For almost three years, the United States’ Commodity Futures Trading Commission (CFTC) has been working to draft and implement new regulations for the $633 trillion global swaps market.
From their inception, swaps—derivatives where two parties exchange financial instruments such as interest rates, cash flows, or credit defaults— had been treated as contracts between individuals. This allowed them to be traded over the counter (OTC), with no required reporting of transactions to a government agency.
In the wake of the US financial crisis, however, there was a new legislative focus placed on the regulation of these derivatives. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 called for swaps to be traded on open exchanges or other platforms, the same as stocks and futures— and with similar reporting requirements.
Dodd-Frank ceded oversight of derivatives to the CFTC, leaving it to the agency to determine how to implement the new rules.
James Moser was party to the wrangling over efforts to regulate derivative trading. He came to Kogod in 2012 after nearly six years as deputy chief economist with the CFTC.
Looking back, Moser said lawmakers cast a wide net on all OTC derivatives, when putting a narrow focus on the biggest problem—credit default swaps—would have tightened up the process significantly and made the biggest impact.
“In my view, we went after the entire enchilada—all derivatives—when we should have been focusing on credit default swaps,” Moser said. “Credit default swaps were the main source of the problem.”
Although credit default swaps—undisputed villains of the financial crisis—account for only about 5 percent of the swap positions, they have had a much larger impact on the economy than that figure might suggest.
In credit default swaps, the lender attempts to hedge against default by paying a third party for protection—insurance in case the debtor, or debtors, defaults. The problems started when the parties selling the “insurance,” such as American International Group (AIG), were unable to keep up with mounting defaults. AIG had to be bailed out at a taxpayer cost of $180 billion.
According to the Bank for International Settlements, the notional value of credit default swaps at the end of 2012 was $25.1 trillion; OTC derivatives as a whole had a notional value of $633 trillion at the end of the year.
Moser said credit default swaps were initially seen as a way to protect against possible defaults. But, he said, no one took a big-picture view of what would happen if the whole system collapsed, as it did when the real estate bubble burst.
“People thought with credit default swaps, ‘Hey, this is the solution,’” Moser said. “And it turned out to actually be the problem.”
In May, despite opposition from the industry and budget constraints stemming from GOP opposition to the regulation, CFTC commissioners approved the first substantive changes to OTC derivative trading. All derivatives were targeted, not just credit default swaps—an approach that Moser believes was too broad.
“Save for [credit default swap] contracts, which constitute a small portion of the derivatives markets, there were very few problems with derivatives during the financial crisis,” he said. “Were Dodd-Frank focused on the source of the 2008 problems, financial regulators would be working almost entirely on appropriate regulation of CDS contracts. Instead, most of their effort has been focused elsewhere.”
While the May orders took a major step forward in pushing derivative trading into the open, some unaddressed areas could still have a major impact. One contentious issue deals with how regulations should be applied to international institutions (or the foreign affiliates of domestic ones).
Moser said he anticipates a lot more battling over how to implement Dodd-Frank before the war is over.
“The rules are still being written and there is still quite a bit of pushback,” he noted. “But the pendulum is swinging in the direction of the regulators, and I think the CFTC is going to push very hard to get what they want while it is like that.”