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Supplementing Dodd-Frank: An Argument for Further

Increasing the Regulation of Credit Default Swaps
Jessica Maharaj

I. INTRODUCTION ............................................................................................................ 247

II. BACKGROUND ............................................................................................................ 248
A. Derivatives ....................................................................................................... 248
B. Credit Default Swaps ....................................................................................... 249
C. Increased Regulation of CDSs Through the Dodd-Frank Act.......................... 251
III. WHERE CURRENT REGULATION OF CDSS STANDS TODAY ....................................... 253
A. The Dodd-Frank Act and Its Aftermath ............................................................ 253
B. The International Swap Derivatives Association as Self-Regulators ............... 255
C. Where the Dodd-Frank Act Went Wrong ......................................................... 256
IV. RECOMMENDATION................................................................................................... 258
A. Limits on Funding Sources for Protection Sellers............................................ 258
B. Increasing Regulation of Clearinghouses and Expansion of Authority ........... 259
V. CONCLUSION: CDSS NEED MORE REGULATION BUT NOT AT THE COST OF
CUSTOMIZATION ................................................................................................... 262

I. INTRODUCTION

Credit Default Swaps have provided protection buyers and protection sellers with
customizable financial protection for nearly three decades, all the while operating under a
changing regulatory landscape. Credit Default Swaps (CDSs) are highly customizable in
nature, allowing a protection buyer to purchase ‘protection’ from a protection seller in the
case of a negative credit event. Then a default payment will be issued, which protects a
protection buyer from making a bad investment. CDSs were poorly regulated when they
were first introduced over thirty years ago. After the Financial Crisis of 2008, the Dodd-
Frank Act was passed and introduced a plethora of new regulations across the entire U.S.
financial industry. While Dodd-Frank was a large step in the right direction, it did not
completely regulate CDSs. For example, Dodd-Frank did not introduce a protocol for
regulating types of CDSs that were not yet in existence when the Act was passed.
This Note examines the weaknesses of the Dodd-Frank Act in terms of regulating
CDSs and suggests ways to more comprehensively regulate CDSs and future developments
in CDSs without sacrificing the ability to customize CDSs. First, the Note begins with an
overview of derivatives, followed by an overview of Credit Default Swaps. Next, this Note
examines the regulation—or rather the lack of regulation—of CDSs before the Financial
Crisis and new regulations that came into effect as a result of the role of Credit Default
Swaps in the Financial Crisis. Then, this Note examines the weaknesses of the Dodd-Frank
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248 The Journal of Corporation Law [Vol. 46:1

Act in terms of regulating CDSs, namely the Act’s failure to respond to new developments
related to CDSs and its weaknesses related to the establishment of clearinghouses. Lastly,
this Note gives recommendations of ways that CDSs can be further regulated without
sacrificing their ability to be customized.

II. BACKGROUND

A. Derivatives
A typical definition of a derivative is “a financial instrument whose value derives from
that of something else.” 1 A financial instrument is simply a contract that lays out a financial
agreement between two parties. 2 The value of a derivative is derived from its underlier. 3
An underlier “can or must be sold on or before a future date, at a predetermined
(guaranteed) price.” 4 Underliers can be any traded item, 5 but some traded items are better
underliers than others. A better underlier for a derivative is one that is both fungible—
which means an asset can be traded for another asset under the understanding both are
equally valuable—and liquid—meaning there are many buyers and sellers of an asset at
any given time. 6 Examples of sufficient underliers which are both fungible and liquid
include: commodities, foreign exchanges, interest rates, and equities such as stocks. 7
Derivatives are typically used for hedging or speculation. 8 Hedging and speculating
have opposite goals. Hedging involves the mitigation of risk in order to contain any
volatility that may occur if the price of a security changes. 9 There is quite a bit of protection
against losses with hedging, but gains are also restricted since hedgers take “an opposite
position in the market to what they are trying to hedge.” 10 Thus, if a negative event happens
in the market, that negative event will essentially be canceled out. 11 Speculation involves
trying to profit off of an educated guess about market fluctuations. 12 Speculations
oftentimes involve purposely taking on additional risk rather than hedging, or decreasing,
risk. 13 They involve speed, 14 high risk, and a potentially high return. 15 Speculations are
incredibly risky because markets can be volatile and highly unpredictable at times. 16 It is
possible to hedge and speculate without using derivatives; however, derivatives have

1. MICHAEL DURBIN, ALL ABOUT DERIVATIVES 3 (2d ed. 2010).

2. Id.
3. Id. at 4.
4. Id. at 11.
5. Id. at 1.
6. DURBIN, supra note 1, at 11.
7. Id. at 11–12.
8. Id. at 4.
9. Brian Beers, Hedging vs. Speculation: What’s the Difference?, INVESTOPEDIA (May 4, 2019),
https://www.investopedia.com/ask/answers/difference-between-hedging-and-speculation/
[https://perma.cc/7D6H-SD3W].
10. Id.
11. Id.
12. Id.
13. Ignace Claeys, Speculation: The Devil Burning Down the House? On Derivatives, Gambling, and
Public Policy, in FINANCE AND LAW: TWINS IN TROUBLE 89, 98 (Ludo Cornelis ed., 2015).
14. Take high-frequency computer trading as an example.
15. Claeys, supra note 13, at 98–99.
16. Beers, supra note 9.
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2020 Supplementing Dodd-Frank 249

