substance vs. form: rethinking the scope of dodd-frank`s end-user

SUBSTANCE VS. FORM: RETHINKING THE
SCOPE OF DODD-FRANK'S END-USER
CLEARING EXCEPTION IN LIGHT
OF SYSTEMIC RISK
David Hamid*
INTRODUCTION ..............................................
I.
DERIVATIVES .........................................
A. Overview of Derivatives and CDSs ..............
B. "Naked Swaps, "Speculation, and Social Utility ......
II. SYSTEMIC RISK ....
.................
......
A. Defining Systemic Risk.........
.............
i. Systemic Risk and the Financial Crisis of
2008 ....
...................
.....
B. FinancialInstitutions, Non-financial institutions, and
Systemic risk ..................
........
i. The view that financial institutions are
inherently systemically riskier than nonfinancial institutions..........................
ii. Systemic Risk is Not Generated Uniformly
Across All Financial Institutions ............
iii. Non-Financial Institutions and Systemic risk...
iv. Speculation and Systemic risk.............
v. Lack of Transparency and Systemic Risk .......
III. DODD-FRANK AND CALLS FOR REFORM ...............
A. Overview of Dodd-Frank
.....................
B. Title VII. Bringing Light to the OTC Derivatives
Market.
.................................
i. Classifying Swaps and Allocating Jurisdiction ..
ii. Registration of Dealers and Major Participants .
iii. Clearing, Trading, and Reporting ...........
IV. ANALYSIS & SCRUTINY OF THE END-USER EXCEPTION.
A. Statutory Requirements &rRulemaking Clarification . .
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* Candidate for J.D., 2014, Benjamin N. Cardozo School of Law; Bachelor of Arts, 2008,
New York University. I would like to express my deepest gratitude to my family for their love,
encouragement, and words of wisdom, not only over the course of this Note until the very end,
but also throughout my law school experience.
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B.
Critique .....
i.
ii.
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To the extent that an end-user is neither a SD
nor MSP, it should be allowed to avail itself of
the exception, irrespective of its financial or
.....................
non-financial nature .
Even assuming that financial institutions are
somehow inherently systemically riskier than
non-financial institutions (while controlling for
interconnectedness and quality of exposures),
the logic of the end-user exception is internally
inconsistent ..................................
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iii. Any end-user exception must always be
formulated against the backdrop of DoddFrank's goals of preventing and mitigating
systemic risk ............................
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INTRODUCTION
We view [credit derivatives] as time bombs, both for the parties that deal
in them and the economic system.
. .
. We try to be alert to any sort of
megacatastropherisk, and that posture may make us unduly apprehensive
about the burgeoning quantities oflong-term derivatives contracts and the
massive amount of uncollateralizedreceivables that aregrowing alongside.
In our view, however, derivatives are financial weapons of mass destruction, carryingdangers that, while now latent, are potentially lethal.1
In Berkshire Hathaway's annual report in 2002, company chairman and CEO Warren Buffet warned investors and the public of the
impending dangers surrounding a ballooning credit derivatives market.
Famously dubbing them "time bombs" 2 and "financial weapons of mass
destruction,"3 Buffet believed the large amount of credit risk that grew
increasingly concentrated among a relatively few derivatives dealers
presented the possibility of widespread systemic risk. He explained the
company's long-term attempts to remove its insurance subsidiary from
the business of derivatives contracts entirely, but acknowledged that it
would likely be many years before such a goal could be accomplished:
1 Berkshire Hathaway Inc. 2002 Annual Report, BERKSHIRE HATHAWAY,
31, 2002), http://www.berkshirehathaway.com/2002ar/2002ar.pdf.
2 Id. at 13.
3 Id. at 15.
4 Id.
INC.,
13-15 (Dec.
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SUBSTANCE VS. FORM
185
"closing down a derivatives business is easier said than done," and "[l]ike
Hell" the derivatives business is "easy to enter and almost impossible to
exit."5
Buffet's admonitions may have been prescient of a larger danger in
the financial markets that erupted in full force in 2008. Around the
same time the report was published, the total notional amount outstanding at the end of 2002 on all surveyed credit default swaps contracts (hereinafter "CDSs"),6 a particular form of derivatives, stood at
approximately $2.2 trillion.7 At the end of 2007, that same figure
8
jumped to approximately $62.2 trillion. While the notional outstanding amount of all CDSs eased to around $25.9 trillion by the end of
2011, the use and pervasiveness of CDSs has been by no means
insignificant.9
The derivatives market was almost entirely unregulated prior to
2010. Derivatives were sold, traded, and settled over-the-counter (hereinafter "OTC") as privately negotiated agreements outside the purview
of regulators. No federal law or regulation required that they be cleared
through a centralized counterparty or exchange traded on a particular
Id. at 13.
A CDS "is an agreement by one party to make a series of payments to a counter party, in
exchange for a payoff, if a specified credit instrument goes into default." 13A COMMODITIES
REG. § 27:19.
7 ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts,
1987-present,INTERNATIONAL SWAPS AND DERIVATIVEs ASSOCIATION (2010), http://www.isda
.org/statistics/pdf/isda-market-survey-annual-data.pdf (last visited Oct. 19, 2012) (hereinafter
ISDA Market Survey). Notional amount in the context of CDSs "refers to the par amount of
credit protection bought or sold, equivalent to debt or bond amounts, and is used to derive the
premium payment calculations for each payment period and the recovery amounts in the event
of a default." UnderstandingNotional Amount, ISDA CDS MARKETPLACEsm , http://www.isdacdsmarketplace.com/market-overview/understanding-notional-amount (last visited Dec. 16,
2013). As the International Swaps and Derivatives Association (hereinafter "ISDA") explains,
this figure is frequently used as a measure of the size of credit default swap market because
notional amount is relatively easy to identify and gather and is consistent over time. However,
the ISDA cautions against interpreting it as a measure of either new credit derivative activity
(since notional amount represents a "cumulative total of past transactions") or as some measure
of risk (since cash flow obligations amounts and mark-to-market exposures are both normally a
small percentage of notional amount, and "netting of obligations under a master agreement and
collateralization of exposures reduces credit exposures to less than one percent of notional
amount"). Id. See also JOHN KIFF ET AL., Credit Derivatives: Systemic Risks and Policy Options?,
INTERNATIONAL MONETARY FUND 4 (Nov. 2009), http://www.imf.org/external/pubs/ft/wp/
2009/wp09254.pdf (positing that actual credit risk lies somewhere between the net and gross
outstanding notional numbers).
8 ISDA Market Survey, supra note 7.
9 UnderstandingNotionalAmount, supra note 7.
5
6
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platform." Many scholars posit that the lack of oversight in a looming
CDS market had allowed some market participants to become heavily
entrenched in it." For example, when the federal government committed nearly $182.3 billion in the form of capital infusions and preferred
equity investments in insurerl 2 American International Group (hereinafter "AIG") in 2008,1 AIG Financial Products, one of AIG's non-insurance subsidiaries (hereinafter "AIGFP"), had sold over $440 billion in
CDS policies.' 4 AIGFP was unable to honor its payment obligations to
10 Clearinghouses "play a crucial role in markets from equities to derivatives, stepping in
between two parties in a trade to guarantee payment if either side reneges" by "requir[ing] their
members - banks and brokers - to be well-capitalized, to deposit collateral, and to pay into a
default fund" to protect against the risk of default. Hester Plumridge, What Ifa ClearingHouse
Failed?,WAu. ST. J., Dec. 2, 2011, http://online.wsj.com/news/articles/SB1000142405297020
4397704577074023939710652. Exchanges also play an important role by creating marketplaces in which financial instruments are traded, ensuring "fair and orderly trading, as well as
efficient dissemination of price information for any securities trading on that exchange." Exchange, INVESTOPEDIA, http://www.investopedia.com/terms/e/exchange.asp
(last visited Dec.
16, 2013). While clearinghouses and exchanges are similar in that they both essentially stand
between market participants, and while most of the large exchanges in the U.S. own their own
clearinghouses, it is important to keep in mind the functional difference between the two especially as it relates to systemic risk: clearinghouses mitigate systemic risk by mitigating losses
suffered by one counterparty to a derivatives contract as a result of the other counterparty's
default, while exchanges provide a formal platform for such transactions to take place and provide potential buyers with pre-trade price transparency. See Exchanges vs. Clearinghouses,EcoNOMICS OF CONTEMPT (April 14, 2010, 4:36 PM), http://economicsofcontempt.blogspot.com/
2010/04/exchanges-vs-clearinghouses-this-is.html (arguing that virtually all of the systemic risk
mitigation in derivatives reform - reduced counterparty risk, the huge increase in transparency,
the reduced complexity, regulatory access to the necessary data, etc. - comes from the clearing
requirement" and not the "exchange-trading requirement").
"1 See, e.g., Regulatory Oversight and Recent Initiatives to Address Risk Posed by CreditDefault
Swaps, U.S. Gov't Accountability Off 14 (Mar. 5, 2009), http://www.gao.gov/new.items/
d09397t.pdf (discussing the concentration risk, which "refers to the potential for loss when a
financial institution establishes a large net exposure in similar types of CDS," that inheres in an
OTC derivatives market).
12 An insurer is a company that "agrees, by contract, to assume the risk of another's loss and
to compensate for that loss." Insurer, BLACK's LAw DICTIONARY (9th ed. 2009).
13 Zachary Tracer, AIG Bailout Ends Four Years After Two-Year Plan: Timeline, BLOOMBERG
(Dec. 11, 2012), http://www.bloomberg.com/news/2012-12-11/aig-bailout-ends-four-years-after-two-year-plan-timeline.htmi. Colloquially known as the "bailout," the federal government
implemented the "Troubled Asset Relief Program" in the wake of the financial crisis to stabilize
the U.S. economy. See Investment in American InternationalGroup (AIG), U.S. DEP'T OF THE
TREASURY, http://www.treasury.gov/initiatives/financial-stability/TARP-Programs/aig/Pages/default.aspx (last visited Nov. 13, 2013) ("AIG's failure would have been devastating to global
financial markets and the stability of the broader economy. Therefore, the Federal Reserve and
Treasury acted to prevent AIG's disorderly failure.").
14
Xinzi, Zhou, AIG, Credit Default Swaps and the FinancialCrisis, RISK MGMT. Soc'v 4
(May 18, 2013), http://clubs.ntu.edu.sg/rms/researchreports/AIG.pdf.
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buyers because it failed to anticipate the high rate of defaults of the
reference entities tied to such policies." AIG's failure to ascertain
AIGFP's true exposure to credit risk from the large concentration of
CDSs it had underwritten, 16 and the convoluted, interconnected nature
of financial institutions and the derivatives market as a whole,' 7 created
systemic risk that threatened the integrity of the broader economy.
In July 2010, President Barack Obama signed into federal law the
Dodd-Frank Wall Street Reform and Consumer Protection Act (hereinafter "Dodd-Frank"), legislation spanning over 13,789 pages" and imposing some of the most significant changes to financial regulation in
the United States since the regulatory response following the Great Depression.' 9 In particular, Title VII of Dodd-Frank, known as the Wall
Street Transparency and Accountability Act of 2010, mandates regulation of the swaps markets by bestowing jurisdictional responsibilities
and rulemaking powers to the Commodities and Futures Trading Commission (hereinafter "CFTC") and the Securities and Exchange Commission (hereinafter "SEC"). By seeking to bring transparency in the
hopes of preventing serious systemic risk, Dodd-Frank marks a departure from the unregulated world of in the shadows OTC trading.
Part I of this Note provides an overview of derivatives: what they
are, why they are used, and normative and utilitarian considerations
(i.e., the should questions). In particular, it looks at CDSs, since they
have been at the forefront of scrutiny and are perceived to pose of all
derivative instruments the greatest threat to systemic risk. It points out
that, despite the negative discourse, they serve useful and beneficial purposes in a modern and efficiently functioning economy. Part II posits a
framework for understanding systemic risk and describes how systemic
'5 Id
16 See Neal S. Wolin, Remarks at the InternationalSwaps and Derivatives Association 25th
Annual Meeting (Apr. 22, 2010), available at http://www.treasury.gov/press-center/press-releases/Pages/tg656.aspx ("Because derivatives like credit default swaps . . . were traded on a
bilateral basis, few understood the magnitude of aggregate derivatives exposures in the system.
Risks embedded in AIG's $400 billion exposure to CDS, which brought that global institution
to its knees and threatened to bring the financial system down with it, went unseen by the
market and by regulators alike.").
17 See infra Part II.
18 This figure includes all rulemaking provisions as ofJuly 22, 2013. The statutory text of
Dodd-Frank is 848 pages. See Joe Mont, Three Years In, Dodd-FrankDeadlinesMissed As Page
Count Rises, COMPLIANCE WEEK (Jul. 22, 2013), http://www.complianceweek.com/three-yearsin-dodd-frank-deadlines-missed-as-page-count-rises/article/303986/.
19 See DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION Acr, Pub.L.
No. 111-203, H.R. 4173 (2010) (hereinafter DODD-FRANK).
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risk manifested itself in the financial crisis of 2008. Part III looks at
how Title VII of Dodd-Frank changes (and creates) the regulatory
framework for derivative transactions, with a particular exposition of a
seemingly narrow exception it carves out for end-users. Part IV then
addresses this exception and argues that some aspects of its current formulation is misguided against the backdrop of Dodd-Frank's overall
goal of preventing systemic risk. By predicating eligibility on the type of
entity involved, the exception's current formulation may be exceedingly
overinclusive by allowing major albeit "non-financial" end-users to avail
themselves of the exception without accounting for their derivative
transactions' potential contributions to systemic risk. Furthermore, it
points out that even if financial end-users ipso facto generate more systemic risk than non-financial end-users because of the "financial" nature
of their businesses, the logic of the exception is internally inconsistent,
as the exception carves out exemptions for institutions that are indeed
"financial" in the nature of the services they provide (and therefore
would be categorically disqualified from invoking the exception but for
such exemptions).
I.
A.
DERIVATIVES
Overview of Derivatives and CDSs
At the end of June 2012, the total notional outstanding amount of
OTC derivatives reached $639 trillion. 2 0 Of this amount, interest-rate
swaps represented the largest risk category, compromising approximately
77% of the entire derivatives market, followed by foreign exchange derivatives (hereinafter "FX") at 10.5%, equity-linked and commodity derivatives at 1.0%, and CDSs at 4%.21 Using the Bank of International
Settlement's (hereinafter "BIS") working definitions, of the total outstanding derivatives contracts at this time, financial entities constituted
approximately 85% of all counterparties, and non-financial entities approximately 8-10%.22 A survey of the world's 500 largest companies
20 Statistical release: OTC derivatives statistics at end-June 2012, BANK FOR INT'L SETTLEMENTS 1 (2012), http://www.bis.org/publ/otc-hyl2l1.pdf.
21 Id. at 2. Percentages here do not add up to 100% because the statistics provide for an-
other market risk category called "Other." See id. at 1.
22 The BIS does not specifically use the term financial entities. It uses three categories of
participants: "reporting dealers," "other financial institutions," and "non-financial customers."
The first two categories roughly correspond to the concept of a financial entity in Dodd-Frank,
and the latter category to that of a non-financial entity. See Id. at 2. Moreover, these percentages were calculated by summing the attributable shares of "reporting dealers," "other financial
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across eight sectors found that in 2009 approximately 94% of them used
derivatives to help manage their commercial risks. 2 3 Of these companies, approximately 98% within the financial sector reported using derivatives.2 4 Companies of other sectors reported that they were using
derivatives, on average, only 5.4% less than financial sector companies. 2 5
Clearly, the usage of derivatives by both non-financial and financial
companies has been by no means trivial.
Derivatives were largely absent from public discourse prior to the
economic collapse. 2 6 However, CDSs, one type of derivatives, have
been well known in the world of finance since the mid-1990s. Investment bank J.P. Morgan & Co. is credited with structuring the first
CDS market, 27 "an idea that changed the entire nature of modern banking, with consequences that are currently rocking the planet." 2 8
A CDS is best understood when one first considers the broader
category of financial products to which it belongs, derivatives, as well as
another category to which it belongs that is a subset of derivatives,
known as credit derivatives. A derivative is a financial instrument that
derives its value from something else, which is usually an underlying
institutions," and "non-financial customers" for outstanding derivatives contracts in each FX,
interest rate, equity-linked, commodities, and credit-default swaps. "Reporting dealers" and
"other financial institutions" were combined as a proxy for "financial entity" as used in the enduser exception. Both percentages here do not add up to 100% because the statistics do not
provide the aforementioned breakdowns by counterparty in the case of commodity derivatives.
See Detailed tables on semiannual OTC derivatives statistics at end-June 2012, BANK FOR INT'L
SETTLEMENTS (2012), http://www.bis.org/statistics/derdetailed.htm.
23 Over 94% of the World's Largest Companies Use Derivatives to Help Manage Their Risks,
According to ISDA Survey, INT'L SWAPS AND DERIVATIVES Ass'N (April 23, 2009), http://
www2.isda.org/attachment/MTY2MQ==/pressO42309der.pdf.
