Article: Sacrificing Functionality for Transparency? The Regulation of Swap Agreements in the Wake of the Financial Crisis

Once the sole province of chief executive officers and hedge fund managers, swap agreements (or “swaps”), most notably credit default swaps,[1] came to the forefront of politicians’ and regulators’ minds with the near-collapse of the U.S. financial system in 2008.  Having operated largely in the shadows of the lightly regulated over-the-counter (OTC) derivatives market, companies went unimpeded when they sold credit default swaps to cover trillions of dollars in securities and bonds.[2] Credit default swaps written by American International Group, Inc. (AIG), for instance, covered more than $440 billion in bonds.[3] Unable to cover the contracts’ costs when they became due at the onset of the financial crisis, the U.S. government, arguably to save the larger financial system,[4] bailed out AIG and some of the largest financial institutions in the world.[5]

In response, and in an effort to gain control over the opaque OTC derivatives market, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in 2010, which, in part, provided authorization to both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to regulate swap agreements.[6]  Acting on its congressional mandate, the SEC in early 2011 released for public comment Regulation SB SEF,[7] which purports to remove many swap agreements from the OTC market and put them on exchanges or swap execution facilities, and thereby inject greater transparency into the OTC derivatives market.

This Article argues that Regulation SB SEF does not adequately consider the fundamental differences between securities and swap agreements that render swap agreements less amenable to securities-like exchanges.  Part I of this Article defines what a swap agreement is and describes the SEC’s attempt to regulate them.  Part II dissects the case for regulating swap agreements and analyzes their fundamentals in order to better understand how to regulate them.  Part III suggests an alternative regulatory structure that will better allow the swaps market to function.

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Reed Schuster: Associate, Faegre Baker Daniels LLP; J.D. 2011, University of Minnesota Law School.

[1]. For a more in-depth discussion of credit-default swaps, see infra Part I.A.1.b.

[2]. See Marco Avellaneda & Rama Cont, Int’l Swaps & Derivatives Ass’n, Transparency in Credit Default Swap Markets 8 (July 2010), available at (“In 1997, the notional open interest in [credit default swaps] was on the order of 200 billion dollars; by 2007 it had grown to approximately USD 60 trillion.”).

[3]. Adam Davidson, How AIG Fell Apart, Reuters (Sept. 18, 2008),

[4]. Cf. Henry M. Paulson Jr., On the Brink: Inside the Race to Stop the Collapse of the Global Financial System 99 (2010) (“A Bear Stearns failure wouldn’t just hurt the owners of its shares and its bonds.  Bear had hundreds, maybe thousands, of counterparties—firms that lent it money or with which it traded stocks, bonds, mortgages, and other securities.  These firms . . . all in turn had myriad counterparties of their own.  If Bear fell, all these counterparties would be scrambling to collect their loans and collateral. . . .  That was how bank runs started these days.”).

[5]. See, e.g., Steven M. Davidoff, Uncomfortable Embrace: Federal Corporate Ownership in the Midst of the Financial Crisis, 95 Minn. L. Rev. 1733, 1737-44, 1754-55 (2011) (discussing the U.S. government’s assistance to AIG, Citigroup, and Bank of America); Matthew Karnitschnig et al., U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up, Wall Street J. Online (Sept. 16, 2008), (reporting on the U.S. government’s bailout of AIG).

[6]. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 762, 124 Stat. 1376, 1759 (2010).  Interestingly, save for section 10(b) of the Securities Exchange Act of 1934, see Commodity Futures Modernization Act, Pub. L. 106-554, § 303(d), 114 Stat. 2763, 2763A-454 (2000) (providing for the regulation of swap agreements under section 10(b)); see also Caiola v. Citibank, 295 F.3d 312, 327 (2d Cir. 2002) (“Sections 302 and 303 of the [Commodity Futures Modernization Act] define ‘swap agreements’ and then expressly exclude them from the definition of ‘securities,’ but amend section 10(b) to reach swap agreements.”).  Swap agreements were expressly exempted from regulation in the Securities Exchange Act of 1934.  15 U.S.C. § 78c-1(a)-(b) (2006).

[7].Registration and Regulation of Security-Based Swap Execution Facilities, 76 Fed. Reg. 10,948 (proposed Feb. 28, 2011) (to be codified at 17 C.F.R. pts. 240, 242, 249).

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