The Dodd-Frank Wall Street Reform and
Consumer Protection Act: Title VII,
Derivatives
Mark Jickling
Specialist in Financial Economics
Kathleen Ann Ruane
Legislative Attorney
August 30, 2010
Congressional Research Service
7-5700
www.crs.gov
R41398
CRS Report for Congress
P
repared for Members and Committees of Congress
The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
Summary
The financial crisis implicated the unregulated 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 new law 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 new requirements placed on the derivatives market by the
Dodd-Frank Act. It will not be updated.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
Contents
Introduction ................................................................................................................................ 1
Background .......................................................................................................................... 1
Pre-Dodd-Frank Act Market Structure and Regulation........................................................... 2
Market Structure for Cleared and Exchange-Traded Derivatives ...................................... 3
Market Structure for OTC Derivatives............................................................................. 4
The Dodd-Frank Act’s Clearing and Reporting Requirements...................................................... 5
Clearing Requirement ........................................................................................................... 5
The Exchange-Trading Requirement ..................................................................................... 7
End-User Exemption............................................................................................................. 8
Prevention of Evasion ......................................................................................................... 10
Reporting of Swaps and Security-Based Swaps ................................................................... 10
Major Swap Participant Definition ...................................................................................... 11
Section 716—Prohibition on Federal Assistance to Swaps Entities ............................................ 13
Enhanced CFTC Authority over Commodities Markets ............................................................. 15
Figures
Figure 1. Pre-Dodd-Frank Act Derivatives Market Structures: Exchange and Over-the-
Counter (OTC)......................................................................................................................... 4
Figure 2. OTC Derivatives Contracts by Type of Counterparty .................................................. 12
Contacts
Author Contact Information ...................................................................................................... 15
Acknowledgments .................................................................................................................... 15
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The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
Introduction
Prior to the financial crisis that began in 2007, over-the-counter (OTC) derivatives were generally
regarded as a beneficial financial innovation that distributed financial risk more efficiently and
made the financial system more stable, resilient, and resistant to shocks. The crisis essentially
reversed this view. The Dodd-Frank Act (P.L. 111-203) attempts to address the aspect of the OTC
market that appeared most troublesome in the crisis: the market permitted enormous exposure to
risk to grow out of the sight of regulators and other traders. Derivatives exposures that could not
be readily quantified exacerbated panic and uncertainty about the true financial condition of other
market participants, contributing to the freezing of credit markets. Under Dodd-Frank, risk
exposures of major financial institutions must be backed by capital, minimizing the shock to the
financial system should such a firm fail. In addition, regulators will have information about the
size and distribution of possible losses during periods of market volatility.
Background
Derivative contracts are an array of financial instruments with one feature in common: their value
is linked to changes in some underlying variable, such as the price of a physical commodity, a
stock index, or an interest rate. Derivatives contracts—futures contracts, options, and swaps1—
gain or lose value as the underlying rates or prices change, even though the holder may not
actually own the underlying asset.
Thousands of firms use derivatives to manage risk. For example, a firm can protect itself against
increases in the price of a commodity that it uses in production by entering into a derivative
contract that will gain value if the price of the commodity rises. A notable instance of this type of
hedging strategy was Southwest Airlines’ derivatives position that allowed it to buy jet fuel at a
low fixed price in 2008 when energy prices reached record highs. When used to hedge risk,
derivatives can protect businesses (and sometimes their customers as well) from unfavorable
price shocks.
Others use derivatives to seek profits by betting on which way prices will move. Such speculators
provide liquidity to the market—they assume the risks that hedgers wish to avoid. The combined
trading activity of hedgers and speculators provides another public benefit: price discovery. By
incorporating all known information and expectations about future prices, derivatives markets
generate prices that often serve as a reference point for transactions in the underlying cash
markets.
Although derivatives trading had its origins in agriculture, today most derivatives are linked to
financial variables, such as interest rates, foreign exchange, stock prices and indices, and the
creditworthiness of issuers of bonds. The market is measured in the hundreds of trillions of
dollars, and billions of contracts are traded annually.
Derivatives have also played a part in the development of complex financial instruments, such as
bonds backed by pools of other assets. They can be used to create “synthetic” securities—
1 For a description of the mechanics of these contracts, see CRS Report R40646, Derivatives Regulation in the 111th
Congress, by Mark Jickling and Rena S. Miller.
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contracts structured to replicate the returns on individual securities or portfolios of stocks, bonds,
or other derivatives. Although the basic concepts of derivative finance are neither new nor
particularly difficult, much of the most sophisticated financial engineering of the past few
decades has involved the construction of increasingly complex mathematical models of how
markets move and how different financial variables interact. Derivatives trading is often a
primary path through which such research reaches the marketplace.
