The Dodd-Frank Act is intended to reform the financial system in order to reduce the chance of any future systemic failure. Obviously, it is very important, and one of the most important parts of Dodd-Frank revolves around swaps. It may be recalled that lack of understanding about Credit Default Swaps (CDS) was a big part of the financial crisis that began in 2008 - and specifically caused AIG to fail. CDS, however, are only one species of swap. Prior to 2008 there had been little regulation of swaps.
Before we go further, there is one other piece of background for those unfamiliar with the sausage-making process of US financial regulation. An Act of Congress is just the beginning. Agencies of the US government must take the Act and turn it in to rules - usually many rules - and then enforce them. This means that if there is a problem in the Act, there can be difficulties across many rules.
Back to swaps. The Dodd-Frank definition of "swap" is given below. It is a pretty mind-numbing read. This definition clearly shows that there is no simple definition of a swap. The definition has a long list of concepts that are included, and a long list of concepts that are excluded (Paragraph B).
What we have is a collection of "things" that the government wants to be regulated in an identical manner - as "swaps". However, the only consistency is the way these "things" are to be regulated. There is no consistency - no common attributes intrinsic to these things - that distinguishes them from other things. If there was a set of common characteristics, then these would presumably have been listed. Instead, we get enumeration of members of the class (a practice frowned upon by traditional logicians). This is seen especially in the items labelled "(I)" through "(XXII)". These are part of the definition, not a list of illustrations.
The definition even abstracts from enumeration of members when it says: "(iv) that is an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap".
I was shocked when I first read this. How can a definition simply point back to common usage of a term? The government is throwing the burden of definition back on the speech community! Even then, what is meant by "the trade" and "commonly known" is puzzling (I cannot find definitions for these terms in the Act). Also, if some bright investment banker figures out a new product that he or she brands as something other than a swap, then they can presumably escape regulation. However, there is an "escape hatch" - the Commodities Futures Trading Commission (CFTC) is delegated the authority to broaden the definition, which should prevent this kind of problem. But suppose something gets called a "swap" that is nothing like a "real swap". That sort of thing happens all the time in the evolution of language. There is no way the definition can be modified to exclude it as the Act is written.
I was shocked when I first read this. How can a definition simply point back to common usage of a term? The government is throwing the burden of definition back on the speech community! Even then, what is meant by "the trade" and "commonly known" is puzzling (I cannot find definitions for these terms in the Act). Also, if some bright investment banker figures out a new product that he or she brands as something other than a swap, then they can presumably escape regulation. However, there is an "escape hatch" - the Commodities Futures Trading Commission (CFTC) is delegated the authority to broaden the definition, which should prevent this kind of problem. But suppose something gets called a "swap" that is nothing like a "real swap". That sort of thing happens all the time in the evolution of language. There is no way the definition can be modified to exclude it as the Act is written.
There is a lot more to be said on the Dodd-Frank definition of "swap" and we will cover more topics in future posts. This post is merely an appetizer to what promises to be a true feast of lessons that can be drawn about definitions.
‘‘(47) SWAP.—
‘‘(A) IN GENERAL.—Except as provided in subparagraph (B), the term ‘swap’ means any agreement, contract, or transaction—
‘‘(i) that is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind;
‘‘(ii) that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence;
‘‘(iii) that provides on an executory basis for the exchange, on a fixed or contingent basis, of 1 or more payments based on the value or level of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred, including any agreement, contract, or transaction commonly known as—
‘‘(I) an interest rate swap;
‘‘(II) a rate floor;
‘‘(III) a rate cap;
‘‘(IV) a rate collar;
‘‘(V) a cross-currency rate swap;
‘‘(VI) a basis swap;
‘‘(VII) a currency swap;
‘‘(VIII) a foreign exchange swap;
‘‘(IX) a total return swap;
‘‘(X) an equity index swap;
‘‘(XI) an equity swap;
‘‘(XII) a debt index swap;
‘‘(XIII) a debt swap;
‘‘(XIV) a credit spread;
‘‘(XV) a credit default swap;
‘‘(XVI) a credit swap;
‘‘(XVII) a weather swap;
‘‘(XVIII) an energy swap;
‘‘(XIX) a metal swap;
‘‘(XX) an agricultural swap;
‘‘(XXI) an emissions swap; and
‘‘(XXII) a commodity swap;
‘‘(iv) that is an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap; ‘‘(v) including any security-based swap agreement which meets the definition of ‘swap agreement’ as defined in section 206A of the Gramm-Leach-Bliley Act (15 U.S.C. 78c note) of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein; or
‘‘(vi) that is any combination or permutation of, or option on, any agreement, contract, or transaction described in any of clauses (i) through (v).
‘‘(B) EXCLUSIONS.—The term ‘swap’ does not include—
‘‘(i) any contract of sale of a commodity for future delivery (or option on such a contract), leverage contract authorized under section 19, security futures product, or agreement, contract, or transaction described in section 2(c)(2)(C)(i) or section 2(c)(2)(D)(i);
‘‘(ii) any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled;
‘‘(iii) any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based
on the value thereof, that is subject to—
‘‘(I) the Securities Act of 1933 (15 U.S.C. 77a et seq.); and
‘‘(II) the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.);
‘‘(iv) any put, call, straddle, option, or privilege relating to a foreign currency entered into on a national securities exchange registered pursuant to section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a));
‘‘(v) any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a fixed basis that is subject to—
‘‘(I) the Securities Act of 1933 (15 U.S.C. 77a et seq.); and
‘‘(II) the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.);
‘‘(vi) any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a contingent basis that is subject to the Securities
Act of 1933 (15 U.S.C. 77a et seq.) and the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), unless the agreement, contract, or transaction predicates the purchase or sale on the occurrence of a bona fide contingency that might reasonably be expected to affect or be affected by the creditworthiness of a party other than a party to the agreement, contract, or transaction;
‘‘(vii) any note, bond, or evidence of indebtedness that is a security, as defined in section 2(a)(1) of the Securities Act of 1933 (15 U.S.C. 77b(a)(1));
‘‘(viii) any agreement, contract, or transaction that is—
‘‘(I) based on a security; and
‘‘(II) entered into directly or through an underwriter (as defined in section 2(a)(11) of the Securities Act of 1933 (15 U.S.C. 77b(a)(11)) by the issuer
of such security for the purposes of raising capital, unless the agreement, contract, or transaction is entered into to manage a risk associated with capital raising;
‘‘(ix) any agreement, contract, or transaction a counterparty of which is a Federal Reserve bank, the Federal Government, or a Federal agency that is
expressly backed by the full faith and credit of the United States; and
‘‘(x) any security-based swap, other than a securitybased swap as described in subparagraph (D).
...
(b) AUTHORITY TO DEFINE TERMS.—The Commodity Futures Trading Commission may adopt a rule to define—
(1) the term ‘‘commercial risk’’; and
(2) any other term included in an amendment to the Commodity Exchange Act (7 U.S.C. 1 et seq.) made by this subtitle.
(c) MODIFICATION OF DEFINITIONS.—To include transactions and entities that have been structured to evade this subtitle (or an amendment made by this subtitle), the Commodity Futures Trading Commission shall adopt a rule to further define the terms ‘‘swap’’, ‘‘swap dealer’’, ‘‘major swap participant’’, and ‘‘eligible contract participant’’.
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