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 Capitol’s 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. Frank’s committee was actively sizing up its policy response. One member ventured to pose the question that was on everyone’s mind: “What is a derivative? I wouldn’t know one if it hit me in the face.”
With many of the subsequent legislative changes in effect, the market is now much more transparent compared with before the 2008–’09 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 it’s been a few years since the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, practical experience with the law’s central features has allowed us to assess its shortcomings and present ideas for fine-tuning.
First off, the market is getting cheaper for some. Dodd-Frank’s clearing mandate was intended to reduce systemic risk by requiring derivatives to be fully margined in a manner that eliminated the interconnectedness that former Treasury secretary 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 by Dodd-Frank.
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-Frank’s 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-Frank’s broad definition of “financial entity,” fall under the law’s funding requirements. Microfinance funds collect money and deploy it to institutions in impoverished countries that make microloans to the world’s 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 derivatives.
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-Frank’s 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 derivative’s 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 AIG’s 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 legislation.
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 Chatham Financial in Kennett Square, Pennsylvania.
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