Financial Innovation and Derivatives Regulation – Minimizing Swap Credit Risk Under Title V of the Futures Trading Practices Act of 1992

Saturday, January 1st, 1994 at 12:00 am by John Andrew Lindholm
John Andrew Lindholm, Financial Innovation and Derivatives Regulation – Minimizing Swap Credit Risk Under Title V of the Futures Trading Practices Act of 1992, 1994 Colum. Bus. L. Rev. 73

Over-the-counter (“OTC”) derivatives have recently come to occupy the regulatory spotlight. Regulators view OTC derivatives as complex, risky instruments which could possibly destroy the international financial system. Market participants argue that derivatives are tools that serve to reduce risk. Title V of the Futures Trading Practices Act of 1992 authorizes the Commodity Futures Trading Commission (“CFTC”) to exempt from the requirements of the Commodity Exchange Act (“CEA”) any swap transaction possibly subject to CEA jurisdiction. The CEA mandates that financial products falling within its jurisdiction be traded on a CFTC-approved exchange. The resulting CFTC-issued Part 35 exempts qualifying swaps from all provisions of the CEA except the anti-fraud and anti-market manipulation provisions.

This Note argues that Title V and the resulting Part 35 minimize the “counterparty credit risk” — the possibility that a counterparty will default on the terms of a swap agreement — present in interest rate swaps. Additionally, taking interest rate swaps to be representative of the body of OTC derivatives products, this Note argues that Title V’s deregulatory provisions are a recognition that, in the hands of financially sophisticated market participants, derivatives are valuable tools for reducing risk. Implicit within Title V is an acknowledgment that market participants understand the risks that derivatives pose better than regulators do. To this end, Title V enables financially stable and sophisticated market participants to realize derivatives’ economic benefits through efficient risk taking while simultaneously restraining their use by riskier institutions. Such measures, if expanded to include a broader range of OTC derivatives, should enable domestic financial markets to continue evolving to meet the changing needs of financial market players.

Part II describes the basic structures and characteristics of derivatives in general, and swaps in particular; explains how swaps are documented; and adduces three economic explanations for their existence. Part III presents the normative arguments concerning the risks and utility of derivatives and summarizes conclusions drawn by three recent studies assessing whether the current regulatory system can accommodate derivatives’ riskiness. Part IV lays out the provisions of Title V and the resulting CFTC-issued Part 35. Part 35 specifies the criteria swap agreements must meet to be exempt from CEA jurisdiction. Part V examines Part 35’s impact upon counterparty credit risk by focusing on four means by which Part 35 reduces the risk of counterparty default. This Note concludes that Part 35 provides a framework that promotes responsible financial innovation without destroying the benefits provided by swaps.

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