“leverage” in the market. 17 In a derivatives market, this typically means hedgers and
speculators can do more with less capital at the outset. 18 For example, buying options in
the derivative market can require less capital than buying stocks in the financial market.
This allows a speculator to enter the marketplace as a participant with less of a barrier.
Similarly, banks can use CDSs to reduce the amount of capital they need to hold in reserve
against loans they issued, which leaves money free for banks to use in other ways. 19
There are four types of derivatives: a forward contract, a futures contract, a swap
contract, and an option contract. 20 A forward contract is an agreement to purchase a
financial instrument at an agreed upon price on a specified future date. 21 A futures contract
is simply a forward contract fulfilled at an exchange, which is where buyers and sellers
come together to conduct transactions. 22 A swap contract is an agreement between parties
to exchange the cash flows or liabilities from separate financial instruments. 23 An option
contract gives one party the right, but not the obligation, to buy or sell a financial instrument
at an agreed upon price, on or before a future date. 24 This paper focuses on a type of swap
derivative, called a credit default swap.

B. Credit Default Swaps

CDSs are the most popular type of credit derivative. 25 A credit derivative derives its
value from an underlier that is the “credit performance of an individual, corporation,
government organization, or sovereign entity.” 26 A credit default swap involves a party,
called the protection buyer and another party, called the protection seller. 27 The protection
seller makes an agreement to protect the protection buyer from credit risk by agreeing to
pay the protection buyer if a credit event occurs. 28 In exchange, the protection buyer pays
premiums to the protection seller. 29 A credit event 30 can be anything the parties agree,
including “bankruptcy, a buyout, or a debtor downgrade.” 31 Most commonly, a credit event
is a debtor default. 32 Since parties can customize what credit risk is involved in their

17. DURBIN, supra note 1, at 5.

18. Id.
19. Houman Shadab, Credit Default Swaps and Regulatory Reform, MERCATUS CTR. GEO. MASON U. 1,
1–2 (Aug. 2009), https://www.mercatus.org/publications/financial-markets/credit-default-swaps-and-regulatory-
reform [https://perma.cc/NZ27-JJTQ].
20. DURBIN, supra note 1, at 2.
21. Id.
22. Id.
23. Id.
24. Id.
25. Benjamin R. O’Connor, Taming the Wild West of Wall Street: Regulating Credit Default Swaps After
Dodd-Frank, 48 J. MARSHALL L. REV. 565, 572 (2015).
26. Id.
27. Id. at 573.
28. Id.
29. Id.
30. The International Swaps and Derivatives Association (ISDA) definitions include six common credit
events: bankruptcy, failure to meet payment obligation, obligation acceleration, obligation default,
repudiation/moratorium, and restructuring. GEOFFREY P. MILLER & FABRIZIO CAFAGGI, THE GOVERNANCE AND
REGULATION OF INTERNATIONAL FINANCE 39 (2013).
31. O’Connor, supra note 25, at 575.
32. Id. at 573.
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250 The Journal of Corporation Law [Vol. 46:1

agreement and what credit event would trigger payment, it has been difficult to regulate
CDSs in the past because CDSs cannot be regulated with a one-size-fits-all standard. 33
CDSs can function like insurance. 34 The protection seller insures the protection buyer
against the risk of loss if the credit event occurs, and the protection buyer pays a premium
for this so-called insurance. 35 CDSs differ from insurance contracts in several ways. For
example, the protection buyer does not own the underlier so “the purchaser of the CDS
protection has no real ‘insurable interest’ to preserve.” 36 Due to the lack of regulation of
CDSs, the only place they could be bought and sold was in over-the-counter (OTC)
markets. 37 Lack of regulation and the nature of the OTC market allowed investors the
freedom to speculate with little oversight. 38 Investors were no longer looking for good
investments in CDSs, and they were not trying to hedge risk. 39 Instead, they would
speculate about how likely it was a credit event would occur. If a credit event did not occur,
a protection seller could collect premium payments from protection buyers without ever
paying the protection buyer. 40 This allowed protection sellers to agree to CDS contracts
without the capital to back up any potential payout to the protection buyer on hand. 41
Protection buyers were also free to purchase bad debt and then use CDSs to protect against
risk of loss. 42 If the credit event occurred, the protection seller would have to give the
protection buyer money so the protection buyer did not face a loss. 43 Additionally, the
number of protection buyers and protection sellers that can create a CDS on the same
underlier is unlimited. 44 All of this together led to oversaturation in the CDS market, as
well as rampant speculation.
“Derivatives and CDSs did play a part in the global financial crisis, but they did not
cause it,” Blyth Masters, Chief Financial Officer of JP Morgan—the same JP Morgan that
invented the CDS—announced at a conference by the European Commission in 2009. 45
He was right. The influx of speculation in CDSs contributed to the cause of the Financial
Crisis in 2008 but did not cause it. The cause is largely attributed to mortgage-backed
securities being used as underlying assets for numerous kinds of transactions. 46 Credit
rating agencies gave subprime mortgage-backed securities AAA ratings even though many
of them should have received lower ratings or even junk status. 47 When the mortgage
bubble burst, homeowners began defaulting on their mortgages in droves, causing the
crisis. 48 CDSs had a role in this because financial institutions used CDSs to hedge risk and

