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.
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