Alma Mater Studiorum – Università di Bologna DOTTORATO DI RICERCA IN DIRITTO DELL’UNIONE EUROPEO Ciclo: XXVII Settore Concorsuale di afferenza: 12/E2 Settore Scientifico disciplinare: IUS/02 Credit-Default-Swaps and the 2008 Financial Crisis --- The Underlying Legal Origins and the European Union’s Regulatory Reforms Presentata da: Zhou Jie Coordinatore Dottorato: Relatore: Lucia Serena Rossi Marina Timoteo Esame finale anno 2015 2 Abstract After the 2008 financial crisis, the financial innovation product Credit-Default-Swap (CDS) was widely blamed as the main cause of this crisis. CDS is one type of over-the-counter (OTC) traded derivatives. Before the crisis, the trading of CDS was very popular among the financial institutions. But meanwhile, excessive speculative CDSs transactions in a legal environment of scant regulation accumulated huge risks in the financial system. This dissertation is divided into three parts. In Part I, we discussed the primers of the CDSs and its market development, then we analyzed in detail the roles CDSs had played in this crisis based on economic studies. It is advanced that CDSs not just promoted the eruption of the crisis in 2007 but also exacerbated it in 2008. In part II, we asked ourselves what are the legal origins of this crisis in relation with CDSs, as we believe that financial instruments could only function, positive or negative, under certain legal institutional environment. After an in-depth inquiry, we observed that at least three traditional legal doctrines were eroded or circumvented by OTC derivatives. It is argued that the malfunction of these doctrines, on the one hand, facilitated the proliferation of speculative CDSs transactions; on the other hand, eroded the original risk-control legal mechanism. Therefore, the 2008 crisis could escalate rapidly into a global financial tsunami, which was out of control of the regulators. In Part III, we focused on the European Union’s regulatory reform towards the OTC derivatives market. In specific, EU introduced mandatory central counterparty clearing obligation for qualified OTC derivatives, and requires that all OTC derivatives shall be reported to a trade repository. It is observable that EU’s approach in re-regulating the derivatives market is different with the traditional administrative regulation, but aiming at constructing a new market infrastructure for OTC derivatives. 3 Table of Contents Abstract .......................................................................................................................... 3 Table of Contents ........................................................................................................... 4 Introduction .................................................................................................................... 7 Part I CDSs and the 2008 Global Financial Crisis ....................................................... 10 Chapter 1 Credit Derivative Swaps and the Market Development before the Crisis .. 10 1. Definition, jargons and trading structure of CDSs ............................................ 10 2. CDSs and the relationship with other financial derivatives .............................. 14 3. Main types of CDSs .......................................................................................... 17 3.1 Single-name CDSs ................................................................................... 17 3.2 Index CDSs .............................................................................................. 18 3.3 Synthetic CDOs ....................................................................................... 20 4. Economic Functions of CDSs ........................................................................... 24 4.1 Hedging .................................................................................................... 24 4.2 Speculation ............................................................................................... 25 5. Features of CDSs .............................................................................................. 27 5.1 High leverage ........................................................................................... 27 5.2 Off-balance trading .................................................................................. 28 5.3 Over-the-Counter trading ......................................................................... 29 6. Legal nature of CDSs ........................................................................................ 30 6.1 Contracts or securities .............................................................................. 30 6.2 Insurance contracts................................................................................... 32 6.3 Gambling contracts .................................................................................. 33 7. Market development of CDSs before the 2008 financial crisis ........................ 34 Chapter 2 CDS and its role in the 2008 global financial crisis .................................... 38 1. The evolution processes of the 2008 financial crisis ........................................ 38 2. CDSs promoted the breakout of the 2008 financial crisis ................................ 43 2.1 Securitization changed the traditional counterparty credit risk control model of extending mortgages ....................................................................... 44 2.2 CDSs facilitated the securitization process .............................................. 48 3. CDSs exacerbated the 2008 financial crisis ...................................................... 49 3.1 CDSs magnified the losses relating to subprime mortgages .................... 49 3.2 CDSs pushed down Systemically Important Financial Institutions (SIFIs) ........................................................................................................................ 51 3.3 CDSs resulted in systemic-risk threat to the financial system ................. 54 4. Conclusion ........................................................................................................ 56 Part II CDSs and the 2008 Financial Crisis: the Legal Origins ................................... 58 Chapter 3 The Abrogation of the Common law Doctrine of “Difference Contract” ... 58 1 Elaborate the common law doctrine of “difference contracts” .......................... 59 1.1 Definition and historical origin ................................................................ 59 1.2 Consequences of the common law doctrine of “difference contracts” .... 61 2. Codifying the common law doctrine of “difference contracts” into statutory 4 law ......................................................................................................................... 63 3. The abrogation of CEA and the common law doctrine of “difference contracts” ............................................................................................................................... 65 4. CFMA caused excessive speculation on CDSs contracts ................................. 69 5. Conclusion ........................................................................................................ 72 Chapter 4 The Erosion of the Bankruptcy Law “Pro-Debtor” Principle ..................... 74 1. The pro-debtor bankruptcy law principle and its main rules ............................ 75 1.1 “Automatic stay” ...................................................................................... 77 1.2 “Cherry-picking”...................................................................................... 78 1.3 “Preferential and fraudulent transfer” ...................................................... 79 2. Conflictions between the “pro-debtor” rules and the OTC derivatives practice ............................................................................................................................... 81 2.1 Special trading rules established by ISDA documentation ...................... 81 2.2 The trading rules of ISDA Master Agreement conflict with the pro-debtor bankruptcy rules ............................................................................................. 87 3. The erosion of the “pro-debtor” bankruptcy law rules in the U.S. ................... 89 3.1 “Patch-work” exemptions for OTC derivatives trading before 2005 ...... 89 3.2 The blanket exemption of Bankruptcy law pro-debtor rules in 2005 BAPCPA ........................................................................................................ 92 4. The bankruptcy safe harbor caused a “bank run” on “too-big-to-fail” OTC financial derivatives traders .................................................................................. 98 5. Conclusion ...................................................................................................... 100 Chapter 5 The Circumvention of the Common Law Doctrine of “Secret Lien” ....... 101 1. Elaborate the common law doctrine of “secret lien” ...................................... 101 1.1 Origin of the doctrine of “secret lien” .................................................... 101 1.2 Functions of the “secret lien” doctrine ................................................... 103 2. From the common law doctrine of “secret lien” to the Uniform Commercial Code .................................................................................................................... 105 3. The “bankruptcy safe harbor” for OTC derivatives and the circumvention of the common law “secret lien”