Since 2000, growth in derivatives markets has been explosive (although the financial crisis has
caused some retrenchment since 2008). Between 2000 and the end of 2008, the volume of
derivatives contracts traded on exchanges,2 such as futures exchanges, and the notional value of
total contracts traded in the over-the-counter (OTC) market3 grew by 475% and 522%,
respectively. By contrast, during the credit and housing booms that occurred over the same
period, the value of corporate bonds and home mortgage debt outstanding grew by only 95% and
115%, respectively.4
Pre-Dodd-Frank Act Market Structure and Regulation
The various types of derivatives are used for the same purposes—avoiding business risk, or
hedging, and taking on risk in search of speculative profits. Prior to the Dodd-Frank Act,
however, the instruments were traded on different types of markets. Futures contracts are traded
on exchanges regulated by the Commodity Futures Trading Commission (CFTC); stock options
on exchanges under the Securities and Exchange Commission (SEC); and all swaps (and security-
based swaps, as well as some options) were traded OTC, and were not regulated by anyone.
Exchanges are centralized markets where all the buying and selling interest comes together.
Traders who want to buy (or take a long position) interact with those who want to sell (or go
short), and deals are made and prices reported throughout the day. In the OTC market, contracts
are made bilaterally, typically between a dealer and an end user, and there was generally no
requirement that the price, the terms, or even the existence of the contract be disclosed to a
regulator or to the public.
Derivatives can be volatile contracts, and the normal expectation is that there will be big gains
and losses among traders. As a result, there is an issue of market integrity. How do the longs
know that the shorts will be able to meet their obligations, and vice versa? A market where
billions of contracts change hands is impossible if all traders must investigate the
creditworthiness of the other trader, or counterparty. The exchange market deals with this credit
risk problem in one way, the OTC market in another way. How this risk—often called
counterparty risk—must be managed was a key element of the reforms implemented by the
Dodd-Frank Act.
2 See Bank for International Settlements (BIS), Table 23B, for year 2000 turnover for derivative financial instruments
traded on organized exchanges, available at http://www.bis.org/publ/qtrpdf/r_qa0206.pdf. For December 2008 figures
for derivatives traded on organized exchanges, see BIS Quarterly Review, September 2009, International Banking and
Financial Market Developments, available at http://www.bis.org/publ/qtrpdf/r_qt0909.pdf.
3 See Bank for International Settlements (BIS), Statistical Annex, Table 19, December, 2000 figure for notional amount
of total OTC contracts, available at http://www.bis.org/publ/qtrpdf/r_qa0206.pdf. See Bank for International
Settlements (BIS), BIS Quarterly Review, September 2009, Statistical Annex, Table 19, for December 2008 figure for
notional amount of total OTC contracts, available at http://www.bis.org/publ/qtrpdf/r_qa0909.pdf.
4 Federal Reserve, Flow of Funds Accounts of the United States, September 17, 2009, accessible at
http://www.federalreserve.gov/releases/z1/Current/z1r-1.pdf.
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Market Structure for Cleared and Exchange-Traded Derivatives
The exchanges deal with the issue of credit risk with a clearinghouse.5 The process is shown in
Figure 1 below: (1) two traders agree on a transaction on the exchange floor or on an electronic
platform. (2) Once the trade is made, it goes to the clearinghouse, which guarantees payment to
both parties. (3) In effect, the original contract between long and short traders is now two
contracts, one between each trader and the clearinghouse. Traders then do not have to worry
about counterparty default because the clearinghouse stands behind all trades.
But the credit risk remains: how does the clearinghouse ensure that it can meet its obligations?
Clearing depends on a system of margin, or collateral. Before the trade, both the long and short
traders have to deposit an initial margin payment with the clearinghouse to cover potential losses.
Then at the end of each trading day, all contracts are repriced, or “marked to market,” and all
those who have lost money (because prices moved against them) must post additional margin
(called variation or maintenance margin) to cover those losses before the next trading session.
This is known as a margin call: traders must make good on their losses immediately, or their
broker may close out their positions when trading opens the next day. The effect of the margin
system is that no one can build up a large paper loss that could damage the clearinghouse in case
of default: it is certainly possible to lose large amounts of money trading on the futures
exchanges, but only on a “pay as you go” basis.
5 Also referred to as a central counterparty or as a derivatives clearing organization (DCO).
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Figure 1. Pre-Dodd-Frank Act Derivatives Market Structures:
Exchange and Over-the-Counter (OTC)
Source: CRS.
Market Structure for OTC Derivatives
In the OTC market, as shown on the right side of Figure 1, the long and short traders do not
interact directly. Instead of a centralized marketplace, there is a network of dealers who stand
ready to take either long or short positions, and make money on spreads and fees. The dealer
absorbs the credit risk of customer default, while the customer faces the risk of dealer default. In
this kind of market, one would expect the dealers to be the most solid and creditworthy financial
institutions, and in fact the OTC market that emerged was dominated by two or three dozen
firms—very large institutions like JP Morgan Chase, Goldman Sachs, Citigroup, and their foreign
counterparts. Before 2007, such firms were generally viewed as too well diversified or too well
managed to fail; in 2008, their fallibility was well established, and the pertinent question now is
whether the government would still consider them to be too big to fail. (Title II of Dodd-Frank
seeks to ensure that it will not.6)
In the OTC market, some contracts required collateral or margin, but not all. There was no
standard practice: all contract terms were negotiable. A trade group, the International Swaps and
Derivatives Association (ISDA), published best practice standards for use of collateral, but
compliance was voluntary.