33. Id. at 576.

34. Id. at 577.
35. Id.
36. O’Connor, supra note 25, at 577.
37. Id. at 578.
38. Id.
39. Id.
40. Id. at 579.
41. O’Connor, supra note 25, at 579.
42. Id.
43. Id.
44. Id. at 580.
45. MILLER & CAFAGGI, supra note 30, at 49.
46. Id. at 50.
47. Id.
48. Kimberly Amadeo, The Causes of the Subprime Mortgage Crisis, BALANCE (Sept. 17, 2020),
https://www.thebalance.com/what-caused-the-subprime-mortgage-crisis-3305696 [https://perma.cc/D6TE-
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2020 Supplementing Dodd-Frank 251

limit their credit exposure. 49 However, more often, CDSs were used to speculate. 50 CDSs
“provided a golden opportunity for bearish investors to bet against the housing boom.” 51
When the housing bubble burst, protection sellers—who were in CDS contracts
guaranteeing mortgage debts—suddenly had to come up with large amounts of capital to
fund payouts to protection buyers. 52 Homeowners were defaulting on their mortgages at a
much faster rate than protection sellers could come up with capital for payouts. 53 This led
to more and more defaults in other sectors in addition to mortgages. 54 Many protection
sellers were unable to come up with enough capital to cover payouts to protection buyers,
so they too began to default on CDSs. 55 The whole system of CDSs began to unravel.
The actions of insurance company, American International Group (AIG) represent a
prime example of how CDSs contributed to the financial crisis. 56 AIG—which was one of
the world’s largest insurance companies—was a protection seller engaging in CDS
contracts. 57 AIG’s potential pay-out in the event the credit events (in this case defaults)
occurred in every one of their CDS contracts was more than $500 billion. 58 AIG grossly
underestimated the risk behind its CDS contracts and did not provide enough collateral to
ensure pay-outs. 59 AIG was not able to control the risk it aimed to hedge, 60 and the
company suffered from too much exposure to risk and greatly lacked liquidity to cover its
obligations. 61 Ultimately the government had to intervene and provide AIG with the
needed liquidity to save it from defaulting on its pay-outs. 62 If AIG had defaulted, it would
have created a grave domino effect, potentially collapsing the entire financial system. 63
This and other contributors to the financial crisis prompted large government bailouts,
bankruptcy, and financial ruin. 64

C. Increased Regulation of CDSs Through the Dodd-Frank Act

The government responded to the Financial Crisis by passing the Dodd-Frank Act in
2010, which is over 800 pages and attempts to regulate most areas of finance. 65 Title VII
of the Dodd-Frank Act is the first time the federal government has attempted to regulate
credit derivatives. 66 One important provision of the Dodd-Frank Act is the insurgence of

ZMSX].
49. Id.
50. Id.
51. MILLER & CAFAGGI, supra note 30, at 50.
52. O’Connor, supra note 25, at 581.
53. Id.
54. Id.
55. Id.
56. MILLER & CAFAGGI, supra note 30.
57. Id.
58. Id.
59. Id.
60. Id.
61. MILLER & CAFAGGI, supra note 30, at 50.
62. Id.
63. Id.
64. O’Connor, supra note 25, at 581.
65. Id. at 582–83.
66. Id. at 583.
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252 The Journal of Corporation Law [Vol. 46:1

power and authority it gives to the Securities and Exchange Commission (SEC) and the
Commodity Futures Trading Commission (CFTC) to regulate different types of swaps,
including CDSs. 67 The Dodd-Frank Act also mandates that all parties to a CDS contract
register with the agency dealing with the kind of swap in the contract. 68 The Dodd-Frank
Act also prohibits “the federal government from bailing out any so-called ‘swap entity.’” 69

