Analysis of the Dodd–Frank Act (Paper written for my Financial Derivatives Class

Congress responded to the economic crisis by enacting the most comprehensive financial reform legislation since the Great Depression. Congress members Barney Frank and Chris Dodd proposed the Act. President Barack Obama signed the bill into law on July 21, 2010. The Dodd-Frank Act introduces significant changes in how over the counter derivatives are regulated. Title VII, the Wall Street Transparency and Accountability Act of 2010 refers to over the counter (OTC) swaps markets, credit default swaps and credit derivatives regulation. The purpose of the legislation is to limit extensive risk in the financial system and to solve the problems of "too big to fail." It also creates consumer protections. According to the Act, a derivative transaction is “any transaction that is a contract, agreement, swap, warrant, note, or option that is based, in whole or in part, on the value of, any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities, securities, currencies, interest or other rates, indices, or other assets.”(Section 610 of the Dodd–Frank Wall Street Reform and Consumer Protection Act, Securities and Exchange Commission). Title VII of the Dodd- Frank Act seeks to avoid systemic risk and increase transparency in the OTC derivatives market. It aims to decrease systemic risk by demanding central clearing of unregulated derivatives and by requiring more capital and liquid collateral to back derivative trades. This allows regulators to monitor and respond to excessive risk taking. Central clearing systems would give regulators and clearing houses the ability to decide which contracts should be cleared. In section 610, the Act discusses lending limits applicable to credit exposure on derivative transactions, repurchase agreements, reverse repurchase agreements, and securities lending and borrowing transactions. It will create stronger lending limits by making derivatives part of the bank’s lending limits. Non-financial companies will not be allowed t have counter party credit exposures. Threats to the financial systems in large volumes of activities in derivatives purchased or sold is subject to capital requirements. A new rule known as the Volcker rule has been added to the Dodd–Frank Act in 2012. This new legislation separates investment banking, private equity and proprietary trading sections of financial institutions from their consumer lending support. Insured depository institutions are not allowed to engage in proprietary trading. Proprietary trading occurs when occurs when a company trades stocks, bonds, currencies, commodities, or their derivatives with the company's own money, instead of its profits from services rendered, to generate income for the company itself. According to section 611, which refers to the consistent treatment of derivative transactions in lending limits, an insured state bank may engage in a derivative transaction in the state in which the bank is chartered. The transaction will be subjected to the credit exposure of a member bank from a securities borrowing and lending transactions. Hedging and other traditional bank activities are permissible.In 2011 the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) conducted a study, which is recorded in section 719.b of the Dodd-Frank Act, on the "feasibility of requiring the derivatives market to adopt standardized computer-readable algorithmic descriptions which may be used to describe complex and standardized financial derivatives." Based on feedback from the public and an investigation and analysis from the staff, the joint study concludes that current technology is capable of representing derivatives using a common set of computer-readable descriptions. These descriptions can be used for calculations of net exposures and to serve as part or all of a binding legal contract. These descriptions will also be used by commercial use and traders, clearing houses, trade repositories and other regulators. The Dodd-Frank Act regulates both the swap transactions and the parties that enter into swap transactions. The Act has deemed it “ unlawful for any person to receive money, securities, or property (or to extend any credit in lieu of money, securities, or property) from, for, or on behalf of a swaps customer to margin, guarantee, or secure a swap cleared by or through a derivative clearing organization (including money, securities, or property accruing to the customer as the result of such a swap), unless the person shall have registered under this Act with the commission as a futures commission merchant, and the registration shall not have expired nor been suspended nor revoked” (section 724 of the Dodd–Frank Wall Street Reform and Consumer Protection Act, Securities and Exchange Commission). Financial institutions that engage in a substantial amount of derivative activity will be heavily affected by this rule, more so than companies that only use OTC derivatives to hedge commercial risk. The CFTC defines a swap as almost every OTC common derivative in the market. This definition includes interest-rate swaps, forwards, and options commodity swaps forwards and options and many types of foreign currency forwards options and swaps. Credit default swaps will be regulated by both the CFTC and the SEC. The Dodd-Frank does not regulate every swap transaction. Interest-rate swaps are transactions that fall under the rules and regulation of the Dodd-Frank Act. Other types such as forward transactions however, may be harder to determine if they are swaps or a type of derivative outside the umbrella of the Dodd-Frank. In keeping with the consistent treatment of derivative transactions, there will be limits on swaps or security based swap activities to hedging and other similar risk avoiding activities. This will be equal to acting as a swaps entity for swaps or security based swaps involving rates or reference assets. Credit risk of asset-backed securities is considered a bank permissible activity unless the swaps or securities are