House Debates Derivatives

Dodd/Frank is not working when it comes to SWAPs.

That was the sharp and partisan message from Michigan Republican Congressman Bill Huizenga, who chairs the powerful Capital Markets, Securities, and Investments sub-committee of the House Financial Services Committee.

“Title 7 of the Dodd/Frank Act restructured the derivatives market to more closely resemble the market for listed securities and listed futures trading. The reforms included mandatory clearing for certain swaps and increased data disclosure meant to promote greater market liquidity and transparency. However, despite these well-intentioned reforms, Title 7 of the Dodd/Frank Act has resulted in a fragmented regulatory scheme of the derivatives market.

CFTC“Perhaps, the largest criticism of Title 7 is one outlined in the recent treasury report on capital markets. It’s the lack of clarity provided to the SEC and the CFTC on how they should propose and issue their rules. Title 7 bifurcated the regulatory jurisdiction over swaps. The CFTC oversees interest rate swaps, index, credit default swaps, foreign exchange swaps, certain types of equity swaps and other commodity swaps. The SEC oversees the security-based swaps market. While the CFTC has finalized their SWAPs rules, the SEC has yet to finalize their regulations for registration and regulation of security-based swap dealers, trade reporting, mandatory central clearing of standardized security based swaps and trade execution requirements. This incomplete and disjointed regulatory structure has resulted in discrepancies between the SEC and CFTC’s interpretation of Title 7 making it difficult for market participants to comply with these inconsistent regulations.”

Huizenga made the comments at a hearing his sub-committee held entitled: “Legislative Proposals for Derivatives.”

Title 7

Title 7 “creates a framework for the regulation of swap markets. Title VII grants the Commodity Futures Trading Commission (the “CFTC”) regulatory authority over swaps, except for security-based swaps, which are regulated by the Securities and Exchange Commission (the “SEC”). The CFTC and the SEC must also coordinate future swap-related rule making to ensure regulatory consistency across both organizations. Subject to limited exceptions, Title VII also requires certain swaps to be cleared by a clearinghouse and executed or an electronic execution facility and imposes registration requires on dealers and major participants, which are entities that engage in very large swap transactions that can significantly impact the health of the U.S. financial system,” according to text from the bill.


While the hearing was about derivatives, it was clear from both Republicans and Democrats that SWAPs were the derivative which both wanted to fight over.

A SWAP is “is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price,”according to the website Investopedia.

The US Treasury Department report noted that SWAPs account for 95% of all over the counter derivatives.

Any security traded over the counter has market makers and is done without a formal exchange.

While Republicans believe that- like with other aspects of Dodd/Frank- that Dodd/Frank imposed a burdensome and confusing regulatory scheme on the swap market, Democrats argue that- also as with the bill in general- that Dodd/Frank was a proper reaction to market excess.

Democrat Carolyn Maloney is from New York and she is the ranking member on the sub-committee.

She noted: “Derivatives played a central role in the financial crisis. They turned the losses in sub-prime mortgages in the US into a global financial crisis. (It) allowed financial institutions to take on excessive risk and created dangerous connections between financial institutions that spread and amplified risk across the entire financial system. It was derivatives that brought down AIG, a ninety year old company that was one of the largest financial institutions in the world. Tax-payers were forced to pay $180 billion to bail out and restructure AIG, which failed because of risky and unregulated gambling on credit default swaps.”

Credit Default SWAPs and the Financial Crisis

It is credit default swaps and their role in the 2008 financial crisis which looms as a large shadow over any debate on swap regulation.

Credit default swaps were originally created for lenders to hedge against widespread defaults in certain classes of loans. So, if a bank took on too many high-risk car loans, they might create a credit default swap to move some of that risk.

As Congresswoman Maloney noted, during real estate boom, this market was unregulated and operated akin to the wild west, with no rules.

Banks- rather than hedging with credit default swaps- began speculating on them.

Since much of the mortgages became toxic- or ones which the borrower could not pay back- banks lost billions and even trillions with these bets.

The Road Ahead

The legislative battle over swaps is only beginning. As Congressman Huizenga noted, many issues are still left to be resolved. Proposals heard at this hearing included to: “except swap transactions between affiliated entities from the swaps rules, excluding hedging swaps from the swap dealer de minimis threshold, and provide clarity regarding the de minimis exception.”

The de minimis threshold is the most any person or entity can trade in swaps before they are required to register as a swap dealer. Currently, the threshold is $8 billion and is scheduled to be reduced to $3 billion in December 2019.