The toughened regulatory stance in the aftermath of the 2008 financial crisis brought back transparency and reliability in the markets, which in turn helped restore investors’ confidence. Out of the many significant measures undertaken by the government to ensure consumer protection, the Dodd–Frank Wall Street Reform and Consumer Protection Act were signed into law by President Obama in Jul 2010.
The Dodd-Frank Wall Street Reform law was enacted so that lawmakers could participate in observing financial market risks. The rule placed greater restrictions on derivative securities and the firms that trade them.
For swaps specifically, the Commodity Futures Trading Commission (“CTFC”) proposed margin requirements in Oct 2014. The margin rules were levied on the uncleared swaps of covered swap entities in order to warrant protection and soundness of swap dealers and major swap participants.
Loophole
Dodd-Frank mandates the margining of every swap trade that is not centrally cleared. However, many firms managed to dodge the rule by transferring trades out of the country through their overseas affiliates.
The companies stopped pledging the trades of their offshore affiliates and pulled out their support, which defeated the purpose of Dodd-Frank intended to reduce risk.
The New Rule
The evasion of Dodd-Frank by large firms compelled the CTFC to propose a new rule, which was voted unanimously yesterday. The new rule states, “Covered swap entities would be required to comply with the Commission’s margin rules for all uncleared swaps in cross-border transactions, with a limited exclusion.”
The covered swap entities include large swap-dealing banks, which will now have to follow the U.S. collateral standards for riskier uncleared instruments traded in a foreign jurisdiction as well. In short, the new rule has been extended to encompass banks’ overseas divisions and envelop only swaps traded directly between two companies and not guaranteed by a third-party clearinghouse.
The Goldman Sachs Group, Inc. GS, Bank of America Corporation BAC, Morgan Stanley MS, JPMorgan Chase & Co. JPM and Citigroup Inc. C are among the 60 firms, which will have to comply with the new regulation. However, the firms will be permitted to conform with foreign laws when the agency deems them comparable to Dodd-Frank standards.
Implications
Though the CTFC’s new rule will ensure continued price competition and transparency in the $700 trillion swaps market, lack of internationally coordinated and harmonized margin rules could trigger problems in implementation. Also, increase in margins will likely discourage hedging, causing a rise in systemic risk along with liquidity constraints.
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