Book review – “Collateral Knowledge: Legal Reasoning in the Global Financial Markets”

This is a rich book, written by Cornell Law School’s Professor Annelise Riles (University of Chicago Press, 2011, xii+295 pages). It is full of ideas and observations drawn partly from extensive fieldwork – particularly in Tokyo over 1997-2001 (p. ix), just as Japan was implementing its “Big Bang” reforms aimed at making its financial markets more “free, fair and global” (p. 120). It deserves careful reading, and re-reading, by those researching Japan as well as those interested in financial markets, regulatory theory, contract law, international commercial law, socio-legal studies and anthropology more generally.

The book focuses on a little-examined aspect in derivatives trading conducted “over-the-counter” (outside an exchange institution), where mostly large financial institutions contract to “swap” things at a future date, either to hedge against risk or to speculate (p. 2). To guard against the “credit risk” that one’s counter-party may default or go bankrupt before the date agreed for the exchange, contracting parties usually require each other to post “collateral” security – assets bound by a separate obligation, independently securing fulfillment of the primary obligation (p. 1). Collateral calls by counterparties to swaps with AIG led to its bailout by the US government during the Global Financial Crisis (GFC), yet more use of collateral is widely seen as one key to avoiding future crises (p. 3).
Riles is intrigued by the way collateral, underpinned by contract and property law, has largely retained its legitimacy – and, more generally, the rise and world-wide spread of such “global private law solutions” (p. 7) seemingly in lieu of direct governmental regulation of financial markets. Through an ethnographical study of how collateral came to be used and regulated in Tokyo’s international swap market, due partly to the standard-form contracts and lobbying efforts from the International Swaps and Derivatives Association (ISDA, founded in 1985 and still based mainly in London and New York), Riles argues that regulation emerges as:

“neither inherently private nor public, neither global nor local. Global financial markets governance is also … a set of routinized but highly compartmentalized knowledge practices, many of which have a technical legal character” (p. 10, original emphasis).