One of the most significant provisions of the Dodd-Frank Act requires all CDSs clear
through public clearinghouses, which are similar to exchanges, instead of free-for-all, over-
the-counter transactions. 70 A clearinghouse “serves as a mediator between the parties to a
transaction.” 71 Transactions can form, trade, clear, and settle at clearinghouses. 72 Instead
of two parties entering into a contract with each other, the clearinghouse will enter into two
separate contracts with each of the two parties. 73 A clearinghouse can decrease risk in three
ways. 74 First clearinghouses take on the administrative functions of the market, 75 so parties
do not depend on each other to create strong and detailed contract terms, for example.
Second, clearinghouses analyze their members’ credit quality ahead of time and require
members to disclose information about their credit quality regularly. 76 “Third, if a party
becomes unable to satisfy its obligations under an agreement registered and processed
through the clearinghouse, then the clearinghouse assumes those obligations.” 77 This
means if a protection seller is unable to fund a payout, then the clearinghouse will step in
and pay the protection buyer to ensure the protection buyer does not have to assume the
risk it is supposed to be protected against. 78 Clearinghouses obtain capital from their
members, which is how they can provide payouts if a protection seller is unable to. 79 By
collecting capital from members, clearinghouses essentially rely on members to check
themselves to ensure they are not assuming too much risk. 80 In theory, members will do
this self-check because other members’ capital is at stake. 81 Clearinghouses must register
with the SEC or the CFTC. 82 This makes clearinghouses trustworthy third parties that can
be supervised by regulators. 83 However, clearinghouses are not perfect and do not provide
the high level of oversight needed to mitigate speculation in CDSs. 84
Despite the sweeping changes brought forth by the Dodd-Frank Act, there is more
work to be done to regulate CDSs. Increased regulation of CDSs should not be made

67. Id.
68. Id.
69. O’Connor, supra note 25, at 583.
70. Id. at 584, 589.
71. Id. at 589.
72. MILLER & CAFAGGI, supra note 30, at 53 n.37.
73. Id.
74. Id.
75. Id.
76. Id.
77. MILLER & CAFAGGI, supra note 30, at 53–54 n.37.
78. O’Connor, supra note 25, at 589.
79. Id.
80. Id. at 591.
81. Id.
82. Id. at 596.
83. O’Connor, supra note 25, at 590.
84. Id. at 592.
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2020 Supplementing Dodd-Frank 253

regarding the substance or terms of a CDS agreement because limiting the terms of CDSs
would destroy the characteristic of customization that makes CDS agreements so desirable.
Instead, further regulation should focus on the external aspects that affect CDSs, such as
funding sources—loans, for example—for protection sellers, increased standardization of
clearinghouses, and the expansion of the authority that clearinghouses hold in order to deter
overly speculative CDSs from saturating the market.

III. WHERE CURRENT REGULATION OF CDSS STANDS TODAY

A. The Dodd-Frank Act and Its Aftermath

The Dodd-Frank Act was passed in the aftermath of the Financial Crisis. 85 Congress’
goal with the Dodd-Frank Act was to not only address the problems brought on by the
Financial Crisis, but also to ensure that such a crisis could never happen again. 86 The Dodd-
Frank Act made sweeping regulations across several areas of the financial sector, 87
affecting nearly every part of the financial services industry from mortgages and securities
to banks and insurance companies. 88 The Act also authorized federal agencies and financial
regulatory bodies to create many new regulations. 89
As detailed as the Dodd-Frank Act is, however, it has several weaknesses. For
example, the Dodd-Frank Act shares some blame in creating obstacles that caused banks
to lend less, which harmed economic growth. 90 Similarly, regulations in Dodd-Frank
originally aimed to address abuses by larger banks and financial firms are in turn resulting
in compliance issues for small community banks, forcing them to sell off assets. 91 The
Dodd-Frank Act introduced thousands of pages of new and complex regulations that are
imposed on all banks, big and small alike. 92 However, small banks and community banks
are unable to afford the increased cost of developing a compliance department or expanding

