'Derivatives Deconstructed' with Professor Dan Awrey

hi everyone I think we're going to get started about 2/3 of the faculty members in the room apparently have to go teach a class well different classes at about 1:30 so we're going to get going pretty quickly and for those of you who don't have this is not some sort of organized protest I hope first challenge of the day is moving the cursor so thanks everybody for coming today this is a bit of a strange project that I'm going to present today I'm not entirely sure what it is whether it's a paper whether it's a book whether it's a teaching aid or whether I'm actually trying to say something that might be a little more profound chances are they're not but I don't know for sure just yet the reason that I originally embarked on this project was I was still a little disappointed with many academic treatments of how derivatives actually work depending on the type of textbook or a type of article we're talking about we see vastly different presentations about what derivatives are one based on a derivatives are kind of like equity securities in that they trade in deep and liquid markets the sort of arm's length finance view of the world and one that used them quite squarely as executive debt contracts that may have equity like features attached to them so one an equity based world public equity based world at that and one a more debt based world I and how I'm attempting to make sense of that in this paper is that especially when things are going well given some trends I'm going to talk about today derivatives do often have many of the same characteristics as highly liquid equity or Security's so shares or bonds but when things go bad and I'll talk about the difference between good and bad a little later on we start to see the debt-based elements of derivatives come to the fore and that all of this has a number of enormous policy implications in terms of how we treat derivatives but also in understanding the social desirability of good time derivatives versus bad time derivatives and whether we think we need to do something about that so the conceit at the heart of this paper at the moment is that one of the ways that we can understand this sort of distinction between good times and bad times is by dividing derivatives up into their constituent elements and then seeing how these different elements interact with one another and I'll go into all of this in a bit greater detail I'll come back to this set up at the end but it's useful I think to have this in your mind as we go through so I'm creating my own periodic table of derivatives elements in effect and the first thing we're going to talk about today is contract and derivatives exhibit some of the most sophisticated state contingent contracting in the financial world relating to things like basic payment and delivery obligations collateral requirements and closeout and payment netting what we also see is the extensive use of property rights however and specifically in relation to the collateral that's posted against the obligations the contractual obligations used in derivatives markets and then and this is where we sort of see a shift in derivatives we also see some pretty extensive non-contractual non property non legal mechanisms used in these markets this code this observation goes back to a couple of things first my own experience working in these markets but more importantly my conversations over the years with derivatives traders derivatives lawyers at the height of the financial crisis where what we saw was very little formal enforcement of contracts even when they were out of the money because of the reputational constraints that were created on the xpect future dealings we're all going to come out of this crisis someday and that litigating to get a short-term gain now could have longer-term reputational effects if we become or if we get a reputation as a litigious counterparty when the system is at stake and so one of the things that I'm trying to grapple with in this paper then is understanding when we see contracts and property dominates and when we see reputation and the expectation of future dealings these informal mechanisms dominates in the context of binding counterparties to derivatives there's another element here this is actually something that is fairly well documented in the literature is that a lot of the way that the contract and property rights work specifically around collateral and closeout netting rely on extensive legislative regimes that exempt the operation of these mechanics from applicable corporate bankruptcy law I'm afraid that up because I'm not going to talk about it too much today except to point out the bits of derivatives contracts where it's immediately relevant and what I'm going to suggest to you guys is that we can see a pattern a general pattern not followed in every case but a general pattern where each of these elements if you will bind and on the left hand side we have states of the world where nothing happens so we see no observable changes in market or counterparty credit risk and they're all the contract really does is provide a blueprint for what obligations are supposed to be performed and when as we move into observable changes in market counter market and counterparty credit risk the contract also has things to say there but we also start to see the importance of property rights playing a role in insulating parties from risks specifically in the form of initial and variation margin then we enter the interesting stuff where we start to see non observable changes in market and counterparty credit risk where we start to see more unfund 'mentally uncertainty or instability in the marketplace here's where relationships and the expectation of future dealings can actually play a role in this kit this role can be a double-edged sword so it can provide parties with flexibility to overcome problems that are as a result of this uncertainty or it can become the thing that when it breaks down actually becomes the trigger for financial instability why because once relationships become important to holding a relationship together when it falls apart we find ourselves in a position where parties face their own solvency constraints and there we start to see the breakdown of these markets so on the left hand side we can think of this is being effectively arm's length financing on the right hand side we start to see more relational financing and then once we get to a critical mass and I'm not sure where this is once we get to this critical point where markets start to break down all of a sudden we see binding legal constraints start to play an important role again especially at the point where derivatives counterparties encounter insolvency all right so I want to briefly start out with what I think is the anatomy of derivative contract for those of you who have read some of my other stuff apologize for being slightly repetitive again I'm a little bit dissatisfied with a lot of the academic literature and understanding what derivatives are and what they're really trying to do I'm talking about a diverse range of instruments all of which historically would have been called over-the-counter derivatives so these I dislike the name but there you have it the defining feature of these agreements is that they're not exchange traded futures as we'll see exchange-traded futures actually exist at the far one end of the spectrum of derivative contracts where through the process of exchange trading and clearing you've completely eliminated the relational aspects of derivatives contracts so you've got the fully commodified version of derivatives contracts I'm dealing with contracts that are bilateral contracts they are at least in some ways bespoke even if it's just the identity of the counterparties that the contracts and they take all these various different forms and don't worry we won't actually go into now what I think are the most important aspects in terms of understanding what the risks are in derivative contract really come down to two things the first is market risk so what I've got here is just a plain vanilla interest rate swap for those of you who are maybe less familiar with derivatives I've got two counterparties counterparty a and B and the essence of their swap contract is that one agrees to pay a fixed rate every given period so in this case every six months for five years and the other one agrees to pay a floating rate and then every six months they calculate both rates obviously the fixed rate is the fixed rate they calculate the floating rate they net out the two and one party owes the other money and you could also have derivatives that are physically settled using some sort of commodity or instrument but I'm going to abstract away from that for the moment and simply note that in this particular example so fluctuations in the rate of the London interbank offered rate or LIBOR is the representation of market risk so the fluctuation of some sort of variable or underlying asset up or down volatility in effect is the essence of market risk and as we'll come on to in a moment market risk is ultimately what you're trying to take in the context of derivative however there's another risk and I think a far more important one in understanding the structure of derivatives contracts themselves and that's the fact that if I promise to do something semi-annually over a period of five years my counterparty is vulnerable to the risk that I'm unable to do that so in effect I'm taking on counterparty credit risk that whatever contractual obligations my counterparty takes on will be performed in due course this is obviously a function of time spot contracts don't have this feature equity securities bond trades also don't have this feature insofar as there's only a very brief period between the execution of a trade and settlement this is a debt specific and an executor a debt specific type of feature and as we come on to is really responsible for 95% of the mechanic underpainting derivatives contracts so the takeaways that I'd like everybody to take away from this are first that there's this distinction between market and counterparty credit risk and it is unique so a question that I get asked all the time what about a bond right doesn't a bond have both market risk and credit risk attached to it absolutely right but they're completely