The working paper, Hardwired Conflicts: The Big Bang Protocol, Libor and the Paradox of Private Ordering, examines the darker side of the private market structures at the heart of the global financial system.
Imagine we allowed referees to place bets on the sporting events they officiated. On one level, this would almost certainly offend our sense of fair play. On another level, however, we might ultimately view this as unproblematic insofar as teams were able to freely contract with those referees willing to make credible commitments not to exploit such conflicts of interest, and so long as compliance with these contracts was relatively easy to monitor and enforce. Imagine now, however, that there exists a limited number of qualified referees, that these referees coordinate in the development of a standard form contract which does not prohibit betting on games, and that they collectively enjoy sufficient market power to ensure that these contracts receive widespread adoption. Imagine further that the costs of determining whether a referee had in fact wagered on a game are extremely high and, as a corollary, that there exists no credible threat of either private contractual enforcement or market-based (reputational) sanctions. Given these additional facts, we might be of the view that this state of affairs is likely to undermine confidence in the integrity of the game. Indeed, it is precisely for this reason that professional sports leagues prohibit referees from wagering on games. It seems remarkable, therefore, that we permit this type of activity in the most high stakes game of all: finance.
We tend to view market participants as possessing high powered incentives to develop market structures – e.g. contracts, private rules and other governance arrangements – with a view to generating credible commitments. Simultaneously however, almost by definition, successful market structures exhibit positive network externalities. These network externalities erect substantial barriers to entry, insulate incumbents from vigorous competition, and prevent the emergence of new and potentially more desirable market structures. Moreover, where a core group of market participants are able to anchor the market to incumbent structures, these externalities enable them to exploit their privileged position without concomitantly risking widespread defection by those at the periphery. Perversely, then, the very success of these market structures may make them more prone to abuse, thereby undermining efficient private contracting, welfare enhancing innovation and market confidence. This is the paradox of private ordering.
This paper explores the paradox of private ordering through the lens of two case studies. The first is ISDA’s so-called ‘Big Bang’ Protocol and, more specifically, the determination committee (DC) mechanism it created to facilitate the adjudication of certain contractual issues arising in connection with ISDA’s widely used credit default swap (CDS) documentation. On the one hand, the Big Bang Protocol has brought much needed standardization and predictability to what was often a chaotic process for settling CDS transactions upon the occurrence of bankruptcy, restructuring and other events. On the other hand, however, the parties responsible for resolving contractual issues under the DC mechanism – principally global derivatives dealers – are also counterparties to the vast majority of these contracts. This structure gives rise to hardwired conflicts of interest: putting dealers in essentially the same position as our hypothetical referees.
In order to shed further light on the problems associated with this market structure, as well as why market forces and private ordering are unlikely to effectively address them, this paper draws a number of parallels between the DC mechanism and another key structural feature of modern financial markets: the now infamous London Interbank Offered Rate (Libor). The parallels between the DC mechanism and Libor are striking. First, the same small group of global financial institutions resides at the core of both structures. Second, the defining characteristic of this core in both cases is that, by virtue of these structures, its members are in a position to influence otherwise exogenous decisions which determine the payoffs under contracts to which they are themselves counterparties. Third, having been designed by industry trade associations over which this core can be seen as exerting considerable influence, internal governance arrangements fail to adequately constrain the hardwired conflicts of interest generated by these structures. Fourth, and perhaps most importantly, positive network externalities and information problems undermine the threat of market-based sanctions. In the case of the DC mechanism, the impotence of market-based sanctions is compounded by bundling and the fact that global derivatives dealers effectively anchor the market to the incumbent structure. In the absence of effective internal or external constraints, both Libor and the DC mechanism are thus left particularly vulnerable to opportunistic behavior.
Ultimately, the objective of this paper is not to single out the financial institutions at the core of these market structures as particularly deceitful, manipulative or untrustworthy. Indeed, in many respects, this paper can be understood as advocating that we treat these institutions in the same way we treat other delegated decision-makers to whom we grant, often enormous, discretion. We do not generally think it wise to permit judges to have a material interest in the cases they hear, to let students grade their own exams, or to allow referees to place bets on the games they officiate. A priori, there seems little justification for allocating authority to financial institutions to adjudicate issues which determine the payoffs under contracts – typically worth millions of dollars – to which they are themselves counterparties. Within a perfectly competitive marketplace, this equilibrium would be unlikely to take hold. In an opaque, concentrated and dealer-intermediated market characterized by positive network externalities, however, all bets are off. The key question in such cases is whether the existing constellation of governance mechanisms – markets, privately generated rules and/or public regulation – adequately constrain the inherent conflicts of interest at the heart of these market structures. In the case of Libor, the answer was a clear and resounding no. Perhaps the only difference in the case of the DC mechanism is that, rather than picking up the pieces, there is still scope to take meaningful preventative action – and we should.
The full paper, recently posted on SSRN, is available for download here.