6 See CRS Report R41350, The Dodd-Frank Wall Street Reform and Consumer Protection Act: Issues and Summary,
coordinated by Baird Webel.
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Because there was no universal, mandatory system of margin, large uncollateralized losses could
(and did) build up in the OTC market. Perhaps the best-known example in the crisis was AIG,
which wrote about $1.8 trillion worth of credit default swaps guaranteeing payment if certain
mortgage-backed securities defaulted or experienced other “credit events.”7 Many of AIG’s
contracts required it to post collateral as the credit quality of the underlying referenced securities
(or AIG’s own credit rating) deteriorated, but AIG did not post initial margin, as this was deemed
unnecessary because of the firm’s triple-A rating. As the subprime crisis worsened, AIG faced
margin calls that it could not meet. To avert bankruptcy, with the risk of global financial chaos,
the Federal Reserve and the Treasury put tens of billions of dollars into AIG, the bulk of which
went to its derivatives counterparties.8
A key reform in Dodd-Frank is a mandate that many OTC swaps be cleared, which means that
they will be subject to margin requirements. This will have the effect of combining features of the
two market structures shown in Figure 1.
The Dodd-Frank Act’s Clearing and Reporting
Requirements
In order to provide more stability to the OTC derivatives market, the Dodd-Frank Act requires
that most derivatives contracts formerly traded exclusively in the OTC market be cleared and
traded on exchanges. Thus, traders in these previously unregulated products will be required to
post margin in the fashion described above and have their contracts repriced at the close of each
trading day. This system likely will have the effect of regulating trade in these contracts more
closely and providing greater transparency to the participants in the market and to the government
regulators. Furthermore, the Dodd-Frank Act presumes that some derivatives contracts will still
be traded in the OTC market; however, it grants regulators broader powers to obtain information
about these derivatives and impose margin and capital requirements on them as well.
Clearing Requirement
Title VII of the Dodd-Frank Act creates largely parallel clearing and exchange trading
requirements for swaps and security-based swaps as those terms are defined by Title VII and will
be further defined by the CFTC and the SEC. Section 723 creates the clearing and exchange
trading requirements for swaps over which the CFTC has jurisdiction.9 Section 763 creates
largely parallel requirements for security-based swaps over which the SEC has authority.10
If a swap or security-based swap is required to be cleared, the final version of the Dodd-Frank Act
makes it unlawful for parties to enter into swaps or security-based swaps unless the transaction
7 The credit events that trigger credit swap payments may include ratings downgrades, debt restructuring, late payment
of interest or principal, as well as default.
8 For an account of this process, see Office of the Special Inspector General for the Troubled Asset Relief Program
("SIGTARP”), Factors Affecting Efforts to Limit Payments to AIG Counterparties, November 17, 2009.
9 Section 723 of the Dodd-Frank Act (to be codified at 7 U.S.C. §2).
10 Section 763(a) of the Dodd-Frank Act (to be codified at 15 U.S.C. § 78a et seq.).
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has been submitted for clearing.11 There are two ways in which a swap or security-based swap
may become subject to the clearing requirement.12 In the first way, the agency of jurisdiction is
required to engage in an ongoing review of the products it has jurisdiction over to determine
whether a particular swap, security-based swap, group, or class of such contracts should be
subject to the clearing requirement. In the House-passed version of the clearing requirement,
determinations made by the agency in this manner would not have resulted in those transactions
becoming subject to the clearing requirement, because in order to be subject to the clearing
requirement, the agency had to make its determination pursuant to a submission of the transaction
by a derivatives clearing organization or a clearing agency.13 The Senate-passed version was more
similar to the eventual statutory language in that determinations made by the agency of its own
initiative regarding transactions required to be cleared may have been subject to the clearing
requirement, without having to first be submitted to the agency as a transaction that a derivatives
clearing organization or clearing agency intended to offer for clearing.14 Determinations made on
the initiative of the commissions will be discussed further in the “Prevention of Evasion” section
below.
The second way in which a swap or security-based swap may become subject to the clearing
requirement under the Dodd-Frank Act is upon submission to the CFTC or the SEC. When a
derivatives clearing organization15 (swaps) or clearing agency16 (security-based swaps) decides to
accept a swap or security-based swap for clearing, the act requires the organization to submit the
transactions to the relevant commission for a determination as to whether the transactions should
be required to be cleared. Furthermore, upon enactment of the Dodd-Frank Act, all swaps and
security-based swaps that were listed for clearing by derivatives clearing organizations and
clearing agencies at the time of passage were deemed submitted to the SEC and the CFTC for a
determination of whether the clearing requirement should apply.