identical in that particular case the market price will reflect credit risk and there's no way of separating them other than actually creating a derivative contract that is designed to separate them out into their constituent elements in a derivative market and counterparty credit risk ideally are perfectly uncorrelated and unless you enter into a derivative agreement with your counterparty that insures you against their account that counterparty is default they will be separated to some certain degree and the important thing here is that you can be perfectly in the money from a market risk perspective but your counterparty fails and now you're out of the money so the contract says you win bankruptcy says you lose and so that there's this distinction and a tension between market and counterparty credit risk that I think makes derivatives different at least derivatives broadly defined different than most other financial instruments the second thing is that nobody really wants counterparty credit risk right I'm seeing there's quite a bit of academic literature out there that says people want to take on counterparty credit risk outside certain regulatory capital arbitrage scenarios I think it's pretty safe to say that counterparty credit risk is just the evil byproduct of using derivatives to take on some sort of market risk and again this is pretty important and I think what evidence is this most of all is that what I'm going to talk about next are going to be all the different ways that derivatives contracts attempt to eliminate counterparty credit risk in order to make the play on market risk as pure as possible and the last thing I want to point out is that derivatives are debt these are executor debt contracts that have future IO use attached to them and so in the process of sort of understanding what the regulatory implications of the widespread use of derivatives are it may not be just issues about market transparency equity markets that were interested in it may not be sort of dedicating the regulation of derivatives to securities regulators as is largely done in the United States that is optimal debt we tend to think of something as raising Prudential concerns that is traditional bank Prudential Regulation concerns and I think that's something that ultimately is important to keep in mind okeydoke so and this little bit is going to be a little bit for those in the room who are less sort of Fame with derivatives but I think it's important to understand some of the basic contractual architecture before we launch into our distinction between good times and bad times most of this architecture again indeed all of the architecture that I'm going to talk about is about how the counterparties attempt to manage this counterparty credit risk but so the first thing they do is payment net so in my original example here I have counterparty a and counterparty B they have one contract I've already talked about a certain type of payment netting that is to say that the fixed-rate going to counterparty B and the floating rate going to counterparty a are often netted on effectively a single contract basis such that only the party that is out of the money has to pay on any given settlement date but if a and B had multiple contracts their contracts also enabled them to elect that across all of those contracts they can globally net out so that and I've given a arithmetic example here so if you've got two contracts where each party is in the money on one contract and out of the money on another contract I can elect that we net globally through all of those contracts and only one amount is paid this is all done by way of contract specifically under these two master agreement that I'll talk a little bit about later on the second thing that we can do is have closeout netting so aside from payment netting we may live in a world where our counterparty defaults and what closeout netting enables you to do is then immediately terminate that contract calculates in affect the closeout value of that contract and then have that paid out so the depending on whether it's the the non defaulting counterparty the defaulting counterparty that is in the money we see a contractual rule that in effect tells you who gets paid how and when this as I said its contract it's also though and here's the first point where legislation comes into it you might think yourself jeez so a party defaults maybe it goes bankrupt and all of a sudden my derivatives counterparties are able to terminate that contract immediately calculates an amount owing and have that paid that sounds like on its face like it violates certain process rules in insolvency law namely the automatic stay and fraudulent preference rules and in countries like the UK indeed jurisdictions like the European Union what you see are very bespoke legislative regimes that are designed to carve out these specific mechanisms from the application of those rules so in this case we see contract supplemented by legislation that gives effect to those contracts and then the third mechanism and one that we're going to spend a lot of time on today is collateral there are two types of collateral in derivatives markets the first is initial margin this is a space that contractually is evolving quite rapidly a generation ago in a derivative generation which I suppose is less than a human generation ago initial margin was just about the risk of counterparty default so if you and if horse and I entered into a derivative contract initial margin would reflect the probability that either horse or I would fail so it would be static and set at the outset of the contract in the wake of the financial crisis however a lot of initial margin terms now have a variable in them that's reflected in changes under Basel three capital requirements that say that well nope we're going to monitor horse denies credibility or probability default over time and we're going to adjust this initial margin periodically you know to account for those changes and there's a we can talk quite a bit about that actually if people have questions later on in terms of what precipitated that change in methodology but the basic idea is that this initial margin or the initial amount as its termed under the contracts is generally thought of as designed as a response to counterparty credit risk the second type of margin that we have is variation margin and here we have a very specific focus on changes in market risk so in between settlement dates obviously the price of the underlying asset can fluctuate up and down and the parties can insulate themselves against those fluctuations by having variation margin applied on a periodic basis so they can do it if they like every three months they can do it every 24 hours really under the in this bilateral world there's no limit on the extent to which the terms of this variation margin can vary both in terms of timing but also in terms of the amount of collateral how it's calculated and things like that but the key for our purpose is putting aside all the the technical details is that this collateral both initial and variation margin is a hybrid creature of both contract and property so it's contractual always in the sense that it is contract that then contemplates when property rights will need to be transferred under a derivative agreement to secure either counterparty credit risk exposures or market risk exposures and then in some jurisdictions depending on the type of security interest system or sorry the type of in effect property transfer use system that you have whether it's one based on exchanging property or exchanging security rights in property we see this attempt to make everything as self executing as possible again using legislative regimes so if I use property for example if I say to horse okay you are out of the money on this contract and I want you to transfer me collateral I take ownership of the collateral at that point and I have the property writes in it and can sell it do whatever I want with it under some regimes however how it would be done would be that horse would grant me a property are sorry a security interest in that collateral but horse would still own and have possession of the collateral what legislation done does in that case is that if horse goes bankrupt again procedural laws under bankruptcy law apply and under normal circumstances I couldn't then go out and enforce my security interest and get that collateral back so we see legislative regimes that are designed to enable me to do that to treat that contract right and security interest combination in effect is a form of property alright so that's the basic make up the what I've called the anatomy of derivative contract mostly based on understanding counterparty credit risk and the various responses to it designed to illustrate both the distinction between market and counterparty credit risk but more importantly that these contractual mechanisms also contain elements of property legislative regimes in them and start to look more like executor debt contracts than anything that we might see in the world of shares or bonds now the next thing I want to do is talk about how all of this plays out under different market scenarios for those of you that read the paper you'll see that this is still a work in progress as denoted by the fact that I've stuck my definition of good time and bad time bad times in an appendix because I can't really figure out where it goes yet in this paper shorthand however good times are where market prices are observable where changes in the price of the underlying and in counterparty credit risk are observable either through changes in market price in the case of the underlying or things like changes in credit rating or other proxies for counterparty credit risk and bad times are really the opposite of that effectively where we start to see information problems and markets and they begin to break down so let's look a little bit about derivatives in good times and specifically how things have changed over the last 20 or 30 years that have I think framed this idea that derivatives markets are becoming increasingly more like arms-length financing and less like loans or other executor a debt contracts I'm gonna look at three different sort of facets of this first the basic payment delivery obligations and then two things we've talked about a bit already