S. Miller Analyst in Financial Economics
Kathleen Ann Ruane Legislative Attorney
financial crisis implicated the over-the-counter (OTC) derivatives market as a
major source of systemic risk. A number of firms used derivatives to
construct highly leveraged speculative positions, which generated enormous
losses that threatened to bankrupt not only the firms themselves but also
their creditors and trading partners. Hundreds of billions of dollars in government
credit were needed to prevent such losses from cascading throughout the system. AIG
was the best-known example, but by no means the only one.
Equally troublesome was the fact that the OTC market depended on the financial
stability of a dozen or so major dealers. Failure of a dealer would have
resulted in the nullification of trillions of dollars worth of contracts
and would have exposed derivatives counterparties to sudden risk and loss,
exacerbating the cycle of deleveraging and withholding of credit that
characterized the crisis. During the crisis, all the major dealers came
under stress, and even though derivatives dealing was not generally the
direct source of financial weakness, a collapse of the $600 trillion OTC
derivatives market was imminent absent federal intervention. The first group of
Troubled Asset Relief Program (TARP) recipients included nearly all the
large derivatives dealers.
The Dodd-Frank Act (P.L. 111-203) sought to remake the OTC market in the image
of the regulated futures exchanges. Crucial reforms include a requirement
that swap contracts be cleared through a central counterparty regulated by
one or more federal agencies. Clearinghouses require traders to put down
cash (called initial margin) at the time they open a contract to cover
potential losses, and require subsequent deposits (called maintenance
margin) to cover actual losses to the position. The intended effect of margin
requirements is to eliminate the possibility that any firm can build up an
uncapitalized exposure so large that default would have systemic consequences (again,
the AIG situation). The size of a cleared position is limited by the firm’s
ability to post capital to cover its losses. That capital protects its
trading partners and the system as a whole.
Swap dealers and major swap participants—firms with substantial derivatives
positions—will be subject to margin and capital requirements above and
beyond what the clearinghouses mandate. Swaps that are cleared will also
be subject to trading on an exchange, or an exchange-like “swap execution
facility,” regulated by either the Commodity Futures Trading Commission (CFTC)
or the Securities and Exchange Commission (SEC), in the case of
security-based swaps. All trades will be reported to data repositories, so
that regulators will have complete information about all derivatives
positions. Data on swap prices and trading volumes will be made public.
The Dodd-Frank Act provides exceptions to the clearing and trading requirements
for commercial end-users, or firms that use derivatives to hedge the risks
of their nonfinancial business operations. Regulators may also provide
exemptions for smaller financial institutions. Even trades that are exempt
from the clearing and exchange-trading requirements, however, will have to be reported
to data repositories or directly to regulators.
This report describes some of the requirements placed on the derivatives market
by the Dodd- Frank Act.
Date of Report: November 6, 2012
Number of Pages: 24 Order Number: R41398 Price: $29.95
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