She perceives such legal knowledge practices as not simply reducible to socio-economic or political forces, but as displaying their own “epistemological and material autonomy” (p. 20). Riles aims to show how such an understanding can suggest a model and techniques for re-regulating financial markets in a space between “the free market mindset and the technocratic mindset” (p. 26).
Chapter 1 (What is Collateral? On Legal Technique) introduces us to the mundane “back room” world of the swaps market. Legally-trained employees “paper the deals” made by the (higher-status and better-paid) traders: “Collateral and collateral managers were documentary and human afterthoughts” (p. 37), despite about 60% of transactions being collateralized for a total of over US$1.3 trillion by 2006 (p. 35). The key attraction of taking collateral is that it puts the holder ahead of other creditors if the counterparty defaults, rather than say undertaking further swaps with that party or others to cancel out or hedge the credit risk, or dealing only with demonstrably more creditworthy or trusted parties (p. 41). Banks that collateralize are permitted to lower their capital adequacy requirements (set by the Basel Committee on Banking Supervision), thus achieving “a delegation of state authority to monitor systemic risk to private parties” (p. 44).
Yet this private law regime of collateral depends not only on effective valuation techniques, but also on the requirements under applicable national law (itself often difficult to identify) for creating an enforceable security interest, and the latter’s status under contract and bankruptcy law. ISDA therefore not only supplies standard-form contracts, containing clauses favored by its traders (such as the right for the collateral-holder to “re-hypothecate” or use it as collateral in other swaps); it also hires local lawyers to investigate possible discrepancies with local law, and lobby for validation or legislative reform to ensure enforceability. Nonetheless, what ISDA members were mostly busy making “were not rules, not norms, not sources of law, but documents” (p. 49). The printed clauses of the standard form were hardly looked at, only the blanks (p. 52); and the collaboration achieved was “normatively and socially thin” (p. 54), “an alternative to developing shared private norms” (p. 55) – as found in other markets, even today, such as diamond trading.
From this ethnology focused primarily on the private governance side, Riles infers several general features of “collateral” technical legal knowledge, which recur throughout the book. For example, this knowledge involves certain ideologies (such as legal instrumentalism), categories of experts (scholars, bureaucrats and lawyers viewing the law as a tool and themselves as technicians), a problem-solving paradigm, and a form of reasoning and argumentation. Such legal technicalities are not inherently either public or private (pp. 64-5); but with public regulation, “the technical as technocratic”, there is even greater attention to the ends rather than the means or the legal tools and craft (p. 73). Accordingly, Riles argues that “there is nothing that inherently impedes private legal technicians from behaving like technocrats or public servants from embracing legal technique, and here lie real nonutopian possibilities for rethinking market regulation” (p. 74).
Chapter 2 (The Technocratic State) delves further, and more concretely, into the public side of technical legal knowledge in this field. The Asian financial crisis in 1997 and then Japan’s own banking crisis highlighted fears of a domino effect, if banks began to fail. Providing collateral could help, but this was expensive if assets had to be tied up for the transaction’s entire value. The ISDA Master Agreement allowed parties to “net out” all their transactions in the event of bank failure, so they only needed to collateralize any remaining outstanding debt – but was this valid under Japanese law? The political implications become stark as swap counterparties are likely to be largely foreign, whereas other creditors consequently losing priority in bankruptcy (such as employees) are more likely to represent more domestic interests (p. 100).
The Vice Minister for the Ministry of Finance (MOF), Eisuke Sakakibara, had responded to the foreign bankers’ association’s request for clarification, declaring netting to be valid (p. 101). Riles does not specify when this occurred but suggests that this followed quite common practice still at the time (except that the response was provided in writing): the regulator provided “administrative guidance”. This was consistent with the broader pattern of informal governance and close relationships still between the industry and the MOF, as well as (especially) the Bank of Japan (BOJ) – responsible specifically for banking supervision , and which became independent from the MOJ in 1997 (pp. 94-99).
However, the foreign banks suggested that courts might rule differently, and so calculated Japanese counterparties’ credit limits for swaps on a gross basis. From the mid-1990s, this began to hurt Japanese banks (increasingly under the gun from non-performing loans), and they had also developed the technological capacity to calculate swaps exposure on a net basis. Moody’s also raised doubts in 1997 the enforceability of close-out netting, which risked consequences for the bond rating of Japanese banks, and an informal BOJ “study group” (combining officials, academics and market players) had looked into this issue in the mid-1990s. Pressure therefore built for a clearer resolution.