these collateral support arrangements so that the process by which collateral is transferred between counterparties and closed that netting so the first thing that we've seen is the standardization of the basic terms of these contracts under the auspices of the International Swaps and Derivatives Association so we see these two master agreements in all their various guises for different types of derivatives being by far the most dominant contract form estimates are a bit dodgy but about 90% of the market if not more are documented in is the agreement um the contractual structure is interesting and feeds into this idea that these things are becoming increasingly commodified so we have for the most parts under these agreements a very basic modus ponens if-then structure right like it's the economists dream of classic state contingent contracting if LIBOR interest rates are above X then Y party will have to pay Zed party a given amount this is also supplemented by what I would call sort of overtime contractual learning about various scenarios that arise that initially were not dealt with in the contract but become embedded in the contract as a result of disputes that have arisen some of the best examples of this are often things like freezing assets as a result of orders in our jurisdiction so the United States freezing Libyan assets and Iranian assets have given rise alone into a wealth of case law dealing with well what the heck happens when the government intervenes and all of a sudden I can't get access to my cash I can't pay you in the normal course of business under this derivative contract and what you see then are detailed terms that are designed to dictate happens in exactly that scenario so we see the gradual this incremental sort of increase in the number of state contingent terms as we learn through case law about what can go wrong and I'm able the parties then to deal with that through stake ins in your contract and again if you look through the history of this the two big problems that arise then this is now reflected in the contractual architecture our capital controls or asset freezes and also physical delivery problems so our modern world of financial derivatives was preceded by a world in which physical delivery of underlying commodities was often an important part of what derivatives did and you see then very detailed contractual terms arising around for example the quality of delivery of grain onions things like that where they have particular storage problems where there are problems with quality that might arise and you see very detailed contracting around things like well you can deliver a hundred units of grade-a grain but if you can't get your hands on a hundred units of grade-a grain you can deliver 125 units of grade B grain and so on and so on and so forth designed in effect to encapsulate as many circumstances as it possibly can next I won't go into too much detail here except to say that there's also quite a bit of State contingent contract in governing the circumstances where parties will be required to post collateral this includes both the basic initial and variation margin requirements but also things around how to calculate what those margin requirements are at any given point in time and as we'll see later on this is one area where it's actually quite possible to find yourself in a world where it's difficult to use detailed state contingent contracting ex-ante in order to resolve these problems specifically what happens if you don't have a market price and you have to calculate collateral requirements and we'll talk about that a little bit later on lastly we have closeout netting and here if there are any derivatives lawyers in the room you can feel my pain here is where lawyers really really get into the nitty-gritty of all the various things that can go that lead to either a termination event under a derivative agreement effectively an event where nobody's to blame but we still want to terminate the agreement or an event of default which is effectively where there's been a material change in one party's ability to perform its obligations just to give you a flavor of this this is section 5 a 7 of the 2002 is the master agreement this is the definition of bankruptcy for the purposes of the is the master agreement it has I think 15 separate heads that define what a bankruptcy event is and even then it's still one of the most litigated provisions in all of derivatives agreements so we see incredibly detailed contracting at the same time we still see enough incomplete contracting that there is litigation designed to clarify these terms all right the standardization this incremental growth of state contingent contracting added to then the standardization under the auspices of is de has facilitated a good deal of automation in derivatives markets I don't have a lot of time to go here what sort of precipitated this the last time I was in derivatives markets most of this was manually done so you would get a fax from your counterparty you'd look at it and your compliance officer would sign off on whether it had the right terms and fax it back when you're talking about several thousands agreements a month that becomes a pretty big headache quite quickly and in fact this came to a head in about 2004 2005 with credit derivatives as a result of which the Federal Reserve Bank of New York I suppose spearheaded an initiative designed to overcome this paper processing problem with the result that we see an increasing proportion of derivatives cleared and settled through automated processes unfortunately this is some data that I've collected on the basis of bis and is the surveys unfortunately of course because the problem only really came go ahead in 2005 detailed statistics when we started in 2006 what you would see and unfortunately have to take my word for it if you could go five years back in time on this chart would be somewhere definitely south of 20 and probably pretty close to zero and what was above zero would just be the industry leaders at the time starting to implement automated processes while most of the marketplace was still not automated and even then really only with the most popular liquid products of things like forward rate agreements and interest rate swaps so we've seen and the red line is the important one here we've seen an increase from about 55 percent in 2006 to about 77 78 percent so about a 50% increase in automation over the course effectively over the last decade knowing I don't have a theory for that at all to be honest yeah I mean the the data doesn't really give you too much of an insight into that it's certainly possible that what happened was that compliance resources were being devoted elsewhere during this period in effect right it could also be although even then I'm not sure that hypothesis bears out because if you look at the derivative sorry the Lehman bankruptcy reports Lehman Brothers who you might think would have been poor at derivatives risk management actually didn't have any open positions so these unn electronically confirmed in settled positions so it was doing pretty well in this regard or didn't have any sorry I'll be more accurate there it probably had manual processes in place for some derivatives but nobody challenged any of those manual processes the yeah some of the think about I haven't really put too much thought into it all all right the last thing in probably the thing that everybody knows about at this point about derivatives and good times the shift from bilateral towards central clearing so it used to be the case that the vast majority of derivatives existed in this dense thickets this network of derivatives dealers and other counterparties everything was done on a bilateral basis and then portfolio hedging took place at the institutional level in effect typically on the balance sheets of derivative dealers investment banks primarily and then for reasons that will come on to there was this shift already taking place in many more standardized derivatives markets prior to the crisis but incentivized even more so by the adoption of the dodd-frank act title seven in the US and the European market infrastructure regulation in Europe that has instigated this shift towards central clearing now the reason for this is sort of twofold the first is that by re routing derivatives trades towards a central counterparty you can collect a lot more data about how the markets work so not surprisingly the clearing mandate was accompanied by a mandate that required a lot more detailed reporting although I certainly think not detailed enough given the Prudential risks associated with derivatives to regulators to the CCP's to enable them to manage risk and then the second thing was that clearing houses are able to coordinate then the mechanisms so the netting Arrangements the collateral requirements and closeout netting and other crisis management tools in the event of market disruption or institutional failure and the reason or the mechanisms by which they do this are often known as a clearinghouse default waterfall we don't really have time to go into it in any great detail today but there are two things I want to note the first is that all transactions of a particular type with all counterparties righted through a CCP are subject to the same rules so you don't get bilateral bespoke negotiation and the second thing is that in relation to things like collateral requirements is that they strictly enforce daily or even more frequent variation margin requirements so changes in the fluctuation of the market price of the underlying are reflected in the margin requirements very rapidly such that in theory at least there shouldn't be large open exposures as a result of changes in the price of the underlying this is then coupled then if this is about managing risk between the CCP and a clear member the allocation of risk depending on which way it flows there's also risk neutralization mechanisms and clearinghouses specifically once we get to things like pre committed insurance funds clearing member and Clearing House capital and contingent capital calls and then things called position portability procedures where effectively the Clearing House can compel clearing members that survived the failure of another clearing member to take on the positions of the failed member and we'll talk a little bit