Following submission to the agencies, the agencies have 90 days to determine whether the swaps
or security-based swaps are subject to the clearing requirement, unless the submitting
organization agrees to an extension. When making that determination, the agencies must consider
(1) “the existence of significant outstanding notional exposures, trading liquidity, and adequate
pricing data”; (2) “the availability of rule framework, capacity, operational expertise and
resources, and credit support infrastructure to clear the contract on terms consistent with material
terms and trading conventions on which the contract is then traded”; (3) “the effect on the
mitigation of systemic risk ... ”; (4) “the effect on competition, including appropriate fees and
charges ... ”; and (5) “the existence of reasonable legal certainty in the event of the insolvency of
the relevant derivatives clearing organization or 1 or more of its clearing members with regard to
the treatment of customer and swap counterparty positions, funds, and property.”17 In the process
11 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(1)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps).
12 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(2)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps).
13 Sections 3103 and 3203 of H.R. 4173 (as passed by the House).
14 Sections 723(a) and 763 of H.R. 4173 (as passed by the Senate).
15 Rules for the registration and regulation of derivatives clearing organizations are enacted by Section 725 of the
Dodd-Frank Act (to be codified at 7 U.S.C. §7a-1).
16 Rules for the registration and regulation of clearing agencies were enacted by Section 763(b) of the Dodd-Frank Act
(to be codified at 15 U.S.C. §78a-1).
17 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps). Similar considerations were mandated by
(continued...)
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of making these determinations, the agencies are also required to allow the public to comment on
whether the clearing requirement should apply.
Should the CFTC or the SEC determine that a particular swap or security-based swap is required
to be cleared, counterparties to that type of transaction may apply to stay the clearing requirement
until the relevant agency “completes a review of the terms” of the swap or security-based swap
and the clearing requirement.18 Under the act, upon completing the review, the relevant agency
may require the swap or security-based swap to be cleared, either unconditionally or subject to
appropriate conditions. The relevant agency may also determine that the swap or security-based
swap is not required to be cleared.
With certain exceptions, counterparties to swaps and security-based swaps that are required to be
cleared must either execute the transactions on exchanges or specialized execution facilities.19
The Exchange-Trading Requirement
With certain exceptions, swaps and security-based swaps that are required to be cleared must also
be executed on a regulated exchange or on a trading platform defined in the act as a swaps
execution facility (SEF) or a security-based swaps execution facility (SBSEF). Such facilities
must permit multiple market participants to trade by accepting bids or offers made by multiple
participants in the facility.
The goal of the trading requirement is “to promote pre-trade price transparency in the swaps
market.”20 Because the old OTC market was notably opaque, with complete price information
available only to dealers, swaps customers were limited in their ability to shop for the best price
or rate. The expectation is that as price information becomes more widely available, competition
will produce narrower spreads and better prices.
SEFs and SBSEFs must comply with a number of core principles set out in the act. While these
are somewhat less prescriptive than the regulation of exchanges where public customers are
allowed to trade,21 the new trading facilities have regulatory and administrative responsibilities
far beyond what applied to OTC trading desks in the past. Among other things, SEFs and SBSEFs
must
• establish and enforce rules to prevent trading abuses and to provide impartial
access to the trading facility;
• ensure that swap contracts are not readily susceptible to manipulation;
(...continued)
the Senate passed version of the bill, but those considerations were to be applied to the agencies’ rulemakings to
identify other classes of transactions that should be subject to the clearing requirement that had not been submitted to
the agency. Section 723(a) of H.R. 4173 (as passed by the Senate).
18 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(3)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps).
19 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(8)); Section 763(a) of the Dodd-Frank Act
(to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps).
20 Section 723 of the Dodd-Frank Act (new section 5h(e) of the Commodity Exchange Act to be codified after 7 U.S.C.
§7b-2).
21 Only eligible contract participants will be able to trade on SEFs and SBSEFs.
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• monitor trading to prevent manipulation, price distortion, and disruptions in the
underlying cash market;
• set position limits;
• maintain adequate financial and managerial resources, including safeguards
against operational risk;
• maintain an audit trail of all transactions;
• publish timely data on prices and trading volume;
• adopt emergency rules governing liquidation or transfer of trading positions as
well as trading halts; and
• employ a chief compliance officer, who will submit an annual report to
regulators.
During consideration of Dodd-Frank, a central issue of debate was the extent to which existing
OTC derivatives trading platforms and mechanisms could be accommodated under the new
regulatory regime. OTC trading practices ranged from individual telephone negotiations to
electronic systems accessible to multiple participants. One concern was that if SEFs were too
much like exchanges, the existing futures and securities exchanges would monopolize trading. On
the other hand, if the SEF definition were too vague or general, the OTC market might remain
opaque.