24 Id
Id
See Janet Morrissey, Credit Default Swaps: The Next Crisis?, TIME MAGAZINE (Mar. 17,
("Not familiar
2008), http://www.time.com/time/business/article/0,8599,1723152,00.html
with credit default swaps? Well, we didn't know much about collateralized debt obligations
(CDOs) either - until they began to undermine the economy. Credit default swaps, once an
obscure financial instrument for banks and bondholders, could soon become the eye of the
credit hurricane. Fun, huh?").
27 Matthew Philips, The Monster That Ate Wall Street: How 'creditdefault swaps'-an insurance against bad loans-turnedfrom a smart bet into a killer, NEWSWEEK MAGAZINE, Sept. 26,
2008, http://www.thedailybeast.com/newsweek/2008/09/26/the-monster-that-ate-wall-street
.html.
28 John Lanchester, Outsmarted:Highfinance vs. human nature, THE NEW YORKER, June 1,
2009, http://www.newyorker.com/arts/critics/books/2009/06/01/090601crbo-bookslanches
ter.
25
26
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asset or benchmark rate.2 9 What a derivative means in the day-to-day
world of finance is that it is a legal agreement between two parties that
specifies payment from at least one of the parties to the other3 0 when
certain predetermined conditions are satisfied.3 1 Such predetermined
conditions could be the occurrence of a date, a resulting value of an
underlying asset or an outstanding notional amount of the contract itself, or a default of an issuer on its debt. Derivatives are primarily used
for three reasons: (i) hedging, which is the practice through which a
market participant mitigates its risk in a particular underlying asset; 3 2
(ii) speculation, through which a market participant acquires the risk in
the underlying asset by betting on the direction of that underlying asset 3 3 and hoping that that bet realizes a profit;34 and (iii) for arbitrage,
which is when a market participant takes advantage of a going price of
an asset in the market that is currently below the price of that same asset
specified in contracts to sell the asset at a future date.3 1
The classic example of a basic and longstanding derivative is a jutures contract, demonstrated by the following hypothetical. Suppose at
the present moment ("tj"), A, a farmer, is concerned that the price of
wheat will decrease at some point in the future. Similarly, B, a miller, is
afraid that the availability of wheat in the marketplace will decrease.
Obviously, A must sell her wheat to a buyer, such as miller B, after she
grows it in order to realize a profit. B must buy his wheat from a seller
such as farmer A so that B may mill the wheat, sell the resulting grain,
and realize a profit. A and B enter into a futures contract with one
another whereby at a specified date ("t 2 ") A agrees to deliver to B a
specified amount of wheat, and B agrees to give A a specified amount of
cash in return. 3 6 The value of the futures contract is derived from the
29 Typical benchmark rates include but are not limited to interest rates, commodities, U.S.
Treasury bonds, stocks, and currencies. See Derivative, BLACK's LAw DICTIONARY (9th ed.
2009).
30 That is, the payment could be either a periodic stream of payments or a one-time lump
sum, and both parties could contract to receive payment(s) from each other.
31 Derivative, BLACK's LAw DICTIONARY (9th ed. 2009).
32 Hedge, BLACK's LAw DICrIONARY (9th ed. 2009).
33 For example, will the price of the asset increase or decrease?
34 Speculation, BLACK's LAw DIcTIONARY (9th ed. 2009).
35 Arbitrage, BLACK's LAW DICTIONARY (9th ed. 2009).
36 Basic economic intuition explains why farmer A and miller B would undertake such a
transaction: if the price of wheat decreases in the future, then, ceterisparibus, A's profits would
be reduced because she would have to sell her wheat at a lower price than at present. Similarly,
if the availability of wheat in the marketplace decreases in the future, then, ceteris paribus, B's
profits would be reduced through reduced output (e.g., the reduced grain he sells) resulting from
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predetermined price and quantity of wheat at te, and the specified condition to trigger this exchange is the specified future date of t2 .7'] Because futures contracts must be cleared and exchanged-traded, 38 A and B
are reassured that their agreed upon exchange will take place if at or
prior to t 2 an event occurs that could otherwise prevent it.39 A clearinghouse will require that both A and B post an initial amount of cash, or
margin, so that if A reneges on her end of the bargain by selling her
wheat on the open market before t 2, the clearinghouse applies that margin to B's loss. An exchange (which may or may not also own the
purchasing a quantity of wheat lower than the most efficient quantity that his business can
process. Thus, A and B have hedged their exposure to future risks: A has hedged against a
decrease in the price of wheat at t2 by locking-in a price at ti, and B has hedged against a
decrease in the availability of wheat at t2 by locking-in a specified quantity at ti. Nonetheless, in
some respects, both A and B have also assumed market risk if A and B's respective expectations
about the wheat market at t2 are both incorrect (i.e., the price of wheat on the open market
actually increases and the supply of wheat is markedly abundant). The market risk here to A
would be the foregone gross profit as a result of selling wheat at a price lower than its fair market
value, and the market risk to B would be the higher cost it would need to pay for wheat per the
contract than the fair market value. See, e.g., Market Risk, INVESTOPEDIA, http://www.investopedia.com/terms/m/marketrisk.asp (last visited Dec. 16, 2013).
37 Every futures contract involves two positions: the party agreeing to buy the underlying
asset in the future, or the buyer, assumes a "long" position in the contract, and the party agreeing to sell the asset in the future, or the seller, assumes a "short" position. This terminology
reflects the expectations of the parties regarding the marketplace at t2 when entering into the
futures contract at t,. In this case, A hopes or expects that the price of wheat will decrease
("short") in near future; otherwise, locking in a price at t would be undoubtedly economically
irrational. The best way of understanding B's "long" position here is focusing on the specified
price of wheat that A agrees to charge B at t 2 for the specified quantity of wheat to be delivered.
While the hypothetical is framed in terms of B's concern over the availability of wheat at t 2 and
not the price of wheat per se, the availability of wheat in the marketplace (or lack thereof),
would, ceterisparibus,invariably affect the price of wheat in the marketplace. Particularly, if the
quantity supplied of wheat in the marketplace at t2 significantly decreases, the market price of
wheat would increase. Thus, it could be said that B is also expecting that the price of wheat at t 2
will increase ("long"), and thus locking in a specified price now (along with a specified quantity).
See Ream Heakal, Futures Fundamentals:How The Market Works, http://www.investopedia.com/
university/futures/futures2.asp (last visited Oct. 21, 2012).
38 See 7 U.S.C. § 6(a) (2010) (Commodity Exchange Act § 4(a)).
39 In particular, A and B might worry about the possibility of the weather destroying the
wheat grains, or one of them defaulting on or reneging on its end of the bargain. An economic
actor in this situation may renege if favorable market conditions present themselves at some
point after t, and on or before t2 - conditions that at least one of the parties may have failed to
account for prior to undertaking the futures contract. For example, if the specified price of
wheat that A is to sell B at t2 is $5/barrel, and at some point at or directly before t2 the fair
market value of wheat spikes to $10/barrel, A may be induced to breach the contract by selling
the wheat at fair market value since that would increase his gross profit two-fold.
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clearinghouse"o) also provides B a platform on which to find another
trading partner and protect itself against default.
A and B may also enter into a swaps agreement to address other
concerns. For example, A and B might be dissatisfied with their respective revenue streams - but it just so happens that A feels more uncertain
about his revenue for the year than does B, and B thinks that A's projected revenue stream is still more favorable in absolute terms than B's.
By swapping their respective revenue streams with one another, A and B
now receive revenue streams that each feels is more preferable than prior
to entering into the swaps agreement and without having to change legal
ownership.4 ' In essence, the swaps agreement has allowed A and B to
efficiently allocate their respective preferences and risk appetites, resulting in what is seemingly a "win-win" situation.4 2
With the increasingly central role of credit in the economy, 3 businesses may also be concerned with credit risk. Credit risk is the "risk
due to uncertainty in a counterparty's
. . .
ability to meet its financial
obligations."4
By applying the same concepts of financial risk management that underlie instruments such as futures and swaps, financial ingenuity spawned the invention of the CDS to mitigate and hedge credit
40
41
See supra, note 10 (discussing the roles of clearinghouses and exchanges).
See, e.g., Kevin Dolan & Carolyn DuPuy, Equity Derivatives: Principlesand Practice, 15
VA TAx REV. 161, 164 (1995).
In addition to mitigating or more efficiently allocating real or
perceived risk as the entity's motivating factor, it is important to consider the tax implications of
entering into a revenue swap transaction as opposed to some other form of risk mitigation/
allocation. See [ 10.03 SWAP TRANSACTIONS, 1999 WL 629829, 1.
42 Of course, this simplistic example does not account for externalities, which are the "spillover" costs or consequences of one's economic activity that cause a third-party not privy to the
transaction to benefit without paying or to suffer without compensation. Externality, BiACK'S
LAW DICTIONARY (9th ed. 2009). A transaction that results in negative externalities is arguably
not a win-win situation; it might be for the parties directly privy to the transaction, but not for
society at large. Moreover, economic theory recognizes that not all transactions in which parties
are free to allocate risks necessarily result in an optimal allocation thereof; some markets are
prone to asymmetries whereby some parties have better access to or simply more information
directly informing the transaction. See, e.g., Joseph E. Stiglitz, Asymmetries ofInformation and
Economic Policy, PROJECT SYNDICATE (Dec. 4, 2001), availableat http://www.project-syndicate
.org/commentary/asymmetries-of-information-and-economic-policy.
43 See Report to the Congress on Practices of the Consumer Credit Industry in Soliciting and
Extending Credit and theirEffects on Consumer Debt and Insolvency, BD. OF GOVERNORS OF THE
FED. RESERVE Sys. (June 2006), available at http://www.federalreserve.gov/boarddocs/rptcongress/bankruptcy/bankruptcybillstudy2006O6.pdf (discussing the history of consumer credit in
America and its increasing demand since the 1920s).
44 Glyn A. Holton, Credit Risk, RISK ENCYCLOPEDIA, available at http://riskencyclopedia
.com/articles/credit risk/ (last visited Dec. 16, 2013).
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risk. It may be easier to understand the ways in which credit risk
presents itself in the context of modern-day banking. Say Bank C is
concerned about a loan of $2 million it has underwritten to a commercial Client X, whose recent activities have exposed it to legal liabilities so
large that they materially threaten its ability to honor its obligations to
Bank C and other creditors. 5 Under standard regulatory requirements,
Bank C needs to reserve a certain amount of cash in proportion to the
45 This hypothetical largely patterns the first CDS transaction in 1994 between J.P. Morgan
and the European Bank of Reconstruction and Development. In 1989, an oil tanker belonging
to (what is now known as) Exxon Mobile Corp. spilled hundreds of thousands of barrels of
crude oil in Alaska, an unprecedented environmental disaster that made Exxon the target of
numerous liabilities. Nonetheless, it approached J.P. Morgan and asked the bank for a multibillion dollar line of credit to cover potential damages of five billion dollars resulting from the oil
spill. Because Exxon had been a long-standing client of J.P. Morgan, the bank was reluctant to
turn the corporation away and risk damaging a relationship with its client. Under regulatory
requirements ("Basel Rules") lenders such as J.P. Morgan needed to reserve a certain portion of
cash to cover the risk of Exxon defaulting on the loan - reserve requirements that, in turn,
limited the amount of lending J.P. Morgan could do, the amount of risk it could take on, and
thus the amount of profit it could make. Where J.P. Morgan parted with convention in the
finance world at the time was by thinking of how to sell the risk of the loan instead of selling the
loan itself. While an outright sale of the loan would have obviously removed the risk of Exxon's
default entirely, J.P. Morgan may have thought that such a sale would be an inappropriate
decision for numerous reasons, namely transactional costs (e.g., time and expense in finding a
buyer), legal requirements (e.g., obtaining consent of the borrower, Exxon), reputational costs
(e.g., Exxon viewing the sale of loan, ascertained by news in the market or media, as J.P. Morgan's distrust of or doubts in Exxon's ability to make good on its financial obligations, thereby
damaging the lender-client relationship), and/or simple pecuniary gain (i.e., why share or sell
potential profit if you don't have to?). By selling the credit risk to the European Bank, J.P.
Morgan's hands were, in effect, washed clean if Exxon did default; in return, the European bank
received premium payments from J.P. Morgan to insure against this possibility. In the end, each
party got ahead - or at least, thought they did - based on the information available to them and
on their individualized assessments of market conditions and their respective businesses: Exxon
got its credit line, the European Bank received regular cash premium payments, and J.P. Morgan
was able to not only honor its relationship with a long-standing client but also free up capital
that it could now reallocate to other more useful and profit-generating activities. John
Lanchester, Outsmarted: High finance vs. human nature, THE NEW YORKER (June 1, 2009),
see
http://www.newyorker.com/arts/critics/books/2009/06/01/090601crbobookslanchester;
Transcript of Money, Power & Wall Street: Part One, PBS, http://www.pbs.org/wgbh/pages/
frontline/business-economy-financial-crisis/money-power-wall-street/transcript-19
(last visited
Dec. 16, 2013) (narrative from B. Masters, member of J.P. Morgan's swaps team that executed
the 1994 deal, explaining what J.P. Morgan sought to accomplish through a credit derivative
swap); see also The Financial Crisis, the FRONTLINE Interviews: Credit Default Swaps, PBS,
http://www.pbs.org/wgbh/pages/frontline/oral-history/financial-crisis/tags/credit-default-swaps
(last visited Dec. 16, 2013) (narrative from T. Duhon, J.P. Morgan banker responsible for
building up the bank's credit derivative trading book after the 1994 deal, explaining the bank's
considerations in executing the credit derivative transaction).
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loan in case Client X defaults. 6 Nonetheless, Bank C may feel like
being extra precautious if it feels that the amount of reserved capital
would not adequately compensate it in case of default by Client X.4 7
Bank C enters into a CDS agreement with Insurance Company D,"
who believes that Client X's risk of defaulting is relatively small. Bank
C and Insurance Company D negotiate the specific terms4 ' of the CDS
agreement, including the ambit of events that are to be deemed a "de5
fault.">
>
Bank C agrees to pay $100,000 in quarterly installments51 to
The basic model of a fractional-reserve banking system assumes that depositing-taking
banks accept depositor money and loan out a significant majority of that money, generating
revenue for itself in the excess of the amount of interest it charges on its loans over the amount
of interest it gives its depositors. Basel III regulations have imposed target capital requirements
on banks to be anywhere from eight to twelve percent. See Lev Ratnovski, How much capital
should banks have?, VOX (July 28, 2013), available at http://www.voxeu.org/article/how-muchcapital-should-banks-have.
47 Looking at this hypothetical from a post-hoc perspective, if Bank C has entered into the
CDS agreement with Insurance Company D at to (as described in the immediately following
sentence), and if Client X defaults on its obligations shortly thereafter, then Bank C has made a
very prudent risk management decision: it is receiving from Insurance Company D the full face
value of $2 million, which is greater than the amount of capital it has reserved (which is a small
percentage of the loan's face value).
48 It should be noted that the entities in this hypothetical were chosen for the sake of clarity.
It may be tempting to think that CDSs are insurance policies, or that only insurance companies
are sellers of CDS protection (they are not). While CDSs arguably resemble insurance policies in
many regards, and while the sellers of CDS protection may be easily analogized to underwriters
of insurance policies, important differences exist between CDSs and insurance policies. CDSs
are not regulated under insurance law in any U.S. jurisdiction, and Dodd-Frank expressly
preempts regulation of swaps or security-based swaps under state insurance laws. Nonetheless,
considerable debate abounds as to the logical coherence of treating CDSs differently from insurance policies; those who support regulating CDSs under the auspices of insurance law argue
CDSs serve substantively the same economic purposes as does insurance.
49 As discussed in infra note 50, the ISDA Master Agreement is used by almost all parties
involved in a real-life derivatives transaction and would likely serve as the framework for defining key terms of the agreement and obligations of the parties.
50 "Default" in the context of CDSs generally encompasses a number of specified credit
events, one of which is the actual default of a reference entity. The International Swaps and
Derivatives Association (hereinafter "ISDA") has crafted a standard form contract called a
Master Agreement (hereinafter "ISDA Master Agreement") and its use is near ubiquitous among
participants in the global OTC derivatives market (which includes CDSs). Charles R. Mills,
2nd Circuit: Credit Default Swap Terms Must Be Strictly Construed 27 No. 4 FTrruREs & DERIVATIVEs L. REP. 1. The ISDA Master Agreement, most recently updated in 2002, serves as the
central document in the framework of derivatives transactions and defines "the legal and credit
relationship between the counterparties, including representations and warranties, events of default and termination, covenants and choice of law." Id. (internal citations removed). "Confirmations" documents supplement the ISDA Master Agreement and allow the parties to define
the "precise risk that [they] wish to transfer, by setting forth the economic terms and transaction-specific modifications to the ISDA Master Agreement . . . [and] define, among other
46
2013]
SUBSTANCE VS. FORM
195
Insurance Company D over five years 52 in return for Insurance Company D paying Bank C if Client X defaults. Thus, if the CDS is executed at to, and, if after maturity of five years and the twentieth and final
quarterly payment at t2 0 no event of default occurs, the CDS terminates
and Insurance Company D makes no payment to Bank C. If, however,
Client X defaults after Bank C's fifth quarterly payment at t5 , Insurance
Company D must pay Bank C the incurred loss, which they had agreed
at to to be the full notional amount of Client X's $2 million liability. In
return, Bank C must deliver to Insurance Company D the debt obligation of Client X, which has a face value of $2 million but a smaller fair
market value at t5.1
things, the specific terms of the Credit Event." Id. (internal citations and quotations removed).