about that again later on why did I just tell you all of this well when you put it all together when you take this standardization when you take the automation when you take the shift towards central clearing and the standardization and automation that come with that all of a sudden derivatives instruments start to look more and more like liquids standardized highly homogeneous products they start to look more like conventional equity and debt securities where we can in a sense if we let ourselves be fooled think that all of a sudden the only things we have to do now or make sure that people have access to price transparency and other sort of market supporting institutions what I want to I guess the the real takeaway from today is then this trend though true disguises most of what happens in the way that derivatives work during bad times and again insofar as I've done anything so far in framing the difference between good times and bad times I'm talking about situations where we can no longer see prices I'm talking about situations where I start to doubt that horse my counterparty is solvent I'm talking about situations where maybe the circumstances around me are tumultuous at a market level and I don't know where risk is going to come from is it going to come from the underlying assets is it going to come from my counterparties is my counter party going to fail because of its exposures to other counterparties these are the sorts of scenarios that both create huge information costs and uncertainty for market but also become I suppose fertile ground for exposing how incomplete derivatives contracts actually are at the end of the day so for all the sort of state contingent contracting that we've talked about for all the details that have been put in these two master agreements all the jurisprudence that is then filtered into honing and revising is the master agreement there's just no way on earth that these contracts are entirely income entirely complete we know this because we see the cases we know this because of case studies like the one that I'm going to talk about in a minute involving the renegotiation between AIG and Goldman Sachs and we kind of know it as a matter of economic theory because the cost of writing truly complete state contingent contracts can be extremely high I this includes both sort of the upfront costs of actually determining what all the different states of the world are and then writing contracts that actually allocate risk and dictate payoffs in each of those potential states there's also the cost from a contractual perspective ex post of actually enforcing our complete contracts in the event that we're able to write them so it's not surprising that our contracts are incomplete given all these costs but that has important implications in terms of how derivatives work during bad times the risks that this creates and you know economic sort of the economic theory of contracting sort of identify are one that we could get suboptimal outcomes so we'll either not say what the parties are supposed to do or what how risk is supposed to be allocated in a given state of the world or two we might open ourselves up to opportunism so if everybody's equal in this state of the world where we don't know how we should act because the contract doesn't specify it it may be the case that were just incentivized to renegotiate but where there are a symmetries and information of bargaining power we might think that one of the pound one of the counterparties might use that in order to renegotiate the contract in a way that enables it to extract value for counterparty uh thankfully the the same economic theory of contracting literature that identifies these problems also identifies sort of broadly the classes of solutions that we might find so we see the use of property rights so rather than contract we can just allocate property rights the key benefit of property rights in this case is that effectively enables self-executing enforcement I don't need to enforce my contract I own it I have the ability to do with it whatever I want the second is the allocation of decision-making rights so if my contracts incomplete and a state of the world arises that exposes that incompleteness the allocation of decision-making rights enables one party to actually say what needs to be done we get clarity by virtue of the fact that one of the parties now clearly has decision-making authority now there's obviously some really thorny questions here that I won't fully avataq a chance to address today namely how do you allocate decision rights to the best party in the circumstance of that incompleteness how do I tell ex ante who should get authority ex post and there are huge issues surrounding that that make this a very difficult type of strategy to implement successfully and one that when we come to the AIG goldman sachs story minute we'll see was not particularly done all that successfully and then lastly we have standards based contract so rather then dictate specific terms we can identify standards that a party is required to meet in the course of dealing with whatever uncertainty whatever in complete contracting exists during those contracts evidence all three of these things just very quickly so property rights well we allocate collateral to counter parties with larger exposures so both initial and variation margin can be viewed as in effect shifting property rights in the event that the exposure of a counterparty becomes heightened as a result of changes in market or counterparty credit risk as we'll come on to in a moment there are decision-making rights most importantly in this case the use of something called a value h valuation agent designed to calculate the applicable collateral requirements and then lastly we have a whole host of standards-based contracting enough to keep you know commercial litigators in business in perpetuity we see this in circumstances where we might expect to see it to be honest so we see it where the valuation agent typically the dealer in a transaction is given authority to calculate margin requirements where they're required to act in good faith and in accordance with standard market practice why well because being a valuation agent especially if we can't observe market prices comes with a lot of power and in this particular case using standards based contracting provides at least in theory some sort of check on the exercise of that power namely it has to be exercised in the standards of good faith and in accordance with standard market practice we also see it in payments where we see things being made in customary manner for those of you who are payment systems geeks which probably only includes me the rate of change in payment systems and settlement systems is so fast that to dictate in detailed terms how payments should be settled is to just ask for trouble so customary manner covers all different types of mechanisms that you might get they vary across jurisdiction they vary across time they vary across different types of derivatives products so given that heterogeneity it makes sense that we see standardization of this term around customary manner of payment lastly and for those of you and I think there's quite a few of you here today taking principles of financial regulation we see standards-based contracting in relation to compliance with regulatory requirements regulation of derivatives and their counterparties move so fast that having somebody maintain authorizations across a detailed list of different types of regulations would be suboptimal certainly very hard even to keep up with and so having a more general standards-based term that says that they have to maintain all our reasonable efforts to maintain all government authorizations makes a lot of sense kind of basic contracting stuff but nice to see it actually play out the theory play out in the context of derivatives markets lastly and here's where I'm either going off the deep end or perhaps saying something is that even after all of those mechanisms there's still something left so collateral it's quite expensive valuing financial assets using the valuation agent mechanism it's actually quite a subjective process and one we're identifying true price especially with more esoteric less liquid instruments is actually something that's not undisputed and of course when it comes to standards-based contracting you've got to go to court to enforce them so there's this role then given the cost associated with these mechanisms for relationships to play a meaningful role in the context of derivatives contracts at least in theory what I'm going to talk about next is that theory in practice for those that may not be familiar I am drawing a distinction here between two types of relational mechanism one between the expectation of future dealings which is that Horst and I expect to do business in the future and how Horst behaves towards me will dictate my behavior towards Horst and the other one is reputation so how Horst behaves towards all of you will influence how I behave towards Horst and this is going to be important to understand how Goldman Sachs saw its relationship with AIG versus its broader relationship with the marketplace okay okay so to illustrate this relational dimension of derivatives contracts and I've gone back to really a treasure trove of information released by the Financial Crisis Inquiry Commission that included a large volume of email correspondence between AIG and Goldman Sachs in relation to its I guess well about thirty-five I think are so derivatives contracts on multi sector CDOs so these were credit default swap contracts where AIG was effectively offering credit insurance against defaults under various CDOs linked to the subprime mortgage market and we have really a large volume of correspondence that takes us from the period where we start to see distress in the subprime market through to the period and after the period where AIG received support from the federal government in September 2008 so the basic idea of these agreements was that AIG provided credit protection in exchange for which Goldman Sachs paid AG a periodic C we also have some of the more detailed elements of these contracts thanks to the FDIC so there were three collateral triggers in the AIG goldman sachs contracts so these were events which would require AIG to post collateral to goldman