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Curtin, Edmond J.; Tanega, Joseph --- "Shadow banking derivative instruments" [2018] ELECD 355; in Chiu, H.-Y. Iris; MacNeil, G. Iain (eds), "Research Handbook on Shadow Banking" (Edward Elgar Publishing, 2018) 229

Book Title: Research Handbook on Shadow Banking

Editor(s): Chiu, H.-Y. Iris; MacNeil, G. Iain

Publisher: Edward Elgar Publishing

ISBN: 9781785362620

Section: Chapter 8

Section Title: Shadow banking derivative instruments

Author(s): Curtin, Edmond J.; Tanega, Joseph

Number of pages: 22

Abstract/Description:

In this chapter, we consider the substance of the legal relationship between a dealer and its client when transacting in derivatives, taking into account both the contractual relationship between the parties and the regulatory relationship arising under the Markets in Financial Instruments Directive (MiFID). We refer to these respective relationships as the contractual model and the regulatory model. The contractual model is derived from a privately negotiated legal framework premised on the idea that the parties are allocating risk inter se and doing so as principals and at arm’s length. Under the contractual model, the parties retain the freedom to allocate risk inter se based on a careful circumscription of respective rights, duties, privileges, powers and immunities. The regulatory model is derived from a legal framework premised on the idea that the dealer is providing the client with a service. Under the regulatory model, where a client interest may be implicated by a decision of the dealer, the dealer should take into account that client interest. These respective models and their combination are discussed further below. The chapter is not a critique of the regulatory model as such. Rather, it is a meditation on the substance of the derivatives contract as the quintessential shadow banking instrument. This quintessence is the acceptance of the investment risk associated with one’s bargain. This chapter is in five parts. The first is a circumscription of the phenomenon of derivatives and its place in shadow banking. The second is a description of the MiFID legal framework and the place of derivatives within that legal framework. The third is a description of the contractual model. The fourth is a description of the regulatory model. The fifth is a reconciliation of the regulatory model with the contractual model. ‘a transaction under which the future obligations of one or more of the parties are linked in some specified way to another asset or index, whether involving the delivery of the asset or the payment of an amount calculated by reference to its value or the value of the index. The transaction is therefore treated as having a value which is separate (although derived) from the values of the underlying asset or index. As a result, the parties’ rights and obligations under the transaction can be treated as if they constituted a separate asset and are typically traded accordingly.’2 We suggest that four further ideas may assist one in understanding derivatives. These are as follows.