Typical credit events stipulated in the agreement usually include the reference entity's bankruptcy, obligation acceleration ("when the obligation becomes due and payable before its normal
expiration date"), obligation default (a "technical default, such as violation of a bond covenant"),
failure to pay due payments, repudiation/moratorium ("compensation after specified actions of a
government," or delay in payment), or restructuring ("reduction and renegotiation of delinquent
debts in order to improve or restore liquidity."). Christian Weistroffer, Credit default swaps:
Heading towards a more stable system, DEUTSCHE BANK RESEARCH, http://www.dbresearch.com/
PROD/DBRINTERNETEN-PROD/PROD0000000000252032.pdf (last visited December
21, 2009). While the typical counterparties to CDS transactions have sophisticated counsel to
ensure that the "default" event encompasses a wide range of circumstances, CDS agreements
have nonetheless "been the subject of several lawsuits, for example, concerning whether an event
of default has occurred," and "are likely to give rise to additional litigation because of the recent
financial crisis. See John D. Finnerty & Kishlaya Pathak, A Review of Recent Derivatives Litigation, 16 FoRDHAM J. CORP. & FIN. L. 73, 89 (2011).
51 CDSs are generally structured so that the buyer of the policy pays the seller quarterly
premium payments in arrears. See MARK ANSON ET AL., CREDIT DERIVATIVES: INSTRUMENTS,
APPuCATIONS, AND PRICING, 49 (2004).
52 Also known as the "maturity." Five years is the most common maturity for CDSs. ANUNDERSTANDING CREDIT DERIVATIVES AND RELATED INSTRUMENTS, 70
(2005).
53 This process is known as "settlement" and is usually agreed upon up-front. It takes two
forms: physical settlement and cash settlement. The example here assumes physical settlement,
whereby "the protection buyer has to deliver the underlying bond in exchange for compensation." Christian Weistroffer, Credit default swaps: Heading towards a more stable system,
TJLIO BOMFIM,
DEUTSCHE BANK RESEARCH (last visited December 21, 2009), http://www.dbresearch.com/
Cash settlement,
PROD/DBRINTERNETEN-PROD/PROD0000000000252032.pdf.
which does not require delivery of the instrument, would occur if the "protection buyer receives
the difference between the bond value at the time of settlement and the bond's nominal value in
cash." Id. In this example, cash settlement would mean that instead of Insurance Company D
paying the full notional amount of $2 billion in exchange for Bank C's delivery of the obligation, it instead pays the difference between that $2 billion and the value of Client X's loan
obligation at the time of settlement. Physical settlement was the most commonly used form
until 2005, constituting 73% of both settlement types by the end of that year. Id. However,
cash settlement has become more widely used due to the incorporation of auction settlement
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In effect, the CDS has allowed Bank C to swap the risk of default
on Client X's credit obligation for a potential payout by Insurance Company D in case Client X defaults. It is a derivative instrument because
its value derives from a specified credit event (the default of the reference entity, Client X) and a swap 4 because the CDS buyer swaps the
risk of default for compensation to the seller. Similar to the futures
contract between Farmer A and Miller B, the CDS agreement between
Bank C and Insurance Company D has allowed each of them to allocate
their risks more efficiently.5 5
Thus, of the three broad reasons as to why derivative instruments
are used, this example demonstrates that credit derivatives can be a
highly effective tool in hedging credit risk. In addition, by shifting the
risk to Insurance Company D, Bank C may keep less capital in reserve
to protect against Client X's default, allowing it to allocate more capital
to the business of making more loans or investing in some other profitgenerating venture. Either way, Bank C has increased liquidity 6 in the
procedures in credit default swap agreements, and due to issuance of "naked swap" agreements
especially in the height of the financial crisis that resulted in an amount of underwritten protection that exceeded the deliverable underlying assets, thereby making physical settlement impossible for at least some CDS buyers. See id.; see also Virginie Coudert & Mathieu Gex, The Credit
Default Swap Market and the Settlement of Large Defaults, CENTRE D'ETUDES PROSPECTIVES ET
D'INFORMATIONS INTERNATIONALES, Working Paper No. 2010-17, http://www.economiein-
ternationale.eu/anglaisgraph/workpap/pdf/2010/wp2010-17.pdf (which discusses the concerns
raised about the market's ability to settle major entities' defaults given the enormous positions
assumed by CDS buyers in CDSs referencing those entities).
54 It could be argued that the term "credit default swap" is a bit of a misnomer because out
of the family of derivative products, CDSs more practically resemble options rather than swaps.
See Rahul Bhattacharya, A CreditDefault Swap (CDS) is a proxy for a Put Option on the Assets ofa
Firm, RIsKLATTE (Oct. 5, 2008), available at http://www.risklatte.com/Articles/QuantitativeFin
ance/QF100.php.
55 If Client X never defaults on its obligation, Bank C recovers its $2 million from Client X
at t2 0 , upon maturity. While the aggregate of the premiums to Insurance Company D are nonrecoverable and would thus result in reduced net return on investment, Insurance Company D
has nonetheless reduced its risk of loss on the loan. If Client X defaults on its debt just over a
year at t5 , then Bank C stops paying the quarterly premiums and Insurance Company C ensures
that the obligation of $2 million is refunded. Even though Bank C still cannot recover the
premiums paid up to and including t 5 , it would have lost the entire $2 million without the
credit default swap contract in place. Obviously, these examples make a number of assumptions, namely the solvency of the CDS seller and its ability to honor its obligations to the CDS
buyer in case of the referenced entity's default. In the case of the financial crisis, this particular
assumption proved highly problematic and simply untrue for many dealers of CDS.
56 Liquidity is a financial instrument's "quality or state of being readily convertible to cash."
Liquidity, BLACK'S LAW DIcnoNARY (9th ed. 2009).
SUBSTANCE VS. FORM
2013]
197
market, which ultimately benefits Main Street57 because businesses will
have access to more capital and at a cheaper cost.
B.
'Naked Swaps, " Speculation, and Social Utility
The example of the CDS agreement above assumes that Bank C
owns the underlying asset that it seeks to protect against default. But, as
it became especially evident after the financial crisis, CDS buyers need
neither own the underlying asset nor have any material exposure to a
particular risk associated with it." Instead, buyers have been able to use
CDSs to speculate or make bets on the outcome of risks associated with
the asset. For example, if Market Participant S believes that the mounting liabilities faced by Client X's business might soon push Client X
into default, S may speculate on Client X's default by doing exactly
what Bank C did: enter into a CDS agreement with Insurance Company D. Market Participant S agrees to pay Insurance Company D
quarterly premiums in return for a payout by Insurance Company D in
the event Client X defaults.5 Market Participant S hopes that Client X
57 "A colloquial term used to refer to individual investors, employees and the overall economy. 'Main Street' is typically contrasted with 'Wall Street.' The latter refers to the financial
markets, major financial institutions and big corporations, as well as the high-level employees,
managers and executives of those firms. . . . Main Street can also describe a small, independent
investment company (i.e., a Main Street firm) as opposed to one of the large, globally recognized
Wall Street investment firms. Wall Street firms tend to serve large investors with multi-million
dollar assets, like institutions, while Main Street firms tend to be better suited to serving small,
individual investors by providing more personalized service." Main Street, INVESTOPEDIA, http:/
/www.investopedia.com/terms/m/mainstreet.asp (last accessed Nov. 18, 2013).
58 In the world of insurance, this concept is known as "insurable interest." An insurable
interest "is necessary to the validity of an insurance contract, whatever the subject matter of the
policy, whether upon property or life." 44 Am. JUR. 2D INSURANCE § 927. While each state
has its own statute that defines the exact parameters of the "insurable interest" requirement, see,
e.g Kelly J. Bozanic, An Investment to Die jbr: From Life Insurance to Death Bonds, the Evolution
and Legality of the Life Settlement Industry, 113 PENN ST L REV 229, 266 (2008) (fn. 146 which
lists each state's statute defining "insurable interest"), a person is generally said to have an insurable interest "if it may fairly be said that that person has a reasonable expectation of deriving
pecuniary advantage from the preservation of the subject-matter of insurance, whether that advantage inures to him personally or as the representative of the rights or interests of another." 44
AM. JUR. 2D INSURANCE § 933 (citing Custer v. Homeside Lending, Inc., 858 So. 2d 233 (Ala.
2003)). While CDS policies are not regulated as insurance contracts, many critics argue that
they are functionally equivalent and thus should be regulated as such. The issue of insurable
interest is further explored in infra note 71 comparing naked CDS policies to viaticle settlement
policies.
59 The terms of the agreement here could be nearly the same as that between Bank C and
Insurance Company D, with Client X as the reference entity and Client X's default on its
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CARDOZO PUB. LAW POLICY & ETHICSJ.
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defaults on its obligation to Bank C, 6 0 since such a default will trigger a
payout that both offsets the premium payments Market Participant S
will have already made to Insurance Company D, conferring upon Market Participant S a realized gain. In effect, the CDS agreement between
Market Participant S and Insurance Company D is a naked credit default swap. 1
While the lack of transparency in the OTC market has made it
difficult to determine precise numbers on their usage, CDS issuance in
which the buyer lacked any ownership interest with respect to the reference entity was widespread leading up to the financial crisis.6 2 One
estimate puts naked CDSs at around eighty percent of the entire CDS
market around mid-2009.6 Some argue that a few substantive changes
in the CDS market in the early 2000s fostered a financial environment
that encouraged naked CDS issuance and trading. First, many new participants became involved in the CDS market, creating a secondary mar-
obligations to Bank C as the triggering event. See supra note 50 (events that may encompass
"default").
60 As discussed in supra note 37, the CDS seller here is said to assume a "long" position in
the CDS agreement since it hopes the agreement runs its entire course until maturity, thus
collecting the sum of premiums from Market Participant M and not making any payout. By
contrast, the CDS buyer here is said to assume a "short" position because it hopes the triggering
credit event occurs as soon as possible, since it would realize net gain in the excess of the payout
from Insurance Company D less the sum of the premiums paid (and, taking into account the
time value of money, a credit event that occurs as closest to the undertaking of the agreement at
to means Market Participant M can invest the realized net gain at an earlier time and thus realize
higher overall returns). Because the speculator, Market Participant M, does not own any insurable interest in the reference entity, Client X, its position is said to be a synthetic short position.
See Testimony Concerning Credit Default Swaps Before the H. Comm. on Agric., 110th Cong.
(2008), available at http://www.sec.gov/news/testimony/2008/tsl01508ers.htm.
61 "The targeted swaps are considered 'naked' because the buyer purchases credit insurance
without owning the underlying bond." John Carney, How Banning "Naked" Credit Default
Swaps Would Crush CreditMarkets, BUSINESS INSIDER (July 24, 2009), available at http://articles.businessinsider.com/2009-07-24/wall-street/30017162-1-credit-default-cds-prices.
62 See, e.g., Yeon-Koo Che & Rajiv Sethiy, Economic Consequences of Speculative Side Bets:
The Case of Naked Credit Default Swap, SELECTEDWORus 2 (Aug. 6, 2010), http://works.be
press.com/cgi/viewcontent.cgi?article=1028&context=yeonkoo ("The notional value of credit
default swap contracts prior to the financial crisis of 2008 was estimated to be about ten times as
great as that of the underlying bonds .
. .
. Even with the netting out of multilateral positions
and the possibility that some naked CDS buyers were facing other exposures that were positively
correlated with default, there is little doubt that much of this volume was speculative . . . .").
63 Dawn Kopecki & Shannon Harrington, Banning 'Naked'DefaultSwaps May Raise Corporate Funding Costs, BLOOMBERG, July 24, 2009, available at http://www.bloomberg.com/apps/
news?pid=20601208.
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SUBSTANCE VS. FORM
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ket 64 that made it more difficult for buyers and sellers to ascertain the
financial strengths of their counterparties.65 Second, demand for CDSs
referencing complex, structured financial instruments66 whose underlying creditworthiness was difficult to evaluate increased. 7 Combined
with increasingly rampant speculation in the CDS market, the result at
the end of 2007 was a market in which the total notional value of CDSs
was $45 trillion, "but the corporate bond, municipal bond, and structured investment vehicles market totaled less than $25 trillion."6' The
difference of $20 trillion between these figures is estimated to be the
total notional value of "speculative 'bets' on the possibility of a credit
event of a specific credit asset not owned by either party to the CDS
contract."69
A discussion on speculation and naked CDSs naturally begs the
broader question of the social utility served for society at large by such a
market. By drawing analogies to insurance law, some critics propose an
outright ban on naked CDSs.70 If the law prohibits an individual from
"The market for goods or services that have previously been available for buying and
selling; esp. the securities market in which previously issued securities are traded among investors." Market, BLACK'S LAw DicroNARY (9th ed. 2009).
65 Richard Zabel, Credit Default Swaps: From Protection To Speculation, RoaINs, KAPLAN,
MILLER & CIREsi L.L.P. (September 2008), http://www.rkmc.com/publications/articles/creditdefault-swaps-from-protection-to-speculation.
66 E.g., Asset-based securities (hereinafter "ABS"), mortgage-backed securities (hereinafter
"MBS"), collateralized debt obligations (hereinafter "CDOs") and structured investment vehicles
(hereinafter "SIVs"). See infra Part II.
67 Zabel, supra note 65. See infra Part II.
64
68
69
Id.
Id
70 See, e.g., Wolfgang Minchau, Time to Outlaw Naked Credit Default Swaps, THE FINANCIAL TIMES LTD. (Feb. 28, 2010), available at http://www.ft.com/intl/cms/s/0/7b56f5b2-24a311 df-8be0-00144feab49a.html (arguing that "there is not one social or economic benefit" flowing from naked CDSs and analogizes a ban on them to a ban on bank robberies). Whether or
not one agrees with Munchau's ultimate proposal, he makes two noteworthy points: (1) that a
"universally accepted aspect of insurance regulation is that you can only insure what you actually
own" - not use insurance to gamble, but "to reduce incalculable risks" - and regulation of CDSs
divergent from insurance policies makes no sense since CDSs function economically as insurance contracts because they "insure the buyer against the default of an underlying security"; (2)
the exchange of cash flows inherent in a CDS should not disturb the treatment of a CDS as a
belonging to a broader category of insurance policies, and the classification of CDS as a swap
vis-A-vis a traditional insurance policy is misleading since the latter "can [also] be viewed as a
swap, as it involves an exchange of cash flows" from the insurance policy-buyer to -seller, "but
nobody in their right mind would use the swap-like characteristics of an insurance contract as an
excuse not to regulate the insurance industry." Id. "[O]nce you strip away the complex technical machinery, you end up with a product that offers insurance-even though it is a lot more
versatile than a standard insurance contract." Id.
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taking out insurance policies on a neighbor's house or on the life of his
boss7 1 then neither should the law allow him to accomplish the same
ends - betting, essentially - but through different means.72
While this Note does not reach the merits of regulating CDSs as
insurance polices,7 3 it points out that naked CDSs and speculation generally serve important market functions that inform their social utility.
First, the buying and selling of naked CDS policies provides additional
liquidity to investors. In turn, that liquidity enables investors to take
non-speculative positions. For example, in order for Market Participant
71 But consider the issue of a viaticle settlement policy, an "investment contract under which
an investor acquires an interest in a life insurance policy of a terminally ill person . . . at a
discount, depending upon the insured's life expectancy, and when the insured dies, the investor
receives the proceeds of that policy." 44 Am. JUR. 2D INSURANCE § 789. Viaticle settlement
policies differ from CDSs because of the former's classification as insurance contracts and thus
being subject to the insurable interest requirement. See supra note 58. While the requirement is
based in common-law and its exact parameters are defined by state law, the Supreme Court has
stated that an insurable interest in the context of a life insurance policy exists when the assignee
of the policy has a greater interest in the survival of the insured than in the insured's death. See,
e.g., Warnock v. Davis, 104 U.S. 775, 779 (1881) (insurable interest exists when there is a
"reasonable expectation of advantage or benefit from the continuance of [the insured's] life");
Conn. Mut. Life Ins. Co. v. Schaefer, 94 U.S. 457, 460 (1876) ("the essential thing is that the
policy shall be obtained in good faith, and not for the purpose of speculating upon the hazard of
a life in which the insured has no interest."). Generally, an "individual has an insurable interest
in his own life and in the lives of others with whom he has a particular relationship," such as
"close familial relationships ... as well as those relationships with demonstrable economic dependencies," including those in a debtor-creditor relationship, and the presence of such an interest is required typically only at the time of the policy's creation - not at a subsequent disposition
of the policy or at collection of the death benefit proceeds. Kelly J. Bozanic, An Investment to
Die for: From Life Insurance to Death Bonds, the Evolution and Legality of the Life Settlement
Industry, 113 PENN ST L REv 229, 251 (2008). Compare Grigsby v. Russell, 222 US 149, 155
(1911) (finding that although an individual lacking insurable interest could not purchase an
interest in the life of another, an individual who purchased a policy with proper insurable interest could then assign that interest to an individual who lacked insurable interest) with Kramer v.