sachs the first one was that there was a change in the ceo's credit rating so if the credit rating was notched down that would trigger collateral the requirement to post collateral if the CDOs price went down by four percent or more that would require AIG to post collateral and if a IG own credit rating was downgraded that would require AIG to post collateral this created quite a pro cyclical dynamic there's quite a bit of writing on this we can talk about a little later on this part of the market has changed dramatically in the wake of the financial crisis precisely because of this exact case study interestingly the valuation agent mechanism in the case of the the edgy goldman sachs contracts was that both parties with a valuation agent I've never in my life seen that before and it may to a certain extent explain what happened next I'm not entirely clear that I've talked to a I geez general counsel from that period about this who didn't hadn't noticed this aspect of the contracts it's strange that you would allocate decision-making authority to both parties because that's kind of like having a a joint venture agreement where you have a 50/50 interest and as soon as there is a dispute you just get deadlock and in this particular case we also see a threshold amount so the amount of collateral that had to be posted had to exceed or the loss or II had to exceed 75 million before a AG would be required to post collateral and importantly at least the agreement said that once that's triggered gold a AG has to post collateral within two business days effectively 36 hours but in fact two business days and then lastly if there's disputes under this agreement specifically as it relates to the pricing of the contracts or collateral this had to go to a dealer pool this is a pretty common provision it basically says that if the valuation agent has given a mark on collateral or the price of the contract that the other counterparties agrees with the dealer has to go to the marketplace and solicit four or five other dealer quotes and that the arithmetic average of those dealer quotes becomes then the price that's relevant for making a calculations under the contract this is going to be quite important to the moment all right then so obviously most of us if not all of us know the story of what happened next what happened in the subprime mortgage market certainly didn't stay in the subprime mortgage market and we see the triggering successively of each of the requirements under the credit support agreement for AIG to post collateral and in July 27 2007 we see Goldman request 1.8 billion dollars worth of collateral from AIG this is obviously not a small amount this is a very large amount especially for firms that you know are engaged in putting capital to use rather than having it sit on their balance sheets for the purposes of for example paying out variation margin requirements by September 2008 that 1.8 number will be increased to about 9 billion making it I think pretty far in a way the largest collateral call in the history of the world so we're talking huge amounts here now the interesting thing from my perspective I think is what happened next so what happened after the 1.8 billion dollar collateral call in July 2007 I on the surface of it it was a renegotiation AAG didn't pay this amount it ultimately paid incremental amounts toward a full amount ultimately I think it paid about 6.5 billion but significantly later months months later not the 48 hours that it no they had under the contract and there could be several reasons for this the first thing the most famous one is that there was a lot of uncertainty and disagreement about the price of the CDOs so if the collateral requirements were linked to the value of the CDOs then the value of the CDOs if it's not observable in the market place become something that's a point of contestation and that's exactly what we see while Goldman was able to mark several of the CDOs to market some of them had had to use its own internal valuations for and it was those internal valuations in effect that AIG was contesting in a in its own unique way as we'll come to see as inaccurate as it turns out AIG was not doing its own calculations to compare against Goldman Sachs so it looks like those objections were just well we don't like this try again yeaji meanwhile saw goldman as a business partner and the head of AI G's financial products unit the unit that had entered into the CVS with Goldman Sachs makes repeated references to the fact that hey no we do a lot of business with Goldman Sachs and we don't want to just tell them to go away we want this relationship to continue and press this to his subordinates that they needed to manage this relationship with Goldman Sachs Fritz part Goldman Sachs also thought that enforcing these collateral requirements could be embarrassing for the firm why once you enforce them this information leaks out into the marketplace and exposes one of two things if not both the first is that somebody thinks that you don't know what you're doing in terms of the valuation of the underlying CDOs which to a firm like Goldman Sachs has clear reputational implications as a market leader the second thing is that rule number one at Goldman is that the client always comes first bankrupting your client because you wanted to get your collateral back sort of chase set that notion in a very sort of obvious way and so we see one of the senior Goldman Sachs structured products guys writing a memo to the Board of Directors saying look we want to be really careful with how you communicate this to both AIG but how you communicate any details about this dispute to the marketplace because any details that make it out can only say bad things about Goldman Sachs of the firm lastly we see yeah I'm sorry love I don't know whether this is a and alternative hypothesis or is part of what you're saying but when you're dealing with a solvency bank like this then managing the future relationship seems the counterparty is going belly-up so so in part of Goldman's strategy here at this time period was its relationship with the government and using the government in some sense to be the counterparty so when AIG says Goldman is a business partner needs to manage the relationship that makes complete sense you are coming to take you but we dollars missing oh gosh we need to match situation yeah but nothing you know just if not for anything just so that they don't go belly-up sooner than they like you and Bolin's perspective it might just simply be a case of saying well we've got actually a much smoother way to to collect all this right and so it's not really managing the future relationship as much as I need to make sure that there are some suckers in the market to divide the crap that we're selling and and so is that the same story is it in different stores so and I completely agree with there's several added elements to this that make it strange well not strange entirely predictable and make for a messy signal and messy relational story here right so as I'll talk about a minute Goldman Sachs also started taking out CBS on AIG so it was actively trying to mitigate its counterparty credit risk AIG or what in effect at that point was the risk that the collateral would ever be delivered I think this story is also consistent with the idea that they were trying to milk AIG for as much of the collateral as they could before they let it fail right because they knew that AIG had a liquidity constraint and the longer that as long as it kept the its foot on their throat it could let AIG sort of liquidate as much collateral as it could because of the car boats the automatic stay in fraudulent preference rules it could theoretically extract more from what is about to be an insolvent estate and it is also consistent although I think my personal view and I know it evidences for this my personal view is that it probably wasn't golden Sachs strategy Oh Angie will get bailed out and will get the print benefits of that bailout which is ultimately what happened but it's consistent with that story as well absolutely so yeah and what I also want to take away from this is not the pure relational story that our relationships great but that this story is actually idiosyncratic to this particular relationship and that because this is idiosyncratic it could be the syncretic in another case and in fact AIG was also entering into parallel negotiations with Societe Generale at the same time that went along entirely different dynamics why because sock Jen was not Goldman Sachs the exposures were significantly smaller and sock Jen had taken the sort of not on unreasonable position that was going to wait to see what golden Sachs did before settling anything hesitation of course there fail and say and what can we learn what we generalize from from a policy perspective or just in terms of describing the well I think so again we actually get on to now because I don't think that the stories are consistent because if Goldman Sachs treated Catholic wakes with government bailout they have to appear as a pretty harsh man towards push the AIG brink if it's all the same work to make it credible but they're happy prevail because government realizes well these guys aren't so tough line on this for anyway so they might method ways that I think there is I mean your intention of his stories was a dissonance that are there right so I'm talking about the relationship between Angie Bolen Sachs the executives in a room talking as such women documented by both Ben Cohen book and then the FCIC material goldman sachs was very good at making sure that it sent its collateral call every day right from a formal legal perspective it was lining up the future litigation perfectly every day new collateral call updated on their current marks that then made them look tough right they didn't so the the formal documentation that you would ultimately expect to be submitted in court was definitely the tough stain what made it interesting was I got accent well we all have access Thank You SCIC to this other conversation that was going on and we also don't see right that these statements were made internally at goldman sachs and internally at AIG you know I wouldn't let my mother read some of the correspondence between AIG and Goldman Sachs that was much more unsavory I suppose but I Ruth her point that I