Another key reform of the Dodd-Frank Act is to lower interconnectedness in the swaps markets by requiring standardized swaps between financial institutions to be brought to central clearing. This interconnectedness was, in part, the reason for the $180 billion bailout of AIG.
Clearing is another area where the Dodd-Frank Act and the E.C.’s proposal generally are consistent. In both cases, financial entities, such as swap dealers, hedge funds and insurance companies, will be required to use clearinghouses when entering into standardized swap transactions with other financial entities. Non-financial end-users that are using swaps to hedge or mitigate commercial risk, however, will be able to choose whether or not to bring their swaps to clearinghouses.
Capital and Margin
The Dodd-Frank Act includes both capital and margin requirements for swap dealers to lower risk to the economy. Capital requirements, usually computed quarterly, help protect the public by lowering the risk of a dealer’s failure. Margin requirements, usually paid daily, help protect dealers and their counterparties in volatile markets or if either of them defaults. Both are important tools to lower risk in the swaps markets.
The Dodd-Frank Act authorizes bank regulators, the CFTC and the SEC to set both capital and margin “to offset the greater risk to the swap dealer or major swap participant and the financial system arising from the use of swaps that are not cleared.”
In Europe, Basel III includes capital requirements for swap dealers. The E.C.’s swaps proposal includes margin requirements for uncleared swaps to lower the risk that a dealer’s failure could cascade through its counterparties.
The Dodd-Frank Act includes robust recordkeeping and reporting requirements for all swaps transactions. It is important that all swaps – both on-exchange and off – be reported to data repositories so that regulators can have a window into the risks posed in the system and can police the markets for fraud, manipulation and other abuses.
There is broad international consensus on the need for data reporting on swaps transactions. The E.C. proposal includes similar requirements to the Dodd-Frank Act’s requirements. Regulators in Japan, Hong Kong and China also have indicated the need for reporting of swaps data.
Business Conduct Standards
The Dodd-Frank Act explicitly authorizes regulators to write business conduct standards to lower risk and promote market integrity. The E.C. proposal addresses similar protections through what it calls “risk mitigation techniques.” This includes documentation, confirmation and portfolio reconciliation requirements, which are important features to lower risk. Further, the Dodd-Frank Act provides regulators with authority to write business conduct rules to protect against fraud, manipulation and other abuses.