The bill reported by the Senate Banking Committee defined SEF as “an electronic trading system
with pre-trade and post-trade transparency.”22 The explicit reference to “pre-trade” transparency
does not appear in the final legislation, in part because of concerns that such a requirement was
not compatible with the business models of a number of intermediaries, such as interdealer swap
brokers providing anonymous execution services.23
As is the case with the clearing requirement, Dodd-Frank provides exceptions to the exchange-
trading mandate. If no exchange or SEF or SBSEF makes a swap available for trading, the
contract may be traded OTC. A swap that meets the end-user clearing exemption is likewise
exempt from the trading requirement. We now discuss the end-user exemption.
End-User Exemption
Sections 723 and 763 of the Dodd-Frank Act provide exceptions to the clearing requirement for
swaps and security-based swaps when one of the counterparties to the transaction is not a
financial entity, is using the transaction to hedge or mitigate its own commercial risk, and notifies
the relevant agency “how it generally meets its financial obligations associated with entering into
non-cleared swaps.”24 This has been widely referred to as the end-user exemption because it
applies only to transactions where at least one counterparty is “not a financial entity.”25 A
22 Section 720 of S. 3217, as reported by the Senate Committee on Banking, Housing, and Urban Affairs, Apr. 15,
2010.
23 Section 720 of the Dodd-Frank Act, P.L. 111-203.
24 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(7)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq. )(security-based swaps).
25 Id.
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financial entity for the purposes of this section is defined as a swap dealer, a security-based swap
dealer, a major swap participant (MSP), a major security-based swap participant, a commodity
pool, a private fund, an employee benefit plan, or a person predominantly engaged in activities
that are in the business of banking, or in activities that are financial in nature.26 Who is and who is
not a financial entity is discussed further in the section describing MSPs.
The definition of who is eligible for the exception is more similar here to the House-passed
version than to the Senate-passed version. However, one important change was made. The House-
passed version allowed any parties who were not swap dealers or MSPs, who were using the
transaction to hedge commercial risk, and who notified the relevant agency properly to qualify for
the exemption.27 The final version narrowed the availability of the exemption to parties who were
not financial entities, as defined above, and the definition of financial entities arguably includes
more parties than only those who are not dealers or MSPs. Furthermore, the definition of
“financial entity” in the act appears to be more narrow than the definition of “financial entity”
contained in the Senate-passed version, because the Senate bill’s definition would have included
“a person that is registered or required to be registered with the Commission.”28 Moreover, the act
allows regulators to exclude depository institutions, farm credit institutions, and credit unions
with $10 billion or less in assets from the definition of “financial entity.” Thus, the final definition
of end-users represented by the act appears to fall somewhere between the House and Senate
definitions in the number of entities that may qualify.
The application of the clearing exemption provided by Sections 723 and 763 of the Dodd-Frank
Act is at the discretion of the counterparty that qualifies for the exemption. Eligible counterparties
may elect to clear the transaction, and may choose which derivatives clearing organization or
clearing agency shall clear the transaction. Under the act, eligible counterparties may also use an
affiliate (“including affiliate entities predominantly engaged in providing financing for the
purchase of the merchandise or manufactured goods of the person”) to engage in swaps or
security-based swaps under the condition that the affiliate “act on behalf of the person [qualifying
for the exemption] and as an agent, uses the swap to hedge or mitigate the commercial risk of the
person or other affiliate of the person that is not a financial entity.”29 The CFTC and SEC may
also prescribe rules to prevent abuse of this exception to the clearing requirement.
26 The CFTC and SEC must consider whether to exempt small banks, savings associations, farm credit systems
institutions, and credit unions from the definition of financial entity in this section. Such a determination could make
the end-user exemption available to these entities. Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C.
§2(h)(7)) (swaps); Section 763(a) of the Dodd-Frank Act (to be codified at 15 U.S.C. § 78a et seq. )(security-based
swaps). (page 822 and 1060).
27 Sections 3103 and 3203 of H.R. 4173 (as passed by the House).
28 Sections 723(a) and 763 of H.R. 4173 (as passed by the Senate).
29 Affiliates of persons qualifying for the end user exception are not eligible to engage in swaps or security-based swaps
on the behalf of qualifying persons if the affiliate is a swap dealer, security-based swap dealer, major swap participant,
major security-based swap participant, companies that would be investment companies under section 3 of the
Investment Company Act of 1940 but for the exceptions provided in subparagraphs (c)(1) or (c)(7) of that section (15
U.S.C. §80a-3), a commodity pool, or a bank holding company with over $50, 000,000,000 in consolidated assets.
Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(3)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps).
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Prevention of Evasion
The CFTC and SEC are required by the Dodd-Frank Act to promulgate rules the commissions
determined to be necessary to “prevent evasions of the mandatory clearing requirements under
this Act.” However, this rulemaking authority, while broad, carries additional nuance described
below.
