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Legal Matters

Lessons Not Learned: The Derivatives 
Market and 
Continued Risks

Illustration by Lincoln Agnew

Photo courtesy of Brooksley Born

Brooksley E. Born, JD ’64 (BA ’61) 


Toward the end of the PBS FRONTLINE documentary about the 2007 economic crisis “The Warning,” former SEC chairman Arthur Levitt issued something of an apology to Brooksley Born, saying “I’ve come to know her as one of the most capable, dedicated, intelligent, and committed public servants. … I wish I knew her better in Washington. I could have done much 
better. I could have made a difference.”

If only. Levitt is referring to Born’s proposals for tighter regulation of the over-the-counter (OTC) derivatives market and her tenacity in the face of fierce opposition.

Brooksley E. Born, JD '64 (BA '61), center, with classmates from the <em>Stanford Law Review</em>

Brooksley E. Born, JD ’64 (BA ’61), center, with classmates from the Stanford Law Review

Now a retired partner at Arnold & Porter LLP, which she joined as an associate in 1965 soon after receiving her JD from Stanford Law School, Born was the head of the firm’s derivatives practice in 1996 when she was appointed by President Clinton to chair the U.S. Commodity Futures Trading Commission (CFTC). It should have been an uneventful tenure in government service for this overachiever who was the first woman president of the Stanford Law Review, graduated at the top of her class, and went on to excel in a male-dominated practice. But soon after her appointment, she could see that regulatory gaps in the still nascent OTC derivatives market posed real risk to the U.S.—and world—economies. She was convinced that greater regulation was needed—and soon. The market was growing quickly and as time went on she became more concerned, losing sleep with the weight of the risks on her shoulders.

But Born walked into an ideological battle that pitted her against some of the most powerful men in government. This was the post-Reagan, post-Communist heyday of deregulation—and Born’s proposals were seen not only as wholly unnecessary but as a dangerous threat to prosperity. Federal Reserve chairman Alan Greenspan, Secretary of the Treasury
Robert Rubin, Deputy Treasury Secretary Lawrence 
Summers, and Levitt lined up against her. When she dared to disagree with them, they convinced Congress to strip her 
agency of its regulatory power and testified against her proposals at committee hearings. With few tools left to do her job, she left the CFTC at the end of her term of office and returned to legal practice in 1999.

Since the 2007 economic crisis—brought on in large part because of the unregulated OTC derivatives market that included toxic real estate assets and insurance trades for companies like AIG—and the slow, unsteady climb out of the worst recession since the Great Depression, there has been much hand-wringing and regret that our nation’s leaders didn’t let Born do her job. While validation may be sweet, Born is still concerned about financial stability and has not sat quietly on the sidelines since her departure from government. From 2009 to February 2011 she served as a commissioner on the Financial Crisis Inquiry Commission, which issued its report in January 2011 on the causes of the financial crisis. And in 2012 Born was invited to be part of a new group, the Systemic Risk Council, set up by Sheila Bair, the former chairperson of the Federal Deposit
Insurance Corporation. The aim of the council is to identify risks that threaten market stability before they become a danger to the general public. And Born believes that there are continuing risks. She points to the over-the-counter derivatives market now valued at $639 trillion—25 times larger than it was in 1996—and the fact that there is still insufficient oversight and regulation of that market.

Born calls the Dodd-Frank Act, signed into law by President Obama in 2010, a “good first step” toward necessary regulation and oversight to protect the American people—but thinks we need fully to implement those reforms—and may need to go further. As the risk council points out, most of the Dodd-Frank Act has yet to take effect, stalled in large part by the financial lobby.

When accepting the John F. Kennedy Profile in Courage Award in 2009, Born said, “Special interests in the financial services industry are beginning to advocate a return to ‘business as usual’ and to argue against the need for any serious reform. We have to muster the political will to overcome these special interests. If we fail now to take the remedial steps to close the regulatory gap, we will be haunted by our failure for years to come.”

