Financial Regulation and Derivatives: The Intersection of Theory and Practice

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Financial Regulation and Derivatives: The Intersection of Theory and Practice

Lexology reports the following summary of the impact of Dodd-Frank on derivatives:

Overhaul of Derivatives Trading -- The derivatives issue was one of the more contentious issues in conference, and the final Act overhauls the regulation of OTC derivatives and major participants involved in such activities.

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Most derivatives trading would be required to be executed on a public exchange

Bank Derivative Trading ñ While the Senate bill would have banned banks from trading in derivatives and would have required any large commercial banks that has access to the FRBís discount window to divest their derivatives trading business to a separate company, a compromise was reached in conference.

Permissible Bank Derivatives Trading -- Banks that are swap dealers would be allowed to trade interest rate and FX derivatives, gold and silver contracts, and cleared investment grade credit derivatives (as well as hedge their own risks) within the deposit-taking bank subsidiary.

Removal of Other Trading to BHC Subsidiaries -- All other OTC derivatives activity would need to be done in a separately-capitalized, non-deposit taking subsidiary of the holding company. This rule becomes effective two years after the date of enactment, and regulators can grant up to an additional three years in order to comply with the transition. Required regulatory rulemaking will be critical in defining how the push-out will be implemented, with much at stake for U.S. banks that conduct their derivatives business inside their bank.

Code of Conduct -- Rather than create a fiduciary duty for swap sales to federal and state agencies, municipalities, pension and retirement plans, and endowments, the Act establishes a code of conduct for dealers and major swap participants when selling swaps to such counterparties.

Greater Regulatory Oversight and Mandatory Clearing Requirements -- Swap dealers and major swap participants will be subjected to heavier regulatory oversight, including mandatory clearing requirements, exchange trading, increased capital and margin requirements, and business conduct practices and standards. Contracts that are deemed clearable by the CFTC (working with the clearinghouses) will be required to be cleared, and those contracts that are cleared must trade on an exchange, assuming one exists that is willing to list the product. Any other contracts may trade over-the- counter and off-exchange on a customized, bilateral basis.

End-User Protection -- Corporate end users of derivatives receive exemptions from the clearing, exchange trading and margin requirements. This protection for end-users was recently emphasized in a letter by Senator Dodd.

Like other sections of the Act, this title requires significant regulatory rulemaking in the coming months to shape the precise contours, and cost, of its requirements.
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