Financial reform becomes law: The devil's in the details

There has been much cheerleading and jeering over the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama July 21, coming from those that have been supporting/opposing the effort all along. However, those whose job it is to provide a more measured analysis of the law are less certain of its ramifications. A lot of details have been passed over in legislation and are to be fleshed out in the regulatory rulemaking process. In fact, to implement the Act, the CFTC released a list of rulemaking for over the counter derivatives that included 30 different categories.

While this would be the case to a certain extent with any such large legislative effort, it appears doubly so in this instance. “I don’t think there is any question that just about every time they could not get unanimity on a particular term they said ‘OK we are going to fob it off.’ Yes there is going to be a lot of rulemaking,” says former Commodity Futures Trading Commission (CFTC) Chairman Philip McBride Johnson, of counsel for Skadden Arps.

“There are two levels of this. First there is the normal rulemaking that follows all legislation but in this case in spades. There are also certain provisions where the CFTC and SEC [Securities and Exchange Commission] are instructed to come up with parallel stuff — and we know how successful they have been [in working together],” Johnson jokes.

While the bill touches on almost every facet of the financial industry, one area that has left traders particularly concerned is its impact on over-the-counter (OTC) derivatives.

“Standardized derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties. This will greatly improve transparency and lower risk in the marketplace,” Gary Gensler, Chairman of the CFTC, said in a statement following the passage of the bill.

The act includes changes in OTC derivatives trading, and gives the regulatory agencies the authority to create new rules for swaps. “This is going to be a net positive for the exchanges regardless of the final details in the rules,” says Kevin McPartland, senior analyst at Tabb Group. “We don’t see a lot of the current swap business moving to an exchange-traded model, but with most of the clearinghouses at least partially owned by the exchanges, there’s going to be some huge benefit because the OTC clearing business will only grow over the next couple of years.”

Johnson agrees. “The exchanges are going to see a boatload of business from the intra-swap dealers. It is very good for the markets and very good for the exchanges.”

And once some OTC products are moved into the clearinghouse, it will attract more business to benefit from offsets. “It would be better to have these things symmetrical,” Johnson adds.

Paul Zubulake, senior analyst at Aite Group, sees OTC business only cleared on exchanges with executions happening on alternate sites. “It’s going to happen on the alternative swap facilities,” he says.

McPartland says the new rules will mean more transparency for traders. “We’ll see much more readily accessible electronic data for swaps trading. We’ve already seen new swap execution facilities announced and the existing platforms will only grow as trading will need to go through those platforms based on the product, so it should make the execution process a lot more transparent regardless of the [trading] venue,” he says.

The passage of the legislation is only the first step in the process, as the bill gives the CFTC and SEC authority to make the rules, which is a process that analysts say could take up to a year.

“The swap execution facility definition in the bill is very vague. What’s required from a reporting perspective and what products will be required for clearing [still need to be decided]. [The CFTC and SEC need] to handle the hundreds of products and the backlog of products that need to be examined to see if they need to be centrally cleared,” McPartland says.

Zubulake says gaps in regulation between the SEC and CFTC could create uncertainty with new products. “There’s still this divide about who gets what. The fragmented regulatory system is still inefficient,” he says.

And Johnson adds that the agencies’ track record on cooperation is not good. “There is an expectation that the two agencies will cooperate with each other far more than history would suggest.”

While there is a hedge exemption for commercial players in the new law, they will still be required to notify the CFTC as to how they plan to meet their obligations. It is unclear what the CFTC will be looking for or if they will hold back the exemption if they are weary of that commercial’s ability to meet their obligation.

McPartland says the rule-writing process could take six to 12 months with another six to 12 months of implementation time for everyone to comply with new rules. Ultimately, he predicts that the new regulatory order won’t be fully in place until 2012.

Jay Gould, head of the investment funds practice at Pillsbury, says, “It will be two to three years before everything is finally implemented. Even then, it will be tweaked and continue to be an ongoing source of lobbying efforts. The real details of the bill will be worked out in the administrative process.”

Bill Isaac, former FDIC chairman and a major critic of the TARP bailout, stated in a Forbes editorial that “The legislation does not address the major causes of the crisis, would not have prevented it from happening, and most certainly will not prevent the next crisis.”

Isaac’s biggest criticisms is that the Systematic Risk Council developed to identify systemic risk will be run by the Treasury, Federal Reserve and SEC who he faults with leading us into the crisis in the first place. Also that the five largest banking institutions will continue to be too big to fail.

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