Story illustrationJoseph A. Grundfest, JD ’78, the W. A. Franke Professor of Law and Business, is a former commissioner of the 
Securities and Exchange Commission and former counsel and senior economist at the President’s Council of Economic Advisers. He is a highly regarded expert on capital markets, corporate governance, and securities litigation and has written widely on these issues. One of the nation’s most influential attorneys, Grundfest is a prominent voice in the field of corporate governance.

Grundfest founded the award-winning Stanford Securities Class Action Clearinghouse, which provides detailed, online 
information about the prosecution, defense, and settlement of federal class action securities fraud litigation. He launched Stanford Law School’s executive education programs and continues to co-direct Directors’ College, the nation’s leading venue for the continuing professional education of directors of publicly traded corporations. He is also a senior faculty member with the Arthur and Toni Rembe Rock Center for Corporate Governance. Additionally, he is co-founder and director of Financial Engines and a director of KKR & Co. L.P. – by Sharon Driscoll


Grundfest: I’d like to start by asking you about Sheryl Sandberg’s new book, Lean In: Women, Work, and the Will to Lead. It seems to me that you were leaning in before Sandberg could stand up. In many quarters, Sandberg’s views are quite controversial. I was wondering if you have any perspectives on her book that you would like to share?

Born: I certainly applaud her bringing to the attention of younger women the need to be proactive and not to accept the current situation in which women are not fully equal, either in the workplace or the home. I do think that the
Lean In philosophy is useful in activating women to stand up for themselves and speak out about what they see as unfair treatment and inequality in the workplace, in the home, in other spheres. And I applaud that.

In the early ’70s a number of young women lawyers of my generation in Washington got together and established the Women’s Legal Defense Fund, which was designed to provide representation to women who were suffering sex discrimination and other gender-related legal problems. But also collaterally, it served as a support group for women lawyers who 
otherwise might have been rather isolated in what was still a very male-dominated profession, even in Washington. And the discussions, the support, the help we gave one another meant a lot in terms of the willingness of the women to bring to the attention of our law firms and the federal government ways in which we were, in fact, being discriminated against and methods for improving our condition. It was a very effective dynamic in that era and I think contributed to the legal and social changes that were gaining momentum. The Lean In effort may provide some of the same benefits.

Grundfest: Intriguingly, some of Sandberg’s critics 
suggest that she’s blaming women when she suggests that women should take responsibility for their own lack of advancement in the professional world, be more assertive, think about their unwillingness to raise their hand, 
their unwillingness to volunteer for the next step, and their unwillingness to take risks the same way that men 
do when volunteering for positions for which they 
may not be fully qualified. Do you agree?

Born: I certainly do not think women are to blame for the 
remaining discrimination in our society. But I do think it is 
important to remind women, which Sandberg is doing, that the remaining problems are not going to be solved unless women are willing to stand up and speak out. And I very much hope that in doing so women aim not only to further their own 
careers but to improve the opportunities of all women, most especially the poor and underrepresented.

Grundfest: Speaking of women standing up and speaking out, during your time at the U.S. Commodity Futures Trading Commission (CFTC), you were warning loudly about serious issues you saw emerging in the derivatives market. Republicans and Democrats alike weren’t too enchanted by your views. I think if anyone’s ever looking for a courageous example of a woman standing up and leaning in, it was you. I wonder if you could take us back a bit in history and describe the derivatives markets at that time and the cause of your concerns.

Born: I took office as chair of the CFTC in 1996. Three years earlier Wendy Gramm, who was then chair of the CFTC, had worked successfully to have the commission adopt an exemption from many provisions of our statute permitting certain over-the-counter derivatives to be traded. Up until then, the statute had provided that derivatives, with a few exceptions, had to be traded on a regulated exchange. The exemption that was adopted by the commission provided that sophisticated traders could enter into customized contracts without complying with any of the provisions of the statute other than the prohibitions on fraud and manipulation. The CFTC maintained the fraud and manipulation enforcement authority for the resulting over-the-counter derivatives market.

What I discovered when I arrived at the CFTC was that we did not have any of the regulatory tools needed to police the market for fraud and manipulation. In fact, we had kept no investigative powers, there were no requirements of record keeping or reporting, there was no transparency in the markets. And I found that we were not only unable to use our enforcement power effectively but also that it was entirely possible that a large systemically important institution could get into trouble with over-the-counter derivatives without any knowledge of that trouble by the CFTC or other federal regulators because of the lack of transparency.

