Regulation of the OTC derivatives market: Before and after the Dodd-Frank Act

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The Dodd-Frank Wall Street Reform and Consumer Protection Act overhauled U.S. financial regulation in 2010, targeting risky derivatives, banks, and consumer abuses.

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If you’re a casual participant in the financial markets, you may not have heard of the over-the-counter (OTC) derivatives, or “swaps” market. So you might be surprised to learn that more than $1 trillion of notional swap value changes hands in a typical trading day.

Most of the time, we can be thankful for this market. It allows banks, companies, and even governments to make better use of their capital, match their income and payment streams, and lower their risk exposure. But for all their benefits, upheaval in the (then largely unregulated) swaps market in 2008 nearly sank the entire global financial system.

Interest rate swaps—along with swaps on foreign exchange, commodities, credit default, and equities—are big business. In the first half of 2023, the International Swaps and Derivatives Association (ISDA) reported that 1.4 million interest rate swaps traded with a notional value of $181.6 trillion, an increase in value of 16.8% from the first half of 2022.

To make a swap—and the swaps market as a whole—work, someone has to bring the parties on each side of the contract (“counterparties,” in OTC derivatives jargon) together, then make sure that they make good on the terms of the contract. But when a few large swap counterparties, including investment banking giant Lehman Brothers, failed in 2008, the government was forced to step in and “backstop” the swaps market. After the dust settled, the decision was made to completely overhaul the OTC derivatives market.

How did we get here? Let’s take a step back in time, then fast-forward to today.

Although ad hoc swap arrangements happened sooner, the formal swap market emerged from the need to manage currencies under the gold standard. In 1962, the Federal Reserve Bank established a formal swaps program that would allow central banks to exchange reserves with each other rather than exchange their dollar reserves for gold. The principle led to the creation of even more ad hoc swap contracts in the 1970s.

1981: The first commercial currency swap. In 1981, Salomon Brothers investment bank worked with the World Bank and IBM to create the first commercial currency swap. Given the size of the organizations, there was little counterparty risk.

The market took off from there, with interest rate swap contracts emerging in short order. Swaps could be in place for much longer than a futures contract, helping organizations manage long-term risk, and they could be customized to fit the needs of the counterparties. The Depository Trust & Clearing Corporation (DTCC), a clearinghouse for a wide range of over-the-counter securities, offered services to ensure that the counterparties delivered on their side of the deal.

1994: Credit default swaps invented. The swap concept soon extended beyond interest rates and currencies to allow financial entities to transfer other types of price risk to those willing to accept them. For instance, in 1994, JPMorgan created the credit default swap (CDS) contract, which was designed to function as an insurance policy without falling under insurance regulation. In essence, one party traded an up-front payment in exchange for a payout if the underlying loan—or loan issuer—were to default. In times of general market stability, issuing credit default swaps was an easy way to collect revenue.

2008: The Lehman Brothers failure and AIG bailout. In September 2008, Lehman Brothers failed. The investment bank was a large player in the swap market. Not only did its failure trigger default clauses in Lehman-related CDS contracts; a panic ensued among counterparties. At the time of its bankruptcy, Lehman’s swap portfolio consisted of more than 66,000 individual swap agreements.

One of the biggest writers of credit default swaps was AIG, a major insurance company. The exposure to these contracts led to a cut in AIG’s credit rating, which then led to a call on the collateral for these contracts even when the underlying loans were sound. By the end of October 2008, the DTCC unwound $5.2 billion in net payments on these contracts, resolving much of the uncertainty in the financial markets. The financial system stayed afloat, but the sheer size and opaque nature of the swaps market were seen as warning signs that a new derivatives regulatory regime was needed.

In 2010, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as the Dodd-Frank Act. It was designed to modernize regulation to improve financial stability following the crisis; a big part of this was regulating swaps.

The swap rules have three pillars: execution, clearing, and reporting.

In addition, financial companies arranging swaps must register with the National Futures Association as swap dealers.

As of 2023, the swaps market has largely adopted the new framework. According to ISDA’s Q4 2022 review, in 2022, 69.6% of interest rate derivatives were traded on SEFs, and 76% went through the central counterparty clearing process. For credit default swaps, 87.1% were traded on SEFs and 88% were cleared.

Swaps have evolved to meet a range of market needs, but the opaque, lightly regulated nature of swaps nearly led to disaster during the 2008 financial crisis. The Dodd-Frank Act kept the OTC derivatives market intact, but with new regulations designed to protect participants and provide market transparency.

With effective regulatory parameters in place, the swaps market can evolve to help more customers with risk management while maintaining the integrity of the financial system.