As noted above, the statutory scheme of Dodd-Frank creates two ways in which a swap or
security-based swap may become subject to the clearing requirement. In one scenario, derivatives
clearing organizations and clearing agencies submit the swaps and security-based swaps they
intend to clear to the CFTC or SEC and the agency determines whether to apply the clearing
requirement to the transactions. In the other scenario, the CFTC and SEC are required to engage
in an ongoing independent review of swaps and security-based swaps under their jurisdiction to
determine whether those transactions should be subject to the mandatory clearing requirement. It
is thus possible that the CFTC and SEC could identify swaps and security-based swaps that
“would otherwise be subject to the clearing requirement” but for the fact that no derivatives
clearing organization or clearing agency accepts them for clearing.
In that event, the relevant agency (CFTC for swaps, and SEC for security-based swaps) is
required to investigate the relevant facts and circumstances, issue a public report of its
investigation, and “take such actions as the Commission determines to be necessary and in the
public interest, which may include requiring the retaining of adequate margin or capital by parties
to the swap [or security-based swap], group, category, type, or class of swaps [or security-based
swaps].”30 However, neither the CFTC nor the SEC may “adopt rules requiring a derivatives
clearing organization [or clearing agency] to list for clearing a swap, group, category, type, or
class of swaps if the clearing of the swap, group, category, type, or class of swaps would threaten
the financial integrity of the derivatives organization.”31 Eliminated from the Dodd-Frank Act was
a requirement in the Senate-passed version that the agencies exempt swaps and security-based
swaps from the clearing and exchange trading requirements if no derivatives clearing
organization or clearing agency accepts the transactions for clearing.32 The removal of this
proposed exemption from the act may grant the agencies more flexibility in determining how to
treat transactions they identify for clearing, but that are not yet accepted for clearing by any
derivatives clearing organization or clearing agency as the agencies begin to implement the
clearing requirement of the Dodd-Frank Act.
Reporting of Swaps and Security-Based Swaps
Swaps must be reported to registered swap data repositories or the CFTC.33 Security-based swaps
must be reported to registered security-based swap data repositories or to the SEC.34 The Dodd-
30 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(4)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps).
31 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(4)) (swaps); Section 763(a) of the Dodd-
Frank Act (to be codified at 15 U.S.C. § 78a et seq.)(security-based swaps).
32 Sections 723(a) and 763 of H.R. 4173 (as passed by the Senate).
33 Section 723(a)(3) of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(h)(5)).
34 Section 763(a) of the Dodd-Frank Act (to be codified at 15 U.S.C. § 78a et seq.).
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The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
Frank Act requires all swaps to be reported.35 Swaps and security-based swaps entered into prior
to the date of the enactment of Dodd-Frank Act are exempt from the clearing requirement if they
are reported in accordance with the act. Swaps and security-based swaps entered into after the
enactment of the Dodd-Frank Act, but prior to the imposition of the clearing requirement, are
exempt from the clearing requirement if they are reported in accordance with the act.
Section 727 of Dodd-Frank outlines the public availability of swap transaction data.36 The CFTC
is required to promulgate rules regarding the public availability of such data. Swaps that are
subject to the clearing requirement, and swaps that are not subject to the clearing requirement, but
are nonetheless cleared at registered derivatives clearing organizations, must have real-time
reporting for such transactions. Real-time reporting means to report data relating to a swap
transaction, including price and volume, as soon as technologically practicable after the time at
which the swap transaction has been executed. For swaps that are not cleared and are reported
pursuant to subsection (h)(6) (requiring reporting prior to the implementation of the clearing
requirement), real-time reporting is required in a manner that does not disclose the business
transactions and market positions of any person. Lastly, for swaps that are determined to be
required to be cleared under subsection (h)(2) (outlining the two ways, discussed above, in which
swaps may become subject to the clearing requirement), but are not cleared, real-time public
reporting is required as well. There is no parallel requirement in the act for security-based swaps,
presumably because national securities exchanges upon which these transactions will be executed
already provide comparable reporting.37
The act also creates reporting obligations for uncleared swaps and security-based swaps
(including swaps and security-based swaps that qualify for the end-user exemption).38 Swaps
entered into prior to the enactment of the act will be subject to reporting and recordkeeping
requirements for uncleared swaps and security-based swaps.39 The purpose of these requirements,
presumably, is to give the relevant commissions access to a more complete picture of the
derivatives market, even for swaps that are not required to be cleared.
Major Swap Participant Definition
A basic theme in Dodd-Frank is that systemically important financial institutions should maintain
capital cushions above and beyond what specific regulations require in order to compensate for
the risk that their failure would pose to the financial system and the economy. In addition to the
margin requirements that apply to individual derivatives contracts, major participants in
derivatives markets will become subject to prudential regulation in Title VII. Two categories of
regulated market participants are enumerated: swap dealers and major swap participants (together
with the security-based swap equivalents).
