One of the landmark events of the financial crisis was the collapse and bailout of insurer AIG and the bailout of many large banks to which it had sold credit default swaps (CDS), including Goldman Sachs ($12.9 billion in swaps), Société Générale ($12 billion), and Deutsche Bank ($12 billion).1 One lesson policymakers drew from this crisis was that financial firms could build up huge risk exposures essentially hidden from the view of regulators in over-the-counter (OTC) derivatives markets. The Dodd–Frank Act sought to shift most derivatives trading from an unregulated and opaque chain of bilateral deals to trades carried out in transparent, central marketplaces under the watchful eye of regulators. As a result, U.S. regulators have spent nearly five years writing and revising regulations governing OTC derivatives. In the U.S., the rulemaking is nearly complete, and market participants have moved a significant share of their business toward centralized trading and settlement.2 European regulators’ rule-making process should be substantially completed by 2016.
Now that the main elements of the new regulations can be described, let’s see how a simplified trade would be typically carried out by a fictional set of institutions both before and after the reform.3 First Bank is a large dealer bank that buys and sells securities and derivatives. High Yield (HY) is a mutual fund that has a large portfolio of junk bonds. HY wants to hedge against the risk of a downturn in the junk bond market.
This article appeared in the Fourth Quarter 2015 edition of Business Review. Download and read the full issue.
A CDS is a type of insurance contract in which the seller pays the buyer when the credit risk of a security or group of securities rises. It is just one type of a wide range of derivative contracts grouped under the general term swaps for regulatory purposes.
In the U.S., mandatory centralized trading for one group of swaps began in February 2014. At the end of 2014, over half of interest rate swaps
and over 80 percent of credit default swaps were trading on centralized platforms.
In this article, I can go over only the basics, as no single rulemaking document gives a complete account of the U.S. regulations. The Commodity Futures Trading Commission’s website provides links to all of its rulemaking. Davis Polk’s memorandum is a readable account of the regulations as of March 2013.View the Full Article