think that there is that tension there in that element of the story for sure did you oh yeah we were gonna go ahead to this so and I'm just gonna put a pin in it for one second so we can get through there just to say that so what a relationships we do here well one in a world where contracts are incomplete they can give us some flexibility I've put this sort of three different ways you can have flexibility this can be a safety valve against contractual rigidity if AIG had to post collateral within 48 hours it would have failed a year earlier is that a good thing or a bad thing I'm not making any judgments there or alternatively from a more finance perspective what the flexibility does is provide one party with optionality effectively to not adhere to strict enforcement of the contract and that can have pretty valuable benefits I've also for those that enjoy sort of the more legal elements of contracting made a couple of points here that things like valuation agents can be useful in so far as to give the parties an opportunity to signal that they're being cooperative or not cooperative in the context of relationship enabling the parties to learn about what type the other counterparty is cooperative or not cooperative and it's sort of consistent with the braiding hypothesis of Gilson sable and Scott that if we know that contractual rigidity can bind our hands when we enter into these contracts it may be useful to also have these escape valves in the contract that then say okay well when things are really bad reputation strains will enable us to inject some flexibility into this contract but back to the question so John's question about what's generalizable here and let me know if you think that I'm not answering this question I think the first thing is that this case study shows as you'd expect from reputational mechanisms that the bigger the relationship the more flexibility you are likely to see when everything hits the fan so if you are a small counterparty with goldman sachs you're unlikely to see that flexibility and certainly as a you know somebody who comes from the asset management side of things and would do deals with goldman sachs i never saw any of this flexibility if you objected to anything in is the Master Agreement that didn't return your calls for three months and everybody was breathing down your neck so the AIG story is not one I necessarily saw when I was on the other side of the table so the size of the relationship could be important in this in terms of general things to take away may complicate the matter more than simplify it is that in derivatives markets there's a lot of mechanisms that then create countervailing incentives so this relational world doesn't or is going to be less important the more the counterparties are collateralized or in the case of Goldman Sachs where one of the counterparties has taken out insurance against the failure of the other counterparty in those worlds where the loss experienced by one counterparty as a result of the failure of the other is going to be lessened we would also expect relational less mechanisms to play less of a role it was also important here that there can be cross purposes I think this is one of the more important elements of this so if the relationship was what was making Goldman Sachs and AIG negotiate Goldman Sachs was also up against the fact that it had relationships with other counterparties with other market participants that it wanted to take into consideration as well so we see a IG very early on say let's go to a dealer pool and then for the next year Goldman Sachs basically resists that even though it's in the contract it's like we don't want to go to a dealer pool why well the internal correspondence makes it clear we don't want to go into the marketplace and say Goldman Sachs does not know how to value these assets please help that sends a negative signal damages the reputation of Goldman Sachs in the marketplace and so understandably they spent quite a lot of time resisting that so in effect their relationship with AIG in a bilateral context had an additional degree of in flexibility because Goldman Sachs was worried about its relationships with other counterparties other market participants the last thing is and this sort of stands to reason or so where the last things is understand see reason is that when the parties don't have equal standing the relational aspects may not prevent opportunism or an AI G's case may not prevent them from biting off their nose to spite their face as it turns out Goldman Sachs had pretty robust methodologies for valuing the nisi so even if there wasn't a market price they had a defensible way of putting a value on these things Angie objected to that but in congressional testimony it ultimately came clear that franca Sano never even attempted to come up with a valuation model for these CEOs so given Goldman Sachs's role as a market making dealer given its at least attempt to value these assets any negotiation over their value against a counterparty who either didn't have the expertise or inclination to do so was likely not to be one of pur arm's length negotiation where the relational mechanisms enabled the parties to avoid situations where one took advantage of the other uh and lastly and again I think this is fairly straightforward once it became clear well once it became relatively clear that one of the parties was going bankrupt or may go bankrupt subject to this specter of state support relational mechanisms go out the window you know a lot of Karelian subcontractors are learning this lesson as we speak right now right all of the attempts since last October I guess are even further in order to save the firm mean nothing once you've got your compulsory liquidation except of course when the government intervenes to bail you out so I don't know if that answers your question John in the sense of what's generalizable I kind of see the the top-level generalization being that there are no generalizations and then the second level I guess gives you some predictors of when you'd expect to see relations dominate so when the numbers are big so when you could lose a lot of money relative to a small amount of money when things like collateral have not been provided thereby exposing counterparties to the full sort of exposure to losses where we don't see these cross-cutting mechanisms like the dealer pole and where we don't see these asymmetries of information in bargaining power and so there's a come to it there we are actually so what I'd expect to see is and I make no representation about the accuracy of this arc but the shape is supposed to sing that the idea that when there's no changes or changes are observable most of the time the contract can do all the work we just look at the world we look at the contract says we're supposed to do in that world and we execute it we have a property right system and a contract enforcement system in the background that enables us to affect those changes but this is contract as blueprint as instruction manual for how the relationship is supposed to work as things get more complex as things to get less observable we would see some sort of increase into the relational world that is to say it may not be big it may be very small and incremental where we work out on a relational basis what we want the contract to do going forward and that to a certain point will get bigger and bigger as the problems get bigger and bigger but then as we start to think about insolvency and we start to think that this relationship may not have a future we should see this drop rather dramatically and again I'm not saying anything about the shape of this particular curve just the general direction of travel that we might see in these markets now you worked on the basis of the assumption that there is advance occur I am okay now how would this push change where there no problem well so I I think that's a really interesting question I think what we would have is well I suppose try to think about how how we want to consider it in shape I think we'd probably see this the last part of the curve moved farther to the left right just recognizing the fact that all of a sudden bankruptcy becomes a strict failure so you and knowing that you'd probably see a lower slope of the curve on the left-hand side because you wouldn't be willing to take as much risk as much exposure to the firm so assuming this is accurate for a second I would think that you would just shift it farther to the left and reduce the slope of the left-hand side of the curve so they would make less relational investment ex-ante and they'd be sooner in pulling that relationship back in when the specter of insolvency started to rear its head would be my first intuition on that all right so what does all of this mean and I'm I want to open this up for discussion if for no other reason than I can eat my sandwich the paper goes into more detail about this one of the horses I've been beating for a very long time is that derivatives should not be treated as securities the paradigm of market our information forcing regulation to force market transparency well perfectly consistent with the idea of deep liquid markets in good times is really inconsistent with the other half of this story where all of a sudden I've got debt contracts that include elements of property and relationships this looks like a commercial loan that's been collateralized not like a publicly traded share or a bond and this is more than simply a categorical issue right the last time that we allowed a securities regulator oversight of a Prudential issue was the consolidated supervised entities program of the SEC labeling the SEC to oversee the capital calculations of the major investment banks that was an unmitigated disaster and understandably so their market regulators their objective is to force information and enable the market to make decisions about things Prudential Regulation the regulation of loans counterparty credit risk is all about private information that is analyzed and then decisions are made by Prudential regulators about how to manage that risk two completely different paradigms and one that then means that we can't get caught up in the institutional path dependency of banks do banking securities our markets most modern financial systems are hybrids and derivatives in that respect are just an example