Investing and Pretending

I. INTRODUCTIONAlthough it may seem as though the financial crisis was only yesterday, it began almost seven years ago, and Congress finalized the statute intended to prevent its recurrence, the Dodd-Frank Act of 2010 ("Dodd-Frank"),1 more than four years ago. Since that time, those most affected by the financial crisis have made substantial strides to rebuild and move on (though, to be sure, for those most severely affected, progress has often been painfully slow). Of course, a substantial subset of those emerging from the crisis-namely, those comprising that vaguely defined group known as "Wall Street"-have also had to face adjusting to the new regulatory world that Dodd-Frank created. Still, commentary and debates about the new regulation and its proper focus and tools have largely faded, as firms have accepted and settled into their new obligations.Or so it might seem. Despite the apparent return to calm and the emergence of other events to draw our attention-new securities statutes such as the Jumpstart Our Business Startups ("JOBS") Act2 and controversial Supreme Court decisions, such as those in the McCutcheon3 and Hobby Lobby4 cases-much remains unsettled and problematic regarding one of the most critical components of Dodd-Frank. That component is Title VII of the statute, which sets forth a comprehensive and entirely new regulatory regime governing swaps."Swaps" are a type of derivative financial instrument, meaning that their value is derived from the value (including the expected future value) of some other financial instrument.5 They are just one of several types of instruments falling within the derivative category. Others are options and warrants, the value of which is derived from the value of particular securities, and futures contracts, whose values are derived from the value of particular commodities or securities.6 Swaps, moreover, are a derivative of the "over-the-counter," or "OTC," variety, meaning that, at least traditionally, parties enter into them privately, outside of any formal exchange mechanism.Swaps were the anointed culprits behind much of the financial crisis's worst assaults on asset values. Recall AIG's near-bankruptcy, the product of the firm's extensive transactions in a certain type of swap-namely, "credit default" swaps.7 AIG, moreover, was not alone. Many financial institutions served as willing counterparties for credit default swaps at the time, given the robust demand for them-but then defaulted on them (or risked defaulting on them) as the housing bubble burst, thereby feeding the systemic contagion that produced the crisis. Still, the rationale for financial and commercial firms' extensive swap participation was clear: They sought to hedge risks, such as the risk of default on mortgage-related or other liabilities,8 and viewed using swaps as a cost-effective way to do that.9 Swap transactions, after all, were not regulated.10 In 1999 Congress effectively forbade both the Securities and 2 3 4 5 6 7 8 9 10 Exchange Commission ("SEC") and the federal agency regulating commodity futures, the Commodity Futures Trading Commission ("CFTC"), from taking any steps to change that circumstance.11This hands-off approach for swaps may have been, in part, a product of the fact that financial-related policymaking focused on transactions involving investing, particularly in securities, and not on those involving pretending. That is, securities transactions, which are governed by extensive federal regulation, fall under the rubric of "investing"-involving an investor's deriving value from an asset actually purchased-whereas swap transactions may be more aptly characterized as exercises in "pretending." Swaps involve pretending because, unlike securities-related transactions, a swap does not involve buying or selling anything-it is an agreement between private parties to speculate on the value of some "reference asset." Importantly, the reference asset is wholly unrelated to the swap itself, a characteristic not typical of all derivatives. …