Riles pauses in this account, however, to conclude the chapter with some broader reflections as to the ways in which legal knowledge was deployed. In this Japanese context, as well as the reform process that resulted in a novel re-conceptualisation of “collateral” and “security” interests more generally in the Uniform Commercial Code (promulgated in 1951 in the US: pp. 89-95), Riles suggests that officials or reformers were more focused on the ends or “market realities” (p. 106). While seeking to retain some distance or perspective, they were also driven to collaboration: “the aim of regulators working towards a Japanese netting law was to give legal effect to already established market practices” (p. 108).
For the sequel, the reader should fast-forward to Chapter 5 (Virtual Transparency). In 1993 and 1994, a former professor of civil procedure (and therefore bankruptcy) law from the University of Tokyo, Koji Shindo, provided two exhaustive legal opinions which essentially concluded that netting was enforceable. Riles emphasizes Professor Shindo’s masterly and exhaustive application of different legal techniques in both opinions (pp. 188-98): analogical reasoning (comparing arguably similar situations where set-offs are permitted in bankruptcy), and the rule/exception paradigm (including some policy arguments, but adopting a formal legal form of reasoning). But soon afterwards, one of ISDA’s key local lawyers (Akihiro Wani, now with Linklaters in Tokyo) who had called upon Professor Shindo, began lobbying with others for enactment of netting legislation – in line with ISDA’s global strategy (p. 199). A key advisor on this initiative was Professor Hideki Kanda, a generation younger at the University of Tokyo, specializing in corporate and financial markets law and an advocate of the Chicago School of law and economics scholarship. The outcome was enactment of a Netting Law in 1998, which Kanda and others saw as formally confirming the enforceability of close-out netting under the bankruptcy law (p. 203).
Riles sees this statute as mostly important for proclaiming to the outside world that Japan had achieved “global best practice”, since other major economies had enacted such legislation over the 1990s (pp. 205-7). Yet she views the statute as “virtual transparency”, pointing out that important aspects of its scope (“specified transactions” and institutions covered by the law) remain to be defined by regulations (p. 201). Nonetheless, Article 3 of the Law did clearly provide for the close-off netting principle. More convincingly, Riles argues that Professor Shindo’s technical legal opinions (translating new global transactions and norms into more familiar domestic law concepts) were complementary to Professor Kanda’s calls for Japanese legislation directly to reflect market realities. There was “continual collaboration” between “these two genres of neoliberal legal knowledge” (p. 211).
Backtracking to Chapter 3 (Unwinding Technocracy), Riles emphasizes the importance for Japan’s “Big Bang” reforms of Hayek’s view of public regulation as a knowledge practice constrained by limited information of market movements, as well as of critiques from public choice theory (p. 114). Combined with leftist calls for reform, mostly under the banner of “transparency” (p. 115) and in the wake of prosecutions of MOF and BOJ officials for accepting invitations for meals with industry members, she shows how these ideas infiltrated even Japan’s elite bureaucracy.
Her case study is a switch in the payment mechanism provided by the BOJ, away from a designated-time settlement system (DTNS) that allowed obligations of banks to accumulate throughout the day, before calculating the balance owed among each other at 3pm. This meant banks were implicitly extending credit to each other, and from 1996 the BOJ voiced concerns that a default from one bank at the designated time could lead to the whole system collapsing. The solution introduced in 2001 was real-time gross settlement (RTGS): each transaction settled individually and in full – responding to “a desire for safe policy, policy that produced less risk even at higher costs” (p. 134). RTGS promised both to eliminate scope for inappropriate regulatory behaviour, and to meet another “global trend” (p. 137).
For key BOJ officials, it also held out the “dream” that not only the bureaucracy but also market actors and individuals in Japan could finally achieve and demonstrate rationality and legal modernity, despite a persistent ambivalence about both highlighted recently by Takao Tanase (p. 140). The same vision arguably underlies the blueprint proclaimed in 2001 by the Justice System Reform Council (JSRC), aimed at reconfiguring civil and criminal justice as well as the legal profession to promote more self-responsible individuals (p. 142). Riles concludes that this shows not only the independent importance of academic theories or ideas, rather than just material interests, but also the perhaps unexpected ways in which they have an impact in different national contexts (pp. 148-9).
The story of this move away from DTNS continues in Chapter 4 (Placeholders: Engaging the Hayekian Critique of Financial Regulation). Riles shows how RTGS left a problem for the BOJ: for banks to have liquidity to clear transactions in real time, they would need massive “daylight overdraft” loans from the government (p. 161, referring to her respondent’s obscure “schematic depiction”). She also argues that the new system invented a new legal fiction, dubbed a “placeholder”, to address liquidity: it was deemed, after the fact, that settlement among banks took place in the proper order – minimising liquidity issues (pp. 178-9, including a somewhat less obscure depiction). Riles draws a parallel with the use of another “placeholder” in the ISDA standard-form contract, a clause allowing the collateral-holder the right to re-hypothecate (p. 169):

