The English courts' view of financial derivatives

Abstract

In 1997 the International Swaps and Derivatives Association (ISDA) sought legal opinion from an English barrister, Robin Potts QC, on whether a financial transaction known as credit default swap (CDS) was likened to be an insurance or wager. His opinion was it is neither insurance nor wager. The concern of ISDA is telling as it bespeaks the ambiguity of the purpose of CDS and derivative transactions in general - whether they are designed for hedging or speculation. But the predominant concern is their speculative nature. If their sole purpose is for speculation, they are opened to the charge that their purpose is wagering. It is inevitable that such a legal problem would find its way to the courts for determination.

In this paper I shall consider the decisions of the English courts on derivatives based on some of the decided cases and discuss the implications of the decisions on the subject. Interestingly, also drawing on the common law courts for an answer on the subject is Lynn Stout. Her view is that the common law rule against contracts for differences is the most prudent way to distinguish hedging from speculation in derivatives. I shall therefore consider her view on the subject.