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Barings Bar None: the Financial Service Agreement of the GATS and Its Potential Impact on Derivatives Trading Vincent Presti

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Barings Bar None: the Financial Service Agreement of the GATS and Its Potential Impact on Derivatives Trading Vincent Presti Maryland Journal of International Law Volume 21 | Issue 2 Article 2 Barings Bar None: the Financial Service Agreement of the GATS and Its Potential Impact on Derivatives Trading Vincent Presti Follow this and additional works at: http://digitalcommons.law.umaryland.edu/mjil Part of the International Law Commons Recommended Citation Vincent Presti, Barings Bar None: the Financial Service Agreement of the GATS and Its Potential Impact on Derivatives Trading, 21 Md. J. Int'l L. 145 (1997). Available at: http://digitalcommons.law.umaryland.edu/mjil/vol21/iss2/2 This Article is brought to you for free and open access by DigitalCommons@UM Carey Law. It has been accepted for inclusion in Maryland Journal of International Law by an authorized administrator of DigitalCommons@UM Carey Law. For more information, please contact [email protected]. ARTICLES BARINGS BAR NONE: THE FINANCIAL SERVICE AGREEMENT OF THE GATS AND ITS POTENTIAL IMPACT ON DERIVATIVES TRADING VINCENT PRESTI* TABLE OF CONTENTS I. INTRODUCTION ........................................................ 146 II. THE ROLE OF DERIVATIVE PRODUCTS IN INTERNATIONAL FINANCIAL TRANSACTIONS .......................................... 148 A. A Functional Definition for Derivative Instruments in International Transactions .................................... 149 1. Derivatives Markets ..................................... 150 2. Derivatives Players ..................................... 153 3. Basic Settlement Systems and Procedures for Exchange-Traded Derivative Instruments ........... 157 III. THE BARINGS CRISIS: MARKET AND MANAGERIAL CIRCUM- STANCES AND THEIR IMPACT ON UNAUTHORIZED TRADING ACTIVrrY .............................................................. 160 A. Barings and Its "Old-Boys" Management Style ......... 160 B. The Role of Derivative Trading in the Expansion and the Collapse of the Barings Group's Structure ........... 164 IV. SOME LESSONS FROM CURRENT DERIVATIVE REGULATORY RE- GIMES AND THEIR ROLE IN FUTURE INTERNATIONAL EFFORTS 171 A. A Brief Review of the U.S. Derivative Regulatory Regim e .......................................................... 172 * The author is a practicing member of the New York and New Jersey bars: B.A. Johns Hopkins University (1990), Prob. M.Litt., Oriel College, Oxford (1991); J.D. Uni- versity of Michigan Law School (1997). The support and encouragement of Professors Philip R. Trimble, Jose Alvarez, and William Bogaard warrant a special mention of gratitude. (145) 146 MD. JOURNAL OF INTERNATIONAL LAW & TRADE [Vol. 21 1. Some Lessons from the SEC ......................... 174 2. Some Lessons from the CFTC ....................... 175 3. Some Lessons from U.S. Bank Regulation ......... 176 4. U.S. Regulatory Lessons Revisited ................... 179 5. Some Lessons from Leeson ........................... 180 B. The Significance of Clearinghouse Operations and Procedures in the Development of Derivative Regulation ....................................................... 182 C. The Potential of International Regulatory Efforts to Preserve the Stability of Global Finance .................. 184 D. Why International Derivative Reform Cannot Occur from within the Existing Regulatory Schemata ........... 188 V. U.S. INVOLVEMENT IN THE FINANCIAL SERVICE AGREEMENT OF THE GATS AND ITS POTENTIAL IMPACT ON SUPRANA- TIONAL BANKING AND DERIVATIVE REGULATORY DEVELOPMENTS ....................................................... 189 A. The U.S. Preference for Bilateral Financial Service Agreem ents ..................................................... 191 B. A Multilateral Financial Service Agreement Can Miti- gate the Influence of Wealthy Interests on Financial M arkets ........................................................... 194 C. America's Refusal to Extend MFN Treatment for the Financial Service Agreement Will Hamper Its Partici- pation in the Development of New Accounting Standards ........................................................ 195 D. Why Current Policies Toward Increased Management Participation in Policing the Risks of Their Firm's Financial Products Necessitate a Multilateral Agreement .................................... 196 VI. A GATS-BASED CLEARINGHOUSE FOR DERIVATIVE TRANSAC- TIONS ................................................................... 197 A. Clearinghouses and Their Current Function in Interna- tional Transactions ............................................. 198 B. The Mitigation of Potential Opposition to the GATS- Based Clearinghouse Through A Gradual Implementa- tion Procedure .................................................. 