cleared by a derivative clearing organization. Most swaps were privately negotiated transactions. The Dodd-Frank Act imposed a mandatory clearing requirement that these types of transactions are to be cleared in clearing houses. A clearing house is a financial institution that provides clearing and settlement services for derivative transactions. Derivative transactions such as ones executed on futures or securities exchanges as well as the OTC. The clearing house acts as a middle man, receiving and distributing payments after forming a contract between the original parties. Its purpose is to decrease the risk of any clearing firm or exchange that is not compliant with rules in its trade settlement. It reduces the settlement risks by demanding margin deposits as collateral, providing independent valuation of trades and collateral, monitoring the credit worthiness of the clearing firms, and by providing a guarantee fund that covers losses that exceed a defaulting clearing firm's collateral deposit. Clearing houses are responsible for settling trading accounts, clearing trades, and regulating delivery and reporting trading data. Swaps or other derivatives that have not been accepted are to be reported to the CFTC. Reduction of systemic risk to financial structure will occur only if clearing houses refrain from accepting the counter party credit risk of another clearing house. Section 731 of the Dodd- Frank act refers to registration and regulation of swap dealers and major swap participants. It states that it will be illegal for any person to act as a swap dealer unless the person is registered as a swap dealer with the commission. It will also be unlawful for any person to act as a major swap participant unless the person is registered as a major swap participant with the Commission. Any swaps or other derivatives that have not been accepted must be reported to the CFTC to reduce systemic risk. Reduction of systemic risk to financial structure will occur only if clearing houses refrain from accepting the counter party credit risk of another clearing house. Section 731 requires the adoption of capital requirements for swap dealers that are not subject to the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration or the Federal Housing Finance Agency regulation. Creating capital requirements ensures the safety of the swap dealers and protects the funds of the consumer. The CFTC and the SEC has consulted these regulators while developing these requirements. The suggested capital requirements also affects swap dealers that may be registered as futures brokers. Margin requirements provided by the capital requirements are designed for risk management purposes in order to protect the financial integrity of transactions and not margin accounts. There are always advantages and disadvantages that come with any major decision. However it seems that when the US. Government steps in to create, control or correct certain reforms certain weakness or loopholes become exposed. The purpose of the Dodd–Frank Wall Street Reform and Consumer Protection Act was to eliminate the risky and abusive practices for OTC derivatives, asset backed securities, hedge funds and mortgage brokers that were unregulated. It implemented new rules for clarity and accountability for credit rating agencies that are tough, in order to protect companies and investors. It enforced need for reporting all derivative transactions. It seeks to strengthen oversight and empower regulators to aggressively pursue financial fraud, conflicts of interest and manipulation discovered in the system that may benefit special interests groups at the expense of Americans and their businesses. The financial industry can make use of the new computer readable descriptions which will give both traders and regulators easier access to the transactions that are happening expose where there might be chances of higher risk taking. Bail outs are not an option under the Dodd-Frank act. Institutions, after having being registered under the Dodd-Frank Act, are going to be held accountable for its actions. Now that the exchange markets must be registered, they have to follow rules enforced by the CFTC. Failure to follow these rules may result in these companies having their licenses revoked or they can simply be fined. Clearing houses as mentioned before will have to report all transactions within a certain time period. The clearing house will also have to report any swap that they did not clear, to the CFTC. The CFTC will then review the un-cleared swaps and serve final judgment. The benefits of more derivative regulation include better risk management. Companies and banks can hedge against the sudden rise or fall in the value of currencies or commodities. More information will be available, thus leading the way to better risk reduction. Another benefit is prevention of a collapse of the economy. More transparency allows for identification of systemic risk build ups. This helps in averting an economy crisis. With more regulation comes more responsibility. This includes more and better tracking of the derivatives market where in the investors can see an assortment of trading in real time, higher levels of clarity concerning the complexities of the derivatives market and regulation facilities for buyers and sellers of such instruments to trade in more regulated exchanges. Although the Dodd-Frank contains rules that go further than regulating banks in order to prevent another financial crisis, Mitt Romney, a presidential candidate in 2012 wanted to repeal the Act. He claimed that it designated a number of banks as too big to fail and rendered them effectively guaranteed by the federal government. In my opinion however, the Dodd-Frank didn’t create “too big to fail” institutions. The banks themselves did because it made them money. Banks are banks, they will continue to grow larger and have actually become more concentrated since the recession. No President was going to let trillion dollar financial institutions go down. The economy would be in