By Jiefei Liu
Derivatives experts differ on the effectiveness of the Dodd-Frank Act’s regulation, placed into effective in 2012, that over-the-ounter swaps be cleared through an established clearing house such as that of the Chicago Mercantile Exchange.
The Act brings comprehensive regulations to swaps, because these previously unregulated products “were at the center of the 2008 financial crisis,” states the U.S. Commodity Futures Trading Commission’s website.
A swap is a derivative contract through which two parties exchange financial instruments, according to Investopedia. The most well-known kind of swap is an interest rate swap, where two parties make payments to each other based on how interest rates move in favor of or against each one of them. In short, it’s like they are betting the trend of interest rates against each other. Credit default swaps, another type of swaps that are thought to be responsible for the 2008 financial crisis, are like betting whether a company will default on its bonds.
The regulation requires swaps to be cleared at a central clearinghouse, which was totally voluntary before the Act. This introduced a third party to swap transactions, and the parties must reveal related information to it in order to be cleared. The CFTC recorded a total of $252.54 trillion notional value of swaps outstanding on December 16, 2016.
Marti Subrahmanyam, a professor at Stern School of Business of New York University, said setting up a central clearinghouse is “the most important” part of the swaps regulation, because it makes swap trading public.
“It increases market transparency and efficiency,” said Patrick Sullivan, president of Great Lakes Trading Co. Inc. When trading privately, a buyer doesn’t know if the price he or she is offered is appropriate, but if there is a central market, you can have many other choices to compare with, he said.
The regulation reduces market risks, said Michael Wong, an analyst at Morningstar Inc. He said American International Group Inc.’s downfall in 2008 was because the company’s counterparties requested more collateral than AIG could provide, while under the new regulation, the parties have to report collateral daily, so it might not happen again.
However, this also raises concerns, because risks that used to be shared among many different parties are now concentrated in a few clearinghouses, Wong observed. He said he worries if there would be a collapse of a clearinghouse.
Subrahmanyam shares that concern. “Although there has not been mature supervision over clearinghouses yet, there should be,” he declared.
Having swaps cleared by a third party means the parties must pay extra clearing fees. It upsets swap dealers as costs go up, but it increases clearinghouses’ revenue. For instance, CME Group Inc. reported $17 million revenue in the third quarter in swaps clearing and transaction fees, 2.4 percent of its entire revenue in clearing and transaction fees.
“Although the revenue is still small, the regulation certainly is not a bad business for CME Group,” Wong said. CME didn’t respond to requests to comment for this story.
Along with extra transaction and clearing fees, compliance costs of the regulation give some brokerages a hard time.
Paul Puchot was an attorney at Amerex Brokers LLC, an energy consulting firm. He said to comply with the regulation, the company had to augment the business process and hire more clerks, which lowered efficiency. Also, he went on, the regulation required the firm to record all conversations regarding any transaction, and should be able to present to regulators “any piece they want to investigate,” and the costs of recording and locating specific conversations were very high.
Some small product markets were closed because they couldn’t cope with the high costs and with a higher capital entrance requirement and other regulations, so the overall swap trading volumes were down around 2012, Punchot said. When trading volumes were down, market liquidity was down and volatility was up, he said.
However, Andrea Kramer, an adjunct at Pritzker School of Law of Northwestern University, said higher barriers to entry can keep people who are not serious about swap trading out of the market.
With all the data required to be sent to the CFTC, Puchot said, he doesn’t believe the regulator has the capability to analyze it. Information of every transaction is required to be disclosed, but the way companies reveal their information makes it almost impossible to understand, because the CFTC does not require a specific submission format, he said.
When JPMorgan Chase & Co. took a large trading loss in the derivatives market in 2012, problematic reports had already been submitted to the CFTC, but no one had found anything wrong, he said. The swap rules have “good intentions,” Punchot stated, but they are very hard to fulfill.
Punchot said, for instance, the energy market should not be in the Act, because the market was very clean and had nothing to do with the financial crisis.
The regulation is undifferentiated with only a few exceptions. All swaps are subjected to the regulation, no matter how small, which makes the regulations too broad and “burdensome” for some swap dealers, said Kramer.
There are a lot of unclear definitions in the Act, like who is required to register as a swap dealer, Subrahmanyam said. He said the main understanding was that it should be market makers, who both sell and buy swaps, but this definition, he contends, is too vague. Moreover, he said an “end-user exception” in the Act is unclear, which is that people who use swaps to hedge rather than to speculate are exempted from the regulation. When big companies like BP PLC buy huge amounts of oil, “you can hardly tell if they are hedging or speculating,” he said.
The swaps regulation is only part of the effort to tackle causes of the 2008 financial crisis. Kramer noted the crisis was also caused by financial firms that irresponsibly promoted subprime mortgages and mortgage-backed securities. However, the process of regulating those companies lags behind the swaps regulation, she declared.
With Donald Trump’s election, the future of the regulation becomes uncertain. After the election, several news media reported that Trump’s transition team said on its official website it would dismantle the entire Dodd-Frank Act, but clicking the link now finds no such statement, merely this notice “404, sorry, but nothing exists here.”