Phoenix Life Ins. Co., 15 NY3d 539 (2010) (holding that New York law allows an individual to
procure an insurance policy on his or her own life and immediately transfer it to an individual
that lacks an insurable interest in that life, even when the policy was procured expressly for the
purpose of that transfer). Notwithstanding the lack of consumer education on life settlement
policies (a possibility that inheres with any investment opportunity), the potential for abuse or
fraudulent activity (especially involving procurement from the elderly or terminally ill), or issues
of morality (should we allow profit from death?), one author defends the market for life settlement policies because, "when the transactions are legitimate and entered into with full disclosure
of the consequences, [they] can be a great way to gain liquidity from an otherwise illiquid asset
... moving assets in a free market to their highest and best use." Kelly J. Bozanic, supra note 71,
at 232. As discussed below, defenders of the naked CDS market make similar arguments.
72 See Munchau, supra note 70, in which MUnchau uses these examples to support his argument that CDS policies should be regulated as insurance policies.
73 See supra notes 70 and 71.
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SUBSTANCE VS. FORM
201
S to purchase a CDS referencing Client X, someone must be willing to
sell such a CDS to him (e.g., Insurance Company D). An active market
of speculators in the CDS market thus ensures that those who have a
direct ownership interest in the reference entity and who want to hedge
their exposure to that entity will have easy access to a seller.
Second, distinguishing between activities that are truly speculative
and non-speculative is an inherently difficult endeavor. Because of the
general nature of financial risks, an entity could purchase a naked CDS
policy to hedge its exposure to another entity to which it believes it is
exposed, but that exposure may not directly correspond to ownership of
an underlying financial asset or security in the other entity. For example, Market Participant S may have an ongoing business relationship
with Client X as a supplier of equipment that S uses in its business.
Because Market Participant S is concerned with Client X's financial
troubles, S may want to hedge its exposure to X's possibility of failure by
purchasing a CDS referencing X's obligations to Bank C, even though S
has no direct ownership interest in the underlying security (i.e., X's obligations to C). In effect, the CDS referencing Client X's obligations to
Bank C may serve as a proxy for Client X's business relationship with
Market Participant S.71
Finally, a market for naked CDS policies provides increased transparency to investors in the form of useful "market-based signals."7 Numerous investors buying CDS policies on a reference entity in which
none of them own any of the entity's underlying securities could indicate widespread lack of confidence in the entity's stability or financial
health. The active trading of naked CDSs may alert investors and regulators to "early indicators of financial stress at particular financial insti-
74 "For example, let's say that someone has an ongoing business relationship, such as a supplier relationship, with a company that is in some financial trouble. In such a situation, the
purchaser of a CDS may be hedging against the collectability of trade receivables. On paper,
this purchaser would not own the underlying security protected by the CDS, but the CDS may
in fact be a legitimate 'proxy' to hedge the exposure of the trade receivables." Ravi Nagarajan,
Don't Ban Naked CreditDefault Swaps if the Law Can't be Enforced SEEKING ALPHA (March 29,
2009), http://seekingalpha.com/article/128319-don-t-ban-naked-credit-default-swaps-if-thelaw-can-t-be-enforced.
75 Robert E. Litan, The Derivatives Dealers' Club and Derivatives Markets Reforms: A Guide
for Policy Makers, Citizens and Other Interested Parties, BROOKINGS.EDU 25 (April 7, 2010),
http://www.brookings.edu/-/media/research/files/papers/2010/4/07%20derivatives%201itan/04
07 derivatives litan.
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tutions."' 6 Thus, speculators in the CDS market are "more likely to be
early messengers of bad news rather than saboteurs."7 7
Of course, any regulatory regime imposed on the markets (or lack
thereof) should ultimately assess its impact and weight its attendant
costs against benefits. While this Note takes the position that the benefits of allowing a market in naked CDSs likely outweigh its costs, it
recognizes that oversight and regulation are still necessary. As Part II
discusses, critics direct particular attention to the systemic risk potentially generated by OTC markets and the products and participants involved therein.
II.
A.
SYSTEMIC RISK
Defining Systemic Risk
As two scholars contend, "One of the most feared events in banking is the cry of systemic risk. It matches the fear of a cry of 'fire!' in a
crowded theater or other gatherings. But unlike fire, the term systemic
risk is not clearly defined."78 Given that averting systemic risk is the
leitmotif of Dodd-Frank, it is critical that legislators, regulators, and researchers find common ground in defining it.
The Financial Stability Oversight Council (hereinafter "FSOC"),
created by Title I of Dodd-Frank, has been tasked with identifying potential risks to the stability of the United States' financial system. 9
76 Id. See also Steffan Kern, Short selling: Important business in need ofglobally consistent rules,
DEUTSCHE BANK RESEARCH (March 17, 2010), http://www.dbresearch.com/PROD/DBRIN
TERNETEN-PROD/PROD0000000000255171.pdf (summarizing the risks and benefits of
"short selling" in the CDS market - which encompasses the active trading of naked CDS policies
- and arguing that "[g]eneral limitations on short selling will do more harm than good"); Floyd
Norris, Naked Truth on Default Swaps, N.Y. TIMEs (May 20, 2010), available at http://www
.nytimes.com/2010/05/21/business/economy/21norris.html ("To most on Wall Street, the answer [to whether the buying and selling of naked CDS should be disallowed] is obvious: let
markets function. My buying that insurance will probably drive up the price, and serve as a
market indication that people are worried about the credit, which is good because it gives a
warning to others.").
77 Id. at 27; Litan, supra note 75 at 25.
78 George G. Kaufman & Kenneth E. Scott, What Is Systemic Risk, and Do Bank Regulators
Retardor Contribute to It?, 7 THE INDEP. REv. 371 (2003), availableat http://www.independent
.Org/pdf/tir/tir_07_3_scott.pdf.
79 Specifically, FSOC is tasked with identifying "systemically important financial institutions" (hereinafter "SIFIs"). While the end-user clearing exception does not contemplate SIFIs
or FSOC's duties with regard to SIFIs, they should, to a limited degree. If preventing and
mitigating systemic risk is a goal that unites all of Dodd-Frank's specific mechanisms (and exceptions, such as the one for commercial end-users), then, for logical coherence, regulators
2013]
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FSOC observes that, although there is "no one way to define systemic
risk, all definitions attempt to capture risks to the stability of the financial system as a whole, as opposed to the risk facing individual financial
institutions or market participants.o80 Given that systemic risk by its
very nature contemplates a broader macroeconomic picture, a formal
measure of systemic risk should thus "capture the linkages and vulnerabilities of the entire financial system - not just those of the banking
industry - and with which we can monitor and regulate the overall level
of risk to the system and its ties to the real economy. "81
This Note will point out that the interconnectedness of financial
firms and their exposures to particularly opaque derivatives such as
CDSs are two significant factors that created the financial crisis of 2008.
It will then point out that, notwithstanding the interconnectedness of
financial firms in particular, any purposeful definition of systemic risk
must not neglect the systemic risk potentially propagated by non-financial firms, and should consider their levels of interconnectedness to the
broader economy and exposures to risky financial products.
i. Systemic Risk and the Financial Crisis of 2008
The systemic risk that characterized the financial crisis of 2008 had
its origins in the housing market. Beginning in the late 1990s, house
should draw a nexus between SIFIs and the exception. In other words, the criteria for identifying an institution as a SIFI and those for allowing an institution to avail itself of the end-user
exception should reflect one another since the underlying rationale for the exception recognizes
the end-user posing little-to-no systemic risk.
80 U.S. Treasury, PotentialEmerging Threats to U.S. FinancialStability, 2011 FSOC ANNUAL
20
REPORT 132, http://www.treasury.gov/initiatives/fsoc/Documents/Potential%20Emerging/
Threats%20to%20U.S.%2OFinancial%2OStability.pdf.
81 Monica Billio et al., Measuring Systemic Risk in the Financeand Insurance Sectors, 1 (MIT
Sloan School of Mgmt., Working Paper No. 4774-10), available at http://www.bis.org/bcbs/
events/sfrworkshopprogramme/billio.pdf. As one scholar notes, a clear definition of systemic
risk also has public policy implications: it "would set boundaries or limits on bailouts," because,
in particular, if a financial firm's failure does not satisfy the definition, "then there would be no
rationale for the government to bail out that firm or its creditors." John B. Taylor, Defining
Systemic Risk Operationally, in SYSTEMIC RISK IN THEORY AND IN PRACTICE 33, 33-34 (George
Shultz et al. ed,, 2010), available at http://media.hoover.org/sites/default/files/documents/EndingGovernment BailoutsasWeKnow Them_33.pdf. Additionally, it "may create heightened public policy concerns" in the form of a collective action problem "because it is not in the
interest of an individual financial institution to take into account the full potential costs of the
risks of its own actions." Edward V. Murphy, CONG. RESEARCH SERV., R42545, WHAT Is
SYSTEMIC RISK? DOES IT APPLY TO RECENT JP MORGAN LOSSEs? 2 (2012), availableat http://
www.fas.org/sgp/crs/misc/R42545.pdf.
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prices began to rise far above historical values.8 2 Analysts "attribute the
rapid growth in the demand for homes and the associated rise in house
prices to unusually low interest rates, large capital inflows, rapid income
growth, and innovations in the mortgage market."83 With a favorable
financial climate, as well as federal policies" and broader cultural attitudes that have strongly encouraged home ownership, commercial banks
and mortgage originators satisfied increasing demand from Main Street.
Issuance of nonprime mortgage loans, especially those with unconventional terms, grew rapidly: while nonprime loans were just 9 percent of
all new mortgage originations in 2001, they jumped to 40 percent in
2006.85 Most "nonprime mortgage loans were made to homebuyers
with weak credit histories, minimal down payments, low income-toloan ratios, or other deficiencies that prevented them from qualifying for
a prime loan."16
Given that nonprime mortgage loans carry a higher risk of borrower default than prime loans,8 7 many originating lenders had offset
some of the associated risk by selling the loans to banks and other financial institutions.8 8 In addition, some of these buyers would securitize
these mortgage loans, a process involving the packaging of these loans
and the subsequent distribution of securities to finance the purchase of
James Bullard, Christopher
J. Nealy
& David C. Wheelock, Systemic Risk and the FinanREVIEW 403, 405 (Sept./Oct. 2009),
http://research.stlouisfed.org/publications/review/09/09/part l/Bullard.pdf.
82
cial Crisis: A Primer, 91 FED. REs. BANK OF ST. Louis
8
Id
The U.S. federal government has historically encouraged homeownership through a variety of means, namely through providing favorable tax treatment to homeowners and purchasing
mortgage debt by government-sponsored entities such as Freddie Mac, Fannie Mae, and the
Federal Home Loan Banks. See, e.g., 26 U.S.C.A. § 163 (West 2013) (allowing income tax filers
to deduct mortgage interest payments on a primary residence); 12 U.S.C.A. § 2901 (West 1977)
("The Community Reinvestment Act," encouraging homeownership for low-income earners).
85 See Bullard, supra note 82, at 405.
84
86
Id
87 The classification of mortgage loans as either "nonprime" or "prime" reflects the risk that
a borrower will default on the loan. In popular vernacular, the term "subprime" and "nonprime" are sometimes used interchangeably; however, as some researchers point out, this distinction can sometimes prove elusive. See, e.g., Rajdeep Sengupta & William R. Emmons, What is
Subprime Lending?, EcoN. SYNOPSEs (2007), http://research.stlouisfed.org/publicationsles/07/
ES0713.pdf (highlighting that, because "unlike prime mortgages, subprime mortgages are not
homogenous," a simpler way to classify mortgages by their respective risks of borrower default is
to "define a prime mortgage and then classify other non-prime mortgages as "subprime" or
"near-prime").
88
See Bullard, supra note 82, at 405.
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these loans. 89 The securities to be distributed would most commonly
take the form of residential-mortgage backed securities (hereinafter
"RMBS") and commercial-mortgage backed securities (hereinafter
"CMBS").90 Thus, in contrast to simple buyer-seller transactions,
which would have usually involved sophisticated institutional parties,
securitization opened up the secondary market of mortgage loans to
many other investors, particularly people on Main Street. This aspect of
risk spreading became an important conduit of systemic risk, since the
securitization process necessarily entails a certain level of
interconnectedness.
The practice of buying and selling mortgage loans has been commonplace since the Great Depression, with the creation of governmentsponsored enterprises (hereinafter "GSEs") 9 ' such as Fannie Mae, "to
assist private markets in providing a steady supply of funds for housing."9 2 GSEs finance their purchases of large pools of mortgage loans
The practice of
through the sale of bonds in the capital markets.
securitizing financial assets is also not novel: mortgage-backed securitization first gained widespread acceptance in the U.S. during the 1880s.9 '
However, what differentiates the secondary market for and the securitization of mortgage loans in the three decades leading up to the financial crisis from when they were first utilized is the role of nonprime
loans and large-scale private securitization by non-GSEs. Before the
1990s most GSEs rarely purchased nonprime loans; instead, the
"originating lenders held most nonprime loans, which comprised a relatively small portion of the mortgage market, until they matured."95
And, while private mortgage securitization in the U.S. can be traced
back to as early as when mortgage securitization generally gained widespread acceptance in the 1880s, it was not until the 1980s that it
reemerged on such a large scale, with mortgage securitizers - both GSEs
and private non-GSEs (such as commercial banks and large investment
89 SECURITIZATION OF FINANCIAL ASSETS
90
§ 1.01 (Jason H.P. Kravitt, ed., 2d ed. 2008).
Id
91 See FEDERAL NATIONAL MORTGAGE ASSOCIATION, GOVERNMENT-SPONSORED
ENTER-
PRisEs (2013), http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/gov.pdf.
Id. at 1431.
93 See Bullard supra note 82, at 405.
94 See Kenneth A. Snowden, Mortgage Companies and Mortgage Securitization in the Late
Nineteenth Century (2007), http://www.uncg.edulbae/people/snowden/Wat-jmcb-aug07.pdf.
95 See Bullard, supra note 82, at 403, 405.
92
206
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banks) - engaged in intense competition with one another, with nonGSEs eventually overtaking GSE securitization in 2005.6
A secondary market in mortgage loans and the subsequent securitization thereof has its advantages. By allowing lenders to free up capital
that would have otherwise been retained as collateral to mitigate borrower defaults, lenders receive an extra source of capital via proceeds
received from mortgage pool sales and may extend loans to more borrowers. Securitization not only provides the same advantages, but
"[u]nlike whole loan sales and participations, securitization is often used
to market small loans that would be difficult to sell on a stand-alone
basis." 97 Moreover, by packaging mortgage loans into different
"tranches" that reflect the relative riskiness of a group of pooled mortgages, securitizers are also better able to meet investor demand, since
investors are able to make investments that match their appetites for
risk. Especially given the long-term nature of mortgages, a secondary
market in mortgage loans and the subsequent securitization thereof promotes liquidity and efficiency.
However, the potential to almost infinitely spread and offset risk
comes at the price of moral hazard. If an originating lender knows that
it is able to sell a loan rather than hold it until maturity," it may have
less of an incentive to ensure that a borrower is creditworthy."9 Indeed,
many analysts contend that "lax underwriting standards contributed to
the high rate of nonprime loan delinquencies."'
Moreover, private
GSEs such as large investment banks recognized that securitization by
its very nature could continue past the initial stage of packaging and
selling RMBSs and CMBSs. In particular, collateralized debt obligations (hereinafter "CDOs") combine multiple RMBSs or CMBSs (or
parts of either), and investment banks would sell portions of a given
CDO's income stream .'0
Further compounding this problem is the creation of synthetic
CDOs, instruments that transfer the credit risk of a referenced portfolio
96 See Michael Simkovic, Competiton and Crisisin Mortgage Securitization, 88 IND. L.J. 213,
219 (2013), available at http://papers.ssrn.com/sol3/papers.cfm?abstractid=1924831.
97 SECURITIZATION, supra note 89 (internal citation removed).
98 The typical maturity for a mortgage loan is 30 years. AN INVESTOR'S GUIDE TO PASSTHROUGH AND COLLATERALIZED MORTGAGE SECURITIES, THE BOND MARKET AssoCIATION
4, http://www.freddiemac.com/mbs/docs/aboutMBS.pdf (last accessed November 18, 2013).
99 See Bullard, supra note 82, at 403, 405.
100 See id.
101 See id. at 406.
SUBSTANCE VS. FORM
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of CDSs. 1 0 2 While the structure of synthetic CDOs is complex and
beyond the scope of this Note, the role they played in the financial crisis
may be thought of as "merely bets" in form of CDSs "on the performance of real mortgage-related securities, "103 such as RMBSs, CMBSs, or
(non-synthetic) CDOs.'0 o In addition, credit rating agencies assigned
high ratings to many of these mortgage-related securities: assuming that
house prices would rise, they believed most nonprime loans would have
performed well because borrowers could refinance or sell their homes (at
a higher price) if they were to default on their mortgages.' 0 5 However,
housing prices began to fall significantly and borrowers owed more on
their homes than their homes were worth - a situation that "created an
incentive simply to default."10 6 When home prices began to fall and a
significant number of borrowers began defaulting, RMBSs, CMBSs,
CDOs and synthetic CDOs referencing these mortgage loans also began
to default.'0 7 As a result, many banks and investors who held large portfolios of these financial instruments experienced substantial losses. 0 8
This domino effect that rippled throughout the entire economy encapsulates the systemic risk that has largely characterized the financial crisis
of 2008.
