Dodd-Frank Missed an Opportunity to Truly Reform Derivatives
To ensure covenants are satisfied, loan syndicates obtain private information that would give an equity market maker an advantage. Reinstating Glass-Steagall may be the only way to prevent reuse of such information.
Title VII of the Dodd Frank Act, much of which will take effect next month, requires over-the-counter derivatives to trade through central counterparties. There are many benefits to such centralization. However, Title VII chose complexity over simplicity through its failure to create uniform rules for exchange-traded and OTC derivatives, a single regulator for all derivatives, or uniform rules for all participants. This represents an unfortunate missed opportunity.
OTC derivatives do not trade on an exchange but instead privately between two counterparties. Examples include interest rate swaps, credit default swaps and cross-currency swaps. OTC derivatives have a rocky regulatory history, shaped by both restrictive and permissive laws and regulations such as the Commodities Exchange Act of 1936; the CFTC's 1993 Swaps Exemption; the efforts by CFTC Chair Brooksley Born to regulate OTC derivatives in 1998; the Commodities Futures Modernization Act of 2000; and, most recently, Title VII of Dodd-Frank.
A key feature of Title VII is the central clearing requirement. OTC derivatives can no longer be private bilateral transactions between two counterparties. Instead, after two counterparties negotiate an OTC derivative contract, a central counterparty becomes the counterparty for all participants. Mandatory central counterparties are used by exchange-traded derivatives. They seem to work quite well and a strong argument can be made that they are beneficial. Two specific characteristics of central counterparties that make me an advocate for them are multilateral netting and superior collateral management. Let's explore each.
First, multilateral netting. When one holds an OTC derivative contract it can be either an asset or a liability, depending on whether your counterparty owes you more than you owe him or vice versa. Consider what would happen if you held an OTC derivative portfolio consisting of an asset position against one counterparty and a liability position against a second counterparty. Should the counterparty to your asset position go bankrupt, the OTC derivative contract is only worth whatever you can collect from the bankrupt counterparty – obviously these losses cannot be offset by the liability position, as it has a separate counterparty. With a central counterparty, you have a single counterparty for multiple contracts. Some will be assets and others liabilities, and these can be netted against each other should a bankruptcy occur. Hence, your counterparty exposure is greatly reduced.
Superior collateral management is another important advantage of central counterparties. Since most OTC derivative contracts obligate both counterparties to make payments in the future, each side will typically require and must manage collateral received from the other. Centralization significantly increases the professionalism of collateral management, as stewardship of collateral is a core mission of the central counterparty. Most notably, executives of central counterparties know that their collateral management techniques are closely watched and evaluated. Hence, a central counterparty works hard to ensure that collateral is sufficient and that rigorous processes are implemented so that positions are accurately valued and margin is adjusted. This protects the central counterparty and its many counterparties.
Despite these improvements, Title VII could have done more to modernize and simplify the way derivatives are regulated. For example, legislative reforms could have simplified derivatives regulation through uniform rules for exchange-traded and OTC derivatives. After all, the provisions of Title VII such as mandatory central counterparties, mandatory trading platforms, and mandatory data repositories are clearly an attempt to create pseudo-exchanges for OTC derivatives. But if that was the objective, why not develop requirements that apply universally to all derivatives, and drop the historical distinctions between exchange-traded and OTC derivatives?
Another way that Title VII could have simplified derivatives regulation is through a single regulator for all derivatives. Instead, Title VII assigns different regulators – the CFTC, the SEC, or both – to oversee OTC derivatives depending on whether the derivative references an index or a security. A further way that Title VII could have simplified derivatives regulation is through uniform rules for all participants. Instead, Title VII includes an "end user exemption" to the mandatory clearing requirement, which effectively means that different swap participants are treated differently.
I recognize that there are historical reasons why derivatives regulation is bifurcated the way that it is, and how the push and pull of the political process often results in messiness. Yet considering the revolutionary nature of much of the Dodd-Frank Act, it is disappointing that the opportunity was not seized to truly simplify and modernize derivatives regulation.
Aron Gottesman is a professor of finance and chair of the Department of Finance and Economics at Pace University's Lubin School of Business in New York.