“The Dodd-Frank Act was a momentous and controversial legislative response to the 2007–09 financial crisis. Although some of its provisions have subsequently been challenged in the courts and overturned by a bipartisan Congress, other aspects of the Dodd-Frank Act are likely to stand the test of time. Chief among these are Dodd-Frank’s Titles VII and VIII, which govern derivatives.”

“The demonization of derivatives is due to a fundamental misunderstanding of the important role that derivatives play in the economy. The primary function of financial derivatives is to transfer risk from a party seeking to ‘hedge’ (limit) risk to a party willing to assume that risk.”

“Derivatives are critical for establishing the prices of the goods and services we all depend on—from oil to the interest on the mortgage on our home. Businesses, including American farmers and manufacturers, rely on derivatives to hedge their price risks. Without derivatives, these businesses would have no insurance against volatile price movements.”

“While I share commentators’ concerns about potential risk concentration in CCPs, Title VII addresses this risk by giving the [CFTC] the power to mitigate it through regulations that implement the ‘core principles’ applicable to registered CCPs. The CFTC has exercised this power by promulgating a comprehensive and effective regulatory structure, in particular Part 39 of the CFTC’s regulations, and by developing and conducting an intensive and in-depth programme of supervision through regular examinations and ongoing risk surveillance including supervisory stress testing.”

“This oversight is supplemented and complemented by Title VIII, which provides enhanced supervision of systemically important financial market utilities … including systemically important CCPs. In other words, Title VIII further addresses CCP risks made more acute by Title VII by giving regulators additional tools to mitigate those risks, without undoing the benefits of Title VII or the supervisory structure it establishes.”

“Far from revolutionary, Title VII borrowed from the CFTC’s long and successful history of regulating the futures markets, applying many of those same principles to regulate the previously opaque, bilateral swaps markets. At the same time, in both Titles VII and VIII Congress worked to ensure that its response to one crisis would not unwittingly sow the seeds of the next.”

“While Congress envisioned that CCPs would play an indispensable role in the post-Dodd-Frank era, it also equipped the CFTC and other regulators with enhanced tools to regulate and supervise CCPs. In this manner, the Dodd-Frank Act carefully balances the need to keep US derivatives markets vibrant with the necessity of ensuring they are shock absorbers for systemic risk, not amplifiers of it. As a consequence, the legacy of Dodd-Frank’s derivatives reforms is likely to be one that endures and benefits the US economy in the decades to come.”

Read the full article here.