Monday, July 03, 2017

Dodd-Frank showdown in the Windy City

By Brad Rosen, J.D.

The opponents of Title VII of the Dodd-Frank legislation, those reforms that brought sweeping changes to the derivatives and swaps industry, came out with guns a-blazing at the recent John Lothian News/FOW conference in downtown Chicago. Over 200 participants representing CTAs, hedge funds, proprietary trading firms, and other trading industry players attended the event, exploring a wide range of regulatory and technology issues facing the trading community during the course of the day.

Craig Pirrong, a free market oriented economist and University of Houston professor of finance, led off the event with a keynote address where he unabashedly called for the repeal of Title VII. His remarks were then followed by an Oxford-style debate where the question posed was: “Should Title VII and the Volcker Rule be repealed in full?” Gary DeWaal, a longtime leader at the Futures Industry Association and special counsel at Katten Muchin Rosenman LLP, argued in favor. Leslie Sutphen, president of Financial Markets Consulting LLC and the co-founder and current president of Women in Listed Derivatives, argued in favor of the Dodd-Frank reforms.

Pirrong referred to the Dodd-Frank legislation as “Franken-Dodd,” and took the metaphor a bit further describing it as having escaped the control of its creators and wreaking havoc on the countryside. He sees four central problems with the Dodd-Franks reforms:

  • Unintended consequences. Dodd-Frank sought to address too big-too-fail problems and concentration among market participants. Pirrong noted the biggest losers in the aftermath of Dodd–Frank have been smaller- and medium-sized players who cannot afford the compliance costs associated with the regulations. “The big guys are doing fine,” he observed.
  • Mischaracterization of sources of risk. According to Pirrong, the underlying narrative of the Dodd-Frank reforms has been that derivative instruments are inherently risky and caused the financial crisis. As a result, Dodd-Frank mandated clearing for everything that could be cleared and margining for everything that couldn’t. Pirrong argues this did not eliminate risk but rather transformed credit risk into liquidity risk. Pirrong is deeply concerned that the next crisis will be marked by a liquidity vacuum. 
  • Imposition of solutions where no problems exist. Pirrong is highly critical of the CFTC’s position limit rule, which he notes has been hanging around for the past seven year. In his view, a position limit rule has no theoretical justification, no supporting evidence, and will solve no existing problem. However, he expects such a rule will impose substantial compliance costs without providing any corresponding benefits. 
  • Forcing a one-size-fits-all model. Another problem with Dodd-Frank, according to the Dr. Pirrong, is that it takes a futures model framework, where contract terms and practice are standardized, and forces it on a swaps market where customization predominates.
Professor Pirrong apparently convinced the crowd. After his talk, 58 percent of the attendees polled favored the repeal of Title VII of Dodd-Frank. Then came the great debate. Gary DeWaal echoed many of the themes from the keynote, and focused further on how the Dodd-Frank reforms have led to greater concentration among industry players, and hence increased systematic risk. DeWaal observed there are only 21approved CCPs, and that ten firms hold 96 percent of the cash value of all swaps. In DeWaal’s view, when the next major crisis arises, we will see greater liquidity risk, credit risk, interconnection risk, and moral hazard risk.

Not surprisingly, Leslie Sutphen, in arguing against the repeal of Title VII, took issue with most of DeWaal and Pirrong’s assertions. “Prior to Dodd-Frank, there was a lack a lack of regulation, poor risk management, and a lack of supervision,” Sutphen observed. She also believes that the margin and liquidity issues are being conflated. Furthermore, Sutphen did not see CCP concentration as being a concern. Margin money is collected on the front end and is available as needed.

In Sutphen’s view, reliance on a futures model for the swaps market is a good thing, noting that the futures markets worked effectively during the financial crisis. “Risk is dispersed in a pay as you go clearing model,” she noted, adding “Dodd-Frank has introduced greater transparency and has been a great service to the swap markets.” Sutphen did, however, acknowledge that Dodd-Frank has more than its share of problems, and modification in some respect is warranted.

At the conclusion of the debate, the attendees were polled again. This time only 37 percent favored the repeal of Title VII. This is not entirely surprising. Even though there is currently much talk of significant overhaul to the regulatory landscape, Title VII remains somewhat sacrosanct. CFTC Acting Chairman Giancarlo has reiterated his support for the basic Title VII framework on a number of occasions recently. Most industry leaders also back the majority of these reforms. Notwithstanding, change is in the air and it remains to be seen where many of these reforms will eventually land.

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