of regulation: As a policy paradigm, it refers to the values and attitudes that shape the actor’s view of the world. (Caramani, Comparative Politics (2nd Publication), Oxford University Press, p.382

⁵² Caramani, Comparative Politics (2nd Publication), Oxford University Press, p.382

⁵³ Rennison, US regulator to outline changes to derivatives rules this year, 2018, Financial Times article, https://www.ft.com/content/93a561b6-2793-11e8-b27e-cc62a39d57a0

⁵⁴ Moloney, EU Securities and Financial Markets Regulation, Oxford University Press, 2014, p. 582