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The Post-Reform Guide to Derivatives and Futures

The Post-Reform Guide to Derivatives and Futures

Gordon F. Peery

ISBN: 978-1-118-20542-6

Jan 2012

432 pages

$61.99

Description

An in-depth look at the best ways to navigate the post-reform world of derivatives and futures

The derivatives market is one of the largest, and most important financial markets in the world. It's also one of the least understood. Today we are witnessing the unprecedented reform and reshaping of this market, and along with these events, the entire life cycle of a derivatives transaction has been affected. Accordingly, nearly all market participants in the modern economy need to view the handling of risk by derivatives in a very different way.

Many aspects of financial services reform are based on a belief that derivatives caused the Great Recession of 2008. While the difficulties we now face cannot be blamed solely on derivatives, the need to understand this market, and the financial products that trade within it, has never been greater. The Post-Reform Guide to Derivatives and Futures provides straightforward descriptions of these important investment products, the market in which they trade, and the law that now, after July 16, 2011, governs their use in America and creates challenges for investors throughout the world. Author Gordon Peery is an attorney who works exclusively in the derivatives markets and specializes in derivatives and futures reform and market structure. Since representing clients in Congressional hearings involving Enron Corp., he has developed extensive experience in this field. With this guide, he reveals how derivatives law, and market practice throughout the world, began to change in historic ways beginning in 2011, and what you must do to keep up with these changes.

  • Explains what derivatives and futures are, who trades them, and what must be done to manage risk in the post reform world
  • Accurately reflects the futures and derivatives markets as they exist today and how they will be transformed by the Dodd-Frank Wall Street Reform and Consumer Protection Act
  • Highlights the risks and common disputes regarding derivatives and futures, and offers recommendations for best practices in light of the evolving law governing derivatives

The financial crisis has changed the rules of Wall Street, especially when it comes to derivatives and futures. The Post-Reform Guide to Derivatives and Futures will help you navigate this evolving field and put you in a better position to make the most informed decisions within it.

Preface xiii

Acknowledgments xix

Introduction 1

PART ONE The Crises That Led to Derivatives Reform 15

CHAPTER 1 Seven Causes of the 2008 Market Crises 17

Ignoring the Warning Signs 18

More than Seven Causes of the 2008 Market Crises 20

An Incomplete Response to Problems Exposed in the Enron Bankruptcy 26

Enron Finance Used by Banks and the Lack of Regulation 29

The Absence of Effective Regulation 30

The Shadow Banking System 34

Development of an Unregulated Global Derivatives Market 39

The Rise of Credit Derivatives and the Credit Default Swap 44

Private-Label Residential Mortgage-Backed Securitization 45

U.S. Policy Fostering Home Ownership and GSE Mismanagement 47

Derivatives and Structured Products Accounting Practices 49

Notes 52

CHAPTER 2 The Crises and Reform Timeline 55

March 17, 2008: Bear Stearns Is Sold 57

March 27, 2008: Barack Obama Introduces Reform Principles 58

September 15, 2008: A Bankrupt Lehman Brothers 59

November 2008 to January 2009: American Leadership Ascends 60

March 26, 2009: Geithner Provides Testimony to Congress on Reform 60

May 13, 2009: Geithner Writes a Letter to Harry Reid 61

June 2, 2009: An Early Voice Speaks Out against the Clearing Mandate 61

June 22, 2009: American Corporations Lobby against Central Clearing Mandates for OTC Derivatives 62

July 22, 2009: Introduction of Legislation Favoring Exemptions to the Clearing Mandate 62

July 30, 2009: Introduction of Broad Outlines of the New Law 63

September 8, 2009: The Industry Demonstrates Commitment to Centralized Clearing 63

October 2, 2009: House Releases Draft of OTC Derivative Legislation 63

November 11, 2009: Senate Releases Draft of OTC Derivative Legislation 64

December 11, 2009: House Passes the Wall Street Reform and Consumer Protection Act of 2009 64

January 1, 2010: The New York Fed Publishes The Policy Perspectives on OTC Derivatives Market Structure 65

April 7, 2010: Financial Crisis Inquiry Commission Begins Hearings 65

April 16, 2010: Senator Lincoln Introduces the Wall Street Transparency and Accountability Act of 2010 66

April 22, 2010: President Obama Returns to Cooper Union to Speak on Reform 66

April 26 to 27, 2010: Senate Votes to Delay Debate on Derivatives Reform 67

April 27, 2010: The Goldman Hearing 67

April 28, 2010: Senate Votes Again to Proceed with Financial Services Reform 70

May 20, 2010: Senate Passes Its Version of the Legislation 70

June 30, 2010 and July 15, 2010: Congress Approves Legislation and Seeks the President’s Approval 71