Since the OTC dealer market is highly concentrated, the proposal that swap dealers be subject to
additional prudential regulation was not controversial. Only a few dozen of the largest financial
35 Sections 3103 and 3203 of H.R. 4173 (as passed); Sections 723(a) and 763 of S. 3217 (as passed).
36 Section 725 of the Dodd-Frank Act (to be codified at 7 U.S.C. §2(a)).
37 See 15 U.S.C. § 78f.
38 Section 729 of the Dodd-Frank Act (to be codified at 7 U.S.C. §6o-1) and Section 766 of the Dodd-Frank Act (to be
codified at 15 U.S.C. §78a et seq.).
39 Id.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
institutions will be affected. The question of how many firms should be included in the definition
of major swap participant (MSP), however, was contentious. How many non-dealer and non-bank
firms should become subject to prudential regulation?
Several MSP definitions were considered in the House; the version of H.R. 4173 that passed the
House in December 2009 defined an MSP as a non-dealer holding a “substantial net position” in
swaps, excluding positions held to hedge commercial risk, or whose counterparties would suffer
“significant credit losses” in the event of an MSP default.40 Neither “substantial net position,”
“significant loss,” nor “commercial risk” was defined in the bill. However, the bill provided
guidance to regulators: the first two terms were linked to “systemically important entities” that
can “significantly impact the financial system through counterparty credit risk.”
The MSP definition in the bill that passed the House in December 2009 sought to prevent
regulators from defining the key terms (“substantial position, “significant loss,” etc.) in a way that
imposed prudential regulation on most firms that used derivatives to hedge risk. In addition,
MSPs are required to clear their swap contracts, and the cost of clearing was regarded as
burdensome for end-users. Under the House definition, it seemed plausible that relatively few
firms would be defined as MSPs—Fannie Mae and Freddie Mac, a few large non-dealer banks
and insurance companies, and perhaps a few large hedge funds.
Figure 2. OTC Derivatives Contracts by Type of Counterparty
(Based on notional value of contracts as of December 2009)
Nonfinancials
9%
Inter-Dealer
33%
Financial
Institutions
58%
Source: Bank for International Settlements, Regular OTC Derivatives Market Statistics, May 2010.
Notes: Includes interest rate, foreign exchange, equity, and credit default swaps.
40 Section 3101 of H.R. 4173, as passed the House of Representatives, Dec. 11, 2009.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
There was an opposite concern: that if the end-user exemption were too broad, and the MSP
definition too narrow, significant volumes of OTC trading might escape the new regulatory
scheme. Figure 2 above suggests that if mandatory clearing were applied only to inter-dealer
trades, two-thirds of the market would be unaffected. Nearly 60% of OTC contracts were between
a dealer and another financial institution: how many of these would be covered? While less than
10% of transactions involved nonfinancial counterparties, was it possible that risky trading
activities could migrate from banks to nonfinancial firms if the exemption for hedging
commercial risk were not in some way circumscribed?
Two versions of the MSP definition were considered in the Senate. The Banking Committee
approved S. 3217 on April 15, 2010, including an MSP definition without the references to
systemic importance that appeared in the House bill.41 In other words, the regulators were given
wide discretion to designate as MSPs firms that were not systemically important. The Senate
Agriculture Committee produced another MSP definition, which was included in the bill that
passed the Senate. It included “systemically significant” language generally similar to the
House’s, but added new prongs to the definition: an MSP would be any financial institution with a
substantial position in any major swap category, or any financial entity that was highly
leveraged.42 This approach (together with changes to the clearing exemption limiting the
exemption to nonfinancial entities) appeared likely to capture many swaps between dealers and
other financial institutions, which make up more than half of the swap market.
Eliminating the clearing exemption for financial entities and bringing more financial firms under
the MSP definition, as the Senate-passed bill did, had the virtue of bringing nearly all of the
swaps trading under the new regulatory regime—the 33% of trades between dealers and the 58%
between dealers and other financial institutions. This approach did raise questions of equity, that
is, should a small community bank or credit union be subject to more stringent regulation than a
giant nonfinancial corporation with a much greater volume of swaps outstanding?
The final version of the legislation made several changes to the MSP definition and the clearing
requirement. The “highly leveraged” prong of the MSP definition was amended to clarify that it
did not apply to regulated depository institutions, which are normally highly leveraged. In
addition, as noted above, regulators were given discretion to exempt certain financial institutions
with less than $10 billion in assets from the mandatory clearing requirement. The precise number
of firms that are named MSPs (and the proportion of swaps that is ultimately cleared) depends on
the SEC and CFTC rulemakings required by the act.
Section 716—Prohibition on Federal Assistance to
Swaps Entities
Section 716 originated in the Senate Agriculture Committee and was included in the bill that
passed the Senate in May 2010. The section prohibited federal assistance, defined as the use of
any funds to loan money to, buy the securities or other assets of, or to enter into “any assistance
41 Section 711 of S. 3217, as reported by the Senate Committee on Banking, Housing, and Urban Affairs, Apr. 15,
2010.