B.
FinancialInstitutions, Non-financial institutions, and Systemic risk
Many working definitions of systemic risk implicitly assume that
non-financial institutions propagate little to no systemic risk.' 09 As discussed below, this assumption is faulty for a number of reasons.
102
See
MICHAEL
S.
GIBSoN, UNDERSTANDING THE RISK OF SYNTHETIC
CDOs (July 2004),
http://www.federalreserve.gov/pubs/feds/2004/200436/200436pap.pdf.
103 FINANCIAL CRISIS INQUIRY COMMISSION, THE FINANCIAL CRISIS INQUIRY REPORT xxiv
(2011), http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
Synthetic CDOs were complex paper transactions involving credit default swaps. Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of mortgage-backed securities, or even tranches of other CDOs. Instead, they simply
referenced these mortgage securities and thus were bets on whether borrowers would
pay their mortgages. In the place of real mortgage assets, these CDOs contained credit
default swaps and did not finance a single home purchase.
Id. at 142.
104 Id. at 142.
105 See Bullard, supra note 82, at 403, 406.
106 See id. at 406.
107 See id.
108
See id.
109
See, e.g., Adam
J. Levitin, In Defense ofBailouts, 99
GEo L.J. 435, 514 n.45 (2011).
208
i.
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The view that financial institutions are inherently systemically
riskier than non-financial institutions
Many scholars believe that financial institutions pose an inherently
greater potential for propagating systemic risk than institutions whose
businesses are primarily non-financial in nature because of three primary
reasons: the interconnected nature of financial institutions, financial institutions' prominent use of leverage, and the mismatch between assets
and liabilities that inheres in the business of financial institutions. 10
Because financial institutions are an important source of capital both for
non-financial and other financial institutions, they are, by the very nature of business in which they engage, interconnected to many other
institutions that depend on their continued operation. As one group of
scholars explains:
[T]he function of (mainly) banks as financial intermediaries - thereby
being a conditio sine qua non for funding of consumption and investments of many of economic participants - implies a close relation with
the real economy. In other words: a disruption of this function has
direct impact on activities in the real economy. This puts financial
institutions at the centre of the systemic risk discussion and the impact
of other sectors is therefore mostly discussed in terms of indirect contagion via the financial sector. 1
By contrast, this type of interconnectedness is not as common among
non-financial institutions.1 12 While the default of a non-financial institution may directly affect its creditors, suppliers, and some of its customers, rarely, it is argued, does it impact much beyond that in the
greater economy. 1 3
Moreover, because evidence suggests a strong correlation between
the amount of financial leverage that an institution utilizes and the industry in which it belongs," financial institutions are often highly
leveraged in comparison to non-financial institutions. That is, they
110 See Bullard, supra note 82.
111 BERT TIEBEN ET AL., CURTAILING
COMMODITY DERIVATIVE MARKETS 12, http://www
.energie-nederland.nl/wp-content/uploads/docs/SEO-rapport-Curtailing-Commodity-Deriva
tive-Markets.pdf.
112 Bullard, supra note 82, at 408.
113 Alan Greenspan, Addressing Systemic Risk, WALL ST. J., June 19, 3009, http://online.wsj
.com/article/SBl24542154883031489.html.
114 Compare Financial Leverage across Diferent Sector, ANALYXIT.BLOGSPOT.COM,
http://
analyxit.blogspot.com/2012/05/compare-financial-leverage-across.html.
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SUBSTANCE VS. FORM
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"fund a substantial portion of their assets by issuing debt rather than
selling equity.""' For example, many investment banks prior to the
financial crisis had debt-to-equity ratios of approximately 25-1, meaning
that for every $100 in assets a given investment bank had, it funded
those assets with $96 of debt on average, leaving only $4 in equity."'
The nature of financial services requires the use of leverage since financial institutions generate profit from the use of other people's money.
Conversely, a non-financial enterprise such as a technology or pharmaceutical company may need a larger amount of cash on hand to support
its continued research and development work, thereby limiting it in the
amount of leverage it can utilize. Maintaining an appropriate balance of
debt to equity is crucial to the financial longevity of any institution
utilizing leverage, since leverage increases the return on equity when the
market works in favor of institution, but also increases the risk of failure
when the market works against it.' 1 7 When we consider this alongside
the interconnectedness of dealers and participants in the CDS market,
the fact that leverage can magnify potential losses means that it can also
compound the threat of systemic risk originating from financial institutions: the "web of credit derivatives means that the financial fragility of
one firm can increase the fragility of other firms or of the entire financial
system.""'
Financial institutions also have a tendency "to finance their holdings of relatively illiquid long-term assets with short-term debt," 9 " a
115
Bullard, supra note 82, at 409.
U.S. Gov'T PRINTING OFFICE, ECONOMIC REPORT OF THE PRESIDENT 71 (Jan. 2009),
http://www.nber.org/erp/2009_erp.pdf. As the authors of this report point out, this practice
can be conceptualized as investment banks owning investments with only a 4% down payment.
Id. Indeed, the concept of leverage is perhaps more intuitive in the context of mortgage financing: using the same figures, if an individual were to purchase a home at the fair market value of
$ 100 (assets), and to finance the purchase with $10,000 of her own money as a down payment
(equity) and the remainder of the purchase price with a mortgage loan of $90,000 (debt), she
would be utilizing a leverage ratio of 10 to 1.
117 Bullard, supra note 82, at 409.
118 Erik F. Gerding, Credit Derivatives, Leverage, and Financial Regulation's Missing
Macroeconomic Dimension, 8 BERKELEY Bus. L.J. 29, 42 (2011).
119 Short-term debts are "all debts and other liabilities that are payable within one year."
Debt, BLACK'S LAW DICTIONARY (9th ed. 2009). The value of a company's short-term debts is
very important when determining a company's financial health:
If the account is larger than the company's cash and cash equivalents, this suggests
that the company may be in poor financial health and does not have enough cash to
pay off its short-term debts. Although short-term debts are due within a year, there
may be a portion of the long-term debt included in this account. This portion per116
tains to payments that must be made on any long-term debt throughout the year.
210
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mismatch that inheres in the business of capital funding, and one that
makes financial institutions more vulnerable to distinctly financial risks,
such as interest rate and liquidity shocks.' 20 For example, commercial
banks have traditionally used demand deposits from customers to fund
the loans they make to other individuals and businesses.121 Similarly,
many investment banks and other non-bank financial institutions have
used commercial paper, 1 2 2 repurchase agreements (hereinafter "repos"),1 2 3 and other sources of short-term funding to finance long-term
investments. The potential for systemic risk here is that if "depositors
suddenly pull their funds from a commercial bank or lenders refuse to
purchase a securities firm's commercial paper or repos, the bank or securities firm could be forced into bankruptcy."1 24 The failure of investment bank Bear Sterns and its subsequent government-backed
acquisition by JPMorgan Chase & Co. in 2008 was the result of this
very reason.1 25 By contrast, the dominant assets of most non-financial
institutions are fixed plant and equipment, which are especially illiquid
assets in that they rarely trade in active markets. The "consequence is a
Short-term Debt, INVESTOPEDIA, http://www.investopedia.com/terms/s/shorttermdebt.asp (last
accessed Nov. 20, 2013).
120 Bullard, supra note 82, at 409.
121 Id
122 Commercial paper is an "instrument, other than cash, for the payment of money." Paper,
BLACK'S LAw DICTIONARY (9th ed. 2009).
Commercial paper is not usually backed by any form of collateral, so only firms with
high-quality debt ratings will easily find buyers without having to offer a substantial
discount (higher cost) for the debt issue. A major benefit of commercial paper is that
it does not need to be registered with the Securities and Exchange Commission (SEC)
as long as it matures before nine months (270 days), making it a very cost-effective
means of financing. The proceeds from this type of financing can only be used on
current assets (inventories) and are not allowed to be used on fixed assets, such as a
new plant, without SEC involvement.
Commercial Paper, INvESTOPEDiA, http://www.investopedia.com/terms/c/commercialpaper.asp
(last accessed Nov. 20, 2013).
123 A repo is a "short-term loan agreement by which one party sells a security to another party
but promises to buy back the security on a specified date at a specified price." Repurchase
Agreement, BLACK'S LAW DICTIONARY (9th ed. 2009).
124 Bullard, supra note 82, at 409.
125 See U.S. Gov't Printing Office, March 2008: The Fall ofBear Stearns, in THE FINANCAL
CRISIS INQUIRY REPORT 280, 291 (2011), http://www.finrm.com/fcic-final-reportchapterl5
.pdf (Financial Crisis Inquiry Commission conclusion that the failure of Bear Stearns was
"caused by its exposure to risky mortgage assets, its reliance on short-term funding, and its high
leverage. . . . Bear experienced runs by repo lenders, hedge fund customers, and derivatives
counterparties and was rescued by a government-assisted purchase by JP Morgan because the
government considered it too interconnected to fail.").
SUBSTANCE VS. FORM
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211
need for a much larger capital cushion of one-third to one-half of the
value of assets, compared with only 5% to 15% for financial firms."1 2 6
ii.
Systemic Risk is Not Generated Uniformly Across
All Financial Institutions
While it is true that financial institutions generally utilize leverage
to a greater extent than non-financial institutions, it is critical to acknowledge how it is utilized intra-industry. Many investment banks
and non-bank financial institutions were grossly overleveraged prior to
the financial crisis, but many commercial banks were not. 1 2 7 Unlike investment banks and non-bank financial institutions, commercial banks
that engage solely in traditional savings and lending activities "are subject to [more stringent] minimum capital requirements," and, on average, "had leverage ratios of approximately 12 to 1.1" prior to the
financial crisis, while investment banks had an average of 25 to 1.128
Thus, to the extent that leverage magnifies the propagation of systemic
risk from financial institutions to other institutions interconnected with
them, investment banks and other non-bank financial institutions arguably have the potential to propagate more systemic risk than commercial banks.
iii.
Non-Financial Institutions and Systemic risk
Financial institutions act as intermediaries and cut across multiple
industries whose businesses rely upon them as potential sources of capital. Thus, one could posit that a marginal increase in a financial institution's contractual relationships increases its exposure to risk and its
ability to transmit risk.12 9 However, this perspective is overly simplistic
because it fails to appreciate the quality of those exposures:
The sheer number of contracts, however, is not sufficient to
gauge systemic risk. Nor is it clear what that number means because a
firm's connections both expose it to risk and transmit risk. Fewer
connections mean fewer exposures, but also mean each exposure
126 Alan Greenspan, Addressing Systemic Risk, WALL ST. J. (June 19, 3009), http://online.wsj
.com/article/SBl24542154883031489.html.
127 Bullard, supra note 82.
128 Id.
129 See e.g., Ross A. Hammond, Systemic Risk in the FinancialSystem: Insights from Network
Science 1 (Pew Fin. Reform Project, Briefing Paper No. 12, 2009), availableat http://www.pewfr
.Org/admin/project. reports/files/EPHammondNetworks-final-TF-Correction.pdf.
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might be more important. On the flip side, fewer connections mean
fewer opportunities to transmit the contagion of failure.130
In other words, an institution could be deemed highly interconnected
by virtue of the number of contractual relationships it has entered into,
but may nonetheless be comparatively less systemically risky because its
exposures are all relatively low-risk (e.g., it utilizes little leverage and
invests in mostly low-risk securities such as Treasury securitiesl 3 1 ). If the
converse of this statement is true - that an institution may be more
systemically risky if its exposures are all higher risk - then the fact that
its services are primarily non-financial in nature should be of no import
in the context of systemic risk.
Indeed, non-financial institutions may propagate systemic risk to
the broader economy through various risk transmission mechanisms.
For example, counterparty contagion, "or the domino effect, occurs
when the failure of one firm leads directly to the failure of other firms
that are its counterparties because the counterparties relied on payment
or future business from the initial failed firm." 1 32 This problem may
manifest itself in the non-financial context when a major manufacturer
fails (e.g., through bankruptcy and subsequent liquidation) and owes a
substantial sum to one of its suppliers. The manufacturer's failure leads
to the supplier's failure, the supplier's failure leads to the failure of its
own suppliers, and so on.' 33 The same type of reaction may also manifest itself when the manufacturer's failure leads to the supplier's loss of
future business with the manufacturer, and so on.134
Counterparty contagion transpired when the U.S. federal government injected over $80 billion in capital into the breach of the thenimpending bankruptcies of auto-manufacturers General Motors and
Chrysler:13 1
Levitin, supra note 109, at 465.
Treasury securities are bonds issued by the U.S. government and come in three different
varieties, depending on their maturities: Treasury bills (mature in one year or less), bonds (in
two to 10 years) and notes (in 10 years or more). Treasury Securities Definition, THE STREET,
availableat http://www.thestreet.com/topic/4728 1/treasury-securities.html (last visited Nov. 30,
2013).
132 Levirin, supra note 109, at 455.
133 Id. at 456 (describing this type of counterparry contagion as "obligor contagion").
130
131
134
Id.
135 David Littman,
What if Taxpayers Hadn't Bailed Out GM and Chrysler, DBUSINESS.COM
(Sept./Oct. 2012), http://www.dbusiness.com/DBusiness/September-October-2012/What-ifTaxpayers-Hadnt-Bailed-Out-GM-and-Chrysler/.
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SUBSTANCE VS. FORM
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Moreover, in the absence of taxpayer-supplied cash to GM, those who
support the government-led bailout suggest the likelihood of a severe
cascade. Supporters assert that GM's liquidation would have sunk
hundreds of suppliers (small and large), as the automaker's purchasing
requirements spanned such an immense and dependable cross-section
of clients among scores of industries throughout Michigan and the rest
of the country. The reasoning is rational: Already mired in a steep
recession, many of GM's suppliers, no longer hopeful of receiving ontime payments for deliveries, would have declared insolvency - causing
Ford, Chrysler, and possibly other Michigan-headquartered
automakers and suppliers to topple.' 3
Even when non-financial institutions are not interconnected by
way of a counterparty contagion effect, they face the problem of information contagion, "which occurs when the failure of one firm results in
market confidence eroding in similar firms, which then fail when they
are no longer able to obtain financing or conduct transactions on viable
terms." 1 3 7 Information contagion similarly transpired during the General Motors and Ford Motor crisis of 2005, when the three major rating
agencies downgraded the credit ratings of both firms from investment
grade to speculative grade, sending a ripple throughout the entire CDS
market as investors began selling their respective CDS holdings in the
two firms. 138 In the case of the food and hospitality industry, one author uses the spread of contagious illnesses as an example of information
contagion:
[A] salmonella outbreak in McDonald's hamburger meat would
likely lead to a contraction of business at Burger King, Wendy's, and
other restaurants serving ground beef because of a fear that their food
might also be tainted, regardless of whether they share a supply chain
with McDonald's or where in the supply chain the contamination
occurred. '3
Thus, the two central characteristics that have largely characterized
systemic risk - interconnectedness and large concentrations of exposures
to risky assets - are not unique to financial institutions.
Id
Levitin, supra note 109, at 458.
138 Viral Acharya et. al., Liquidity Risk and Correlation Risk: A Clinical Study of the General
Motors and Ford Downgrade of May 2005, (London Business School, Working Paper, June
2008), http://www.london.edulfacultyandresearch/research/docs/june_08.pdf.
139 Levitin, supra note 109, at 459.
136
137
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Speculation and Systemic risk
Additionally, excessive speculation in derivatives markets could
trigger systemic risk in the broader markets.14 0 In the case of CDSs,
buyers are not required to own any of the reference entity's underlying
securities. At a theoretical level, an OTC market for naked CDSs leaves
open the possibility that a potentially unlimited number of CDSs referencing one particular entity could be bought and sold.' Such a possibility may exacerbate the risk of seller defaults because the naked CDS
market's opacity could prevent sellers from adequately accounting for
the credit risk of the CDSs they are selling. In turn, a given seller's
default increases the chance that a buyer could default on its own outstanding obligations to third parties. 1 4 2 This effect may ripple throughout the markets creating systemic risk if these buyers have also sold
CDSs to other parties. Given that a relatively small and interconnected
group of institutions engage in the majority of derivatives trading, "massive derivatives losses at one firm leading to defaults could quickly lead
to a chain reaction of defaults among other firms." 143
v. Lack of Transparency and Systemic Risk
Compounding the problem of interconnectedness in an OTC derivatives market is its lack of transparency. Allowing buyers and sellers
of CDSs to engage in private, off-exchange dealings may save transaction costs and other costs related to regulatory compliance,14' but could
140 Laurin C. Ariail, The Impact of Dodd-Frank on End-Users Hedging Commercial Risk in
over-the-CounterDerivativesMarkets, 15 N.C. BANKING INST. 175, 179 (2011) (internal citation
removed).
141 Therefore, it is possible for the total notional gross values of outstanding CDS policies to
vastly exceed the par value of the underlying bonds of the entity referenced in those CDS
policies.