shambles. However, the economy is still not at its greatest. The negative aspects to more derivative regulation unfortunately include the very purpose of the bill, the reduction of risk. Most investors are attracted to derivative transactions because of its well-known characteristic of being high risk. To them the risk implies greater reward, higher profit potential. The introduction of more regulation, to the investors means undermining the very concept of derivatives, which are disguised bets. Investors are likening derivative regulation to playing poker while everyone can see your hand. More regulation might mean the shrinking of the derivatives market. Transparency within the market can lead to more liquidity, making the market more competitive. High levels of competition will result in dealers of derivatives experiencing low profits yields. Another undesirable effect is that the amount speculation within the market has increased. Speculators do not mind risk. They prefer to bet on a price of an asset, on whether it will go up or down. The joint transactions of hedgers and speculators create the advantage of price discovery. By including all data and expectations concerning future costs, derivatives markets generate prices that usually function as indicators for transactions within the underlying money market. Senator Bill Nelson of Florida is apprehensive about increased speculation. He said that “Despite a clear directive from Congress to rein in excessive speculation, regulators still are listening too much to Wall Street and not acting quickly enough to protect American consumers.” Unfortunately people will always find a way to do what they want, to bend the rules. The Dodd-Frank Act certainly cannot combat human nature. According to the Dodd-Frank Act, investors must retain large amounts of money to cover any derivative losses. Traders are now repackaging swaps into futures. Since futures are less regulated, some investors are taking larger positions while reserving smaller amounts of money. Some investors are exploiting the commodities market by way of buying and selling swaps without having to report it. When the rules in the Dodd-Frank Act became effective, exchange markets that operate a futures marketplaces, introduced commodities that enabled swaps traders to become futures traders. In a survey conducted by the Swiss Bank of UBS, it is expected that investors may replace 20-25% of their swaps with futures. The trend of turning swaps contracts futures undermines the purpose of the rules of the Dodd-Frank, rendering them unreliable. Congress felt that the lack of regulation of derivatives added to the 2008 fall of the financial industry. Warren Buffet was quoted in 2003 as saying that “Derivatives are financial weapons of mass destruction”. Prior to the economic downfall, a lot of large financial institutions experienced a lot of unrealized losses from highly leveraged speculative positions in OTC markets. This lead the government to then hand down a series of stimulus packages, and bail-out ‘Too big to fail’ companies such as insurance company American International Group Inc. (AIG) The company nearly collapsed under the weight of losses on credit derivatives Since the trades were not regulated, the exposures of investors throughout the entire system could not be quantified. Coincidentally, there are commonalities between the Great Depression of 1929 and 2008's recession. The Dodd-Frank Act was formed to prevent repeating history. I fear however that it was just a hasty reaction and the quest to regulate everything will not work fully. When a crisis affects an economy, investors end up being more wounded than the rest of society. With that fact, more regulation of the derivatives market does bring added benefits to the investors, but the question is does the good outweigh the bad. I do not think so. For the past several decades, Wall Street told the government that if it cannot do things the way it always has, and if the government changes the rules to mandate greater transparency and consumer protection, they will not be able to make money and it would stunt the industry. That is a bit extreme, but I do believe there should be some regulation, just not one of a constricting nature. The reason behind regulating derivatives is that they stimulate systemic risks within the financial system. However some derivatives, like interest rate swaps, have not been known to cause systemic risk because their values change slowly and seasoned investors understand its characteristics. Even though there has been no indication that interest rate swaps played a part in the economic downturn of 2008, Congress has suggested more regulative rules for physical commodities and stock. Thoughtlessly grouping commodity regulation with financial derivatives applies the wrong tool within the wrong application. The result would be ineffective regulation Congress should consider searching for proof of the actual derivatives that caused the financial crisis. They should then create specific rules to tackle specific problems instead of trying to regulate everything, apply the new regulation to the derivative products, institutions, or market systems that caused economic harm. These rules should drive them investors rather than discourage them into risk-mitigating uses of financial derivatives. The Dodd-Frank Act is a reform that is a little more than a frantic resolution to do anything to regulate financial derivatives. Congress must figure out a way to show why particular derivatives need to be more closely regulated and that the rules they propose will actually reduce risks in financial markets. Is the Dodd-Frank Act a good thing? It could do one of two things, perfect the system or it could drive the whole derivative system to fall apart. I don't think the bill should be repealed, but it should definitely be reworked. It seems that the Act will be left to serve its purpose. Whether the Act will, and the degree to which the reform will reduce systemic risk is a mystery. We will have to wait and see.