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Vital Dodd-Frank rule adopted

By Sheyna Steiner · Bankrate.com
Thursday, April 19, 2012
Posted: 4 pm ET

On Wednesday, the Securities Exchange Commission, or SEC, adopted a new rule defining who needs to be regulated in the over-the-counter swaps market as mandated by the Dodd-Frank Act.

Great. What's a swap?

A swap is a type of derivative, or a financial contract whose value is based on something else. For instance, a futures contract is another type of derivative. A futures contract could be sold agreeing to sell a bunch of coffee at a certain price on a certain date in the future. The contract has a value apart from the coffee.

Swaps are also contracts between a seller and a buyer. In a credit default swap, or CDS, the buyer pays for insurance against the default of a company, government or borrower on a bond. They don't have to own the investment. The CDS is a contract with value of its own.

Swaps can cover all sorts of other things: interest rates, currency, energy and more.

Obviously, we're all vaguely familiar with credit default swaps as esoteric instruments that were some part of the complicated process that crippled the financial system. But the confused acquaintanceship belies how vast the market for credit default swaps is. According to the International Swaps and Derivatives Association, the gross notional CDS amount was $25.5 trillion as of Dec. 31, 2010.

So it's big. Before 2008, it was much bigger. Not only that, it was pretty much the Wild West in terms of regulation, and we all know how well that turned out.

The Dodd-Frank Act set up some parameters by which the swaps market could be monitored and made less treacherous. The Commodity Futures Trading Commission, or CFTC, and the SEC divide regulatory authority, and this is the first step toward bringing some regulatory order to the swaps market by defining who exactly they will be regulating.

No easy feat.

Dealers are big -- very big. Major participants are as well

Here's the definition of a security-based swap dealer as envisioned by Dodd-Frank.

  • Holds themselves out as a dealer in security-based swaps.
  • Makes a market in security-based swaps.
  • Regularly enters into security-based swaps with counterparties as an ordinary course of business for their own account.
  • Engages in activity causing them to be commonly known in the trade as a dealer or market maker in security-based swaps.

The SEC set some exceptions. Not all dealers will be subject to higher capital and margin requirements, which are what Dodd-Frank calls for -- in addition to other requirements.

Only companies, institutions and individuals transacting $8 billion or more of CDS dealing transactions over the prior 12 months will need to register with the SEC as dealers. For security-based swaps, the phase in level is $400 million.

They exempted individuals or institutions deemed too little to matter, or the de minimis exceptions, as those entering into less than $8 billion of credit default swaps in the previous year.

The de minimis exception could fall to $3 billion after the SEC completes a study on the swap market.

The SEC also drew a line around what major participants in those markets look like.

Major participants hold a lot of security-based swaps -- enough that substantial counterparty exposure could have destabilizing effects on the U.S. banking system or financial markets and thus should be subject to oversight.

Counterparty risk should sound familiar

AIG is the cautionary tale for counterparty risk in credit-default swaps.

This is from Investopedia's excellent primer by David Harper, "Introduction to counterparty risk.":

AIG famously leveraged its AAA credit rating to sell (write) credit default swaps (CDS) to counterparties who wanted default protection (in many cases, on CDO tranches). When AIG could not post additional collateral and was required to provide funds to counterparties in the face of deteriorating reference obligations, the U.S. government bailed them out. Regulators were concerned that defaults by AIG would ripple through the counterparty chains and create a systemic crisis. The issue was not only individual firm exposures but the risk that interconnected linkages via derivative contracts would jeopardize the system.

What's the problem?

A lot of the uproar over the new rule has to do with the thresholds delineating dealers from nondealers, and many reports have pointed out that industry lobbying had a lot to do with that.

From the Financial Times website, FT.com, "U.S. regulators ease derivatives rules":

The new $8bn interim threshold, approved by both agencies on Wednesday, comes after more than a year of intense lobbying by energy companies, hedge funds and banks who argued that the $100m threshold proposed in December 2010 was far too low.

Bart Chilton, a CFTC commissioner who has chided the agency for not cracking down further on Wall Street, said: “My first thought is how do you even say ‘de minimis’ and then the figure $8bn without laughing?”

What do you think?

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1 Comment
Richard
April 20, 2012 at 9:41 am

Every penny from the first through the last involved a default on credit gambling (DCG), the real term for CDS should be factored in.