142 For example, if Insurance Company D feels fairly confident that Client X's chance of
default is low and decides to become an active seller of CDSs referencing Client X - but has
gravely miscalculated Client X's financial health which is actually poor - Insurance Company
D's own solvency could be threatened when Client X defaults and the buyers of the CDSs seek
settlement. In turn, the solvency of those CDS buyers could be threatened if Insurance Company D fails to honor its financial obligations to them, especially if those buyers have concentrated their exposure to particularly risky entities and are relying on cash proceeds from
settlements of those CDSs to meet their third-party obligations.
143 Ariail, supra note 140, at 179.
144 See, e.g., David Oaten & Robert Sichel, Shock awaits unprepared thanks to Dodd-Frank,
PENSIONS & INVESTS. (Sept. 2, 2013), availableat http://www.pionline.com/article/20130902/
PRINT/309029993/shock-awaits-unprepared-thanks-to-dodd-frank ("[Critics] lament the costs
of clearing associated with establishing relationships with clearinghouses, hiring clearing mem-
2013]
SUBSTANCE VS. FORM
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easily create costs in other ways. Namely, an OTC regime deprives the
marketplace of important information, particularly in the form of price
information and the financial positions of the participants involved,
about each trade. A marketplace lacking transparency is prone to being
an inefficient one because participants may lack the information necessary to exercise fully informed investment decisions."' For example, a
prospective buyer of an OTC derivative may have little idea of the extent to which its seller is entrenched in other OTC markets, information
that could be useful to the buyer in determining the amount of
counterparty risk it is assuming - especially if the seller is already heavily
entrenched in derivatives contracts referencing default-prone entities.
Additionally, some research supports the finding that pre-trade transparency in an OTC market actually reduces transaction costs to the
buyer, which in turn improves market liquidity and increases the gains
made from trading. 4 6
Dodd-Frank recognizes the threat of systemic risk posed by an entirely OTC derivatives market and imposes certain data collection, central clearing, and exchange trading requirements. As discussed in Part
IV, because the commercial end-user exception to clearing requires that
the entity claiming the exception be non-financial in nature and engaged in a given swaps transactions for non-speculative purposes, this
Note also analyzes systemic risk in relation to the type of entity involved
and the purpose underlying a particular swaps transaction.
bers, negotiating legal agreements, the increased margin requirements and new compliance
procedures.").
145 Indeed, if the cornerstone of efficient markets theory is that the "lower the transaction
costs in a market, including the costs of obtaining information and trading, the more efficient
the market," then the lack of transparency in the CDS market also makes it inefficient. Steven
L. Jones & Jeffrey M. Netter, Efficient Capital Markets, THE CONCISE ENCYCLOPEDIA OF
EcON. (2008), http://www.econlib.org/library!Enc/EfficientCapitalMarkets.html.
The efficient
markets theory assumes that greater transparency leads to greater efficiency and liquidity. For a
discussion challenging that assumption in specific situations involving OTC markets such as that
for CDSs, see Marco Avellaneda & Rama Cont, Transparency in Credit Default Swap Markets,
FIN. CONCEPTS 3 (July 2010), http://www.isda.org/c and alpdf/CDSMarketTransparency.pdf
(arguing that "the underlying assumption that more transparency necessarily increases liquidity
is far from obvious, especially in OTC markets where the incentive for market participants to
trade is partly based on their asymmetric information," and that "increasing transparency has a
cost and any discussion of efficiency must assess the benefits of increased transparency and weigh
them against these costs.").
146 See, e.g., Fan Chen & Zhuo Zhong, Pre-trade Transparencyin Over-the-CounterMarkets 2
(Univ. of Okla., Working Paper, Aug. 2012), http://www.ou.edu/dam/price/Finance/CFS/paper/pdf/Fan%20Chen%20Paper.pdf (concluding that "greater pre-trade transparency improves
market liquidity and increases the gains from [OTC] trade" in corporate bond markets).
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DODD-FRANK AND CALLS FOR REFORM
A.
Overview of Dodd-Frank
On July 21, 2010, President Barack Obama signed into law the
Dodd-Frank Wall Street Reform and Consumer Protection Act, an "Act
[t]o promote the financial stability of the United States by improving
accountability and transparency in the financial system, to end 'too big
to fail,' to protect the American taxpayer by ending bailouts, to protect
consumers from abusive financial services practices, and for other purposes."' 47 Many commentators and scholars consider Dodd-Frank to be
the most sweeping legislative overhaul of the financial and banking system in the United States since the Great Depression,' some having
coined it the "New Financial Deal."1 4 9
In accord with its purported objectives, Dodd-Frank changed the
regulatory regime by creating 5 o and eliminating 51 certain federal agencies, and increasing various agencies' oversight of key financial institutions1 52 (particularly those identified as "systemically important"1 53),
147 DODD-FRANK, Supra note 19.
148 See, e.g., Press Release, U.S. Dept. of Treasury, Treasury Secretary Timothy Geithner Remarks on Passage of the "Wall Street Reform and Consumer Protection Act" (July 15, 2010),
http://www.treasury.gov/press-center/press-releases/Pages/tg777.aspx ("the strongest financial reforms this country has considered since the Great Depression"); see generally, Saule T. Omarova,
The Dodd-FrankAct: A New Dealfor A New Age?, 15 N.C. BANKING INST. 83 (2011).
149 See, e.g., David Skeel, Making Sense ofthe New FinancialDeal, 5 LIBERTY U.L. REv. 181
(2011).
150 Most notably, it created the FSOC to oversee financial institutions and identify risks to
the financial stability of the United States. See 12 U.S.C.A. § 5321 (West 2010). See also, 12
U.S.C.A. § 5342 (West 2010) (creating the Office of Financial Research within the Treasury to
support FSOC); 31 U.S.C.A. § 301 (West 2012) (creating the Office of National Insurance
within the Treasury); 15 USCA § 78o-7 (West 2010) (creating the Office of Credit Rating
Agencies within the SEC); 12 U.S.C.A. § 5491 (West 2010) (creating an independent Bureau of
Consumer Financial Protection within the Federal Reserve).
151 See 12 U.S.C.A. § 5413 (West 2010) (eliminating the Office of Thrift Supervision,
"OTS," and, as authorized by same section, transferring its functions, powers, authorities, rights
and duties to the Federal Reserve, the OCC, or the FDIC).
152 See, e.g., 12 U.S.C.A. § 5412 (West 2010) (empowering the Federal Reserve to regulate
thrift holding companies and subsidiaries of thrift holding companies, and the OCC to regulate
national banks and federal thrifts of all sizes); 12 U.S.C.A. § 5321 (providing that FSOC is to
evaluate systemic risk).
153 "[FSOC] is empowered to identify 'systemically important' nonbank financial companies,
thus bringing such companies under regulation by the Federal Reserve, and to recommend
heightened prudential standards for the Federal Reserve to impose on these companies. [FSOC]
also has the power to recommend heightened prudential standards to primary financial regulators to apply to any activity that [it] identifies as contributing to systemic risk." Summary ofthe
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SUBSTANCE VS. FORM
217
hedge funds, and investment intermediaries.15 1 It significantly strengthens protections in the areas of credit card and bank account fees, mortgage lending, student loans, and mutual fund information access,'15 and
creates an independent agency to oversee consumer protection reforms.15 6 It imposes stringent regulatory capital requirements' 57 on financial institutions and prohibits proprietary trading and certain fund
activities by bank holding companies and their affiliate entities. 55 To
help contain systemic risk in the face of another financial crisis, it implements a resolution planning and liquidation process to allow for the
orderly winding down of certain failing financial institutions. 5 9 DoddDodd-Frank Wall Street Reform and Consumer ProtectionAct, Enacted into Law on July 21, 2010,
DAVIS POLK (2010), available at http://www.davispolk.com.
154 See, e.g., 15 U.S.C.A. %§ 80b-2 et. seq. (West 2010) (Title IV of Dodd-Frank, requiring
registration of and reporting from certain hedge funds and investment advisers pursuant to
criteria established by the SEC).
6
155 See, e.g., 15 U.S.C.A. %§ 1 93p, 1693q (West 2010); 12 U.S.C.A. § 5603 (West 2010).
156 See 12 U.S.C.A. § 5491 (West 2010) (creating the Bureau of Consumer Financial
Protection).
157 See 12 U.S.C.A. § 5371 (West 2010).
s58See 12 U.S.C.A. § 1851 (West 2010). Better known as the "Volcker Rule," its application
may be conceptualized as prohibiting banks who are involved in the business of deposit-taking
from buying and selling securities for their own account rather than those of their clients. Some
commentators contrast the Volcker Rule to The Banking Act of 1933 (hereinafter "Glass-Steagall Act"), which was passed shortly after the Great Depression and required the separation of
commercial (i.e., deposit-taking, lending) activities from investment activities. See, e.g., Louis
Uchitelle, Glass-Steagallvs. the Volcker Rule, N.Y. TIMES, January 22, 2010, available at http://
economix.blogs.nytimes.com/2010/01/22/glass-steagall-vs-the-volcker-rule; 12 U.S.C.A. § 227
(West 1933). In 1999 Congress passed the Gramm-Leach-Bliley Act, which repealed the GlassSteagall Act in part and thus removed much of the latter's division between commercial and
investment banking activities. See GRAMM-LEACH-BLILEY Ac, Pub. L. No. 106-102, 113 Stat
1338 (1999). Many commentators suggest that this repeal contributed to the financial collapse
of 2008. See, e.g., Systematic Risk: Examining Regulators Ability to Respond to Threats to the
FinancialSystem: Hearing Before the H. Comm. On FinancialServices, 110th Cong. 12 (2007)
(statement of Robert Kuttner) available at http://www.gpo.gov/fdsys/pkg/CHRG-1 Ohhrg399
03/htrml/CHRG-110hhrg39903.htm. But cf Jerry W. Markham, The Subprime Crisis-A Test
Match for the Bankers: Glass-Steagall vs. Gramm-Leach-Bliley, 12 U. PA. Bus. L. 1081 (2010)
(arguing that the events that led to the passage of the Gramm-Leach-Bliley Act did not lay the
groundwork for the subprime crisis of 2008); 7 THOMAs LEE HAZEN, THE INTERTWINING OF
FINANCIAL SERVICES: COMMERCIAL BANKS, INVESTMENT BANKING, AND INVESTMENT SERVICEs § 22.6, TREATISE ON THE LAw OF SECURITIES REGULATION (2009) (observing that the
division between commercial and investment banking activities increasingly eroded in the years
leading up to legislative repeal of Glass-Steagall because of liberal administrative and judicial
interpretations, and the Gramm-Leach-Bliley Act served as a legislative answer to realigning an
increasingly conflicting regulatory scheme).
159 12 U.S.C.A. § 5365 (West 2010) (requiring banks holding $50 billion or more in assets
to complete a resolution planning process, the product of which is colloquially referred to as a
218
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Frank reforms the securitization process by imposing greater disclosure
and due diligence requirements,16 0 and requiring certain participants involved in the securitization process to retain some of the credit risk on
their own books.' 6 1 And, as is the focus of this Note, Title VII of
Dodd-Frank massively overhauls the OTC derivatives market through
registration, disclosure, exchange, and clearinghouse requirements.1 6
The above description provides a cursory overview of DoddFrank's main provisions. While the Act spans over sixteen titles and 848
pages, it leaves many substantive provisions unfilled and bestows
rulemaking powers on various federal agencies to fill them in. One major law firm estimates that the Act has imposed a total of 398 rulemaking requirements across 11 federal agencies and bureaus.' 6 3 At the time
of this Note, approximately only forty percent of the 398 total rulemaking requirements have been met with finalized rules; nearly threequarters of the total rulemaking requirement deadlines have already
passed.16' Thus, many provisions have yet to be finalized and promulgated by their respective agencies, an issue that has subjected the Act to
increased public scrutiny.16'
B.
Title VII Bringing Light to the OTC Derivatives Market
Congress recognized that an unregulated derivatives market played
a large role in laying the groundwork for and exacerbating the financial
corporate "Living Will"); 12 U.S.C.A. § 5384 (West 2010) (providing the framework for orderly liquidation of covered financial companies).
160 15 U.S.C.A. %§780, 77g (West 1980, 2012) (imposing certain disclosure, reporting, and
due diligence analysis issues involving asset-backed securities).
161 15 U.S.CA. § 78c (2012) (requiring securitizers to retain not less than 5% of the credit
risk of certain assets that, through the issuance of an asset-based security, are transferred, sold, or
conveyed to a third party).
162 See 15 USCA %§8301 et. seq. 77b (West 2010).
163 Dodd-FrankProgress Report, DAVIs POLK & WARDWELL LLP (Nov. 2013), http://www
.davispolk.com/sites/default/files/Nov2013_Dodd.Frank .Progress.Report_0.pd.
164 Id
165 Consider, however, the distinction between required rulemaking and permissive rulemaking. See, e.g., Gabriel D. Rosenberg & Jeremy R. Girton, Beyond "Shall"-Dodd-Frank'sPermissive Rulemakings, Newsletter of the ABA Business Law Section Banking Law Committee, Am. BAR
Ass'N. (March 2012), http://apps.americanbar.org/buslaw/committees/CL130000pub/newsletter/201203/rosenberg-girton.pdf (pointing out that there are 198 places in the Act that authorize, but do not require, regulatory action, and presents three dimensions that regulators will need
to consider in prioritization of permissive and required rulemaking).
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SUBSTANCE VS. FORM
219
meltdown.""' Allowing parties to enter into derivatives contracts on
standardized yet entirely privately negotiated terms left open the possibility that parties would not post collateral or margin (or not post an
adequate amount thereof). Indeed, large uncollateralized losses accumulated in the OTC derivatives market prior to the financial crisis. 16 7
%Whenthe only parties to OTC contracts are dealers (e.g., protectionsellers, such as AIG) and traders, the dealer entirely absorbs the risk of
the trader defaulting, and the trader entirely absorbs the risk of the
dealer defaulting. No intermediary such as a clearinghouse would stand
between both parties to guarantee payment in case one party fails to
make good on its side of the deal. Moreover, an OTC regime allowed
derivatives to escape the purview of regulators entirely, leaving regulators toothless in implementing ex ante solutions to mitigate and prevent
systemic risk.
Title VII of Dodd-Frank imposes a comprehensive regulatory regime by way of the joint rulemakings of primarily the CFTC and SEC.
First, it provides for registration of certain participants (i.e., dealers and
major participants) in the swaps marketplace with either the CFTC and/
or the SEC.16 Second, it imposes clearing requirements' 6 9 on most
swaps transactions and empowers federal regulators to promulgate minimum capital and margin requirements.1 70 Third, it creates recordkeeping and real-time reporting requirements on certain cleared and
uncleared swaps transactions, including pricing and volume data.' 7
Fourth, it imposes "business conduct" rules on most dealers and participants to conduct certain due diligence and disclose certain material information.172 Additionally, Title VII contains a controversial
166
The FinancialCrisis Inquiry Report: FinalReport of the National Commission on the Causes
of the Financialand Economic Crisis in the United States, U.S. GOV'T PRINTING OFFICE
(Jan.
2011), http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
167 See Rena Miller & Kathleen Ruane, The Dodd-Frank Wall Street Reform and Consumer
Protection Act: Title VII, Derivatives, CONG. RESEARCH SERV. 4-5 (Nov. 6, 2012), http://assets
.Opencrs.com/rpts/R41398_20121106.pdf ("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 [ISDA], published best practice standards for use of collateral, but
compliance was voluntary.").
168 7 U.S.C.A. § 6 (c) (West 2010).
169 7 U.S.C.A. § 2 (West 2008).
170 7 U.S.C.A. § 6s (West 2010).
171 7 U.S.C.A. § 6r (West 2010).
172 7 U.S.C.A. § 6s (West 2010).
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provision that specifically prohibits federal assistance to any "swaps
entity."17 3
Title VII does not entirely eliminate the OTC market for all swaps
transactions. Instead, the commercial end-user exception allows some
swaps transactions to bypass the clearing and exchange requirements if
the transaction and one of the counterparties to it meet particular criteria. This exception is premised on the idea that not all entities in the
swaps markets (particularly non-financial entities), generate systemic
risk, and that such entities primarily use swaps to hedge or mitigate a
risk to which they are already exposed and not to speculate. 1 74 Thus,
these entities should not have to bear increased transaction, compliance,
and other costs that could hamper firm efficiency and overall economic
growth.1 7 1 If the real culprit in generating systemic risk was not derivatives generally but rather unregulated and rampant speculation of derivatives by financial institutions, then arguably Dodd-Frank should reflect
that conclusion by directing its attention to those entities.
Because qualification for the end-user exception first requires a determination of the classification of the entity invoking it, the following
section provides an overview of how Dodd-Frank classifies entities involved in the swaps marketplace for purposes of the exception.
i.
Classifying Swaps and Allocating Jurisdiction
Dodd-Frank divides regulatory jurisdiction over the swaps market
between the CFTC and SEC, depending on whether a swap is "securitybased," which is within the jurisdiction of the SEC, or has elements of a
"mixed" swap, which is subject to joint SEC and CFTC jurisdiction. 176
173
15 U.S.C.A. § 8305 (West 2010) (commonly referred to as "The Lincoln Provision" or
"Swaps Push-Out Rule"). The provision requires "commercial banks to cease or divest their
participation in certain classes of swap transactions, or lose access to several types of federal
assistance," including FDIC insurance and Federal Reserve credit facilities or discount windows.