Grundfest: So the situation evolved, as we might say. What gave you cause for concern?

Born: When I took office, the over-the-counter derivatives market had grown from quite small to approaching $20 or $25 trillion in notional amount. And we were seeing some significant problems. First, there had been episodes of fraud. Bankers Trust was a large over-the-counter derivatives dealer, and it became clear, through suits brought by some of its customers—primarily Procter & Gamble and Gibson Greeting Cards—that Bankers Trust had defrauded some of its derivatives customers. Second, there was evidence of manipulation in the markets. Sumitomo Corporation had managed to manipulate the world market in copper, in part using over-the-counter derivatives to disguise its operations and fund them. Third, there had been some very major losses in the markets. Most prominently, Orange County, California, had gone bankrupt because of its speculation in over-the-counter interest rate derivatives using taxpayer funds—an entirely inappropriate use of those funds. And there had been a number of other big losses—some by big public institutions, some by large corporate interests. I was concerned that the market was unregulated and rapidly growing and was characterized by lack of transparency, unlimited leverage, and interconnections between large institutions through counterparty credit risk. Those features of the market appeared to create the potential of systemic risk, as was later confirmed in the financial crisis of 2008.

Grundfest: By way of historical perspective, the latest BIS [Bank for International Settlements] data show that the total notional value of OTC derivatives is approximately $639 trillion today. So the market is about 25 times larger than it was in 1996. Also, just recently, Bart Chilton, one of the current commissioners of the CFTC, observed that even with disclosures that are now required post-Dodd-Frank, it would have been impossible for the CFTC to discover the positions of J.P. Morgan in what’s known as the Whale Trades, because the way the data are organized is simply insufficiently transparent to government regulators.

Born: The lack of transparency in the market is obvious. In fact, there are some very useful regulatory reform provisions concerning over-the-counter derivatives in the Dodd-Frank Act of 2010, but more than two and a half years after its enactment, those reforms are just starting to be implemented. The reporting of over-the-counter derivatives positions began in a limited way in December. It is far from complete, and it may not be effective. Mandatory clearing is just beginning with a few contracts and a certain segment of traders.

Grundfest: What do you think is needed?

Born: For the markets to have the transparency and regulatory protections that are necessary, I believe that most if not all derivatives need to be centrally cleared to reduce counterparty credit risk and, subject to exchange trading, to provide price transparency and an ability for regulators and self-regulatory organizations to effectively oversee them. It is not clear that that is going to happen because it is not clear that full implementation of the Dodd-Frank reforms will occur. And even if they do occur, it is not clear that we are going to get a large portion of the market onto regulated exchanges and clearinghouses.

Grundfest: Why do you think that full implementation of Dodd-Frank might not occur?

Born: There has been tremendous pushback by the financial services industry. They have gone to Congress with various proposed amendments to the Dodd-Frank Act that would retard or deter full implementation. They have tried to delay and object to implementation on the regulatory level. The CFTC has had to respond to many thousands of public comments on its proposed rules filed by the industry, many of them negative. And to the extent that rules have made it through the laborious rulemaking process and been finalized, some of them have been challenged in the courts and are stalled in litigation.

There have also been efforts to delay other provisions of the Dodd-Frank Act—the Volcker Rule, for instance. And the Financial Stability Oversight Council and its Office of Financial Research are not yet fully operating at the level it was hoped they would be. Other provisions are being delayed as well.

Grundfest: There’s an evolving phenomenon known as 
the futurization of swaps—in which the futures markets are inventing new derivative instruments that are intended 
to synthesize swaps and these instruments are traded on traditional contract markets, which are fully exchange traded and fully cleared. These futurized swaps are potentially quite popular with many market participants because of lower margin requirements and lower transactions costs. Do you have any opinion about this potential trend of futurization of the swaps market?