of this the other three policy implications that I talked about in the paper all come down to this question of whether the flexibility injected by the relational mechanisms is a good thing or a bad thing and for those who read the paper you'll see that my answer is both depending on what stage of the relationship were actually at so in terms of central clearing central clearing basically takes out the relation elements right so we have entirely standardized contracts we have automated rules about the collection of collateral so for example but for a couple of mechanisms I'll talk about in a second a Clearing House doesn't have the ability to say okay gee you look like you're going to fail so I'm not going to collect collateral from you today I can't do that the rules have bound their hands to a system where you see both a high degree of credible commitment because the rules are so binding but also potential contractual rigidity one of the things that's not appreciated entirely about these clearinghouses is that there are mechanisms designed to alleviate this contractual rigidity and the two that I talked about in the paper are things called partial or complete terrip procedures which is the name implies enables you to tear up contracts and then variation margin haircut gains which effectively enable you to accept collateral from counterparties that are on the money but not pass it on to the counterparties there in the money thereby enabling you is the Clearing House to fortify your own balance sheet in the middle of market distress now that in turn raises some questions about the governance of clearing houses and who you want to have control over this flexibility and I talked a little bit about in the paper but isn't fully developed right now who you want controlling those decisions depends on the governance model of the Clearing House so is it owned by members or is it owned by another sort of independent firm like a stock exchange or independent third party investors if the former well then you have one set of incentives when it comes to exercising these mechanisms if the latter and there are sort of third parties and detached from this one might think that their incentive is actually to download as much risk as possible onto the clearing members in which case there may be conflicts of interest between the survival of clearing members and the survival of the Clearing House and in that case it may be useful then to allocate that discretion to potential supervisors as opposed to the Clearing House itself I it wouldn't be a paper these days if it didn't have some blockchain component to it it probably doesn't surprise you to know that the International Swaps and Derivatives Association has doubled down on using distributed ledger technology to even further automate clearing and settlement within derivatives markets and again this makes a lot of sense given the state contingent nature of the lot of a lot of the contract features but also presents potential contractual rigidity that is to say that if I have these systems where I automate in effect things like variation margin requirements things like variation margin haircut gains that if those rules aren't complete if they don't entirely automate every potential response to every future state of the world we may end up in states where we end up with what's called wrong-way risk where we end up enforcing things like collateral requirements in ways that undermine the integrity of his system so they cause a clearing member to fail and the reallocation of losses among surviving clearing members cause the Clearing House to fail which then has feedback effects to the surviving clearing members this has happened in the past and could happen again again the key then is coming up with similar mechanisms safety valves that are designed then to alleviate the pressures of contractual rigidity in those circumstances and there's a couple of computer scientists at Cornell who have developed a protocol for permission distributed ledger system that then says basically okay we can press the stop button no transactions go through but we crystallize at that moment in time what the obligations are and then when whatever crisis has passed when we have more information we have two choices we can press play in which case the performance at that given moment in time is then executed or we can amend performance given new information that we now have in the marketplace so we inject some judgments and human judgment back into what would otherwise be an entirely automated system lastly and I think I'll just mention this very briefly we don't have a great conceptual basis at this point for understanding why we do things like support markets during periods of market turmoil so that was you know thirteen or fourteen different initiatives that the Federal Reserve in the United States took to support markets during the financial crisis not financial institutions but to support very specific markets they asked that commercial paper market the ABS market derivatives markets I and I think understanding these these contracts as having a relational element that then if it works during good times breaks down during bad times gives us a sense of what the wrote state's role is in that circumstance where the trust breaks down the role of the state then as the counterparty that can't default is to stand behind contracts put in a market floor that raises a lot of interesting institutional questions about how you do that without creating moral hazard without having people gaming the system but it at least provides a theoretical basis for understanding what the problem is and then providing some sort of justification for failure unless the insurance concerned you can have to give it all back again it wasn't a matter of going this money so that we keep it they were saying we want this money as worms against you're not paying claims in the future and in calling that collateral will cause the collapse of the insurance company then you were disastrous position because you had the money you lost the benefit of times worse so ideas very useful demonstration of the value as soon as you get into the weird world collapses you have to stop you know thinking in a very different way from the way that you think about payments and in the context of credit derivatives particularly yeah I think that's right I think those that in the case of AIG there's also the basic financial economics of insurance that comes into it where a AG was underwriting the insurance of a large part of its markets and if insurance had to be paid out for these events it was going to be highly correlated in which case the insurance company fails which is just sort of a vindication of the idea that you can't insure against systemic risk which came out of space I should say there's a paper a great paper in the Harvard Law Review by Richard Squire at Florida who says that AIG understood this perfectly and was actually on the other side of this market in the securities lending market as well because it knew that if it you know either heads I win or tails you lose if the market survives I make money on both sides of the table if the market fails I'm done anyway and it's somebody else's problem if you can't get your pass from me tough luck so that the I'm dead you're dead scenario so yeah I think it's a I sort of the intermediate and higher levels this is exactly to look at yeah it's a full well I think that the way you frame the problems case study I think that somehow whose is the systemic dimension which i think is at play here because most of the incentives relational or not probably almost motivated by the idea that like I said this is going to do it anyway somehow your partner it is something that that beyond the sheer size of the contractual relations markets I agree it bugged me about that case study as well you know this idea sort of sat for a really long time until I came across the FCIC material but I think to fully deal with the implications I need more material and what market participants were actually doing and thinking at that time the problem is coming up with some sort of toehold to be able to say that I think exactly that there is a savage dimension of systemic instability and of course then that would enable me to be much more robust in my discussion down here of what the dynamics actually are in that context in case of a department that in case the counterparty goes bankrupt those informal Gobbo need to extend reputation still and so fascinating question right so I'm the administrator of a banker's if Arg and gone bankrupt and it looks at what a financial institution is right it's its reputation charter value is everything in financial services so if I just liquidate in effect or if I start cherry-picking contracts that I've been callin her versus those that I'm not going to in bankruptcy that can have a knock-on impact in terms of the viability and value of the entity that reads bankruptcy subsequently now that's complicated by a few things right how much is firm reputation with invidual reputation but I think you're absolutely right that there there's reason to believe and especially for financial services firms if any anything where the assets are primarily intangible there will be something that survives bankruptcy in the relational sense in fact that may be another bankruptcy scholars in the room there may be something that I could talk to them about because which is also I mean immediately I shouldn't do it for the precise reasons that you've mentioned but that's part of why this isn't a straight line right because if the relational story died at bankruptcy then I would just have a point here that was bankruptcy and then it went straight to the horizontal axis so yeah now actually the reason for drawing and bombs and for sure the in terms of contractual relationship I think the difference there would be that that story requires on a specialized intermediary acquiring the bonds right so the the the parts of it that make it look similar are then because a specific injury the area requires a specific acquires a threshing around to the specific type of claim if I understand you as opposed to the the instrument itself does that answer Russian yeah it's not every people to provide a threat know that that the tragedies they would there be be instruments to deal with that