Regulating the Over the Counter Derivatives Market: Focusing on Bilateral Coordination and Substituted Compliance Regimes

Abstract

Charged with being the true cause of...the credit crisis, over-the-counter (OTC) derivatives have received considerable flack and regulatory attention since 2008. This attention is in stark contrast to the pre-2008 regulatory world, where calls to police the OTC derivatives market were rejected as unnecessary and OTC derivatives were hailed as utopian financial instruments. The crisis soon shattered such exaltations as the highly interconnected nature of the OTC derivatives market exposed its dark side: enormous systemic risk, reckless leverage, and opacity. Recognizing these issues, global leaders agreed, post-2008, that a co-existing national and international framework was necessary to successfully regulate OTC derivatives. Five years later, however, no adequate regulatory framework has been implemented by the G-20. Following the G-20’s proposed regulatory reforms, much has been written on the specific, technical aspects of OTC derivative regulations. However, very little — aside from calls for an international framework — has been written on how countries should proceed in coordinating their regulatory reforms and rules. This paper seeks to fill that void and suggests that focusing on global coordination is a mistake: While global goals, harmonization, and macro-level policy statements are informative for directing domestic regulatory reforms, focusing on a gold-standard global governance regime for the OTC derivatives market diverts attention away from where real progress can be made: at the bilateral and regional level. International financial institutions and organizations should focus on facilitating information about the domestic regulatory frameworks of their Members (through production and dissemination), rather than trying to facilitate actual rule-specific global coordination. Further, because the vast majority of OTC derivatives dealers are based in just a few countries, the goal of reducing systemic risk and contagion in the OTC derivatives market can be largely achieved by focusing coordination efforts in just these few markets.