Swaps regulation after Dodd-Frank: how the rules work

A swap is a private contract in which two parties agree to exchange payments tied to an interest rate, a currency, a commodity price, a credit event or another reference. Before the 2008 financial crisis, most swaps were negotiated one to one, held on dealers’ books and largely invisible to regulators. Swaps regulation after Dodd-Frank replaced that arrangement with a system built on registration, central clearing, trading on regulated platforms, reporting and margin.

The reforms came from Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Commodity Futures Trading Commission (CFTC) implements the rules for most swaps, and the Securities and Exchange Commission (SEC) handles security-based swaps. This guide explains the main pieces and how they fit together.

In brief

• Dodd-Frank gave the CFTC expanded authority over the swaps market.
• Swap dealers must register and meet capital, margin, conduct, recordkeeping and reporting requirements.
• Standardized swaps are meant to be cleared through central clearinghouses and traded on regulated venues.
• Swap data is reported to repositories so regulators can see exposures.
• The details sit in CFTC regulations and are revised through rulemaking, so readers should check current text.

Why swaps were singled out

The swaps market mattered in the crisis because exposures were large, concentrated and opaque. When a major counterparty weakened, other firms could not easily tell how much they were owed or how much they owed, and a failure at one dealer threatened to pass through to others. Policymakers concluded that the market needed transparency and that credit risk between dealers needed to be reduced and managed centrally.

The reforms follow from that diagnosis. Reporting addresses opacity. Clearing and margin address counterparty credit risk. Trading on regulated platforms addresses price transparency. Dealer registration addresses the question of who is running these books and under what standards.

Swap dealers and major swap participants

A swap dealer is a firm that holds itself out as a dealer in swaps, makes a market, regularly enters swaps as an ordinary part of its business or otherwise meets the statutory definition. Firms that exceed regulatory thresholds for dealing activity must register. The CFTC’s overview of Dodd-Frank says swap dealers face capital and margin requirements meant to reduce risk to the financial system, plus business conduct standards and recordkeeping and reporting obligations.

In practice that means a registered swap dealer must maintain written policies on risk management, have a chief compliance officer, keep communications and transaction records, and follow rules about how it deals with counterparties. These include disclosure of material risks and conflicts, and special duties when the counterparty is a government entity or a pension plan. Registered dealers are also members of the National Futures Association, which performs examinations on the CFTC’s behalf.

Banks that are swap dealers are subject to capital and margin rules set by their prudential regulators, such as the Federal Reserve or the OCC. Dealers that are not banks fall under the CFTC’s own capital and margin rules. That split is a common source of confusion when people search for “the” margin rule.

Clearing: putting a clearinghouse in the middle

The CFTC describes the clearing mandate this way: standardized derivatives must move into central clearinghouses, which stand between the parties to a trade and absorb the risk that a counterparty defaults. Rather than each dealer carrying a web of bilateral exposures, a clearinghouse becomes the buyer to every seller and the seller to every buyer, a process known as novation.

Not every swap must be cleared. The Commission determines which classes of swaps are subject to a clearing requirement, and these have historically been standardized contracts such as many interest rate swaps and index credit default swaps. Exceptions exist for certain end users, including commercial companies that use swaps to hedge business risk and meet the statutory conditions.

A clearinghouse that clears swaps for US persons must register with the CFTC as a derivatives clearing organization (or be exempted if it is subject to comparable supervision at home). Registered clearinghouses must follow 17 core principles on financial resources, risk management, participant standards, default procedures, recordkeeping and governance, among other topics. Our guide on clearinghouses and central counterparties describes what those principles require.

Trade execution on regulated platforms

The Dodd-Frank framework also pushed swap trading toward organized platforms. According to the CFTC, standardized derivatives must trade on regulated exchanges or swap execution facilities rather than privately, a change intended to increase competition and improve pricing.

A swap execution facility, or SEF, is a trading system that lets multiple participants see and respond to quotes. Swaps that are subject to the clearing requirement and that are made available to trade must be executed on a SEF or a designated contract market, with exceptions for block trades and certain other cases. SEFs register with the CFTC and must comply with core principles on fair access, surveillance and recordkeeping.

