Substituted Compliance and Systemic Risk: How to Make a Global Market in Derivatives Regulation

International financial regulators have sought to contain the systemic risk of OTC derivatives transactions by introducing mandatory clearing. In the absence of a global financial regulator, however, this regulatory approach must be implemented by national actors. Fearing the prospect of regulatory arbitrage, regulators have sought to impose global uniformity through either multi-lateral efforts at harmonization or unilateral assertions of extraterritorial jurisdiction. Either approach, however, may compromise the ultimate goal of containing systemic risk.

This Article argues that regulatory uniformity, however achieved, threatens to exacerbate the problem of systemic risk. Because the benefits of mandatory clearing are not as great as is sometimes claimed, the adoption of mandatory clearing on a globally uniform basis will leave the world financial system less safe from systemic collapse than a regulatory approach that permits more flexibility and variation. This Article, therefore, proposes a regulatory super-structure that would encourage a diversity of regulatory approaches aimed at containing the systemic risk of OTC derivatives transactions, offering practical guidance on how such an approach could be adopted on either a national or international basis.

International financial regulators have sought to contain the systemic risk of OTC derivatives transactions by introducing mandatory clearing. In the absence of a global financial regulator, however, this regulatory approach must be implemented by national actors. Fearing the prospect of regulatory arbitrage, regulators have sought to impose global uniformity through either multi-lateral efforts at harmonization or unilateral assertions of extraterritorial jurisdiction. Either approach, however, may compromise the ultimate goal of containing systemic risk.

This Article argues that regulatory uniformity, however achieved, threatens to exacerbate the problem of systemic risk. Because the benefits of mandatory clearing are not as great as is sometimes claimed, the adoption of mandatory clearing on a globally uniform basis will leave the world financial system less safe from systemic collapse than a regulatory approach that permits more flexibility and variation. This Article, therefore, proposes a regulatory super-structure that would encourage a diversity of regulatory approaches aimed at containing the systemic risk of OTC derivatives transactions, offering practical guidance on how such an approach could be adopted on either a national or international basis.