This is part 9 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 8, we discussed the role of interest rate swaps in the demise of Greece. Given the importance of swaps in the U.S. housing crash, new regulation has arisen that could threaten the future of this important financial derivative.

In late-2008, financial markets were a mess: credit markets had dried up; equity markets plummeted, eliminating trillions of dollars of wealth from the economy; and politicians needed someone to blame. Given the fact that a series of complex transactions involving swaps ultimately accentuated the market crash, OTC derivatives, specifically swaps, were an easy target.

Interest rate swaps an easy target

With public outcry high for a scapegoat, U.S. Congressmen and Congresswomen called for action to regulate OTC derivatives, what the Bank of International Settlements has characterized as a $415.2 trillion market. Led by House Financial Services Committee Chairman Barney Frank, new regulations were set forth in December 2009 to curb risk tanking by large financial institutions. Regulations focused on two main issues:

  1. Should financial institutions have ownership in swaps clearinghouses? Should ownership be limited? A conflict of interest may arise provoking riskier activities if not addressed properly.
  2. Should regulators have the power to set capital and margin requirements for non-financial participants in the swaps market? Would this regulation result in lower market participation rates, thus creating a premium for liquidity?

When the Dodd-Frank Act (named after Senator Christopher Dodd and Representative Barney Frank, the chief architects) was signed into law by President Barack Obama in July 2010, many of the large financial institutions operating within the OTC market were forced to sell off operations involving swaps deemed uncritical to their in-house hedging operations; or the arms of the financial institutions trading in swaps markets for speculative purposes were forced to close. Additionally, OTC derivatives trading would be funneled through clearinghouses and exchanges for greater accountability.

Financial Scholars Group published perhaps the best perspective on the Dodd-Frank Act in July 2012:

Dodd-Frank legislation was passed in 2010 to overhaul the financial market with the objective of removing or alleviating systemic deficiencies. With respect to OTC IR swaps, Dodd-Frank seeks to lower systemic risk through centralized clearing of trades, better risk management, and trade reporting transparency. Yet despite its size, the IR swap market is small in important respects. Any policy attempting to address a market hundreds of trillions of dollars in size must also take into account that in some ways the swap market is quite nuanced, with some IR swaps trading very thinly and thus potentially substantially disrupted by even finely tuned regulatory policies.

FSG continued to say, “In thin markets disclosing deal terms can have the opposite effect. This is because statistical data is no longer anonymous. With a small number of trades, parties can potentially make inferences about the investment strategies of others. Thus, trade data for thin markets can have an undesirable, amplified signaling effect revealing the market expectations of some participants.”

Under the microscope

Given these observations, we can draw a few necessary conclusions: first, OTC derivatives markets, especially those related to swaps, are under a microscope, especially in the United States. Second, a fundamental lack of understanding by legislators could lead to overregulation, diminishing the effectiveness of interest rate swaps (and other variations of swaps) as hedges.

Over the next few years, it is unlikely that regulation comes down hard on the OTC derivatives market barring a major financial crash with swaps at the center once more. This is a far-fetched outcome going forward, considering that loose monetary policies across the globe have introduced trillions of dollars of liquidity over the past few years, driving down borrowing rates in both developed and developing economies. As such, and in light of the increased globalized nature of financial markets in contemporary times, swaps will remain an important financial instrument for years to come.

In part 10 of 10 of this series, we’ll talk about the role of swaps in your company’s hedge portfolio and why, despite the bad rap they get from the U.S. housing crisis, the Goldman Sachs-Greece debacle, and political posturing, swaps remain an integral and important part of global financial markets