Reporting and data

Reporting turns a private market into one regulators can observe. Parties to a swap must report creation data and continuing data to a swap data repository, which is a registered entity that collects and maintains the records. A subset of that data is publicly disseminated in real time, typically with size caps or delays for large trades so that dealers can manage the risk of a big position.

The reporting rules have been amended several times to improve data quality, harmonize fields internationally and clarify who reports. Industry participants often point to the cost of building these data pipelines; regulators point to the ability to see concentrations of risk. Both observations can be true.

Margin for uncleared swaps

Swaps that are not cleared still carry credit risk, so Dodd-Frank directed regulators to set margin requirements for them. The rules require covered dealers to collect and post initial and variation margin with certain counterparties, using prescribed methods and eligible collateral. Variation margin tracks daily changes in value, while initial margin is a buffer against potential future losses if a counterparty defaults.

The CFTC and the prudential regulators issued separate but similar margin rules, and international bodies coordinated standards so that cross-border dealers could comply with similar requirements across jurisdictions. Phase-in schedules applied margin requirements to progressively smaller firms, so a firm’s obligations depend on its size and the rules in force at the time.

The CFTC and SEC split

Swaps under CFTC jurisdiction are those that reference things like interest rates, broad-based indexes, currencies and commodities. Security-based swaps, such as a swap on a single stock or narrow group of securities, belong to the SEC. Mixed swaps have features of both. The two agencies must consult and, for some definitions, act jointly. Firms that deal in both types can register with both agencies.

Cross-border reach

Swaps are global, so the reforms address when US rules apply to activity involving foreign entities. The CFTC’s cross-border approach looks at factors such as whether a counterparty is a US person and whether a foreign affiliate is guaranteed by a US parent. It also lets the agency find that compliance with a foreign regime is substantially comparable and therefore sufficient. The rules and staff letters on this are intricate and change over time.

Common misconceptions

“All swaps are cleared now.” Many are not. The clearing requirement applies to specified classes, and exceptions exist for qualifying end users.

“Dodd-Frank banned derivatives.” It did not. It created a framework for oversight, with a goal of reducing and managing the risks they pose.

“One agency writes every swap rule.” The CFTC, the SEC and the prudential regulators each have a role, depending on the product and the type of firm.

“The rules are fixed.” Agencies revise the framework through rulemakings, exemptive relief and staff guidance. Anyone who must comply needs to read the current regulations.

A worked example

A manufacturer borrows at a floating rate and wants certainty about its interest cost. It enters an interest rate swap with a bank dealer to pay a fixed rate and receive a floating one. The bank is a registered swap dealer, so the transaction falls under dealer conduct standards. If the manufacturer qualifies as a commercial end user hedging a business risk, it may use the end-user exception from the clearing requirement. If the swap is cleared, a registered clearinghouse takes on the credit risk and margin flows daily. Either way, the trade is reported to a swap data repository.

If the manufacturer elects to trade a cleared swap that is available to trade, it would typically be executed on a swap execution facility. That one hedge touches registration, clearing, execution, reporting and potentially margin rules.

FAQ

What is the difference between a swap dealer and a swap participant?

A swap dealer makes markets or regularly enters swaps as a dealer. Other participants, such as end users, enter swaps for their own purposes. Dealers register and face business conduct, capital, margin and reporting requirements.

Do end users have to clear swaps?

Not always. The statute provides an exception for certain commercial end users who use swaps to hedge or mitigate commercial risk and who meet reporting and other conditions.

Who regulates security-based swaps?

The SEC. The CFTC regulates swaps on broad-based indexes, commodities, rates and currencies.

Where can I read the rules?

CFTC regulations are in Title 17 of the Code of Federal Regulations on the eCFR. Prudential regulators’ margin rules appear in their own titles. The CFTC’s website lists final rules and staff guidance.

Has the swaps framework changed since it was adopted?

Yes. Agencies have amended reporting, clearing and margin rules over time. Check cftc.gov and the Federal Register for the current version.