IS DODD-FRANK TOO BIG NOT TO FAIL?
The consequences of the 2016 presidential election are likely to have a profound impact on over-the-counter derivatives markets. In particular, the expected changes to the Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)—if not an outright repeal—could significantly impact a wide range of industries and customers globally. Title VII of Dodd-Frank was intended to ensure transparency and accountability to swaps markets. Over the past six and a half years, all market participants, including end-users, swap dealers, and major swap participants, spent billions of dollars implementing the Dodd-Frank statutory requirements, as detailed and enforced by the Commodity Futures Trading Commission (“CFTC”). Some of the Dodd-Frank requirements, such as mandatory margin implementation, position limits, cross-border swap application, and other rules are yet to be finalized.
One of the many major flaws of Dodd-Frank is the failure to exempt from its scope a large number of commercial activities that had nothing to do with the financial crisis of 2008-2009 and that already had a robust risk management history and infrastructure. One such commercial activity is the production and transport of energy commodities. If anything, the financial crisis of 2008-2009 demonstrated the energy industry’s ability to safely and calmly navigate the worst financial landscape. However, the energy industry, among many other industries, was forced to implement numerous Dodd-Frank regulation and to spend enormous sums of money to comply with many regulatory requirements that were misplaced and often overreaching. For example, when an energy company needs to borrow money to build its asset – a pipeline, an electric generation facility, or a crude oil storage tank—it often needs to lock-in a favorable interest rate for its financing. Then, the energy company enters into a plan vanilla fix-for-float swap agreement with an investment bank, i.e., a swap dealer. However, before the swap can be executed, the swap dealer usually sends over a long list of documentation requirements, as it is required to do by Dodd-Frank (or its European equivalent—“EMIR”), to the energy company, including a board resolution authorizing the exemption from swap clearing, a set of policies and procedures “reasonably drafted” to ensure that the energy company’s employees are sufficiently familiar with swaps, various ISDA protocols, margin rule representation letter, EMIR representation letter, and the list of “corporate events” and “life cycle” events the energy company, as an “end-user” under Dodd-Frank must communicate to the swap dealer in order for swap dealer to comply with its reporting requirements.
The nature of Dodd-Frank compliance requirements is very burdensome for most commercial market participants such as energy and agricultural commodities producers, transporters, and marketers, small and medium size banks, insurers, dealers and brokers, because most of them only use swaps occasionally to hedge their commercial operations and, consequently, do not have a robust risk management structure. End-users of swaps do not represent a systemic risk to the U.S. financial system, and the enormous amounts of resources spent on Dodd-Frank implementation only increases the financial burden of the commercial end-users’ customers as those costs are passed down the market chain. However, it does not appear that the CFTC differentiates between those market participants that could jeopardize the global financial system on one hand, and those commercial market participants that only use occasional swaps to manage price risk of their commercial enterprise on the other. In the rush to expand the jurisdiction and assume oversight of all commodities and derivatives, the CFTC appears to have overlooked the need to propose a measured and systemic approach toward a reasonable regulation. The best example of this rush to regulate was the re-labelling of dozens of swap products as futures. The CFTC renamed many swaps and began calling them futures, obliging market participants to trade those products on an organized exchange (and pay exchange fees) and to clear those products on the exchange (and pay clearing fees). While this name change may have been the easiest way to force market participants to trade on organized exchanges, the market participants were left with a complex and expensive task of restructuring their trading, hedging, credit and collateral processes in order to minimize the operational and financial impact of the short-sighted rulemaking. Many natural gas companies are still baffled by the CFTC’s decision that certain natural gas transport contracts could be swaps. The fact that the principal regulator of all commodities markets would label a service contract (natural gas transport) that can only be settled by physical flow of natural gas and called it a swap only demonstrates a lack of basic understanding of energy business. It begs the question, if a regulator does not have a basic understanding of the business it regulates, should such a regulator even continue regulating that business?
As the new U.S. administration forms its strategic vision for financial regulation, many market participants are anxiously awaiting to hear what will become of Dodd-Frank. While a wholesale repeal of the statute seems unlikely because it would create a regulatory vacuum and operational uncertainty, it is clear that many provisions of the statute are unreasonably burdensome. The most likely approach to rolling back Dodd-Frank would be to start eliminating those regulations that burden commercial market participants, especially those that only use swaps to manage their price risk exposure. Also, the regulation of liquidity providers such as dealers, investment banks, and brokers should not be so cost-prohibitive to force such liquidity providers to withdraw from the markets and, thereby, make it more difficult for commercial market participants to find a readily available hedging providers. Any path to rolling back Dodd-Frank is going to take a while because the devil will be in details. For example, the pending final rules on position limits and mandatory margin requirements, just to name two, are much better left to the underlying trading exchanges to manage because the exchanges have the historical data and technical resources to properly monitor and manage them. A margin requirement for bilateral, noncleared, swaps should be left to the counterparties to manage. Most of those bilateral swaps already include some kind of credit support document with margin thresholds. However, each market participant’s creditworthiness should be considered on a case-by-case basis and the best way to do that is at the time of a transaction, in the context of such a transaction and not by a Federal regulator. If the energy market participants had the necessary risk management and business acumen to safely navigate the financial crisis of 2008-2009, they can certainly continue to do so now without the need for the CFTC to hold their hand.
Since some Dodd-Frank final rules are still being finalized, six and a half years after the statute was enacted, any rolling back of the statute is also likely to take several years. What is important during this process is to ensure legal certainty and enforceability of swap and commodity transactions. Also, while it is uncertain where will Dodd-Frank end up, it may be helpful to remind ourselves how Dodd-Frank came about. The primary reason for creating Dodd-Frank was the notion that financial products such as credit default swaps created financial crisis because they were not regulated. The truth was much more simple but, politically uncomfortable–the financial crisis of 2008-2009 was created because some market participants using credit default swaps, mortgage backed securities, and other financial instruments acted irresponsibly, disregarded the most basic risk management principles and common sense. There were plenty of state and Federal statute on the books at the time to punish anyone who engaged in fraud, deception, market manipulation, and similar conduct. However, that would have created some uncomfortable choices for many regulators, prosecutors, and lawmakers. A more convenient approach was to declare that the swaps and other financial products went out of control and caused the financial crisis because they were not regulated. Therefore, a major statute with global impact was enacted, in a large part, based on a false premise. Let’s hope that its replacement will be based in reality and truth.