It was five years ago that, in my role as an adviser to
treasurers and chief financial officers on how to use
derivatives to manage risk, I stepped into a cramped room in
the Capitols Rayburn House Office Building with a half
dozen congressmen who were members of the House Financial
Services Committee, then led by long-serving Massachusetts
Democratic Representative Barney Frank. We were already well
into a financial crisis that had revealed gaping
vulnerabilities in the system. Franks committee was
actively sizing up its policy response. One member ventured to
pose the question that was on everyones mind: What
is a derivative? I wouldnt know one if it hit me in the
With many of the subsequent legislative changes in effect,
the market is now much more transparent compared with before
the 200809 financial crisis. There is a greater
backstop cushioning exposures incurred by participants in the
$710 trillion market. And many of the hopes of reformers, such
as former Commodity Futures Trading Commission chair Gary
Gensler, have been realized.
Now that its been a few years since the promulgation
of the Dodd-Frank Wall Street Reform and Consumer Protection
Act, practical experience with the laws central features
has allowed us to assess its shortcomings and present ideas for
First off, the market is getting cheaper for some.
Dodd-Franks clearing mandate was intended to reduce
systemic risk by requiring derivatives to be fully margined in
a manner that eliminated the interconnectedness that former
Tim Geithner described as the complicated spaghetti
of the derivatives market. Additionally, new electronic
trading rules were intended to compress derivatives pricing in
a market that has long consummated trades over the phone by
increasing competition and transparency. Have these reforms
made derivatives cheaper?
For many, the answer is yes. One company that uses the new
derivatives trading and clearing infrastructure to reduce
temporary risks that arise in the ordinary course of borrowing
is saving approximately $2,500 for each $1 million it hedges
with interest rate swaps. This benefit does not come without a
cost. The company sets aside more cash than it once did to fund
margin calls, amounting to about $700 per $1 million hedged.
The roughly $1,800 in net savings directly benefits the firm
and its shareholders a clear improvement brought about
Yet the market is prohibitively expensive for others.
Central clearinghouses that can weather financial storms
require extraordinary financial resources and considerable
expertise. The firms that pool these resources generally
require from each of their customers a minimum fee, ranging
from $60,000 to more than $300,000 a year. Some firms that must
use clearinghouses see enough trading to disperse these fixed
costs across thousands of trades. Firms with low transaction
volumes are often unable to stomach the financial burden
associated with clearing, however. When lawmakers were drawing
up Dodd-Franks clearing mandate, they had no idea the
impact of these costs would have and what players would
suffer as a result.
One casualty is microfinance funds, which, because of
Dodd-Franks broad definition of financial
entity, fall under the laws funding requirements.
Microfinance funds collect money and deploy it to
institutions in impoverished countries that make microloans to
the worlds working poor. It would be no service to the
poor to lend money that must be paid back in a foreign
currency, because the exchange rate might fluctuate and vastly
increase the amount necessary to repay the loan. So
microfinance funds try to make loans in local currency and
remove their own resulting
currency and interest-rate risk with over-the-counter
Microfinance funds are just one asset class whose risk
mitigation has little to no ability to foist risk onto the
financial system yet are caught up in Dodd-Frank regulation.
Other such classes include real estate and private equity
funds, whose investments flow into economic necessities such as
infrastructure and capital improvements.
Another consequence of Dodd-Frank is that
the market has become more transparent. For years the
derivatives market has been characterized as opaque and
for good reason. Much of Dodd-Franks firepower targeted
this problem. The electronic trading rules have enabled better
visibility into the fair-market price of cleared transactions.
Companies also benefit from required bank disclosures on a
derivatives wholesale price. Although this information
was available prior to Dodd-Frank, it is now more widely
available and at a lower cost.
Despite the opened channels of information, when it comes to
cross-border trading, confusion abounds. Applying derivatives
rules in a global marketplace is an inherently complex
undertaking. Unlike stock market transactions, derivatives
create an ongoing relationship between parties that is not
severed once the transaction has been consummated. Dodd-Frank
left scant instructions on whether its requirements should
apply when banks and their counterparties are domiciled in
different countries and how guarantees might affect the
regulatory requirements. Regulators have thus been working
through the fine details. How have their decisions impacted
companies trying to navigate this global market?
Whereas the U.S. was first out of the gate with its
regulatory regime, the rest of the world particularly
Europe has been catching up quickly. Market participants
are now finding themselves subject to multiple rules that could
change depending on the bank with which a market participant
transacts. The result has been confusion about whose rules
apply, with larger market participants needing to develop
compliance infrastructures to address multiple regulatory
regimes. Small and midsize market participants take pains to
avoid crossing borders so as to avoid triggering rules with
which they are ill-equipped to comply. One compliance officer
recently told me that he has instructed his business teams to
avoid certain counterparties to avoid activating reporting
requirements for this very reason.
Other regulatory uncertainties remain. Among them are margin
requirements for uncleared swaps, important because many swaps
including the mortgage-indexed credit default swaps that
contributed to AIGs taxpayer-funded bailout are
not suitable for clearing. In recent years a G-20 working group
has labored to reach agreement on a set of harmonized global
rules. Now countries are preparing to graft these rules into
their national legal regimes. Corporate treasurers in the U.S.
have been vexed by statements from bank regulators including
the Federal Reserve, which believe Dodd-Frank rules require
margin on all market participants. Europe and other regimes
around the world are widely anticipated to exempt nonfinancial
end users, in line with the G-20 agreement. For the U.S. to
adopt these rules, the country will have to pass and adopt new
And so, even while the hopes of derivatives regulation are
beginning to be realized, policymakers must use the significant
experience they are gaining to increasingly bring the costs and
benefits of regulation into balance.
Luke Zubrod counsels companies on risk management and
derivatives regulations at global risk management advisory firm
Financial in Kennett Square, Pennsylvania.
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