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Derivatives, Volcker Rule top 2012’s new Dodd-Frank regulations

When the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in the summer of 2010, it promised to impose a series of new regulations on financial markets many years into the future. The majority of the bill was unwritten at the time, instead setting deadlines for various agencies to write various rules on a range of issues.

Most deadlines for the bill’s new rules have been missed, or are expected to be missed.

But there are two primary areas of Dodd-Frank expected to be fleshed out over the course of 2012.

Rulemakers are expected to finalize by July of this year the provisions of Title XII of Dodd-Frank, the section of the bill that calls for regulation of over-the-counter derivatives, such as credit default swaps (CDSs) and collateralized debt obligations (CDOs), which have been credited with having an outsized hand in the global financial crisis.

The other major aspect of Dodd-Frank ready to be straightened out this year is the so-called Volcker Rule. Proposed by former Federal Reserve Chairman Paul Volcker, it restricts certain entities from engaging in so-called proprietary trading.

Bill Holland, owner of San Diego-based investment firm The Holland Group, said the introduction of regulations on mechanisms that had a direct role in inflating the financial bubble should be viewed as a positive for investors.

Even if the new restrictions act as a drag on financial markets in the short term, they’d provide a “psychological positive” for the market as a whole, he said.

Derivative regulations will ultimately need to define what qualifies as a derivative to begin with. They’ll also require registration for the largest players in the market, most of whom are swaps dealers. But other large institutions that might not even deal in such swaps, based on what happened to American International Group (NYSE: AIG) in 2008, will be forced to register as well.

It’ll need to be clarified to what extent foreign entities fall into the definition and need to register as swaps dealers.

The regulations are also expected to create a clearinghouse that acts as the middle man in derivatives trades.

As is, the bilateral nature of a derivatives trade and the credit exposure it presents means a single event can trigger a series of dominoes falling that threatens the entire market. Clearinghouses seek to address that issue, according to Gabe Rosenberg, an associate in the financial institutions group of Davis Polk, a law firm that releases regular reports on the progress of Dodd-Frank implementation.

“The clearinghouse is the central counterparty to all trades,” Rosenberg said. “Instead of you and me having exposure to each other, we each give up our sides of the trade to the clearinghouse. I face the clearinghouse on one side, you face it on the other, and so it has no real market risk.

“The clearinghouse mitigates credit risk in a number of ways, including the requirement to post collateral and a guaranty fund structure for its members,” he continued. “The idea is that, instead of dominoes falling, you have a central counterparty whose job it is to absorb credit risk and manage it. This is used in the futures market and has been for decades.”

The bill also seeks to increase the transparency of derivative swaps. If an entity is required to be cleared and is also traded on an exchange, the swap itself must occur on that exchange.

The derivatives rules are expected to be finalized by July 16. The Securities and Exchange Commission and the Commodities Futures Trading Commission will determine which swaps are subject to the clearing house.

The statutory component of the Volcker Rule goes into effect on July 10.

“The way the Volcker Rule works statutorily is it says proprietary trading — trading with short term intent in securities and derivatives — is generally banned for banks and bank affiliates,” Rosenberg said. “Certain activities are explicitly allowed by Congress. These are called permitted activities, like market making, hedging and transactions in U.S. treasuries. The really difficult task for regulators is defining which transactions fall into the Volcker Rule to begin with, and how broad or narrow each of the permitted activities should be.”

In October, the Federal Reserve Board released and requested public comment on the proposed implementation of the Volcker Rule.

“The proposal in October takes an extremely narrow view of the permitted activities and would have a very harmful effect on the U.S. markets,” Rosenberg said.

Neil Hokanson, president of Hokanson Associates, said the problem for businesses facing the regulations is in preparing to deal with rules that aren’t yet clear.

“There’s a lot of opacity with respect to what the rules are,” he said.

The rules are written by good people with good intentions, according to Kelley Wright, chief investment officer of Investment Quality Trends.

Rather than destroy the market, new regulations are going to enter into an experimental period, he said, filled with a series of adjustments by the regulators and industry until they together arrive at a workable solution.

“That’s just business as usual,” Wright said.

The fundamental problem facing regulators, according to Wright, is that as with sports organizations seeking to control the use of performance enhancing drugs, they’ll always be forced to react to the actions of the industry. Wall Street will always be a few steps ahead of its overseers.

“They can’t regulate what they don’t understand,” he said.

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