From the January 01, 2011 issue of Futures Magazine • Subscribe!

Dodd-Frank: Moving from theory to practice

Finally, regulators are being asked to create new market structures and rules on the cheap. Besides the initial task of writing all the new rules, they also have to be able to monitor, regulate and enforce them once they actually are enacted.

The CFTC has been acting swiftly and Chairman Gary Gensler says he has appropriate resources to complete the rule writing but will need considerable additional funding to implement the rules once they are in place (see "Gensler: Correcting the record," September 2010).

"Resources are a big issue for the regulators. While they have hired some additional staff, it is a task that is much bigger than anything they have had to deal with in the past," Bruckner says. "Once the rules are in place, they then have to implement and enforce them, so the resource issue will continue to be a challenge for them unless they get a lot more funding from Congress in order to meet those resource needs."


Those additional funds are going to be a difficult sell. "We’re in a major crisis in terms of the federal deficit and we need to see cuts and fiscal responsibility in general, and that is going to affect the CFTC and SEC as well," Brown-Hruska says. "There’s probably going to be some cutback in resources. That just makes it more and more difficult for the CFTC to get its work done."

The cost dilemma is mostly outside the CFTC’s hands as a new Congress consisting of many who opposed Dodd-Frank prepares to take power (see "Major turnover"). "[Republicans] may not be able to reverse the legislation, but they will be looking at other ways of modifying or impacting the outcome of that legislation. Not providing additional funding may be one way of doing that," Bruckner says.


That could be as effective as overturning it. "If the House won’t approve an expanded budget for the CFTC and SEC, it is almost impossible for them to implement the provision. It is a very indirect way of influencing," says Gary DeWaal, general counsel at Newedge. "It would be inappropriate, though, because the CFTC is an independent government agency."

These are challenges Congress will be facing in the upcoming session and ones whose impact may not be evident for some time. One thing working in the regulators’ favor that multiple experts mentioned is that many of the new Congressional representatives have little or no political experience, which may dampen the effects they are able to have on the budget and thus reform.

Finally, end-users, dealers and traders all are anxiously awaiting the finish of rule writing to see the new costs and capital requirements that now will be required.

"The problem is going to be the cost. This is going to be an incredibly costly proposition for firms to implement," DeWaal says. "The proposals out there are all about increasing cost and decreasing revenues. The economics of this business are really going to be challenged. If at the end of the day you have great theoretical rules but no participants, then you have defeated the purpose."

Those added costs to market participants are shaping up to take a variety of forms, including increased compliance costs, additional technology requirements and connectivity requirements. Finally, there are added requirements for business conduct as well as back office standards.

However, many have argued that by opening OTC markets to a broader group of participants, end user costs could go down. While compliance costs will go up, much of the complaining is coming from dealer participants who will face greater competition and reduced margins.

Included in the legislation are a number of provisions that drastically will change the marketplaces, including areas such as swaps and position limits. New requirements for swaps trading and clearing probably have the most far-reaching potential.

"This area is among the more controversial. On the one hand, they want to be careful not to discourage the use of exchanges to transact business that is a bit more customized," Waldman says. "On the other, they want to make changes to market structure to encourage more pre- and post-trade transparency. It is a delicate balance they are trying to strike."

What the new swap execution facilities (SEFs) will even look like has drawn considerable attention. "The nature of an SEF is going to be very important. There is a lot of sentiment out there that it should be more than just an exchange," DeWaal says.

Not only is the structure of the SEFs in question, but exactly what must be openly traded and cleared has left dealers wondering. "They have to be very sensible about what is eligible for clearing. They have to realize a significant number of these swaps are customized and not eligible for clearing," Brown-Hruska says.

The Dodd-Frank Act is a sweeping and far-reaching overhaul of the financial markets that calls for many changes in the coming months and years. Yet, there are nearly as many opinions as there are experts as to the actual benefits that Dodd-Frank will bring to the markets.

"It will certainly be a great help to have a lot of the bilateral products traded through a clearinghouse and executed on an exchange. Transparency is a good thing," DeWaal says. "The CFTC and SEC have to keep in mind the requirement of open access. If at the end of the day, the only people engaged in swap clearing are the current dealers, then this will be a failure."

This is a major issue for non-bank FCMs who feel the initial structure for CME Group’s interest rate swap clearing solution favored the major investment banks that have dominated the space — and were major contributors to the financial crisis — for years.

Brown-Hruska is less optimistic on changes. "[Reform] will be detrimental to the quality of the derivatives market. I am a proponent of exchange trading and the SEF is a great idea. On balance, though, they overshot the mark and are doing too much in terms of trying to decrease systemic risk and raise transparency."

At this point, most rules have been proposed and are in their comment period. As such, experts and regulators are urging dealers and traders to share their views with the regulators through comment letters so that rules can be adjusted and made to better fit the markets.

Moving forward, answers and basic structures are beginning to take shape, but there are still a lot of questions and definitions that needs to be added to reform. Brown-Hruska remembers her time as a commissioner and recalls burning the midnight oil just to stay up on her own reading at the time, and says she does not envy the job the current commissioners have of creating rules to reshape an entire market.

Considering the speed at which new rules are being written, it is apparent the current commissioners are burning their share of oil. It also might help explain the climb in coffee prices.

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