The crisis essentially reversed this view. The Dodd-Frank Act ( P.L. In addition, regulators will have information about the size and distribution of possible losses during periods of market volatility. Thousands of firms use derivatives to manage risk. The market is measured in the hundreds of trillions of dollars, and billions of contracts are traded annually. Futures contracts are traded on exchanges regulated by the Commodity Futures Trading Commission (CFTC); stock options on exchanges under the Securities and Exchange Commission (SEC); and all swaps (and security-based swaps, as well as some options) were traded over-the-counter, and were not regulated by anyone. In the OTC market, contracts are made bilaterally, typically between a dealer and an end user, and there was generally no requirement that the price, the terms, or even the existence of the contract be disclosed to a regulator or to the public. Clearing depends on a system of margin, or collateral. Before the trade, both the long and short traders have to deposit an initial margin payment with the clearinghouse to cover potential losses. The effect of the margin system is that no one can build up a large paper loss that could damage the clearinghouse in case of default: it is certainly possible to lose large amounts of money trading on the futures exchanges, but only on a "pay as you go" basis. Perhaps the best-known example in the crisis was AIG, which wrote about $1.8 trillion worth of credit default swaps guaranteeing payment if certain mortgage-backed securities defaulted or experienced other "credit events." A key reform in Dodd-Frank is a mandate that many OTC swaps be cleared, which means that they will be subject to margin requirements. The Dodd-Frank Act's Clearing and Reporting Requirements

The Dodd-Frank Act requires that most derivatives contracts formerly traded exclusively in the OTC market be cleared and traded on exchanges. When making that determination, the agencies must consider (1) "the existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data"; (2) "the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms consistent with material terms and trading conventions on which the contract is then traded"; (3) "the effect on the mitigation of systemic risk ..."; (4) "the effect on competition, including appropriate fees and charges ..."; and (5) "the existence of reasonable legal certainty in the event of the insolvency of the relevant derivatives clearing organization or 1 or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property." End-User Exemption

Sections 723 and 763 of the Dodd-Frank Act provide exceptions to the clearing requirement for swaps and security-based swaps when one of the counterparties to the transaction is not a financial entity; is using the transaction to hedge or mitigate its own commercial risk; and notifies the relevant agency "how it generally meets its financial obligations associated with entering into non-cleared swaps." Major Swap Participant and Swap Dealer Definitions

A basic theme in Dodd-Frank is that systemically important financial institutions should maintain capital cushions above and beyond what specific regulations require in order to compensate for the risk that their failure would pose to the financial system and the economy. Since the OTC dealer market is highly concentrated, the proposal that swap dealers be subject to additional prudential regulation was not controversial. in a way that imposed prudential regulation on most firms that used derivatives to hedge risk. The phase-in period would last two and a half years from the time data starts being reported to swap data repositories. The purpose of these requirements, presumably, is to give the relevant commissions access to a more complete picture of the derivatives market, even for swaps that are not required to be cleared.
The financial crisis implicated the over-the-counter (OTC) derivatives market as a major source of systemic risk. A number of firms used derivatives to construct highly leveraged speculative positions, which generated enormous losses that threatened to bankrupt not only the firms themselves but also their creditors and trading partners. Hundreds of billions of dollars in government credit were needed to prevent such losses from cascading throughout the system. AIG was the best-known example, but by no means the only one.
Equally troublesome was the fact that the OTC market depended on the financial stability of a dozen or so major dealers. Failure of a dealer would have resulted in the nullification of trillions of dollars worth of contracts and would have exposed derivatives counterparties to sudden risk and loss, exacerbating the cycle of deleveraging and withholding of credit that characterized the crisis. During the crisis, all the major dealers came under stress, and even though derivatives dealing was not generally the direct source of financial weakness, a collapse of the $600 trillion OTC derivatives market was imminent absent federal intervention. The first group of Troubled Asset Relief Program (TARP) recipients included nearly all the large derivatives dealers.
The Dodd-Frank Act (P.L. 111-203) sought to remake the OTC market in the image of the regulated futures exchanges. Crucial reforms include a requirement that swap contracts be cleared through a central counterparty regulated by one or more federal agencies. Clearinghouses require traders to put down cash (called initial margin) at the time they open a contract to cover potential losses, and require subsequent deposits (called maintenance margin) to cover actual losses to the position. The intended effect of margin requirements is to eliminate the possibility that any firm can build up an uncapitalized exposure so large that default would have systemic consequences (again, the AIG situation). The size of a cleared position is limited by the firm's ability to post capital to cover its losses. That capital protects its trading partners and the system as a whole.
Swap dealers and major swap participants—firms with substantial derivatives positions—will be subject to margin and capital requirements above and beyond what the clearinghouses mandate. Swaps that are cleared will also be subject to trading on an exchange, or an exchange-like "swap execution facility," regulated by either the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC), in the case of security-based swaps. All trades will be reported to data repositories, so that regulators will have complete information about all derivatives positions. Data on swap prices and trading volumes will be made public.
The Dodd-Frank Act provides exceptions to the clearing and trading requirements for commercial end-users, or firms that use derivatives to hedge the risks of their nonfinancial business operations. Regulators may also provide exemptions for smaller financial institutions. Even trades that are exempt from the clearing and exchange-trading requirements, however, will have to be reported to data repositories or directly to regulators.
This report describes some of the requirements placed on the derivatives market by the Dodd-Frank Act. It will be updated as events warrant.