One of the primary objectives of the Dodd-Frank Wall Street Reform and Consumer Protection Act is to protect investors by reducing risk in the financial markets. In light of the recent subprime collapse and ongoing economic downturn, such remedial measures are undoubtedly appropriate. However, unexpected consequences could impinge upon the operations of domestic businesses by reducing the availability of financing. As such, regulators are faced with the challenge of implementing a framework that balances the need for risk reduction with the availability of financing for local businesses.
Title VII of Dodd-Frank gives regulators the authority to impose "position limits" on a wide variety of over-the-counter derivatives, including credit default swaps (CDS). A position limit restricts the size or number of contracts that a single trader may own of a particular derivative. Position limits were first implemented in the agricultural commodities markets, successfully discouraging excess speculation and price manipulation.
A CDS is a contract that protects the CDS-buyer against the risk of default of a bond or loan. When an entity borrows money, the lender is exposed to the borrower's risk of default, or credit risk. A CDS allows the lender to pass the borrower's credit risk to the CDS-seller, in exchange for which the lender, or CDS-buyer, makes periodic payments to the CDS-seller. In the event of default, the CDS-seller makes a single payment to the CDS-buyer, usually for the face value of the loan or bonds. Through this process, the CDS-buyer protects itself against the risk of the borrower defaulting on its repayment obligations.
CDS liquidity is beneficial to debt market liquidity. Because CDS provide protection against the risk of default, lenders are more willing to lend knowing that they can readily and affordably obtain CDS protection. The secondary debt market, in which bonds and loans are resold to investors, also benefits from the protection afforded by CDS. This in turn increases secondary market liquidity, as participants can readily purchase protection against default and thus, are more willing to purchase debt. The combination of increased liquidity in the primary and secondary markets makes financing more readily available and more affordable. Businesses, particularly small and new businesses with less certain cash flows, are sensitive to lending liquidity constraints. In the event of poor lending liquidity, what might be a matter of borrowing on less favorable terms or financial belt-tightening for a larger, more well-established company could be financial ruin for a smaller or less established company that is more vulnerable to credit constraints.
Earlier this year, the Commodity Futures Trading Commission proposed position limits for commodity derivatives referencing 28 different commodities. One of the frequently raised concerns is that too severely limiting the size of positions that traders could take would decrease liquidity.
In the CDS markets, position limits must balance liquidity preservation with the ability of CDS buyers and sellers to meet their contractual obligations. Position limits should take into account the net CDS position for a particular "reference obligation," the bond or loan referenced by the CDS, or sector of similar reference obligations, which would share similar credit risk. Ideally they would do this by netting together the "notionals," or face values, of like CDS held by a single trader. Position limits should also take into account non-CDS hedges, such as the bond or loan actually referenced by the CDS, or a bond or loan that has similar credit risk to the reference obligation, such as a company in the same industry. Companies within a particular industry often share similar credit risks; for example, agricultural companies in one region that produce identical crops would be equally sensitive to poor weather conditions in that region. Thus, a CDS referencing a loan to one such company would have similar credit risk to a loan, or CDS referencing a loan, to another such company. A trader holding that CDS and an offsetting loan, or offsetting CDS referencing a loan, to a related agricultural company as a hedge would have less credit risk than a trader holding a single CDS with no related offsetting position. Including the CDS and its related offset/hedge is a more accurate calculation of the trader's position than his CDS position alone, which incentivizes well-hedged, risk-averse trading strategies and reduces the restrictive effect of CDS position limits on lending liquidity, which would be far more severe were the position calculated based on the CDS alone.
Andrew Cali-Vasquez is a senior staff member on the St. John's Journal of Civil Rights and Economic Development. He received his undergraduate degree in Asian and Middle Eastern Studies from the University of Pennsylvania in 2005. Before entering law school, Cali-Vasquez worked in several operational and financial control roles, including the interest rate derivative businesses at The Bank of New York Mellon and Barclays Capital. He has also worked with the Department of Enforcement at the Financial Industry Regulatory Authority. The views expressed do not necessarily reflect the views of any of these industries or organizations.
Suggested citation: Andrew Cali-Vasquez, Financial Reform Position Limits Do More Harm Than Good, JURIST - Dateline, Oct. 3, 2011, http://jurist.org/dateline/2011/10/andrew-cali-vasquez-dodd-frank.php.
This article was prepared for publication by Megan McKee, the head of JURIST's student commentary service. Please direct any questions or comments to her at firstname.lastname@example.org