“In the meantime, that is, in the near future, the parties simply agree to act as if the holder of the collateral (the pledgee) already has clear and complete rights over the collateral” (p. 169).

The validity of this right under Japanese private law remains controversial, yet the placeholder creates its own market reality, argues Riles. Indeed, any clever re-characterisations produced by lawyers and academics generate further placeholders for future government law-making (p. 172).
In the overall Conclusion, Riles states that the book aims to “democratize the practice of global financial regulation by making it at once more technical and more political” (p. 223, original emphasis). Examining seemingly innocuous or marginal (collateral) legal techniques, particularly the role of collateral as a security interest in international swaps transactions, opens up “a larger political and theoretical conservation about markets and democracy” (p. 223). Riles is more interested in understanding and adapting existent legal knowledge practices, from the bottom up, than developing new overarching architecture.
Regarding compliance, for example, she argues that the goal is engage actors in the regulator’s way of thinking of the market – like central bankers can do with policy statements, or “operationalizing existing social relations in the market, as regulators do in Japan” (p. 236) – although with much tougher rules on who pays for any socializing, since the late 1990s. Another possibility is to consider expanding existing redundancies remaining (or collateral) in financial systems, to make them less tightly coupled (p. 240). Perhaps we can use more placeholders, including statutes with “a hollow core” (p. 241). While such proposals may seem quite general and mundane, or not political enough, Riles helpfully reminds us that much regulatory work takes place not just at the level of policy design, but also in “practices of enforcement, information collection and management, and bureaucratic routine” (p. 244).
With the chapters re-ordered perhaps in the way outlined above, this dense but lucidly-written book provides much food for thought. The biggest question, especially for those interested specifically in international financial markets and their now painfully-evident capacity to wreak havoc on the world economy, is whether Riles still gives too much credence to the way things have tended to be done “on the ground” since the swaps market started its phenomenal growth. Have financial institutions really learned enough lessons? Consider recent admissions from the UK’s big four banks that they persisted in mis-selling complex interest rate swaps to small businesses – and, even more disturbingly, news that Barclays Bank (and potentially many others) repeatedly falsified the interbank lending rate to appear more creditworthy. Are lawyers not also implicated in such market failures and the GFC more generally, as “gatekeepers” to corporate activity? Like other professions, such as rating agencies, they seem to have got off lightly. Maybe it would not be a bad idea to question basic concepts like collateral more fundamentally, encouraging those in the market to use “old-fashioned” or seemingly less efficient alternatives such as dealing only with the most trustworthy counterparties.
Riles’ book also leaves many questions for contract law theorists. First, “the documents” and associated legal knowledge practices may be far less important outside the context of swaps or other transactions where collateral can and is often used to support the underlying promises. Long-term contracts for large-scale processing and sales of certain types of natural resources, for example, may still rely very heavily on extra-contractual socio-economic norms; spot contracts for other commodities may instead draw on quite formal legal rules.
Second, in contracts where those with very different bargaining power or cognitive capacity are more directly involved, such as consumers, there may exist somewhat similar practices as in swaps market, such as form-filling (especially in online contracting). But a more central (and clearly political) issue becomes who drafts the “boilerplate” clauses, and whether those should be enforceable.
Third, does the use of legal techniques, such as legal fictions (or at least legal presumptions), differ depending on whether a particular jurisdiction prefers and promotes more contextualist and substantive reasoning (open to social norms or market realities, as arguably true in both Japan and the US even today), compared to more formal reasoning and supporting legal institutions (as in the English common law tradition)? In particular, what happens when we add judges into the equation? These actors hardly figure in the world of swaps, in Japan or elsewhere, yet judges probably deploy their own distinctive legal knowledge practices. These are particularly timely questions, as Japan embarked in 2009 on its first comprehensive overhaul of general contract law in over a century.
For Japanese Studies specialists, Riles’ book resonates with studies from political scientists and comparative lawyers identifying some significant shifts since the 1990s in the governance regimes for financial markets and corporate activity more generally – but not dramatic or straightforward changes. Again, however, one wonders how far we can generalize beyond her particular field and specific examples. Even with the Netting Law,* it would have been helpful to know what regulations have been promulgated and why; has its scope been limited, perhaps due to domestic political concerns? Most importantly, have legal knowledge practices changed much in Japan’s financial markets since the GFC – have influences from Hayek, public choice theory or Chicago School law and economics lost their luster?
Even in 2006, for example, major re-regulation occurred in the field of consumer credit, as the socio-economic costs of partially deregulating interest rate caps became more apparent. And despite the JSRC reform package, aimed at empowering citizens to take greater responsibility vis-à-vis the state, there have not been large changes in administrative lawsuit patterns, nor in the way the Japanese government manages its litigation services. Maybe, as Tanase argues more generally, Japan’s “social blueprint” and contemporary communitarian norms have reasserted themselves quite robustly against an influx of new legal rules or knowledge practices over the last two decades.
* Stacey Steele, “Japan’s Bankruptcy Safe Harbour Provisions and Repurchase Agreements: A Commentary and Annotated Translation of the ‘Act Concerning Close-out Netting of Specified Financial Transactions Undertaken by Financial Institutions Etc.’,” Journal of Japanese Law, Vol. 15, No. 30 (2010), pp. 175-201.

Author: Luke Nottage

Prof Luke Nottage (BCA, LLB, PhD VUW, LLM LLD Kyoto) is founding co-director of the Australian Network for Japanese Law (ANJeL), Associate Director (Japan) of the Centre for Asian and Pacific Law at the University of Sydney (CAPLUS), and Professor of Comparative and Transnational Business Law at Sydney Law School. He specialises in international dispute resolution, foreign investment law, contract and consumer (product safety) law.