Christopher T. Fowler, The Swaps Push-Out Rule: An Impact Assessment, 15 N.C. BANKING
INST. 205 (2011). The government used the latter to extend emergency liquidity to failing
financial institutions, such as AIG, during the financial crisis. See Investment in American Inter-
national Group supra note 13.
See Letter from Christopher Dodd, Chairman, Senate Comm. on Banking & Blanche
Lincoln, Chairman, Senate Comm. on Agric., to Barney Frank, Chairman, H. Fin. Servs.
Comm. & Colin Peterson, Chairman, H. Comm. on Agric. (June 30, 2010), available at http://
www.truebluenaturalgas.org/wp-content/uploads/2011/07/2010-06-30DoddLincolnEndUser
Letter.pdf.
175 See id.
176 7 U.S.C.A. § 2.
174
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SUBSTANCE VS. FORM
221
All other non-security-based swaps are subject to exclusive CFTC jurisdiction."' This jurisdictional bifurcation has resulted in giving the
CFTC exclusive jurisdiction over the majority of formerly OTC derivatives."' Pursuant to the rulemaking provisions in Title VII, both agencies have coordinated to set forth finalized operational definitions of
these terms.' 79
A swap, in its most general sense, is a "bilateral agreement to exchange cash flows at specified intervals (payment dates) during the
agreed-upon life of the transaction (maturity or tenor). 18 0 The cash
flows may or may not be a continuous exchange of cash between both
parties. s8 Swaps may take many forms, depending on the underlying
asset or variable from which they derive their value. CDSs in particular
derive their value from the risk of a referenced entity's credit event (e.g.,
the entity's default), interest rate swaps derive their value from a referenced interest rate, and so on. In the same manner, a "security-based
swap" may be conceptualized as a "bilateral, privately negotiated derivative contract in which a protection buyer makes periodic payments to a
177 Id.
Using a narrow/broad approach, swaps based on a single security or narrow-based
index of securities are "security-based swaps" and regulated by the SEC, while swaps based on
broad-based security indices are classified as "swaps" and subject to CFTC regulation. Id.
Specifically, it provides that swaps based on commodities or interest rates are treated as "swaps"
subject to CFTC oversight, while treatment of a CDS depends on whether it references a singlename security (hereinafter "security-based swap") or index of securities (hereinafter "swap"). Id.
In the basic example in Part I involving Speculator X, Title VII would subject the CDS agreement to classification as a security-based swap and subject to SEC oversight. Nonetheless, Title
VII requires that the SEC and CFTC establish and maintain comparable requirements to the
maximum extent practicable, thus making in many cases these distinctions immaterial. See 15
U.S.C.A. § 8302 (West 2010).
178 Marc Horwitz, David Khrohn & Jay Taylor, Implications to Derivatives Users of the DoddFrank Wall Street Reform and Consumer Protection Act, 13 INT'L SECURmTIzATIoN & FIN. REP.
(No. 14) 8 (July 31, 2010), available at http://www.dlapiper.com/files/Publication/31el5b4e1-91
5a0f-448b-88cc-c8bcb5794368/Presentation/PublicationAttachment/7e565320-2e4f-4d1
33-d9b4ed2dldO2/SR073110_final.pdf ("According to recent estimates, the majority of outstanding OTC derivatives by notional amount would fall under the exclusive jurisdiction of the
CFTC. Therefore, the CFTC has primary jurisdiction over the currently composed marketplace
for OTC derivatives.").
179 15 U.S.C.A. § 8302; See Further Definition of "Swap Dealer," "Security-Based Swap
Dealer," "Major Swap Participant," "Major Security-Based Swap Participant" and "Eligible Contract Participant", 77 Fed. Reg. 30,596-01 (May 23, 2012) (to be codified at 17 C.F.R. Part 1 &
17 C.F.R Part 240).
180 Product Descriptions and Frequently Asked Questions, INT'L SwAPs AND DERIVATIVES
Ass'N, http://www.isda.org/educat/faqs.html (last visited Dec. 16, 2013).
181 That is, it could also be a single payment from one party in exchange for either a continuous flow of payments or a single payment from the other party.
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protection seller, in return for a contingent payment if a predefined
event occurs in a reference security or group of securities."182
ii.
Registration of Dealers and Major Participants
Dodd-Frank requires an entity involved in the swaps marketplace
to register with and report its swaps activity to the SEC and/or the
CFTC if it meets the criteria for a "swaps dealer" (hereinafter "SD"),
"security-based swaps dealer" (hereinafter "SBSD"), "major swap participant" (hereinafter "MSP"), or "major security-based swaps participant" (hereinafter "MSBSP"). 18 3 Because the criteria for SDs and MSPs
are substantially similar to their security-based counterparts,18 1 this Note
will refer to both SDs and SBSDs as simply swap dealers or SDs, and
both MSPs and MSBSPs as major swap participants or MSPs, unless
otherwise indicated. In general, a SD is an entity which:
(i) holds itself out as a dealer in swaps;
(ii) makes a market in swaps;
(iii) regularly enters into swaps with counterparties as an ordinary
course of business for its own account; or
(iv) engages in any activity causing the person to be commonly
known in the trade as a dealer or market maker in swaps. . ."
A SD may be classified as such for a "single type or single class or
category of swap or activities and considered not to be a swap dealer for
other types, classes, or categories of swaps or activities." 186 The CFTC's
interpretative guidance provides that the determination of whether an
entity is a SD "should consider all relevant facts and circumstances, and
focus on the activities of a person that are usual and normal in the
person's course of business and identifiable as a swap dealing busiBarry Le Vine, The Derivative Market's Black Sheep: Regulation of Non-Cleared SecurityBased Swaps Under Dodd-Frank, 31 Nw. J. INT'L L. & Bus. 699, 708-09 (2011) (emphasis
added).
183 7 U.S.C.A. § 6s (registration of swap dealers and major swap participants); 15 U.S.C.A.
§ 78o-10 (West 2010) (registration of security-based swap dealers and major security-based swap
participants).
184 Cf 7 U.S.C.A. § la (West 2010) (criteria for swap), with 15 U.S.C.A. § 78c (criteria for
security-based swap).
185 7 U.S.C.A. § la (West 2010).
182
186
Id
2013]
SUBSTANCE VS. FORM
223
ness." 18 7 Specifically excluded from categorization as SDs are entities
that are FDIC-insured depository institutions (but only "to the extent
[they offer] to enter into a swap with a customer in connection with
originating a loan with that customer" "), use swaps for their own account and not as a part of a regular business,'" and engage "in a 'de
minimis quantity' of swap dealing"'o which the CFTC has specified as
an "aggregate gross notional amount of the swaps .
..
over the prior 12
months in connection with dealing activities [not exceeding] $3 billion."'
A MSP is any person that is not a SD, and:
(i) maintains a substantial position in swaps for any of the major swap
categories as determined by the Commission, excluding-(I) positions
held for hedging or mitigating commercial risk; and (II) positions
maintained by any employee benefit plan. . . for the primary purpose
of hedging or mitigating any risk directly associated with the operation of the plan;
(ii) whose outstanding swaps create substantial counterparty exposure
that could have serious adverse effects on the financial stability of the
United States banking system or financial markets; or
187 COMMODITY FUTURES TRADING COMM'N,
FINAL RULEs
REGARDING FURTHER DEFIN-
ING "SwAP DEALER," "MAJOR SWAP PARTICIPANT" AND "ELIGIBLE CONTRACT PARTICIPANT"
3, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/msp-ecpfactsheetfinal.pdf
7 U.S.C.A. § la (West 2010). Interestingly, this exception does not apply to the definition of "security-based swap dealer." See 15 U.S.C.A. § 78c. The finalized rules issued by the
CFTC further defining "swap dealer" provide that this exclusion applies to any swap that meets
the following conditions:
* the swap is connected to the financial terms of the loan or is required by loan
underwriting criteria to be in place as a condition of the loan in order to hedge the
borrower's commodity price risks;
* the swap is entered into within 90 days before or 180 days after the date of the loan
agreement, or any draw of principal under the loan;
* the loan is within the common law meaning of "loan;" and
* the insured depository institution is the sole lender or, if it is a participant in a
lending syndicate, it is responsible for at least 10% of the loan (otherwise, the
notional amount of the swap may not exceed the amount of the insured depository
institution's participation).
188
COMMODITY FUTURES TRADING COMM'N,
supra note 187, at 2.
189 7 U.S.C.A. § la.
190
Id
191
COMMODITY FUTUREs TRADING COMM'N,
supra note 187, at 3. This last exception also
allows "for a phase-in [period] of the de minimis threshold to facilitate orderly implementation
of swap dealer requirements .... [during which] would effectively be $8 billion." Id.
CARDOZO PUB. LAW POLICY & ETHICS.
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(iii) (I) is a financial entity that is highly leveraged relative to the
amount of capital it holds and that is not subject to capital requirements established by an appropriate Federal banking agency; and (II)
maintains a substantial position in outstanding swaps in any major
swap category as determined by the Commission. 1 92
The definition of MSPs (but not MSBSPs1 9 3) specifically excludes
certain subsidiary entities "whose primary business is providing financing, and uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures."194
Once an individual or entity meets the criteria for a dealer or major
participant, it is required to register with the SEC and/or CFTC and be
subject to capital, margin, recordkeeping, and business conduct requirements, as well as duties with respect to special entities. 1 " As discussed
below, the determination of whether an entity meets the criteria for
dealers or major participants is necessary in determining if an entity may
avail itself of the end-user exception, as the exception expressly disqualifies entities that qualify as either dealers or major participants per the
registration requirements.
iii.
Clearing, Trading, and Reporting
Without a centralized counterparty, such as a clearinghouse, standing in between dealers and buyers, each party to an OTC derivatives
contract fully assumes counterparty credit risk - "the risk . . . that the
other party will not perform the contractual obligations" as specified in
the swaps agreement.' 9 While margin and collateral requirements help
mitigate this risk, such requirements nonetheless "do not take into account the counterparty credit risk that each trade imposes on the rest of
the system, allowing systemically important exposures to build up without sufficient capital to mitigate associated risks."' '7 In other words,
7 U.S.C.A. § la.
See 15 U.S.C.A. § 78c.
Id
195 7 U.S.C.A. § 6s; 15 U.S.C.A. § 78o-10 (mandating minimum capital requirements, and
with respect to uncleared swaps, initial and variation margin requirements).
196 U.S. Gov'T ACCOUNTABILITY OFFICE, GAO-09-397-T, SYSTEMIC RISK, REGULATORY
OVERSIGHT AND RECENT INITIATIVES To ADDRESS RISK POSED BY CREDrr DEFAULT SwAP 3
(2009), available at http://www.gao.gov/new.items/d09397t.pdf. Credit risk in this context, as
it is applied to the buyer and seller, should not be confused with the credit risk of a reference
entity to a CDS.
197 Id.
192
193
194
2013]
SUBSTANCE VS. FORM
225
even if parties to a derivatives contract are contractually required to post
collateral and margin to help mitigate potential losses that may result
should one of them default, the lack of any centralized clearing regime
makes it difficult to ascertain the frequency and magnitude of losses
accumulating throughout the marketplace - a macrofinancial inquiry
that is especially relevant in the context of systemic risk.
Dodd-Frank attempts to solve this problem by requiring swaps to
be cleared if identified by the applicable regulator as required to be
cleared, and if a derivatives clearing organization (hereinafter "DCO")
or clearing agency, each a type of clearinghouse, accepts the swap for
clearing.'" Similar to the registration requirements, the Dodd-Frank
creates largely parallel clearing requirements for both swaps and securitybased swaps.' 99 DCOs and clearing agencies must register with their
appropriate regulator and meet an extensive list of criteria to ensure that
they can fulfill their role in absorbing potentially large losses of
counterparties to a swaps trade. 2 0 0 If a clearinghouse is "well-designed
and its risks are prudently managed, it can limit counterparty credit risk
by absorbing counterparty defaults and preventing transmission of their
impacts to other market participants.1"201 They can also provide centralized information on market dealers and participants "by releasing information on open interest, end-of-day prices, and trade volumes," 2 0 2
thereby increasing transparency.
If a swap or security-based swap is required to be cleared, it must
also be traded on a designated contract market (hereinafter "DCM") or
a registered swap execution facility (hereinafter "SEF"), or, in the case of
a security-based swap, a national exchange or security-based swap execution facility (hereinafter "SB SEF").2 03 While mandatory clearing mitigates counterparty risk and facilitates transparency through various
reporting mechanisms, an exchange requirement simply mandates that
"eligible derivatives use a particular type of trade execution venue. "204
198 7 U.S.C.A. § 2; 15 U.S.C.A. § 78c-3. DCOs are used in the case of swaps, and clearing
agencies in the case of security-based swaps.
199 Id.
200 In the case of DCOs, see 7 U.S.C.A. § 7a-1 (West 2010) (stipulating that each DCO
must have adequate financial, operational and managerial resources, determined by the CFTC).
201 U.S. Gov'T ACCOUNTABILITY OFFICE, supra note 196, at 3. See also supra note 10 (discussion on clearinghouses).
202 U.S. Gov'T ACCOUNTABILITY OFFICE, supra note 196, at 22.
7 U.S.C.A. § 2; 15 U.S.C.A. § 78c-3.
R.A., Whats a clearinghouse?,THE EcONOMIsT (Apr. 22, 2010, 4:18 PM), http://www
.economist.com/blogs/freeexchange/2010/04/derivatives. "People tend to think of exchanges as
203
204
226
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Clearinghouses may be conceptualized as third parties that guarantee the
consummation of trades, while exchange platforms that match up buyers and sellers at pre-disclosed prices.
IV.
ANALYSIS & SCRUTINY OF THE END-USER EXCEPTION
A.
Statutory Requirements & Rulemaking Clarification
Recognizing that reducing systemic risk and increasing transparency must be balanced against inevitable transaction and compliance
costs, Dodd-Frank allows some commercial end-users of swaps and security-based swaps to bypass the clearing and exchange requirements.
In particular, the end-user exception allows a commercial end-user to
continue utilizing the OTC market if it: (i) is not a financial entity; (ii)
is using swaps to hedge or mitigate commercial risk; and (iii) notifies the
[CFTC or SEC, as applicable] ... how it generally meets its financial
obligations associated with entering into non-cleared swaps.2 0 5
A financial entity for purposes of this exception is defined as a SD,
a SBSD, a MSP, a MSBSP, 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." 206 The exception allows eligible counterparties who use "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 exception] 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." 207 It
also allows the CFTC and SEC to exempt farm credit institutions, and
credit unions with $10 billion or less in assets from the definition of
"financial entity," allowing small financial entities (e.g., small banks) to
qualify for the end-user exception, 208 which the SEC has proposed to
synonymous with clearinghouses because, at least in the US, the big exchanges own their own
'captive clearinghouses,' so most exchange-traded derivatives are also cleared through the exchange's clearinghouse. But they are two separate functions entirely." Exchanges vs. Clearinghouses, ECONOMICS OF CONTEMPr, (April 14, 2010, 4:36 PM), http://economicsofcontempt
.blogspot.com/2010/04/exchanges-vs-clearinghouses-this-is.html.
205 7 U.S.C.A. § 2; 15 U.S.C.A. § 78c-3.
206 7 U.S.C.A. § 2; 15 U.S.C.A. § 78c-3.
207 7 U.S.C.A.
2; 15 U.S.C.A. § 78c-3.
208 7 U.S.C.A. § 2; 15 U.S.C.A. § 78c-3. In July, CFTC finalized its rulemaking on the
end-user exemption and plans on implementing.
2013]
SUBSTANCE VS. FORM
227
exercise 2 0 9 and which the CFTC has exercised and finalized 2 1 0 in their
respective rulemakings.
The second prong of the exception requires that the swaps transaction at issue be used to hedge or mitigate commercial risk and not for "a
purpose that is in the nature of speculation, investing or trading." 2 1 1
The general idea is that the swaps transaction must be economically
appropriate to the reduction of a commercial risk or have already qualified for hedging purposes under other relevant law.21 2 Moreover, it cannot be used "to hedge or mitigate the risk of another swap or securitybased swap position, unless that other position itself is used to hedge or
mitigate commercial risk." 2 1 3 The CFTC, which has finalized its
rulemaking provisions with regard to the criteria of this second prong, 2 14
has emphasized that such determination be on a transaction-by-transaction basis, taking into account all the relevant facts and circumstances
that exist when the transaction takes place, and will be "based on the
underlying activity to which the risk relates, not on the type of entity
claiming the end-user exception." 2 1 5
209 End-User Exception to Mandatory Clearing of Security-Based Swaps, Release No. 3463556; File No. S7-43-10, SECURITIES AND EXCHANGE COMMISSION 5-6 (December 5, 2010)
(proposed addition to 17 C.F.R. § 240), available at http://www.sec.gov/rules/proposed/2010/
34-63556.pdf ("[T]he Commission is proposing Rule 3Cg-1 under the Exchange Act to specify
requirements for using the exception to mandatory clearing of security-based swaps established
by Exchange Act Section 3C(g), together with proposed alternative language to provide an exemption for small banks, savings associations, farm credit system institutions and credit
unions.").
