April 17, 2011
Utset on Systemic Risk
Complex Financial Institutions and Systemic Risk, by Manuel A. Utset, Florida State University College of Law, was recently posted on SSRN. Here is the abstract:
This Article takes a novel approach to the “too-big-to-fail” problem. It begins by asking a foundational question: given the extraordinary volume of transactions between complex financial institutions, what mechanisms do these institutions use to deal with the transactional risks created by their mutual complexity? I explore two general approaches available to them. A party can acquire information to pierce through the complexity - an information-intensive strategy. But since information costs increase with complexity, at some point the costs will be so great that a party will enter into the transaction only if it can transact “blindly”. A blind strategy is one in which one party treats the other as a “black box” and protects itself by using other types of contractual mechanisms. I develop a theory of “blind-debt” contracting and show that a debtholder can transact blindly by taking sufficient collateral and making maturities infinitesimally small. In the period leading to the recent crisis, financial institutions increasingly turned to overnight repos - which are essentially, collateralized overnight debt - to finance their operations. As the maturity of repos became increasingly short they began to resemble a second type of blind debt - demand deposits. As institutions became increasingly dependent of blind debt they open themselves to the same type or “runs” to which demand deposit accounts are susceptible. I then develop various legal implications, particularly with regard to the Dodd-Frank Act.
Lynch on Derivatives
Derivatives: A Twenty-First Century Understanding, by Timothy E. Lynch, Indiana University Maurer School of Law - Bloomington, was recently posted on SSRN. Here is the abstract:
Derivatives are commonly defined as some variation of the following: a financial instrument whose value is derived from the performance of a secondary source such as an underlying bond, commodity or index. But this definition is both over-inclusive and under-inclusive. Thus, not surprisingly, derivatives are largely misunderstood, including by many policy makers, regulators and legal analysts. It is important for interested parties such as policy makers to understand derivatives, because the types and uses of derivatives have exploded in the last few decades, and because these financial instruments can provide both social benefits and cause social harms. This Article presents a framework for understanding modern derivatives by identifying the characteristics all derivatives share.
All derivatives are contracts between two counterparties in which the payoffs to and from each counterparty depend on the outcome of one or more extrinsic, future, uncertain event or metric and in which each counterparty expects such outcome to be opposite to that expected by the other counterparty. The framework presented in this Article will facilitate the development of more rational and comprehensive derivatives regulations, including (i) those required under the recently enacted Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act) and (ii) those addressing the particular risks associated with “purely speculative derivatives,” (those in which neither party is hedging a pre-existing risk).
Week 6: Rajaratnam's Defense
The defense in Raj Rajaratnam's criminal insider trading case began this week, and the testimony of two important witnesses took up most of the week. Rick Schutte, former Galleon president for U.S. operations, testified at the beginning of the week. His testimony was intended to show that RR's trading was based on discriplined, diligent analysis of publicly available information. For example, he described a staff of analysts who met every morning, with RR the most prepared at the meetings. The defense introduced numerous articles and research reports on the companies involved in the trading transactions to reinforce its point that the trades were made on publicly available information. The government, on cross-examination, elicited testimony from Schutte that RR invested $25 million in Schutte's investment fund months before the trial started, making RR the biggest investor in Schutte's fund.
Gregg A. Jarrell, a business professor at University of Rochester and former SEC economist, was the defense's second key witness. His testimony, at the end of the week, was intended to show that RR's trades were consistent with publicly available information. He went through a detailed Power Point presentation highlighting the trades and linking them to publicly available information. He also emphasized that Galleon lost $67 million on AMD trading. On cross-examination, the government sought to show that Jarrell's selection of articles was "cherry-picking" and that there were numerous articles with contrary views.
Another defense witness was intended to show RR's generosity. Geoffrey Canada, president of Harlem Children's Zone, testified about RR's support for his program.