85. Id. at 582.

86. Id.
87. More Than Just Financial Reform: Analysis and Observations on the Dodd-Frank Wall Street Reform
and Consumer Protection Act, JONES DAY 6 (Aug. 2010), https://www.jonesday.com/en/insights/2010/08/more-
than-just-financial-reform-analysis-and-observations-on-the-dodd-frank-wall-street-reform-and-consumer-
protection-act [https://perma.cc/JGP2-M7LU] (“The Act . . . address[es] public anger over the ‘bailout’ rather
than to the actual causes of the financial crisis[;] [d]elegates most detail and authority to regulatory agencies[;]
[g]oes well beyond traditional financial institutions by mandating changes to corporate governance provisions
that negatively affect all public companies[;] [i]mposes a significantly increased compliance burden on banks and
other financial institutions that is likely to further industry consolidation[;] [c]reates a public market for
derivatives that increases the cost of doing business for most corporations[;] [i]s likely to continue to limit access
to capital by causing banks and other financial institutions to lend less to comply with enhanced regulatory
requirements.”).
88. Eric Revell, Obama Signed the Dodd-Frank Wall St. Reform & Consumer Protection Act on This Date,
CAUSES (July 21, 2019), https://www.causes.com/articles/31648-obama-signed-dodd-frank-wall-st-reform-
consumer-protection-act-date [https://perma.cc/Y677-HELW].
89. Id.
90. Id.
91. Id.
92. Jonathan Sargent, Community Banks Under Siege by Dodd-Frank, AMS. FOR TAX REFORM (Oct. 14,
2016, 12:39 PM), https://www.atr.org/community-banks-under-siege-dodd-frank [https://perma.cc/8RWF-
AQQ5].
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their already existing compliance departments. 93 Ninety percent of banks have revealed
that compliance costs have risen since the Dodd-Frank Act was passed. 94 Community
banks have been forced to stop offering certain products and services to keep up with the
increased cost of compliance. 95 Many smaller banks have been sold to larger banks. 96
Larger banks have the capacity to absorb the increased cost of compliance due to the Dodd-
Frank Act; 97 thus, by subjecting banks of all sizes to nearly identical regulation, the Dodd-
Frank Act has had a devastating effect on small banks and community banks. 98 However,
critics on the other side of the spectrum wish the Dodd-Frank Act went further by breaking
up large banking institutions and holding institutions that received large multi-billion-
dollar bailouts, like Fannie Mae and Freddie Mac, more accountable. 99
Title VII of the Dodd-Frank Act sets out regulations applying to swap markets. 100
However, these regulations do not apply to derivatives that are “not concluded by a
counter-party that is the end user and it is hedging its own commercial risk with the
swap.” 101 In Title VII, the Dodd-Frank Act expands the regulatory functions of the
Securities and Exchange Commission (SEC), in charge of regulating security-based swaps,
and the Commodity Futures Trading Commission (CFTC), in charge of regulating non-
security-based swaps. 102 For example, swap dealers and all other participants in the swap
market must register with and be examined by the CFTC or the SEC depending on whether
they deal with security-based swaps or other types of swaps, like swaps on
commodities. 103 Before the Dodd-Frank Act, the SEC and CFTC were severely limited in
how they could regulate OTC derivatives. 104 The Commodity Future Modernization Act
(CFMA) was passed by Congress in 2000, 105 overriding the Commodities Exchange Act
(CEA). 106 Under the CEA, derivative contracts, then codified as difference contracts, were
not legally enforceable if they were too speculative. 107 Derivative contracts made for
hedging purposes were the only ones that were legally enforceable. 108 Speculation was

93. Id.
94. Hester Peirce et al., How are Small Banks Faring under Dodd-Frank? 34 (Mercatus Ctr. Geo. Mason
U., Working Paper No. 14-05, 2014), https://www.mercatus.org/system/files/Peirce_SmallBankSurvey_v1.pdf
[https://perma.cc/PNJ7-AKU8].
95. Sargent, supra note 92.
96. Id.
97. Id.
98. Id.
99. Revell, supra note 88.
100. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376
(2010).
101. MILLER & CAFAGGI, supra note 30, at 54.
102. “Before commencing any rulemaking or issuing an order regarding swaps, swap dealers, major swap
participants, swap data repositories, derivative clearing organizations with regard to swaps, persons associated
with a swap dealer or major swap participant, eligible contract participants, or swap execution facilities pursuant
to this subtitle, the Commodity Futures Trading Commission shall consult and coordinate to the extent possible.”
Dodd-Frank Wall Street Reform and Consumer Protection Act, 15 U.S.C. § 8302(a)(1) (2010).
103. MILLER & CAFAGGI, supra note 30, at 54.
104. Derivatives, SEC (May 4, 2015), https://www.sec.gov/spotlight/dodd-frank/derivatives.shtml
[https://perma.cc/7GZY-8SDQ].
105. Id.
106. MILLER & CAFAGGI, supra note 30, at 45.
107. Id. at 47.
108. Id.
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allowed, but if courts refused to enforce the derivative contract, parties were left on their
own to figure out how to enforce their contracts. 109 According to the CFMA, the SEC and
the CFTC were not allowed to regulate OTC swaps markets. 110 The only authority the SEC
had over swaps markets was anti-fraud authority over security-based swap agreements. 111
Anti-fraud authority was broad but simultaneously restrictive. 112 The SEC was explicitly
not allowed to impose reporting requirements, require recordkeeping, or mandate
disclosure requirements, which severely limited the SEC’s ability to make anti-fraud
regulations. 113 Furthermore, in the same year, the State of New York Insurance Department
decided that CDS agreements would not fall under their oversight despite having some
attributes that function like insurance. 114 The State of New York Insurance Department
determined pay-outs triggered by credit events do not depend on any sort of loss suffered
by the buyer, and therefore, CDSs would not be regulated by the Department. 115 These two
occurrences left CDSs highly unregulated and shifted derivatives from a small and
regulated market to a largely unregulated OTC market. 116 A decade later, the Dodd-Frank
Act completely overhauled the CFMA.