201 VII. CONCLUSION .......................................................... 202 I. INTRODUCTION As the need for alternative income sources for international banking 1997] BARINGS BAR NONE institutions increases with the decline of traditional lending activities,' de- rivative trading has become a significant source of profitable activity.2 Banks have participated in this highly speculative, risk allocating, en- deavor in a search for expanded client bases and financial service prod- ucts. 3 The recent Barings and Daiwa scandals demonstrate some of the problems associated with volatile financial products. Both external man- agement interaction with local market exchange trading systems and their bureaucracy, compounded by internal management controls that promote profit-seeking activity to the detriment of effective supervisory manage- ment control procedures, warrant an international response to regulation 4 in this area. Recent negotiations on the General Agreement on Trade in Services (GATS) and America's protestations to a multilateral financial service agreement' illustrate problems with the existing international framework to develop appropriate derivative regulatory policy. Moreover, any unilat- eral efforts to regulate the use of derivative products will not only frus- trate an international financial service agreement, but will be ineffective to deal with future Barings-type crises. 6 Uniformity in risk valuation and accounting standards, 7 along with an incentive structure that encourages management compliance with "preferred" internal controls,' necessitates 1. See Laurence H. Summers, G-7 Expects A Global Currency Shift, INVESTOR'S Bus. DAILY, May 1, 1995, at B1. 2. See, e.g., Joe R. Shuman, Global Perspectives: The International Competitiveness of U.S. Banks, 77 J. CoM. LENDING 10 (Aug. 1995). 3. See Justin Fox, Basel Committee to Grapple with Market Risk at Meeting, AM. BANKER, Nov. 27, 1995, at 4. 4. Id. See also Peter Neilsen, Banks Must Set Aside Capital for Market Risk-BIS, REuTERs. BC CYCLE, Apr. 12, 1995, available in NEXIS, World Library, TXTNWS File. 5. See, e.g., SIA Treasury Committed to Financial Reform, Trade Liberalization, Summer Tells SIA, BNA BANKING DAILY, Mar. 6, 1996, available in LEXIS, Bna Library, BNABD File; see also Treasury Sees Progress, But Continuing Barriers to U.S. Banking Abroad, BANKING POL'Y REPORT, Jan. 16, 1995. 6. See generally STEPHEN FAY, THE COLLAPSE OF BARINGS (1997) (highlighting the role of local regulatory laxity and poor management supervision in improper trading ac- tivity). See also Derivatives: Regulatory Compatibility Needed in Global Market, Dial Says, BNA INT'L Bus. & FIN. DAILY, April 14, 1997, available in LEXIS, Itrade Library, BNAIBF File (discussing Commodity Futures Trading Commissioner Joseph Dial's con- cem for unified, minimum regulatory standards to protect the global marketplace). 7. See generally International Accounting Standards Panel Accelerates Release of Rules, BNA INT'L Bus. & FIN. DAILY, Apr. 18, 1996, available in LEXIS, Itrade Library, BNAIBF File; Alistair Osborne, Guide draws on horror cases; Coopers & Lybrand offers GARP, a risk-control checklist, S. CHINA MORNING POST, Apr. 2, 1996, Bus. Sec., at 2 (discussing Generally Accepted Risk Principles (GARP) and its role in risk management of financial derivatives). 8. Brent McClintock, International FinancialInstability and the Financial Deriva- 148 MD. JOURNAL OF INTERNATIONAL LAW & TRADE [Vol. 21 the expansion of the GATS to harmonize the regulatory policies of ex- isting international institutions 9 that promulgate standards for international financial market participants. This article evaluates the role of derivative trading in the Barings Crisis, its potential impact on regulatory developments, and a "potential" international solution. Part II of the article analyzes the role of derivative products in financial transactions and defines their role in the conveyance of market information and the allocation of market risk. Part III outlines the Barings crisis and how exchange rules and management structure and procedure facilitated unauthorized trading activity. Part IV of the article describes the role of derivative products in American banking institutions and the U.S. regulation that governs such transactions. It also details the current regulatory schemes for risk-based capital standards for which the Basle Committee on Banking Supervision and the U.S. Federal Reserve Bank are advocating. Part V describes the evolution of America's current position on the Financial Service Agreement of the GATS and its pejora- tive impact on supranational banking developments. Finally, Part VI of the article argues that the GATS should be expanded to include a clearinghouse that harmonizes existing settlement systems, such as SWIFT, FEDWIRE, and clearinghouses that affect exchange-traded deriv- atives. It also analyzes the costs and benefits of a GATS-based
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