Wednesday, December 14, 2011

Dodd-Frank "Swap" Definition: Industry Reaction (Part 1)

In an earlier post I attempted to analyze the definition of "swap" in the Dodd-Frank Act.  I have come across some articles about the definition which are worth looking at to see if they teach us anything about definitions in general.

The first is an article from, an online magazine about financial risk management, entitled "US power bodies call for clarity on Dodd-Frank “swap” definition" (  The article was published on 2011-07-26.  It presents the opinion of the National Rural Electric Cooperative Association that Dodd-Frank has defined "swap" too broadly.  The definition would include transactions "long used to manage electric grid reliability" - essentially putting a rural electric cooperative in the same category as Goldman Sachs.  These transactions are used to optimize generation resources to ensure grid reliability.  The industry wants all these types of transactions exempted from the Dodd-Frank definition of "swap".  Ominously, however, the FERC's (Federal Energy Regulatory Commission)  general counsel, Michael Bardee, also stated that “a detailed listing of all such excluded commercial and merchandising agreements commonly used in the electric and natural gas industries is not feasible”. 

Here are my take-aways from this story:
  • I would guess that the individuals responsible for the definition of "swap" were not aware of these electric energy transactions, based on the fact that there is no response justifying the inclusion of such transactions in the definition of "swap".  This illustrates the difficulty of trying to produce a definition without complete understanding of the ontology covered by the definition.  How does one obtain such a complete understanding?  I am not sure I have the answer to that.
  • The individuals responsible for the definition of "swap" were certainly not aware of the consequences for participants in certain subsectors of the energy industry.  Thus we can clearly see that poor definitions play an important role in "the law of unintended consequences".  How can effects be predicted accurately at the point in time that a definition is made?  It would seem an even more complete understanding of the ontology covered is needed.  But how to achieve this is something I do not know how to do. 
  • A legislative definition should be right from the outset.  That is quite different to other kinds of definition, which can be gradually improved over time (e.g. those of science).  A legislative definition, such as provided for "swap" is part of a more general act of creation - the overall Dodd-Frank Act in this case.  I would argue that if the conceptual system created is to be stable, the definitions of the concepts involved must be complete and coherent.  If this is not done, then the system will be unstable, and will create problems until such time as it is modified (or crashes).  Regrettably, we cannot model this kind of system to see what behavior is exhibited, and then optimize the definitions to achieve the intended results.
  • Mr. Bardee's comment about the impossibility of creating an exhaustive list of types of contract to exclude is worrying because he is dealing with a subset of the general problem.  It is unclear why such a list cannot be produced.  Maybe different types of contract come and go frequently over time.  However, if this kind of difficulty exists in this narrow area, there is pretty much no hope for an adequate definition at the higher level of "swap".  Perhaps an approach would be to try to establish completeness in a sample of small subareas under a definition.  If completeness cannot be achieved, then it is pointless to continue with the higher level definition.   

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