Hedging Their Bets: Understanding Corporate Loopholes in the Dodd-Frank Act

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Since the financial crisis of 2008 collapse of Lehman Brothers and beyond, the need for regulators to create new means of quelling excessive risk has been met with questions remain as to how effective these rules have been. Many of the new post-crisis rules have not yet gone into effect, and even once executed, a broker’s capability for evasion remains. To learn more about regulation on a national scale, visit the Governmental, Regulatory, and Self-Regulatory Proceedings page of our firm’s website.

A section of the Dodd-Frank Act legislation, the Volcker Rule, is to be implemented over the next two years with an aim at averting certain types of trading. While this regulation prevents banks from doing speculative trades with their own money, it will not stop hedging activities. The Volcker Rule contains guidelines that are meant to help regulators decide whether a hedge masks proprietary trading.

Other parts of Dodd-Frank resist undue risk more covertly. The Act looks to shift many derivatives to central clearing houses, the groups who collect the payments on a trade. This is said to theoretically strengthen the market, because companies are required to back their trades with margin payments of cash or safe securities. In theory, the financial burden of supplying margin to clearinghouses could make excessively risky trades restrictively expensive, and therefore less attractive for banks.

Yet the derivative in many loss-making trades is already centrally cleared in large amounts, according to figures from clearing house ICE Clear. If such positions are executed through a clearing house, it would mean that the added costs of clearing did not prove a deterrent, and might not stop similar traders in the future.

However, one part of these regulatory efforts may yet serve as a disincentive. Regulators look to demand much higher margin payments on derivatives. If regulators do set this new margin above current clearinghouse levels, such trades may become too expensive for banks.

New international banking regulations set by the Basel Committee offer further encouragement for regulators. In legally binding documentation, they will require banks to hold a lot more capital against high risk/reward trading positions. JPMorgan Chase’s chief executive Jamie Dimon last week said in Congressional testimony that the new Basel rules’ impact on JPMorgan’s credit bets could be capable of raising the “risk-weighted” value of one high profile credit derivatives portfolio from $20 billion to $60 billion. Here, a tripling of the position’s risk-weighted size would lead to a tripling of capital held against it. Notably, proposed Basel trading rules could force banks to hold more capital if regulators see evidence that hedges may not perform effectively in distressed situations.

For new and experienced investors alike, having the best possible intelligence and data motivating one’s investments is the difference between either making smart investments, or being led astray by those brokers who aim to deceive. For a free consultation on this matter and an array of others, contact the team of esteemed securities attorneys at Malecki Law. It is both your benefit and your legal right to have the accuracy of your securities data reviewed by legal professionals. We believe that our financial markets are only as strong as the consumers who make solid, informed investments that allow securities industry to flourish.