210 End-User Exception to the ClearingRequirementfr Swaps, Federal Register, 77 Fed. Reg.
42,560, 42,578 (July 19, 2012) (to be codified at 17 C.F.R. pt. 39), available at http://www.cftc
.gov/ucm/groups/public@lrfederalregister/documents/file/2012-17291a.pdf ("the Commission
is adopting § 39.6(d) to provide an exemption from the definition of 'financial entity' for small
Section 2(h)(7)(C)(ii) institutions.").
211 See COMMODITY FuTUREs TRADING COMM'N, supra note 187, at 3.
212 End-User Exception to the ClearingRequirementfr Swaps, supra note 210 ("[T]he Commission and the CFTC recently proposed a definition of'hedging or mitigating commercial risk'
under proposed Exchange Act Rule 3a67-4 that the Commission preliminarily believes should
also govern the meaning of 'hedging or mitigating commercial risk .
213 See id
214 Id. As of the date of this Note, the SEC has not yet finalized its rulemaking provisions
with regard to the criteria for "hedging or mitigating commercial risk."
215 Id. Specifically, a swaps transaction subject to CFTC jurisdiction may qualify for treatment as hedging or mitigating commercial risk for purposes of the end-user exception if it:
Is economically appropriate to the reduction of risks in the conduct and management of a
commercial enterprise . ..
Qualies as bonafide hedging for purposes of an exemption from position limits under the
Act; or
CARDOZO PUB. LAW POLICY &rETHICS J
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If the end-user is an issuer of securities registered under the Securities Act or reporting under the Exchange Act, Dodd-Frank requires that
it first obtain approval from its board or committee for its decision to
rely on the exception.2 1 6
Even if an eligible counterparty relies on the exception, it must still
disclose to the appropriate regulator relevant information regarding the
swaps transactions, including information on how it plans to meet certain financial obligations. 2 17 In particular, if an end-user relies on this
exception while executing a swaps trade, it must notify the appropriate
regulator through a swap data repository (hereinafter "SDR").2 18 If no
SDR is available, the swap must be reported directly to the regulator.2 1 9
The CFTC's finalized rules require a "check-the-box" reporting format
for each swap in which the exception is invoked, asking the reporting
counterparty to provide notice of the election and the identity of the
electing counterparty. 220 It also allows end-users to comply with most
of the reporting requirements through a single annual filing that will
compile basic information about the entity, its basis for relying on the
exception, and how it plans on meeting its financial obligations.22 1 In
many cases, the end-user will not be the reporting party, except in swaps
transactions with other end-users.22 2
Qualifies for hedging treatment ...
Id. (emphases added). For purposes of brevity, this Note will, where applicable, focus on the
"economically appropriate" subcategory. The criteria used to satisfy each of these three subcategories could easily be the subject of another separate and lengthy discussion. As consulting and
advisory firm Deloitte points out, this last subcategory of hedging or mitigating commercial risk
encompasses a broader scope of transactions than those envisioned under bona fide hedging
(which, for example has limits on the tenor for anticipatory hedges) or under [hedge accounting
treatment] (which has strict criteria in the assessment of the degree of offset as being 'highly
effective' and limits what types of risks may be identified and designated as being hedged)."
Thus, while the first two criteria have more clearly defined parameters, there are more "gray
areas that may warrant consideration in the application of the 'economically appropriate' test.
An interpretationofthe 'hedge or mitigate risk' criteriaand the impact to compliance with the DoddFrank Act, DELOITTE, available at http://deloitte.wsj.com/riskandcompliance/files/2013/05/
Dodd-FrankHedgeMitigate.pdf.
216 7 U.S.C.A. § 2; 15 U.S.C.A. § 78c-3.
217
218
219
220
221
222
2012).
7 U.S.C.A. § 2; 15 U.S.C.A. § 78m-1 (West 2010).
7 U.S.C.A. § 2; 15 U.S.C.A. § 78m-1.
7 U.S.C.A. § 2; 15 U.S.C.A. § 78m-1.
See End-User Exception to the Clearing Requirementfor Swaps, supra note 210.
Id
"Swap Data Recordkeeping and Reporting Requirements." 17 C.F.R. § 45 (January 13,
2013]
SUBSTANCE VS. FORM
B.
229
Critique
Use of derivatives is a double-edged sword. They are a tool of
financial ingenuity to help offset commercial risk and allow businesses
to operate more efficiently. Derivates can also wreak havoc on a
macroeconomic level without proper oversight. If we accept the general
premise of Dodd-Frank - that transparency of the swaps market is fundamental in mitigating systemic risk, and that the clearing, exchange
trading, and reporting requirements of market dealers and participants
are necessary mechanisms to increase transparency - then the scope of
the end-user exception is an exceedingly important consideration
wrought with many consequences. Its precision must be neither overly
underinclusive, in that entities whose swaps transactions pose little to no
systemic risk are unduly burdened, nor so overinclusive as to allow entities that are not (but should be) captured by Title VII's mandates but
for the end-user exception. Any honest evaluation of the exception's
utility must thus bear in mind the overall goals of Dodd-Frank, particularly the prevention and mitigation of systemic risk.
i.
To the extent that an end-user is neither a SD nor MSP, it
should be allowed to avail itself of the exception, irrespective
of its financial or non-financial nature.
In order to qualify for the exception, the end-user cannot be a
financial entity, which for purposes of the exception is defined as a SD,
MSP, 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,"2 2 3 unless, in the
case of a transaction between a financial and non-financial counterparty,
the non-financial counterparty elects to use the end-user clearing exception.22 4 Otherwise, the financial counterparty is required to clear any
swap subject to the clearing mandate.
Interestingly, because neither the definition of SDs nor MSPs differentiates between financial and non-financial entities, the exception
leaves open the possibility that non-financial SDs or MSPs could be
categorically disqualified from availing themselves of the exception.
When certain lawmakers urged regulators to exempt certain end-users
such as airlines, manufacturers, and other non-financial entities from
223
7 U.S.C.A. § 2; 15 U.S.C.A. § 78c-3.
224
Id
230
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Title VII's requirements, chairman of the CFTC Gary Gensler testified
before the House Financial Services Committee that the CFTC's rules
would "focus only on transactions between financial entities," and clarified that the rules would not apply to non-financial entities, or so-called
end users, that use derivatives to hedge financial and other commercial
risks. 225 Conversely, the exception also leaves open the possibility that a
financial entity that is neither a SD nor MSP may be nonetheless disallowed from availing itself of the exception because it is engaged in banking "or in activities that are financial in nature." 2 2 6
While the Act does not take a bright line approach to defining SDs
or MSPs, 2 2 7 to some degree it accounts for a firm's level of interconnectedness and the quality of its swaps exposures, two important factors
in systemic risk as discussed in Part II. In particular, the definition of
MSPs captures any entity that "maintains a substantial position in swaps
for any of the major swap categories as determined by the [CFTC]" or
"whose outstanding swaps create substantial counterparty exposure that
could have serious adverse effects on the financial stability" of the
U.S. 2 2 8 Thus, in light of the fact that non-financial entities may also
propagate systemic risk,229 it would be inappropriate to allow a nonfinancial entity that is otherwise highly interconnected and whose exposures are substantial enough to cause adverse effects on the broader
economy to qualify as an end-user and bypass Title VII's mandates. On
the other hand, it would make little sense to disallow a financial firm
whose swaps exposures are not otherwise substantial enough to cause
systemic risk from availing itself of the exception.
For example, consider non-financial entities that are heavily involved in the energy derivatives market. Large energy and utility companies have extensively lobbied Congress and the CFTC to adopt rules
most favorable to its industry.2 30 In 2009, the top five dealers in the
energy derivatives market were large banks: Morgan Stanley, Barclays
225 Benn Protess, Republicans Push for Exemptions to Derivatives Rules, N.Y. TIMES (Feb. 15,
2011), http://dealbook.nytimes.com/2011/02/15/republicans-push-for-exemptions-to-deriva
tives-rules/.
226 7 USCA § 2; 15 USCA § 78c-3.
227 See supra Part III.
228 7 USCA § la.
229 See supra Part II.
230 Ben Protess, Regulators to Ease a Rule on Derivatives Dealers, N.Y. TIMES (Apr. 12, 2012),
http://dealbook.nytimes.com/2012/04/17/regulators-to-ease-a-rule-on-derivatives-dealers/.
2013]1
SUBSTANCE VS. FORM
231
Capital, Deutsche Bank, Socidtd G6n6rale, Goldman Sachs. 2 3 1 But two
large energy and utility companies - BP and Shell Energy, respectively occupied the sixth and seventh spots. 2 32 While these entities certainly
use energy derivatives to help hedge commodity price volatility, it does
not always explain their simultaneous usage of derivatives for operations
not directly related to risk management and indistinguishable from
"classic financial house non-commercial derivatives dealing and prop
trading." 2 3 3 As one critic aptly states:
The average man-on-the-street thinks of Shell as a company with gas
stations, refineries, storage tanks and oil wells. It is. But that's not the
whole picture.... The average Wall Street investment banker running
an energy derivatives trading desk also thinks of Shell Energy as one of
its biggest competitors, dealing derivatives and running a proprietary
trading business.2 34
Indeed, the energy and utility companies' lobbying efforts had
been so vigorous that it prompted Gary S. Gensler, the current chairman of the CFTC, to dub it "the BP loophole." 2 3 5 Thus, to the extent
that a non-financial entity such as BP is just as much as a SD or MSP in
the swaps market as a financial entity such as Goldman Sachs, it would
be a seemingly absurd result to allow the former to bypass Title VII's
mandates while requiring the latter's adherence.
ii. Even assuming that financial institutions are somehow inherently
systemically riskier than non-financial institutions (while controlling
for interconnectedness and quality of exposures), the logic of
the end-user exception is internally inconsistent
In the CFTC's finalized rulemaking provision, it exercised its authority under section 4(c) of the Commodities Exchange Act, which
231 J. Parsons & A. Mello, When is an end-user not an end-user?, BETTING THE BusINESS
(Feb., 17, 2011), http://bettingthebusiness.com/2011/02/17/when-is-an-end-user-not-an-enduser/.
232
233
Id
Id.
234 Merrill Goozner, Business Groups Seek Swaps Exemption, FiscAL TIMES (Apr. 1, 2011),
http://www.thefiscaltimes.com/Articles/2011/04/01/Business-Groups-Seek-Swaps-Exemption
.aspx#pagel.
235 Silla Brush & Robert Schmidt, How the Bank Lobby Loosened U.S. Reins on Derivatives,
BLOOMBERG (Sept. 4, 2013), http://www.bloomberg.com/news/2013-09-04/how-the-banklobby-loosened-u-s-reins-on-derivatives.html.
CARDOZO PUB. LAW POLICY & ETHICS
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grants the CFTC general exemptive authority,236 to permit qualifying
cooperatives to elect to use the end-user exception.2 37 Cooperatives may
elect the exception provided that its members are either non-financial
entities or other cooperatives whose members are non-financial entities,
and that the swap is entered into in connection with originating loans to
cooperative members or with hedging or mitigating commercial risk related to loans to, or swaps with, members.2 3 8
Cooperatives are businesses owned and run by and for their members, such as credit unions and Farm Credit System (hereinafter "FCS")
lenders. 2 3 9 The CFTC's rationale for exempting cooperatives from the
definition of financial entity is that "the relationship between a cooperative and its members . . . is different from the relationship between
banks and their customers" in that "they exist to serve their members'
interests and act as intermediaries for their members in the
marketplace. "240
On the other hand, banks generally are for-profit, publicly or privately
held corporations whose investor-owners are not required to be the
users of the bank's services, and often are not..
.
. As such, unlike the
member-focused purposes of exempt cooperatives, a primary purpose
of banks is to generate value for their owners, who generally are not
their customers. 2 4 1
In a public comments letter to the CFTC after its preliminary
rulemaking on this topic, the Independent Community Bankers of
America pointed out the logical inconsistency in treating cooperatives
differently from community banks, in that they both serve the same
functions in serving customers. 2 4 2 "Community banks, for example, ac236
7 U.S.C. § 6(c)(1).
Clearing Exemption for Certain Swaps Entered into by Cooperatives, COMMODITIES FuTuREs TRADING COMM'N 5, http://www.cftc.gov/ucm/groups/publicl@newsroom/documents/
237
file/federalregister081313.pdf.
238
239
Id
See What is a Cooperative?, COOPERATIVE CTR. FED. CREDIT
UNION,
available at http://
www.coopfcu.org/about-us/what-is-a-cooperative.html (last accessed Nov. 30, 2013).
240
241
ClearingExemption for Certain Swaps Entered into by Cooperatives, supra note 237
Id at 15.
242 See Letter from Mark Scanlan, Senior V. Pres., Agriculture and Rural Policy, Indep.
Cmty. Bankers of America, to David Stawick, Sec'y of the Comm'n, Commodity Futures Trading Comm'n (Aug. 16, 2012), http://www.icba.org/files/ICBASites/PDFs/ICBA%20Comments
%20RIN%20%23%203038-AD47-ClearingO/o20Exemption%20for%20Cooperatives%20816
12%20_2_.pdf.
2013]
SUBSTANCE VS. FORM
233
cumulate deposits, transfer money and help manage maturities and risks
of various loans and financial products on behalf of their customers who
would not be able to accomplish the same tasks on an individual basis." 24 3 Additionally, community banks' "use of swaps also 'pose less
risk to the financial system' and use swaps to hedge the underlying risks
of loans made to their customers, in the same or similar manner as do
FCS lenders and credit unions." 2 4 4
The exception also specifically includes pension plans in the list of
institutions that qualify as financial and thus ineligible for availing itself
of the exception. 2 45 "Swaps are commonly used for pension plan management" because "[t]hey help manage risk, reduce portfolio volatility,
facilitate plan transition among investment managers and minimize
transaction costs associated with rebalancing portfolios." 246 Categorically disqualifying pension plans from end-user status is ill contrived
because they are not interconnected with the broader economy in any
sense meaningful for assessing systemic risk. As the Ontario Teachers'
Pension Plan, the largest single-professional pension plan in Canada,
explained in a letter to the Basel Committee on Banking Supervision:
It is important to emphasize that pension funds are end-users of OTC
derivatives. Dealers, banks and other intermediaries, by their nature,
are exposed to both the OTC derivatives transaction entered into with
a client and a corresponding hedge, often in the form of one or more
other OTC derivatives. An intermediary's role in the market gives rise
to the problem of interconnected cross-defaulting, the hallmark of systemic risk. By contrast, end-user pension funds are exposed to only
the credit risk of their counterparty in any given transaction. In addition, pension assets are held separately from the pension sponsor's assets and generally from the assets of its custodian. . . . Bilateral
arrangements do not give rise to the problem of interconnected crossdefaults, and therefore do not contribute to the element of systemic
risk caused by such interconnectedness and pension funds' assets are
isolated from the insolvency of sponsors and custodians.2 47
243
244
245
246
Id. at 3.
Id at 4.
7 U.S.C.A. 5 2; 15 U.S.C.A. § 78c-3.
Oaten & Sichel, supra note 144.
247 Letter to the Basel Committee on Banking Supervision, ONTARIO TEACHERS' PENSION
PLAN 3 (Sept. 28, 2012), http://www.bis.org/publ/bcbs226/otpp.pdf. See also, Are Pension
Funds too Important to Fail? Or too Big to Save?, NETSPAR 18 (Dec. 2011), available at http://
arno.uvt.nl/show.cgi?fid=121904 ("One difference to start with is that the banking sector is
234
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Additionally, because pension plans are typically subject to "comprehensive prudential regulatory regimes spanning from governance to investment concentration restrictions, "248 the quality of its exposures is
generally not a concern. Thus, even if we accept that financial entities
are somehow inherently systemically riskier than non-financial entities,
the internal logic of the end-user exception with respect to financial
entities such as cooperatives and pension plans makes little sense.
iii.
Any end-user exception must always be formulated against the
backdrop of Dodd-Frank's goals of preventing
and mitigating systemic risk
Dodd-Frank comes a long way in overhauling an entirely OTC
derivatives market. It recognizes any realistic and economically appropriate reform must ultimately balance the costs of regulatory compliance
against the goals of preventing and mitigating systemic risk. As discussed in Part II, a firm's systemic risk profile is largely characterized by
factors such as its interconnectedness with other institutions and the
broader economy as well as the quality of its exposures and the levels of
risks it assumes by making certain investments. However, these factors
are not inherently limited to financial institutions, and the end-user exception should reflect that. Additionally, to the extent that the criteria
for SDs and MSPs already accounts for the qualities typically associated
with systemic risk, such as high levels of interconnectedness and risky
counterparty exposures, whether the business of a given entity is primarily financial or non-financial in nature should be of no import. By
revisiting (or finalizing its rulemaking with regard to, in the case of the
SEC) the end-user exception with a focus on substance over form, federal regulators may help not only ensure fairness but also prevent regulatory arbitrage.
globally interconnected and is part of the global financial system. In contrast, pension funds are
only users of the financial system. They do not bring products into the financial market that are
traded there. They use the financial market to invest their assets and try to profit from these
investments.").
248 Letter to the Basel Committee on Banking Supervision, supra note 247, at 3.