B. The International Swap Derivatives Association as Self-Regulators

Besides the Dodd-Frank Act, an additional body that attempts to regulate CDSs is the
International Swap and Derivatives Association (ISDA). However, the ISDA has a
different reason for targeting CDSs. The ISDA is one of the world’s biggest financial trade
associations and strives to reduce sources of risk in the private derivatives industry. 117 It
was founded in 1985 by 18 swap dealers and now has over 820 members from 57
countries. 118 After the CFMA was passed, the ISDA stepped up as a “private industry self-
regulator.” 119 The ISDA created standard contract forms, published definitions, created
supplemental documents, and more, publishing everything in several languages to facilitate
use around the world. 120 One of the most significant documents created by the ISDA—in
the aftermath of the deregulation of derivatives by the CFMA—was the ISDA Master
Agreement, which was released in 2002. 121 The ISDA Master Agreement is typically
signed by parties before they conduct a derivatives transaction. 122 The ISDA Master
Agreement specifies “the obligations and representations of each party, and the relevant
events of default and termination . . . [and] also define[s] the market conventions to be
followed in derivatives transactions.” 123 While the ISDA contributed to reforms at a time

109. Id.
110. Derivatives, supra note 104.
111. Id.
112. Id.
113. Id.
114. MILLER & CAFAGGI, supra note 30, at 45.
115. Id.
116. Id. at 46.
117. Id. at 40.
118. Id.
119. MILLER & CAFAGGI, supra note 30, at 41.
120. Id. at 41–42.
121. Id. at 42.
122. Id.
123. Id.
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when regulations on derivatives were being eliminated and still continues to produce useful
reforms and documents today, its reach is limited to its members and it has little
enforcement power. It was not until the Dodd-Frank Act was passed that all derivatives
were subjected to enforceable regulations once again.

C. Where the Dodd-Frank Act Went Wrong

By expanding the authority of the SEC and the CFTC, the Dodd-Frank Act limited its
authority as a statute and, in effect, deferred to these two agencies to do the heavy lifting
when it came to regulating CDSs and other derivatives. 124 In a way, this makes sense.
Agencies may be better informed and therefore more effective in rolling out regulations
responding to changes in the finance world. But this can also work disadvantageously if
the SEC and CFTC are unable to combat certain problems due to limitations in authority
and enforcement capabilities. The SEC and CFTC may have more authority to regulate
securities, but they do not have an unlimited amount of authority to address every
suspicious type of swap. Furthermore, the Dodd-Frank Act uses fines as its main method
of punishment, 125 essentially allowing the SEC to punish actors violating its regulations
with fines. 126 This may not be effective, since the cost of being fined can be factored into
financial transactions and the profit margin negotiated in financial transactions, minimizing
the deterrent effect that fines are supposed to have. 127 The Dodd-Frank Act expands the
authority of agencies like the SEC and the CFTC but does not give them enough power to
use the authority as effectively as they need to.
Furthermore, the separation of the types of financial instruments regulated by the SEC
and the types regulated by the CFTC can confuse swap market participants about which of
the two agencies’ regulations should be followed. For efficiency’s sake, it is important to
know which agency’s regulations need to be followed when setting up a swap. The SEC
and the CFTC have the discretion to tailor regulations to the types of swaps they regulate,
so regulations can and do differ. Furthermore, swaps sometimes do not fit neatly within
any of the definitions stated in the Dodd-Frank Act. 128 For instance, equity swaps and
equity index swaps are swaps regulated by the CFTC. 129 However, if an equity swap or an
equity index swap is security-based—for example, based on a single security or a narrow-
based index—then those types of equity swaps and equity index swaps should technically
be regulated by the SEC, not the CFTC. 130 This example shows how a swap can be set up
in various ways, and how it can easily fall into the jurisdiction of the SEC when it would
usually be regulated by the CFTC. Knowing which jurisdiction a swap falls under is
important so a swap dealer will know which agency’s regulations they must follow. This
confusion is not addressed in Dodd-Frank and is even compounded by the Dodd-Frank Act
through its separation of regulating duties between the SEC and CFTC depending on the
type of swap.

124. Larissa Roxanna Smith & Victor M. Muniz-Fraticelli, Strategic Shortcomings of the Dodd-Frank Act,
58 ANTITRUST BULL. 617, 626 (2013).
125. Id.
126. Id.
127. Id. at 627.
128. JONES DAY, supra note 87, at 50.
129. Id.
130. Id.
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2020 Supplementing Dodd-Frank 257

