Implementation of Swap Trade Regulation Aimed at Reducing Investment Risk for American Financial Firms

Hubert Shingleton

Associate Editor

Loyola University Chicago School of Law, J.D. 2019

In September 2017, United States economic markets implemented swap-regulating rules to reduce risk to U.S. investment firms. Signed into law in 2016, this regulation curbs the risk associated with swap derivatives in the United States. The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Financial Conduct Authority, and the Federal Housing Finance Agency (the “Agencies”), constructed a joint rule requiring taxpayer-insured banks and financial institutions to collect greater collateral and provide greater transparency when involved in swap derivative agreements.

Foundation of the regulation

Swap derivatives are financial transactions intended to mitigate the investment risk created by price swings, variable interest rates, and fluctuations in the stock market. In a swap, two parties agree to exchange the value of assets in such a way that the assets never actually change hands. Swap agreements are typically beneficial to both parties, and they are conducted through a swap broker, or clearinghouse.

During the 2008 economic crisis, a number of large financial firms invested heavily in bad derivatives. Inevitably, these derivatives failed to appreciate in value, and the clearinghouses orchestrating these trades demanded collateral to guarantee the security of the investments. Many of the firms were unable to pay the additional collateral and turned to the federal government to intervene on their behalf. Subsequently, the government bailed out the investment firms to prevent financial instability arising from the failure of taxpayer-insured banks.

As a result, U.S. regulators adopted the Dodd-Frank Act (the “Act”) in 2010, which enacted new rules to reduce risks in securities and derivatives. In 2015, the FDIC proposed an early form of the swap-regulating rule enacted September 1st, 2017. Under the FDIC’s early rule, investment firms are forced to provide tax-payer insured banks and their subsidiaries with considerably larger margins as collateral before entering into a swap agreement.

Outlining the rule

In the final draft of this rule, the Agencies agreed to draw from two sections of the Act. Sections 731 and 764 of the Act require that the Agencies collectively establish the capital requirements and the initial and variation margin requirements for all entities on all swaps not established through clearinghouses or tax-payer insured banks. All entities engaged in trading swap derivatives must register as swap dealers through the Commodity Futures Trading Commission or the SEC. Once registered, these entities are considered covered swap entities (“CSEs”). Additionally, all swaps not routed through clearinghouses require public written agreements detailing the collateral arrangements involved.

The FDIC outlines the margin and capital regulations for swap entities to operate as follows:

  1. Collect initial margin and variation margin from other CSE counterparties
  2. Post and collect daily initial margin when trading with financial end-user counterparties with material swaps exposure, defined as a notional exposure of $8 billion or more.
  3. Post and collect daily variation margin when trading with financial end-user counterparties, regardless of the level of swaps exposure if the required amount of variation margin and initial margin exceeds $500,000.
  4. Does not require CSEs to exchange margin with commercial end-users or financial institutions with total assets of $10 billion or less, provided that the swaps are entered into for hedging purposes.
  5. Establishes minimum quality standards for acceptable initial and variation margin collateral. It also establishes minimum safekeeping standards for initial margin collateral posted by CSEs and counterparties to ensure collateral will be available to support the trades if defaults occur.
  6. Applies only to new swaps entered into after the applicable compliance dates. These dates range from September 2016 to September 2020.

Through these guidelines, the Agencies seek to curb the economic risks involved within swap trading as well as provide greater transparency to the public about swap trading not conducted through a clearinghouse.

Outlook for the future of swap derivatives

The rules outlined by the Agencies are part of a global initiative to better regulate swap trades both within the U.S. and in foreign countries. While the largest international organizations and firms are already bound by these regulations, September 1st, 2017, marked the deadline for smaller firms in the U.S. and Europe to comply with the new regulation.

Currently, the European markets are implementing similar regulations. As a matter of procedure, the European markets are constricted by greater jurisdictional issues than the United States in matters of economic regulation; however, the European markets are in compliance aside from the regulations concerning swaps not routed through clearinghouses.

Firms engaged in non-cleared swap trades are most heavily impacted when the trades are not carried out through a clearinghouse. Historically, swap trades were private affairs not transparent to the public, but domestic and international regulators have ordered nearly all swap trades onto open platforms and through clearinghouses. The increased transparency of these trades will provide investors with a better idea of a firm’s real assets at any given time.

The new regulations require that all non-cleared swap trades have a written requirement detailing the exact collateral between the two parties. Any firms not complying with the new regulations run the risk of being blocked from the market.

Moving forward, these domestic regulations will provide greater security to the trade of swap derivatives. There will be greater stability in the investment community, and as the rest of the world adopts these regulations, global regulators will be unified in regulating domestic and international markets.  However, this security does not come at a low a cost. This regulation is expected to add billions of dollars to the global cost of swap agreements. The increased collateral required for an agreement provides a safety net to taxpayers and their institutions, but investment firms will be forced to place a much greater emphasis on their collateral offered during a swap agreement. Additionally, smaller firms will feel an increased economic pressure as the need to pay a clearinghouse will be greater than ever before. How the aggregate effect of these changes influences the economy is yet to be seen, but it is certain that there will be a greater stability to the world of investments.