For two years, regulators and business tussled over which companies that trade derivatives must submit to strict oversight as part of the Dodd-Frank financial reform. Credit default swaps and other derivatives, of course, were a major cause of the 2008 financial crisis. In meetings, reports, hearings, and letters, they sought to resolve issues like “What is a swap dealer?” and “What is a ‘financial entity?’”—questions that sound almost existential but have real-world ramifications in the $700 trillion global derivatives market.
Federal regulators made their first proposal in 2010, saying that only small players that trade less than $100 million a year would be exempt from rules requiring them to hold more capital and report more information on their trades. Regions Financial, energy giant BP, and other companies that write and use derivatives pushed back. They argued that a broader exemption makes more sense because derivatives trading is highly concentrated. According to the Office of the Comptroller of the Currency, five large banks—JPMorgan Chase, Bank of America, Citigroup, Morgan Stanley, and Goldman Sachs—hold almost 96 percent of the notional value of all derivatives contracts. The smaller players, the argument goes, shouldn’t be burdened with extra requirements that would ultimately drive up costs for consumers.
The counterargument was that relatively small players can still create systemic risk. Before the financial crisis, American International Group, for example, was not a top-five trader, but, as we all learned, was still a linchpin in the interwoven world of mortgage derivatives. Indeed, the OCC also says (PDF) that the notional value “does not provide a useful measure of either market or credit risks.” It says risk can hinge on a lot of different factors, like leverage, liquidity, and volatility.
This week, the regulators finally settled the issue, and generally the industry won out. Regulators expanded the exemption to include companies that do less than $8 billion in swaps a year—80 times more than the initial proposal. By one estimate, that means 60 percent of swap dealers will now be exempt. Those companies, ranging from banks to energy and agricultural firms, can breathe easier now that they’re exempt. As for what the new rules mean for risk in the market, regulators say they’ll reevaluate in five years, when the threshold defaults down to $3 billion.