Dodd-Frank Law - Key Parts and Implications:
Derivatives Marketplace Structure
Pre Dodd-Frank Act - Executing broker/dealers must be clearing members and vice versa.
Post Dodd-Frank Act - Now provides for:
- Executing broker/dealers can be clearing members and vice versa.
- New and/or Independent (don't have trading desks) qualified clearing members e.g. New Edge, Bank of NY, MF Global, Mizuho, State Street, etc. who meet the clearinghouse requirements can clear execution-only broker/dealers and other customers. These new clearing members will help diversify risks within the system.
- New entrant Execution-only non-clearing member broker/dealers: e.g. Cantor Fitzgerald, Jefferies, Seaport etc. SDMA members plus others who individually and collectively have both balance sheet and massive sales and trading distribution to help provide liquidity and market intelligence in both good times and crisis. These broker/dealers just need someone to clear them like a futures or bond trade. Note: All of these firms employ former incumbent highly experienced derivatives risk managers, salespeople and traders who service the same customers as the incumbents.
- New entrant investors: Since standardization of the derivatives markets eliminates the need for bilateral ISDA agreements many new players should emerge. For example, capital arbitrage, algorithmic, traditional credit and equity funds realizing the increased liquidity and transparency of the product will adapt their strategies to take advantage of the potential for increased returns.
Some highlights from the Dodd-Frank Act (Law)
The Dodd-Frank Law states that there will be mandatory clearing of standardized interest rate and credit default swaps through clearinghouses. Mandatory centralized clearing for standardized derivative contracts gets rid of the use of ISDA and outlaws bilateral trades.
SEC. 723 CLEARING.(Reference in PDF Search Function: 124 STAT. 1675/1676)
(3) MANDATORY CLEARING OF SWAPS.
(A) STANDARD FOR CLEARING.—It shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization that is registered under this Act or a derivatives clearing organization that is exempt from registration under this Act if the swap is required to be cleared.
The SDMA collaborated with legislators to establish a "Chinese Wall" provision alongside Antitrust language in the Dodd-Frank Law. It means that the incumbent trading desks cannot influence clearing decisions which includes approving new customers who may also happen to be competitors.
Reference: 124 STAT. 1711
‘‘(5) CONFLICTS OF INTEREST.—The swap dealer and major swap participant shall implement conflict-of-interest systems and procedures that—
‘‘(A) establish structural and institutional safeguards to ensure that the activities of any person within the firm relating to research or analysis of the price or market for any commodity or swap or acting in a role of providing clearing activities or making determinations as to accepting clearing customers are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in pricing, trading,or clearing activities might potentially bias their judgment or supervision and contravene the core principles of open access and the business conduct standards described in this Act; and
‘‘(B) address such other issues as the Commission determines to be appropriate.
‘‘(6) ANTITRUST CONSIDERATIONS.—Unless necessary or appropriate to achieve the purposes of this Act, a swap dealer or major swap participant shall not—
‘‘(A) adopt any process or take any action that results in any unreasonable restraint of trade; or
‘‘(B) impose any material anticompetitive burden on trading or clearing.
Equity Ownership/Control/Voting for Swap Execution Facility/Derivatives Clearing Organization/Boards Of Trade. The "Lynch Amendment Lite" provision. It was put into the Act so that no one firm can dominate these organizations.
SEC. 726 (124 STAT. 1695/1696) & SEC. 765 (124 STAT. 1796/1797)
Regulators (SEC & CFTC) “shall adopt rules which may include numerical limits on the control of, or the voting rights with respect to, any derivatives clearing organization that clears swaps, or swap execution facility or board of trade designated as a contract market that posts swaps or makes swaps available for trading...”
(c) CONSIDERATIONS.—In adopting rules pursuant to this section, the Securities and Exchange Commission shall consider any conflicts of interest arising from the amount of equity owned by a single investor, the ability to vote, cause the vote of, or withhold votes entitled to be cast on any matters by the holders of the ownership interest, and the governance arrangements of any derivatives clearing organization that clears swaps, or swap execution facility or board of trade designated as a contract market that posts swaps or makes swaps available for trading.