The international financial system is by no means unified. Currencies, securities, assets, cryptos, and commodities have no centralized exchange and no single regulator. Instead, the institutions of modern international finance are knit together with derivatives: contracts that relate to, or derive their value from, other assets. The classic example is a swap, in which one party exchanges the cash flows generated by an asset with the cash flows generated by an asset owned by another party. Each retains ownership of the underlying asset, but the cash the assets generate goes to the respective counterparty.
These often-complex commercial relationships were a focus of regulators worldwide after the Global Financial Crisis (GFC). While derivatives did not cause the financial crisis — financiers are quick to point out that derivative markets arguably performed as expected throughout the crisis — the relationships they created allowed defaults of United States mortgages to affect the balance sheets of companies the world over. That risk of contagion has caused many institutions, including the Vatican, to call for derivatives to be more tightly regulated or outlawed altogether.
Since the crisis, the G20 agreed to reform their derivative markets, but many have implemented only some of the reforms in the ensuing years. In the United States, the comprehensive Dodd-Frank Act of 2010 expanded the powers of derivative regulators such as the Commodity Futures Trading Commission and the Securities Exchange Commission, however, the agencies infamously put off exacting their statutory mandate. The SEC, for instance, just this year updated Regulation S-K Item 402 on executive compensation, finishing a rulemaking process they were compelled to undertake over a decade ago. Other countries have implemented even less of the agreed reforms, highlighting the age-old maxim that knowing the right thing to do and doing it are not the same.
This year in particular has shown that derivatives can still pose an outsized threat to the international financial system. On September 28th, the Bank of England had to intervene in gilt markets— the U.K. term for a 30-year treasury bond — after the derivative positions taken on gilts by pension funds threatened to blow up their economy. The pension funds entered into the derivative contracts for logical reasons. Derivatives are used to hedge, or reduce the riskiness of a financial position, and therefore decrease the volatility of an asset. Essentially, it is not nice to see that your retirement savings are $50 one day and $20 the next. Using a simple “vanilla” derivative, the pension funds were able to stabilize that value, but it also intertwined the funds with other aspects of the U.K. economy. When the economy was sent into a tailspin due to Prime Minister Liz Truss’s new economic policies, the resulting exposure threatened the pension funds’ ability to pay out benefits to pensioners.
The fact that the derivative positions taken here were relatively simple bears repeating. Derivatives are some of the most complicated financial products available, meaning long, complex contracts which create a web of relationships between the underlying asset and the aspect of that asset captured in the derivative. This can be used to solve boutique solutions for clients, insulating them from specific risks. However, it also means that even knowledgeable traders can miss schemes to manipulate the market and create fake transactions.
Further clouding the waters is the lack of any comprehensive disclosure regime for derivative contracts. Just earlier this year, Archegos Capital Management founder Bill Hwang was arrested on fraud charges after Archegos lost $20 billion dollars on total return swaps, a type of derivative. The lack of reporting requirements for the swaps allowed Archegos, which managed Hwang’s personal fortune, to obfuscate its holdings from lenders. Archegos would negotiate for debt financing with banks, but the banks did not have sufficient information to accurately gauge his credit risk. Archegos defaulted when the lenders came calling following market turmoil associated with the COVID-19 pandemic, resulting in the largest derivatives-related loss since the GFC. Those losses were worldwide, with the brunt of the losses being felt by Credit Suisse in Switzerland, UBS in Scotland, Morgan Stanley in the U.S., as well as Nomura and Mitsubishi in Japan.
Whether these two incidents portend misfortune remains to be seen. International financial organizations have turned their attention toward derivative contracts in the past two years. That said, it is unsurprising there is little political will to follow through on promises made over a decade ago. Some G20 countries which agreed to derivative market reforms have only implemented one of the five-part reforms. Even these proposed reforms are not sufficient to expose much of the fraud in the derivatives market. In the Archegos example above, the biggest losses fell upon banks in Japan, which had completely implemented reforms, as well as Switzerland and the U.S., which each implemented four parts.
Perhaps the turmoil of the COVID-19 pandemic exposed enough cracks in the worldwide financial system that legislators and financial regulatory authorities will improve oversight of derivative markets. If too little attention is paid to these remaining gaps, any coming financial downturn will wind up spreading faster and become more serious than it need be.
About the author: Evan Conner is a 3L at the George Washington University Law School. Evan is a Senior Moderator of ILPB. He is interested in international financial regulation and how governments foster capital formation and protect investors.