42 This was not a “net” position, and applied to individual categories of swaps, as opposed to the institutions aggregate
swaps book.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
arrangement” with, a “swaps entity.” Swaps entities included swap dealers and major swap
participants (and the equivalents in security-based swaps), securities and futures exchanges,
SEFs, and clearing organizations registered with the CFTC, the SEC, or any other federal or state
agency.
The intent of the provision was to ensure that taxpayers would not have to bail out financial
institutions engaged in risky derivatives trading. Such activity was deemed too risky to be under
the federal safety net that covers insured depository institutions. Agriculture Committee
Chairwoman Lincoln explained it this way:
This provision seeks to ensure that banks get back to the business of banking. Under our
current system, there are a handful of big banks that are simply no longer acting like banks....
In my view, banks were never intended to perform these [derivatives] activities, which have
been the single largest factor to these institutions growing so large that taxpayers had no
choice but to bail them out in order to prevent total economic ruin.43
Supporters of the original version of Section 716 described it as an appropriate means to compel
banks to spin off their swap dealings, or to “push them out” into separately capitalized affiliates.
Opponents of the measure argued that the definitions of federal assistance and swaps entity were
so broadly drafted that there might be unanticipated consequences. For example, if Citigroup sold
off its swap dealer operations, it would still have hundreds of billions of loans and other risky
assets on its balance sheet, which it would need to hedge with interest rate swaps and other
derivatives. This hedging activity would likely put the bank into the major swap participant
category, and thus foreclose access to the discount window, FDIC insurance, and other features of
the safety net. Similarly, if the Federal Reserve were supplying liquidity to the financial system
during a future crisis, would it be prudent to deny such support to clearinghouses which represent
concentrations of risk?
The conference committee adopted a modified version of Section 716, which narrowed the
definitions of swaps entity and permitted banks to act as swap dealers under some circumstances.
In the final legislation, exchanges, SEFs, and clearing organizations are not swaps entities. In
addition, the term “swaps entity” does not include a major swap participant or major security-
based swap participant that is an insured depository institution.
The final version clarifies that the prohibition on aid does not prevent a bank from creating an
affiliate that is a swaps entity, provided that the affiliate complies with sections 23A and 23B of
the Federal Reserve Act and other requirements of the Fed, the SEC, and the CFTC. Moreover,
the bank itself may continue to act as a swaps dealer for contracts involving rates or reference
assets that are permissible for investment by a national bank. This means that banks can continue
as dealers in swaps linked to interest rates, currencies, government securities, and precious
metals, but not other commodities or equities. Credit default swaps are treated as a special
category: banks may deal in them if they are cleared by a derivatives clearing organization
regulated by the SEC or CFTC. Dealing in uncleared credit default swaps, however, is not
deemed to be a permissible bank activity.
Finally, Section 716 mandates that no taxpayer funds may be used to prevent the liquidation of a
swaps entity. Any funds expended in such a liquidation proceeding, and not covered by the swaps
entity’s assets, may be recouped through assessments on the financial sector.
43 Remarks of Senator Blanche Lincoln, Congressional Record, May 5, 2010, p. S3140.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives
Enhanced CFTC Authority over Commodities
Markets
In 2008, as energy and grain prices set new records, speculators in derivatives were blamed by
some for price volatility and for price levels that many observers believed were not justified by
the underlying economic fundamentals. Although the CFTC maintained that markets were
functioning normally and that the price discovery process was not being distorted, the 110th
Congress considered legislation intended to insulate commodity prices from the impact of
excessive speculation and manipulation. Title VII includes a number of the specific provisions
that appeared in those bills:
• Margin. The CFTC is given authority to set margin levels on the futures
exchanges. (Previously, CFTC could change margins only in emergencies.)
Section 736.
• Position Limits. The CFTC is directed to establish position limits for both swaps
and futures. (CFTC has long had authority to set limits on the size of futures
positions, but has generally delegated this function to the exchanges.) Section
737.
• Anti-manipulation Authority. New prohibitions against manipulation by means
of false reporting or false information. Section 753.
• Foreign Boards of Trade. Foreign futures exchanges offering direct electronic
access to their trading systems to U.S. persons must maintain rules regarding
manipulation and excessive speculation comparable to those in U.S. law and
regulation and must provide the CFTC with full market information.
Beyond these specific provisions, the increased transparency Dodd-Frank will bring to the OTC
markets responds to a frequently heard criticism of the regulatory regime in 2008: that regulators
could not be sure that price manipulation was not occurring because they lacked information
about the volume of OTC trades and the identities of the big players in that market.
Author Contact Information
Mark Jickling
Kathleen Ann Ruane
Specialist in Financial Economics
Legislative Attorney
mjickling@crs.loc.gov, 7-7784
kruane@crs.loc.gov, 7-9135
Acknowledgments
Parts of the introductory material in this report are adapted from CRS Report R40965, Key Issues in
Derivatives Reform, by Rena S. Miller.
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