The derivatives section of the legislation is arguably as important to Congress’s reforms as the new systemic risk framework and changes to the banking industry. Indeed, one may view the reforms to the OTC swaps market as an additional pillar supporting systemic risk regulation. In the summer before the recent financial crisis, the notional amount of the credit derivatives portion of the swaps market reportedly approximated the combined total of the GDPs of every country in the world.

For the last decade, swaps transactions have been virtually unregulated and have often taken the form of highly customized bilateral agreements. As a result, margin requirements (if any) have not been uniform. In trading out of swap positions, counterparties often would simply write offsetting contracts. The result of all this trading was a so-called “daisy chain” of counterparties throughout the financial system, with little transparency and gross notional amounts that bore little discernable relationship to actual exposure. When counterparties began failing to meet margin requirements or even declaring insolvency, this chain of counterparties created the possibility of a systemic domino effect, the dimensions of which could not be estimated with precision and were potentially catastrophic.

The legislation attempts to resolve the perceived systemic risk and transparency deficiencies of the current OTC swaps market by requiring the centralized clearing of all swaps suitable for the clearing process. The daisy chain of counterparties is broken with each swap because, when a contract is cleared, the clearinghouse serves as the counterparty to each of the original parties to the swap. While the overall risk in the financial system is not necessarily reduced, the risk is concentrated and made visible in the clearinghouse. Regulators can then carefully monitor the clearinghouse to ensure it is well-managed and well-capitalized. The legislation charges the CFTC and the SEC with the joint oversight of the OTC swaps market; the SEC will regulate security-based swaps and the CFTC will regulate all other kinds of swaps. The CFTC and the SEC are required to consult with each other and with the relevant bank regulators when exercising their rulemaking authorities in this regard.

Jurisdiction of Agencies
Security-based swaps SEC
Mixed swaps CFTC/SEC
All other swaps CFTC

The legislation broadly defines “swap” to ensure that the term encompasses interest rate swaps, foreign exchange swaps, credit default swaps, commodity swaps, and many other transactions. A security-based swap is a swap based on a narrowly based security index, a single security or loan, or the occurrence or nonoccurrence of an event relating to a single issuer of a security or the issuers of securities in a narrowly based security index. The CFTC and the SEC also have the power to define swaps and security-based swaps further through their rulemaking authority. A third category of swaps, known as “mixed swaps,” will be jointly defined by the CFTC and the SEC and will be regulated as security-based swaps. Under the legislation, a swap—even though it passes certain risks from one party to the other—is not considered to be insurance and may not be regulated as an insurance contract under the laws of any state.