Subsidizing Liquidity or Subsidizing Markets? Safe Harbors, Derivatives, and Finance

Abstract

This paper ultimately seeks to promote a discussion that would have ideally been held before the safe harbors – defined as the provisions that allow market participants to ignore the core provisions of the Bankruptcy Code and other insolvency laws – were adopted by legislatures throughout the world. The recent financial crisis should be ample to revisit the discussion. In particular, I use this paper to push against the contention that because the safe harbors enhance liquidity in the derivatives market, that alone justifies the existence of the safe harbors.Liquidity is, in essence, “moneyness.” The safe harbors enhance the money-like qualities of one class of financial instruments by removing them from legal institutions that apply to most other classes of financial instruments. By doing so, the safe harbors convert swaps and other derivatives into a special class of contracts that are exempt from at least one area of non-contractual statutory law.I contend that granting these sort of exceptions is a zero sum game. By removing part of the costs of default from swaps, lawmakers have increased the costs that will be incurred by other financial instruments or other creditors, in other parts of the capital structure. That is, the holders of non-safe harbored financial instruments are subsidizing the safe harbored part of the capital structure. The core question is whether that subsidy – which we are told is vital to the very existence of the derivatives market – is worth more than its cost? The costs of the subsidy include any increase in the cost of other, non-safe harbored financial instruments, the costs to involuntary creditors who are unable to price the safe harbors at all, and the larger social costs of undermining legal institutions designed “to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources.” By subsidizing liquidity for swaps, and thus facilitating the growth of the swaps market, we are incurring these costs. Is it worth it? My analysis herein suggests reason for doubt. We need to have the conversation.