Do End-Users Get the Best of Both worlds?—Title VII of Dodd–Frank and the End-User Exception

Table of ContentsI. Introduction 1760II. Over-the-Counter Derivative Market 1766A. Market Overview 1766B. Types of OTC Contracts 17701. Options 17702. Forwards 17713. Swaps 1771III. End-User Participation in the OTC Market 1773IV. Regulation of the OTC Market 1777A. Past Regulation 1777B. Dodd-Frank Regulation 1781V. End-User Exception to the Mandatory Clearing of Swaps 1784A. Rule Design: Narrow Versus Broad 1785B. Alternative Rule Design 17871. Alternative Approaches to OTC Derivatives Regulation 1788VI. Amendment to the End-User Exception 1 790A. Proposal for End-User Disclosure 1791VII. Conclusion 1794I. Introduction"Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."1 Warren Buffet made this statement to Berkshire shareholders in 2002. 2 The potential threat of the derivatives market was known then and became real in 2008. Now the government is taking action to control it.The financial crisis of 2008 was one of the largest in American history and almost led to the collapse of the U.S. financial system.3 Factors likely contributing to the crisis include the repeal of the Glass-Steagall Act, the influx of foreign money, the popularity of hedge funds and private equity, and the rise of mortgage-backed securities.4 Although the financial crisis of 2008 had numerous causes, the over-the-counter (OTC) derivative market was one of the most noted.6Some say that the OTC market's influence on the financial crisis was a result of the market's large financial volume and a lack of corresponding government regulation.6 As of July 2010, the OTC derivatives market had a notional value of approximately $300 trillion in the United States.7 This amount is roughly twenty times the size of the American economy.8 The notional amount is a way in which derivatives are priced, but it does not consider the risk involved.9 This risk can be much smaller or larger than the notional contract amount.10 Because this market is large and rapidly growing, regulation is necessary but will never completely eliminate the risks the market poses because of the complexity of the contracts and the rate of innovation in the market.11The widespread use of OTC derivatives for speculative purposes exposes market participants to systemic risk.12 Systemic risk arises when investors hold highly leveraged positions that could trigger a crisis like that of 2008. 13 Due to the number of OTC contracts and their interconnection with other trading instruments, a small market shift in the value of an OTC derivative could lead to a major international liquidity problem.14 OTC derivatives enhance systemic risk dramatically because they lack transparency.15 Improving transparency in the OTC market is precisely why regulation and disclosure are necessary for all participants.To protect the economy from systemic risk, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act16 (Dodd-Frank) in an effort to increase transparency, regulate pricing in the derivatives market, and, most importantly, minimize the risk to the American people. …