The Dodd-Frank Wall Street Reform and Consumer Protection Act will transform the derivatives industry. In a Q&A, Sean Owens of Woodbine Associates offers the key elements included in Title VII of the Dodd-Frank Act.
Q. What are the major provisions included in the Dodd-Frank Act?
The Dodd-Frank Act is all about reducing leverage and risk in the financial system. Two of its more far reaching provisions are section 619 the “Volcker rule”, banning proprietary trading at banks, and Title VII, regulation of the over-the-counter derivative markets. Both will have a fairly significant and widespread effect on trading and risk in the markets. Section 619 reduces leverage by limiting ownership and participation in hedge funds and private equity and forces banks to limit trading activity to underwriting, market making, hedging and customer oriented activity.
Title VII creates a regulatory framework for OTC derivatives. It places market participants into categories that determine their obligations under the law, and requires that transactions be centrally cleared and traded on regulated platforms. It mandates real time trade reporting and disclosure. It also requires regulators to establish capital and margin thresholds for cleared and non-cleared trades. Regulators have a great deal of discretion developing rules and guidelines necessary to implement the law, which will largely determine how it impacts the markets.
Q. What is the significance of Participant Classification?
There is a much greater regulatory burden placed on market participants that fall into two defined categories: swap dealers and major swap participants (the term swap in the law is synonymous with all types of derivative transactions). These entities are subject to mandatory clearing and trading requirements, minimum capital and margin thresholds, as well as registration and business conduct guidelines. Market makers and participants with “substantial” derivative positions or exposure will fall into one of the categories.
Q. What are the requirements for Central Clearing?
Clearing is generally required for all transactions. Regulators will specify an initial list of trades that will be excluded on the basis of economics, risk, operational or other considerations. Certain trades are specifically exempt, such as those done by end users (who are not dealers or major participants) that hedge commercial risk. Certain institution may be exempt from clearing their transactions, such as credit unions and banks with under $10 B in assets. Regulators will set thresholds for exempting “small” trades with little or no consequential risk.
Q. What are the changes related to Trading?
All trades required to be cleared are also required to trade on a regulated platform, such as an exchange or a registered swap execution facility, provided a platform is able to trade the product. Ultimately, most standardized transactions will trade on an exchange or SEF. Exotic or highly customized trades, as well as those exempt from clearing, will continue to be executed directly between counterparties. One significant requirement that will boost transparency in the markets is the law’s mandate for real time trade reporting for all transactions regardless of the method of execution.
Q. What are the new Capital & Margin Requirements?
This is area that applies most directly to dealers and major participants. Both categories will be subject to minimum capital and margin thresholds for cleared and non-cleared trades. For those that are not cleared, the threshold will be set higher to reflect the additional risk of the trade.
Q. What are the changes related to Push-out Provision?
Banks will have to separate elements of their derivative trading to a separately capitalized entity outside of the bank. Interest rate, currency and investment-grade credit derivatives can remain in-house. Other areas such as equity, commodity and non-investment grade CDS will be moved outside the bank. The change is largely organizational, with customers facing a non-bank derivative affiliate for some trades.
Q. What are the key takeaways for how financial participants should prepare for the changes the Dodd-Frank Act will bring?
Many of the provisions in Title VII are designed to increase transparency and liquidity in the derivative markets, which should particularly benefit buy-side participants. Real-time reporting will enhance price discovery, especially among more complex products. They will also benefit from the greater liquidity offered on regulated platforms or SEFs for most standardized types of transactions. Participants can still execute customized trades directly with dealers, if they are not available to trade on an exchange/ SEF. In all likelihood, participants will use a combination of exchange/SEF and direct execution to get the best liquidity and necessary customization to hedge their risk.
Central clearing will reduce counterparty risk for most transactions and will become a standard business convention for derivative transactions. In most cases participants will be required to clear transactions, however, end users with hedging trades that are exempt will be in the enviable position that they have discretion over clearing and execution. They have the flexibility to evaluate the costs and benefits on a trade-by-trade basis. Non-cleared transactions will face a pricing concession, reflecting the additional capital and risk involved, which some might find favorable to the margin requirements at clearers.
Overall the law imposes a fairly substantial change to the derivative markets. The requirements for clearing, trading and reporting go a long way toward reducing risk while increasing transparency and liquidity, which will be welcomed by most buy side participants.
* This article is based on the brief "The Dodd-Frank Act – Implications for the OTC Derivatives Markets," produced by Woodbine Associates in September. The full brief is available for purchase.