July 21, 2010: President Obama Signs Dodd-Frank into Law 71

U.S. Rule Making in 2010 and 2011 73

U.S. Reform Blazes the Trail for Global Derivatives Reform 79

Notes 80

PART TWO Derivatives Reform 83

Introduction to Part Two 83

CHAPTER 3 Introduction to Futures, Margin, and Central Clearing 85

Three Crises and the Need for the Futures Model 87

A Brief History of Futures Contracts and Markets 92

The Commodity Futures Modernization Act of 2000 98

Introduction to the Futures Model and Basic Futures Concepts 100

Regulation of Futures 112

A Futures Contract in Action 114

Default by a Clearing Member in the Futures Model 117

Global Reform and the Futures Model 120

Notes 126

CHAPTER 4 U.S. Derivatives Law in Title VII of Dodd-Frank 131

Organization of Dodd-Frank 131

Introduction to Titles VII and VIII 134

The Approach to Understanding New Derivatives Law in the United States 136

Products 137

People 147

Taxpayers 153

Whistleblowers 169

Platforms 170

Notes 175

CHAPTER 5 Title VIII of Dodd-Frank 177

Opposition to Title VIII 178

Before Title VIII 180

What Exactly Does Title VIII Set into Motion and When? 182

What Is a Systemically Important Activity? 183

Practical Results of the New Law 184

Notes 186

CHAPTER 6 A Primer on Legal Documentation 187

Background 190

“Let’s Use an ISDA” 191

History of the ISDA 194

Basic OTC Architecture 195

The ISDA Documentation in Practice, and Problems in 2008 202

Glossary 208

Notes 210

CHAPTER 7 The Life Cycle of a Cleared Derivatives Trade 211

Step One: Legal Documentation 211

Step Two: Trade Execution via an SEF, SB-SEF, or DCM 215

Step Three: Alleging and Affirming a Trade; Reporting in Real Time 221

Step Four: The FCM Take-Up 222

Step Five: Trade Is Centrally Cleared 223

Step Six: The Trade Is Reported for the Second Time 225

Notes 226

PART THREE Trading Before and After Reform 227

CHAPTER 8 The History of Derivatives and Futures 229

The Earliest Derivative 230

Trees, Forests, and Wildfires 231

Did They Exist in Antiquity? 233

OTC and Exchange Derivatives 233

Back to Biblical Times 234

The Dark Ages and Medieval Europe 239

The Muslim Empire 240

Development and Early Use of the Bill of Trade or Exchange 241

After the Protestant Reformation 244

An Early Sighting of the Term Commodity Pools 249

Ten Wise Men 250

The Modern Era Begins in the States in 1848 258

Early-Twentieth-Century America 259

1907 Bankers Panic 260

S&Ls and Mortgage Finance Functions Well Before Abuses 268

The Creation of Fannie and Freddie 268

Disco, Dealers, Swaps, and Redlining in the 1970s 269

U.S. Regulators Formally Recognize Swaps 273

The Birth of the OTC Market 274

The Evolution of Options Markets 275

The Futures Trading and Practices Act and the 1993 Swaps Exemption 276

ISDA 277

The 1987 Crash and 1990s Crises 279

The Commodity Futures Modernization Act of 2000 286

Enron Loophole 287

The First Decade of the Twenty-First Century 288

Notes 289

CHAPTER 9 Market Structure Before and After 2010 299

Ancient Commodity Markets 299

Earliest Modern Exchanges 300

The Great Depression and Bucket Shops 301

Open Outcry and Pits Give Way to the Machines 302

Reform of U.S. Market Structure 305

Derivative Clearing Organizations (DCOs) 307

Swap Data Repository 308

Market Participants in the OTC Derivatives Trade 309

Notes 311

PART FOUR Continuing Education 315

CHAPTER 10 Survey of Derivatives 317

Overview of the Strategies and Trade Structure 319

Early Derivatives and the Beginnings of the OTC Market 320

Forwards versus Options 320

Option Basics 322

Options Pricing 324

Basic Option Strategies 326

Exchange-Traded Options 328

Swaps Follow Options in the Evolution of Derivatives 329

Credit Derivatives 330

Credit-Linked Notes and Other Securities 336

Total Return Swaps 336

Interest Rate Swaps 338

Equity Swaps 340

Currency Derivatives 341

Property Derivatives 342

Commodity Derivatives 344

Energy Swaps 345

Structured Products, Securitization, CDOs, and CDOs Squared 346

Exchange-Traded Derivatives: Futures and Other Listed Products 348

Additional Resources 349

Online Resources 349

Glossaries 350

Notes 350

About the Author 351

Index 353