uncertainty and the promise of having that so anything like long agents or collective action positive things like that and the fact that there's a market where these interests and be aggregated and you can't negotiate so I mean my starting points for that is that you can't negotiate the terms of all what in the secondary market right it is what it is you can create derivatives that then divide to that but you've just created derivative to do that whereas derivatives because these are executor effect contracts right because we've actually got an individual counterparty who may have entirely uncorrelated payoff patterns to the actual underlying that creates the difference here so there's an idiosyncratic nature to it that just I can't see existing in a more commoditized product so if I want so the the longer answer is so if if the alternative version whose rights and that bonds are derivatives and rivers or ponds why would I have a derivative right and putting aside that maybe my bond market is incredibly illiquid now the idea that their economic equivalents and their knowledge and I know this because I can intentionally derivative on a bond that gives me a very different portfolio of risks primarily contrary creditors which doesn't exist in the Bowman even though my payment structure under derivative can be identical in terms of just linking it to the current market price of the bond and recreating the cash flows associated with any to lawmakers so I'm freed a new risk by using derivatives there and that new risk can't predict this in most states in the world ideally should be uncorrelated and if that uncorrelated company credit risk because I find to be a different thing and it just so happens that 95% of the contract is dedicated to what do we do with that uncorrelated champ right cutter is does that make sense have any sufficient similarity which you can either go to bankruptcy or not so he was the issue with their reservation that of minutes the same save that for a marketable security are unlikely to have unilateral power of renegotiation and because we don't have the unilateral power to renegotiate any relation mechanism will be lessened it's because your relationship is necessarily less important another way to put this in which case I'm totally agree because as you get more concentrated holdings in any security there's likely to be more relational mechanisms you know that's sort of let's acknowledge you corporate finance literature and acknowledged in the rules around things like controlling shareholder laws and that I'm totally agree with but it and it's on a spectrum right so a derivative contract gives you that from day one because it's a bilateral contract between you completely analyzed two Spurs markets where I'm a price taker if I was a price taker in the market I'm probably a price taker in any renegotiation as I gain more control though I can use that control for the purpose of influencing outside of the balance of the contract that is relationally on the issuer of those securities not I totally agree with that it's a very nice boy I think the first question becomes identifying which markets you actually want to support and to me the first answer to that question is the interest rate swap are you different swap market is largely dictated by macroeconomic policy issues around short-term versus long-term interest rates and expectations of productivity and growth that's exactly what central bank macroeconomics departments do for a living aside from that guess who the primary players are on that market already it's the government right open market operations are entirely affect understanding your employment pricing within those markets so that lends up fairly well but that's the easy case from there it's really easy to talk at the same time from there we have to sort of well what are the other markets we want to really support I mean really support do we want to be an esoteric commodity futures markets may not so we want to be in equity derivatives markets probably not do we want to be in single ABCDs markets probably not both because absent other factors they shouldn't be systemic important but also can I agree with you that we wouldn't expect the states to have any additional expertise over the markets within those markets now the interesting one that leaves is actually the foreign exchange market and I can't get my head around this one both because you know miss will talk about the deepest marketing world right there more transactions and exchange market per day then well every 20 days before exchange market does more volume than all of the world equity markets in the year it has never experienced the type of fundamentally liquidity that would experience in the financial crisis spreads widen quite a bit but we haven't had the experience yet where market making dealers actually believe so that you can't get a price now that's not to say it can't happen because it can but I think the it's a special case today philosophies firstly because money and FX is the most information in sense for the asset you could possibly imagine so it's not like market participants to look at the government to the United States and say I know where the US dollars gonna be in five years I mean lots of people think of good living and trying to do that but it's difficult to come up with rationale for why they be a better doing it than the government themselves so the short answer to my long answer interest rate swap markets I think that both of the incentives and expertise land up quite well a lot of other derivatives markets so especially equity CBS and quantity future markets not systemically important I probably wouldn't advocate them intervening and the one I've got to think about is FX markets right they're big they're important but historically we haven't seen them break down in the same way that we've seen others right now maybe we could hide question I think I just want to research earlier actually you've got like but they're also very separate things do you have any idea that how there's relational making it play out was it the first hole is based on the attacker in the online everything the making of the Atlanta so that's that's a market where it is which were then lead to credit podraces but they always kind of inspire is some kind of intuition I have been lobbying the Office of Financial Research in the United States and the Bank English in the UK to start collecting that data for quite a long time I can't stress enough how the FDIC sort of report on this one contract represents what academics know about what these triggers look like the interaction sponsored Association has definitely said to market participants look these posts difficult records to get them out of your contracts but we don't have anything that tells us whether they've been removed and you know a beautiful research question maybe one day the Bank of England roll the seeds by request and we'll be able to look at the evolution of the market if there has been so but it's a different spectrum right so if I can turn to during the contract with horses and I interviewed you for contract with goldman sachs chances are the relational dynamic between a horse tonight will be bigger but you'll always be different because tokens accent different kind of horse bargaining but in a bond market both horse dry or woman sex if we went out and bought enough of the bonds could exert relational sort of dynamics on this situation so it's and that's the difference right in derivatives it's about the security or the instrument the instrument confers possibilities or relationships in the case of bonds and shares it's about who holds it which is a different thing also the fact that there's no depth in their rights are in a sense that I've got the deck but in the in the sense that if I just hold a whole bunch of bonds I have credit risk the other side of my right all there is is darkness and the threat that I might sell or say that everybody else should sell or something like that there's no reciprocal exposure that brings the two of them together whatever there's no natural reason why they should have a relationship unlike a derivative where the existence of the contract is the reason to be is but I mean this is not you know this is not a clean answer so this question at all and I think that it's you know I've been working on this question probably for about five years now this is my second or third paper on it and these objections are still degenerate objections to this issue so we're still drilling it down I still think that there's there's something there there's a new section of paper that I'm not sure it isn't the one that I've circulated that attempts to distill this more cleanly but it does so on the basis of if I'm holding it what is it to me right and if I'm just holding a bond so we take the smallest unit of the poem and the smallest unit of derivative and it seems to me that there is no idea what the smallest unit is right but a contract and a bond is that that bond is gonna have no relation of elements to it how do I know this I can toss it to somebody else who's gonna pay for it right the smallest amount of the derivative contract I just can't punt it to somebody else I have to punch to somebody else who's willing to take the counterparty credit risk it using traffic risk of my partner party so it's incomplete risk transfer in economic terms and in practical terms I don't sell it and then forget about it myself and continue to have to worry about it because I still have the original risk and I've just created a new contract also with market risk but not the kind of pretty credit risk associated over that contract I am that's the basis whether it works or relational whether a relational dynamic is the best way to characterize that is I can even have a question for me and I'm the one it's like you I think it's time for close of nothing about this contract out and there's an in the money there's a net payment and I think that I we owe to you thank you very much for showing us

Channel: Oxford Law Faculty

Views: 2,018

Rating: 4.7333331 out of 5

Keywords: masters in law and finance, law, finance, university of oxford, oxford law, oxford law faculty, faculty, oxford, university, masters degree, derivatives, professor, dan awrey

Id: o89jdp9nKwI

Length: 92min 0sec (5520 seconds)

Published: Tue Jan 30 2018