There are other significant setbacks in the Dodd-Frank Act. Notably, the Dodd-Frank
Act was passed as a response to past behavior by banks, financial institutions, and other
financial actors. 131 The Dodd-Frank Act does not consider or focus on future innovations
in the financial sector. 132 Financial markets are continuously changing and innovating. A
decade ago, the credit default swap was an innovative financial instrument whose
customizable nature made its use difficult to regulate. 133 Similarly, there are other
innovations potentially entering the industry despite new, more strict regulations the Dodd-
Frank Act implemented—for instance, narrowly tailored credit events, sometimes referred
to as manufactured credit events. The ISDA characterizes narrowly tailored credit events
as “arrangements with corporations that are narrowly tailored to trigger a credit event for
CDS contracts while minimizing the impact on the corporation.” 134 The ISDA amended
its 2014 Credit Derivatives Definitions to incorporate this definition of narrowly tailored
credit events. 135 Narrowly tailored credit events were created in 2013, after the Dodd-
Frank Act was passed, but they did not garner much attention until 2017 when Hovnanian
Enterprises used narrowly tailored credit events in its refinancing scheme and was sued by
a CDS seller for market manipulation. 136 The ISDA released its 2019 Narrowly Tailored
Credit Events Protocol, “NTCE Protocol,” on July 15, 2019. 137 The cut-off date for
adherence to the 2019 NTCE Protocol was moved from early October 2019 to Friday,
November 8, 2019. 138 The ISDA 2019 NTCE Protocol was implemented on January 27,
2020. 139
Narrowly tailored credit events trigger a credit event on credit default swap
agreements referencing a company (referred to as a reference entity), but they are narrow
so they will not impair the company’s debt. 140 A reference entity and a protection buyer—
that is the party paying premiums for protection—contract together and the protection
buyer will offer financing to the reference entity with incredibly favorable terms. 141 The
reference entity will then agree to default on debt payments, which will give the protection
buyer the opportunity to profit on CDSs it bought from third parties. 142 Profiting from a
CDS contract by using narrowly tailored credit events can saturate the market with CDS
contracts created to make a profit.
Even though narrowly tailored credit events have been used since 2013, the SEC and
the CFTC have been reluctant to begin regulating them. It has been nearly three years since
Hovnanian Enterprises was sued for market manipulation because of the way it

131. Smith & Muniz-Fraticelli, supra note 124, at 624.

132. Id.
133. O’Connor, supra note 25, at 576.
134. 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions,
INT’L SWAPS & DERIVATIVES ASS’N 3 (2019), https://www.isda.org/book/2019-narrowly-tailored-credit-event-
supplement-to-the-2014-isda-credit-derivatives-definitions/ [https://perma.cc/P74R-KENC].
135. Id.
136. Decision Time for the ISDA 2019 Narrowly Tailored Credit Events Protocol, JONES DAY (Sept. 2019),
https://www.jonesday.com/en/insights/2019/09/decision-time-for-the-isda [https://perma.cc/6C4A-DKH].
137. INT’L SWAPS & DERIVATIVES ASS’N, supra note 134.
138. Id.
139. Id.
140. JONES DAY, supra note 136.
141. Id.
142. Id.
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258 The Journal of Corporation Law [Vol. 46:1

incorporated narrowly tailored credit events in its CDS contracts. However, little light has
been shed concerning how narrowly tailored credit events should be regulated. During the
summer of 2019, the chairman of the SEC, the chairman of the FCTC, and the chief director
of the U.K. Financial Conduct Authority issued a Joint Statement on Opportunistic
Strategies in the Credit Derivatives Market in an attempt to recognize the severity of
manipulation possible by incorporating a narrowly tailored credit event:
outline[s] mutual concerns about the pursuit of these [opportunistic] strategies
and the adverse impact they may have on the integrity, confidence and reputation
of the credit derivatives market, as well as markets more generally. These
opportunistic strategies include, but are not limited to, what have been referred
to as ‘manufactured credit events’ or ‘narrowly tailored credit events’. 143
An updated version of the Joint Statement acknowledged the ISDA 2019 Narrowly
Tailored Credit Events Protocols, even giving a nod of approval, saying “[w]e welcome
these efforts.” 144 However, in the Joint Statement, the SEC and CFTC were quick to say
the ISDA Protocols were not comprehensive and did not address everything of concern. 145
The SEC and CFTC have yet to propose any regulations to address narrowly tailored credit
events. 146 The lack of action by the SEC and the CFTC regarding the regulation of
narrowly tailored credit events exemplifies the failure of the Dodd-Frank Act to account
for future innovations in the financial sector.
By delegating most of its power to agencies, such as the SEC and the CFTC, the Dodd-
Frank Act weakened its authority to regulate the derivatives market. It also introduced
ambiguities in determining which agencies regulate certain types of financial instruments,
such as swaps. One of the biggest setbacks of the Dodd-Frank Act is that it did not account
for mechanisms used to regulate future innovations in the financial markets to promote
fraud. Additions to the Dodd-Frank Act or even entirely new legislation is needed in order
to more thoroughly regulate derivatives and other financial instruments.