Born: Yes. I think it is a very hopeful sign, and I hope that there is a shift from swaps and from customized instruments to more standardized instruments and to futurization, if you will. Such a shift should reduce systemic risk by bringing the instruments into a more regulated sphere.

The futures markets, with required trading on regulated exchanges and required clearing through regulated clearing-houses, have been comparatively well regulated, although they too were subject to the deregulatory pressures that have occurred over the last 30 years. In 2000, the year after I left the CFTC, Congress adopted the Commodity Futures Modernization Act, which took away regulatory authority from the CFTC and also the SEC (Securities and Exchange Commission) over the over-the-counter derivatives market and essentially left it without federal oversight. That same statute weakened futures regulation as well, in several regards. One issue that I think the futurization of swaps raises is a need to examine whether there are aspects of futures regulation that need to be strengthened. For example, block trading rules are among the issues being discussed now because some of the futures exchanges are allowing large trades to occur off exchange under such rules. That is a potential area of opacity that I think needs to be examined.

Grundfest: You mentioned the Volcker Rule, which may be one of the more controversial rules that federal 
regulators are dealing with in a post-Dodd-Frank world. Can you describe how you envision the Volcker Rule?

Born: The Volcker Rule is an attempt to prevent commercial banks from using government-insured deposits for proprietary trading, that is, from speculating with those deposits for the benefit of the commercial bank itself.

Grundfest: And for clarity, we should mention that
Goldman Sachs, J.P. Morgan, and Morgan Stanley today all fall within the rubric of institutions that would be subject to the Volcker Rule.

Born: Yes, they are bank holding companies. The Dodd-Frank Act provision creating the Volcker Rule states that “market making” (acting as a securities or derivatives dealer) is to be permitted by commercial banking institutions while proprietary trading is to be forbidden. And a great deal of effort is going on in Washington to try to draw a meaningful distinction between proprietary trading and market making in formulating and implementing the rule.

Grundfest: Assuming the Volcker Rule is implemented, 
is it sufficient?

Born: I would like to see a rule that is simpler and more easily implemented. I think that the distinction between proprietary trading and market making has been demonstrated to be a very difficult one to make. I also feel that derivatives dealing is an inherently risky activity and, as such, inappropriate for institutions with government-insured deposits. After all, as found by the Financial Crisis Inquiry Commission on which I served, derivatives trading by large financial institutions played a significant role in the financial crisis.

Grundfest: Before we finish, I’d like to circle back to our earlier discussion of leaning in. During your time as chair of the CFTC you were often the “only woman in the room.” Did gender play a role in how your views were taken and your proposals for regulation being so strongly rebuked?

Born: I am not sure how much that played a role. It may well have. These were individuals with stature who disagreed with me: Alan Greenspan and Bob Rubin and Larry Summers and Arthur Levitt. I wouldn’t be surprised if the fact that I was a middle-aged woman played some role in at least the way they approached the dispute. I think there was astonishment that I was not willing to defer to their judgment on the issue of the dangers posed by the over-the-counter derivatives market and that I continued to voice my concerns despite their disagreement.

The CFTC was an independent regulatory agency that had the responsibility to oversee this market, and I felt that it was not only important but also my responsibility to voice my concerns. Since the agency could not act effectively under the regulatory structure that my predecessors had adopted and since the over-the-counter derivatives market appeared to pose significant risks, I thought I had a duty to make those risks clear to Congress and to the other financial regulators and to the American public.

Grundfest: I can’t imagine it was easy to hold your ground with the most powerful guys in Washington against you.

Born: I and the CFTC staff certainly were very careful and thorough in doing research on the dangers of the over-the-counter derivatives market and in formulating our views about them. But once we had done a full analysis and come to conclusions that we felt were fully warranted, we had to have the courage to express them. Whether you’re doing that in a law firm as part of your advice to clients or in dealing with your colleagues in a corporation or on a public stage, as I was at the CFTC, that is a fundamental responsibility.

Grundfest: Madam Chairman …

Born: Madam Chairperson!

Grundfest: Madam Chairperson, I stand corrected. 
And that’s a wonderful example of leaning in. It’s been an absolute pleasure. It’s been a real joy. Thank you.

Born: This has been fun. SL

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