Dodd-Frank Act seems to be gaining momentum and traction over the last month as the Commodity Futures Trading Commission has moved into overdrive. First, they moved to regulate the futures market under stricter rules and now they are monitoring the swap markets in a better manner as well.
Swaps are contracts between two parties where one party promises to make a fixed payment to the other while receive a floating or variable amount from the other party. There is a series of swap payments made to each other depending on who has to pay the higher amount and then the notional principal is swapped at the end of the contract like it was done in the beginning. The basic purpose of the agreement is to hedge against the change in interest rates that takes place. For example, a party who has taken a loan based on the infamous LIBOR can enter a swap where they receive the LIBOR while they pay a fixed amount. This way, this party would be able to make a fixed payment and cover its loan payments simultaneously.
As it should be expected, the swap market is custom made as every party would want rules or terms which favour it. That means there is no standardisation and contracts are negotiated and then drafted. The nature of the market is Over-the-Counter (OTC) which makes both parties liable to pay the other. The will to pay or meet their obligations depends on the parties themselves and that means they can default or run away from their obligation whenever they want. In order to gain flexibility and custom terms, the parties have to be exposed to a default risk. There is regulation in place to rectify this.
The CFTC has proposed a clearinghouse mechanism for interest rate and credit default swaps (CDS). Both parties would be asked to keep a certain amount or margin with the clearinghouse so that if the loss to one party is too large and they might back away, the clearinghouse can move in and pay the party which is expected to get the payment respectively. By allowing a clearinghouse, there would be more certainty injected into the market and there is a guarantee instilled in the system.
Investors are safe from an open credit risk with regards to each other and there is a certain safety net in case a party cannot fulfil the obligations expected from it. The proposal is going to cover four types of interest rate swaps which are denominated in the four major currencies. This proposal is the most significant step yet under the Dodd-Frank Act and is line with regulating the highly volatile CDS market which led to the crisis of 2008. At this point, the move is only going to govern interest rate swaps with similar proposals expected on energy, agriculture and equity indexes.
This is just another step towards a safer financial system and even though the financial sector would be expected to cringe at the sight of any regulation, it should be taken with a grain of salt. There are always going to be certain parts of the financial system that will raise questions to the added supervision and regulation. The previously unregulated market will have measures and systems in place which would be under the scrutiny of all the participants. The undermining of competitive advantage will be seen as prosecution and there is going to be a pushback in this regard. However, the end is the benefit of the investors and all the participants in the financial world and this will be a bitter pill that companies will have to swallow.