20001 SYNTHETIC COMMON LAW the choice between ever-expanding federal legislation or unpredictable private arbitration is increasingly unattractive In one area in particular -disputes involving complex financial Instrument synthetic common law could solve a seemingly intractable problem for private parties. The $100 trillion market for financial derivatives is subject to piecemeal regulation by statute, or none at all, and the development of common law in this area has been slow and sporadic. Private contracting, while extensive, has failed to ameliorate these problems. Private parties to such transactions who end up in disputes face either costly and inefficient statutory law highly uncertain common law, or even less certain arbitration Thus, the derivatives markets are plagued by uncertainty. The costs to the market are substantial, and market participants are desperate for reform. A synthetic common law system would ameliorate this uncertainty by providing clarity regarding future disputes immediately while avoiding the high costs associated with heavy-handed regulatio More generally, synthetic common law is an alternative regime to consider for legal scholars writing in the area of institutional competence and public choice. A public choice analysis need not compare only a legislature captured by special interests to a sluggish and ill-equipped judiciary. In certain areas of practice, synthetic common law might be a reasonable middle road. To the extent a system of synthetic common law is successful in the derivatives markets, it could be adapted to other areas, especially those with rapidly evolving technologies. The model system proposed here for financial derivatives could apply equally well to private parties contracting in telecommunications, intellectual S Derivatives are financial instruments such as options and forwar whose value is derived from some underlying instrument or index. For description of the classes and uses of derivatives, see Frank Partnoy, Fi Derivatives and the Costs of Regulatory Arbitrage, 22 J CORP. L 211, 216-26 (1997). Derivatives may be traded on an exchange or over-the-counter (OTC)in the size of the otc derivatives market in notional amounts as of year-end 1999 was approximately $88.2 trillion. See BANK FOR INTERNATIONAL SETTLEMENTS, THE GLOBAL OTC DERIVATIVES MARKET AT END-DECEMBER 1999 3(May 18, 2000) http://www.bis.org>.Interestinglythegrossmarketvaluesofthesecontractshas declined dramatically from 4.02 percent of the notional amounts at year-end 1998 to 3. 19 percent of the notional amounts at year-end 1999, a decline of more than 20 percent. See id. This decline in market value may be a sign of very large losses in he industry during 1999, a fact which is very difficult to ascertain. Trading in OTC derivatives is highly concentrated, with the worlds ten largest banks accounting for almost 90 percent of oTC derivatives activity worldwide. See ALFRED STEINHERR DERIVATIVES: THE WILD BEAST OF FINANCE 155(2000). The Bis also has estimated hat the otc derivatives market comprises approximately 86% of the overall derivatives market. See id. at 152-53. Estimates of the size in notional amount of he exchange-traded derivatives market are in the $13 to 14 trillion range. See id. at 152. Hence, the total size in notional amount of the derivatives industry is greater han $100 trill See infra Part V B 3 nra See infra Part V B VB.4. See infra Part VA I See, e.g. Ed Rubin, Law and Legislation in the Administrative State, 89 COLUM. L REv. 369(1989)(advancing a theory of legislation independent from judicial interpretation of legislative provisions)2000] SYNTHETIC COMMON LAW 3 the choice between ever-expanding federal legislation or unpredictable private arbitration is increasingly unattractive. In one area in particular – disputes involving complex financial instruments – synthetic common law could solve a seemingly intractable problem for private parties. The $100 trillion market for financial derivatives5 is subject to piecemeal regulation by statute, or none at all, and the development of common law in this area has been slow and sporadic. Private contracting, while extensive, has failed to ameliorate these problems.6 Private parties to such transactions who end up in disputes face either costly and inefficient statutory law,7 highly uncertain common law,8 or even less certain arbitration.9 Thus, the derivatives markets are plagued by uncertainty. The costs to the market are substantial, and market participants are desperate for reform.10 A synthetic common law system would ameliorate this uncertainty by providing clarity regarding future disputes immediately while avoiding the high costs associated with heavy-handed regulation. More generally, synthetic common law is an alternative regime to consider for legal scholars writing in the area of institutional competence and public choice. A public choice analysis need not compare only a legislature captured by special interests to a sluggish and ill-equipped judiciary.11 In certain areas of practice, synthetic common law might be a reasonable middle road. To the extent a system of synthetic common law is successful in the derivatives markets, it could be adapted to other areas, especially those with rapidly evolving technologies. The model system proposed here for financial derivatives could apply equally well to private parties contracting in telecommunications, intellectual 5 Derivatives are financial instruments such as options and forward contracts whose value is derived from some underlying instrument or index. For a detailed description of the classes and uses of derivatives, see Frank Partnoy, Financial Derivatives and the Costs of Regulatory Arbitrage, 22 J. CORP. L. 211, 216-26 (1997). Derivatives may be traded on an exchange or over-the-counter (OTC) in private transactions. The Bank for International Settlements (BIS) has estimated that the size of the OTC derivatives market in notional amounts as of year-end 1999 was approximately $88.2 trillion. See BANK FOR INTERNATIONAL SETTLEMENTS, THE GLOBAL OTC DERIVATIVES MARKET AT END-DECEMBER 1999 3 (May 18, 2000) <http://www.bis.org>. Interestingly, the gross market values of these contracts has declined dramatically from 4.02 percent of the notional amounts at year-end 1998 to 3.19 percent of the notional amounts at year-end 1999, a decline of more than 20 percent. See id. This decline in market value may be a sign of very large losses in the industry during 1999, a fact which is very difficult to ascertain. Trading in OTC derivatives is highly concentrated, with the world’s ten largest banks accounting for almost 90 percent of OTC derivatives activity worldwide. See ALFRED STEINHERR, DERIVATIVES: THE WILD BEAST OF FINANCE 155 (2000). The BIS also has estimated that the OTC derivatives market comprises approximately 86% of the overall derivatives market. See id. at 152-53. Estimates of the size in notional amount of the exchange-traded derivatives market are in the $13 to 14 trillion range. See id. at 152. Hence, the total size in notional amount of the derivatives industry is greater than $100 trillion. 6 See infra Part V.B.3. 7 See infra Part V.B.1. 8 See infra Part V.B.2. 9 See infra Part V.B.4. 10 See infra Part V.A. 11 See, e.g., Ed Rubin, Law and Legislation in the Administrative State, 89 COLUM. L. REV. 369 (1989) (advancing a theory of legislation independent from judicial interpretation of legislative provisions)