Reforming derivatives markets after the financial crisis: systemic risk and transaction costs analysis

The 2008 financial crisis revealed how many countries suffered from highly myopic views and approaches in regulating (or de-regulating) their markets. Two causes in particular, an overly strong belief in the effectiveness of financial industry self-regulation combined with an underestimation of the systemic and global spread of risk, ensured the financial meltdown. This paper is structured in three parts. In the first part, we address the areas of opaqueness and uncertainty, which characterized the regulation of financial markets before the financial crisis, with a specific focus on financial derivatives. Pre-crisis national regulators lacked effective tools to supervise derivative dealers and transactions. Derivatives markets were ‘subsidized’ by the US and EU governments with de-regulation policies that had been based on the myth of the expertise and ability of the private industry to self-regulate itself. Moreover, the absence of functional international agreements fostered cross-border development of the derivatives market and the consequent systemic spread of financial risk. These two factors contributed to the global contagion of the financial crisis, which on one side, triggered national governments to rapidly adopt international harmonized guidelines to re-regulate financial markers and on the other, persuade regulators to re-evaluate global financial markets policies in order to greater harmonize regulatory strategies. Part II of this paper examines the extent to which current reforms and proposed reforms both in the US and in the EU will expand ‘public’ derivatives markets, while correspondingly reducing the scope of ‘private’ markets (which broadly coincide with the ‘unregulated’ OTC markets). We also question whether these reforms will, on the whole, reduce the scope and impact of systemic risk – a macro level issue – and reduce transaction costs of derivatives trading – thus promoting liquidity and creating a more efficient market. In the third part, we will then analyze how market participants are reacting to the current changes in the regulatory scenario, with a focus on both cross-market and cross-border regulatory arbitrage. In fact, already, market participants are anticipating the implementation of new rules on derivatives, which might increase the implementation costs for the financial industry, by re-modeling and transferring their derivatives activities to existing platforms, while national regulators are still working on adopting final regulation of derivatives