Financial derivatives are used for two main purposes: to speculate and to hedge investments. A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Derivatives can be traded privately (over-the-counter, OTC) or on an exchange. OTC derivatives constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized. OTC derivatives generally have greater risk for the counterparty than do standardized derivatives.
Some common types of derivative structures include:
- Collateralized debt obligations (CDOs)
- Credit default swaps
- Forwards
- Futures
- Mortgage-backed securities (MBS)
- Options
- Swaps
Regulation
In 2000, Congress passed the Commodity Futures Modernization Act (CFMA) to provide legal certainty for swap agreements. The CFMA explicitly prohibited the SEC and CFTC from regulating the over-the-counter (OTC) swaps markets, but provided the SEC with antifraud authority over “security-based swap agreements,” such as credit default swaps. However, the SEC was specifically prohibited from, among other things, imposing reporting, recordkeeping, or disclosure requirements or other prophylactic measures designed to prevent fraud with respect to such agreements. This limited the SEC’s ability to detect and deter fraud in the swaps markets.
Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 addresses the gap in U.S. financial regulation of OTC swaps by providing a comprehensive framework for the regulation of the OTC swaps markets.
The Dodd-Frank Act divides regulatory authority over swap agreements between the CFTC and SEC (though the prudential regulators, such as the Federal Reserve Board, also have an important role in setting capital and margin for swap entities that are banks). The SEC has regulatory authority over “security-based swaps,” which are defined as swaps based on a single security or loan or a narrow-based group or index of securities, or events relating to a single issuer or issuers of securities in a narrow-based security index. Security-based swaps are included within the definition of “security” under the Securities Exchange Act of 1934 and the Securities Act of 1933.
The CFTC has primary regulatory authority over all other swaps, such as energy and agricultural swaps. The CFTC and SEC share authority over “mixed swaps,” which are security-based swaps that also have a commodity component.
In addition, the SEC has anti-fraud enforcement authority over swaps that are related to securities but that do not come within the definition of “security-based swap.” These are called “security-based swap agreements.” The Dodd-Frank Act provides the SEC with access to information relating to security-based swap agreements in the possession of the CFTC and certain CFTC-regulated entities, such as derivatives clearing organizations, designated contract markets, and swap data repositories.