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The Derivative Market’s Black Sheep: Regulation of Non-Cleared Security-Based Swaps Under Dodd-Frank

Barry Le Vine

Abstract

This paper seeks to comprehensively analyze the SEC's security-based swaps mandate and how it should regulate those non-cleared OTC derivatives within its regulatory ambit to promote market stability, protect counterparties, and reduce the incentives for cross-border regulatory arbitrage which leads to systemic risk creation. It argues that there are many legitimate and compelling reasons for entering into bespoke security-based swap transactions and that imposing collateral and margin requirements would only distort the economics of these trades. It further argues that the SEC should not be in the business of setting margin requirements, which would be an unprecedented move for the Agency, because it is likely to set them sub-optimally, leading to overtrading and imposing an opportunity cost on the market. Ex ante counterparty risk management is the sine qua non of OTC derivatives and regulators should allow it to continue for certain contracts. Regulators should instead shift their focus to ex post systemic risk mitigation. To do this, I recommend implementing a mandatory auction-based process for replacing defaulted non-cleared positions. Similar to an equity call auction for swaps, this will allow the market to absorb these contracts, preventing a loss spiral that precipitates another financial crisis. Dodd-Frank gives regulators adequate tools to facilitate effective oversight of the non-cleared OTC derivatives market without having to resort to collateral and margin. But U.S. regulators must be prepared to coordinate their efforts with their international counterparts, harmonizing the regulatory treatment of OTC derivatives to counter the incentives for cross-border regulatory arbitrage which causes systemic risk.

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