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In Case You Missed It: "Hangover, Part III: Another Unintended Dodd-Frank Consequence"
Tamara Hinton, 202.225.0184
WASHINGTON – More than a 100 provisions of Title VII of Dodd-Frank are set to take effect on July 16, 2011 despite the fact that regulators have yet to issue final rules establishing a comprehensive, regulatory regime. This delay is creating angst and uncertainty for market participants, especially those who use swaps to hedge business risk. There are concerns about the validity of swaps contracts once the existing regulatory regime expires without establishing a new one to replace it. This would leave businesses vulnerable to costly legal challenges.
An editorial from The Wall Street Journal today explains that a solution exists to avoid the legal limbo. H.R. 1573, a bill that has passed both the House Agriculture Committee and the Financial Services Committee, extends the statutory deadline for implementing Dodd-Frank. This legislation will give regulators the necessary time and data to develop rules governing derivatives and it will also remove the legal uncertainty surrounding swaps contracts.
The complete editorial from The Wall Street Journal is below:
The Hangover, Part III: Another unintended Dodd-Frank consequence
Review & Outlook
June 9, 2011
Last summer, Congressman Barney Frank and then-Senator Chris Dodd stayed up all night writing new rules for America's multitrillion-dollar derivatives markets. The reforms were sold as punishment for Wall Street, but Main Street woke up to new regulations that are giving corporate treasurers headaches. Now all market participants could be suffering from a wicked legislative hangover come July 16.
According to the Dodd-Frank law, that's the day when the old legal regime for so-called swaps contracts must expire. As the name implies, swaps are contracts in which two parties agree to exchange, say, a fixed interest rate for a floating one, or an obligation to pay in dollars for a commitment to pay in euros. The use of such products has exploded as companies try to reduce their financial risks while focusing on their core business. Caterpillar wants to spend its time making bulldozers, for example, rather than guessing about currency movements in every country where it sells equipment.
But even the regulators now acknowledge that there's no way they will be able by July 16 to finalize all the new rules that are supposed to replace those destroyed by Dodd-Frank. So what happens to all these swap deals? Legal opinions differ on whether parties on the losing side of such contracts will be able to sue and have them declared null and void.
A 2000 law clarified that swaps were not considered futures contracts, which by law must trade on exchanges. But by knocking out the 2000 law and replacing it with nothing, Dodd-Frank made it possible for a judge to rule that over-the-counter swaps are now illegal futures contracts, and therefore invalid. This latest Dodd-Frank gift to the U.S. economy could throw into question all existing swaps trades. The stakes are enormous given that these markets have a notional value of close to $600 trillion.
Commodity Futures Trading Commission Chairman Gary Gensler says his agency and the Securities and Exchange Commission are working on clarifications to guide derivatives markets for the period between July 16 and whenever regulators decide on new rules. He promises to post something on the CFTC website soon.
But not everyone is convinced that Gary's web posting is going to defuse the bureaucratic bomb that Chris and Barney have programmed to detonate next month. Mr. Gensler can't prevent private lawsuits if the law becomes murky. It doesn't take too much imagination to see trial lawyers trolling the ranks of underachieving municipal finance officials who might want a do-over after some bad derivatives bets. We could immediately be talking about real money.
It's hard to say if these consequences were intended or not. Even on a good night's sleep, the esteemed lawmakers on Dodd-Frank's conference committee barely understood the markets they were reshaping. The notion that they could perform this work while also participating in a sleep-deprivation experiment is a comedy premise worthy of Hollywood. Savvy market analysts are no doubt forecasting Zach Galifianakis in the role of Mr. Frank.
But almost a year later, neither Wall Street nor Main Street has any reason to laugh. At least a temporary solution exists to prevent a possible lawsuit explosion next month. A bill to move the swaps deadline into next year has already passed two House committees and ought to move through Congress immediately to avoid any economic fallout.