IV. RECOMMENDATION

A. Limits on Funding Sources for Protection Sellers

One way CDSs can be regulated is to target their sources of funding. Restrictions on
the number of loans a protection seller can take out to pay off a CDS contract in the event
of a negative credit event may deter protection sellers from entering into overly speculative
CDS contracts. If a negative credit event were to occur, then restrictions on loans could
make it more difficult for a protection seller to raise the funds to cover the amount of the
pay-out. As a result, only protection sellers with large amounts of cash on hand would be

143. Jay Clayton et al., Update to June 2019 Joint Statement on Opportunistic Strategies in the Credit
Derivatives Market, SEC (Sept. 19, 2019), https://www.sec.gov/news/public-statement/update-june-2019-joint-
statement-opportunistic-strategies-credit-derivatives [https://perma.cc/56CM-AWE6].
144. Id.
145. “However, by itself, the proposed ISDA protocol will not address many of the concerns identified in
the Joint Statement, such as opportunistic strategies that do not involve narrowly tailored credit events. We look
forward to further industry efforts to improve the functioning of the credit derivative markets and welcome
continuing engagement with market participants.” Id.
146. Id.
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2020 Supplementing Dodd-Frank 259

able to enter into a CDS contract involving a large pay-out. This would decrease the number
of protection sellers in the market as well. Many protection sellers will be unable to enter
into several CDS agreements if they are unable to easily secure funding.
Protection sellers also may be unwilling or unable to enter into CDS agreements
dealing with large amounts of money if they are only able to rely on their own finances for
funding. This could be positive or negative depending on the details of the agreement. Not
being able to enter into CDS agreements involving large amounts of money has the
potential to deter manipulation in the CDS market, since large payouts will not be possible.
On a negative note, it could potentially add an obstacle to protection buyers looking for
protection sellers to enter into an agreement regarding a large transaction that would have
a large payout (unless the protection seller has a large amount of cash on hand or the credit
event does not occur and thus a pay-out is not triggered). However, such an obstacle can
also deter risky borrowing or speculative investing through CDS agreements.
It may be difficult to track whether banks are giving loans for the purpose of a
protection seller paying out a CDS contract, especially if the loans are taken out from one
institution and the CDS contract is handled by another. One way to address this would be
to extend authority to clearinghouses to investigate the funding sources for CDS pay-outs.
For example, the extended authority of clearinghouses might allow them to require
financial disclosures from protection sellers, who are required to pay out a certain number
of days after the credit event occurred or require financial disclosures from all protection
sellers (regardless of whether the credit event in their CDS agreements have occurred or
not).
Limiting funding sources for protection sellers may saturate the market with
protection sellers with deep pockets. This could lead to a positive or a negative outcome.
Clearinghouses offset risk by requiring collateral from parties entering into a CDS
agreement. 147 Clearinghouses also act as a stand-in to mitigate losses to the protection
buyer in case a protection seller is unable to pay out the entire amount agreed to. 148 A
restriction on sources of funding for protection sellers may put clearinghouses in the
precarious position of stepping in if a protection seller cannot pay out the full amount more
often than this occurs now. However, restricting sources of funding may prompt protection
sellers to self-regulate and only enter into CDS agreements they can actually afford in the
event of a pay-out being triggered. This would decrease the likelihood of a clearinghouse
having to step in if a protection seller cannot afford the pay-out.

B. Increasing Regulation of Clearinghouses and Expansion of Authority

Another way that CDSs can be better regulated is through the increased regulation of
clearinghouses. Since every CDS must be cleared through a clearinghouse, 149
clearinghouses are already in a position to help protect against increasingly speculative
CDSs or manipulated credit events that are embedded in CDS contracts. By “requiring each
[party] to post appropriate collateral, a well-capitalized clearinghouse prevents

147. Squam Lake Working Grp. on Fin. Regul., Credit Default Swaps, Clearinghouses, and Exchanges 3–4
(Council on Foreign Rels., Working Paper 2009), https://www.cfr.org/report/credit-default-swaps-
clearinghouses-and-exchanges [https://perma.cc/L6UB-UGDN].
148. Id.
149. O’Connor, supra note 25, at 583.
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260 The Journal of Corporation Law [Vol. 46:1

counterparty defaults from propagating into the financial system.” 150 Requiring collateral
is only a precaution, however, not a fool-proof method to ensure each pay-out is adequately
financed and fulfilled. “Clearinghouses, however, are not panaceas. In the fight for market
share, they may compete by lowering their operating standards, demanding less collateral
from their customers, and requiring less capital from their members.” 151 Clearinghouses
need to be regulated and should have standardized requirements in terms of required
collateral and membership capital. Clearinghouses should not be able to “compete” for
members or try to get “business.” Clearinghouses have evolved as a new type of
powerhouse and are emerging as “a new group of institutions that are too big to fail.” 152
Clearinghouses are made up of members who provide capital. This capital, in turn, is used
to fund defaulted payouts. The risk is essentially spread across all of the members, which
means if one party defaults, its repercussions are felt by other members. 153 Furthermore,
most clearinghouses are for-profit, 154 so an increased volume of transactions yields
increased profits. Losses are spread among members. 155 The goal of increasing profits
typically drives a decrease in standards, 156 such as a reduced amount of collateral or capital
required from members. To control this business, clearinghouses are requiring standardized
methods to determine how much capital to collect from members and a standardized
formula to calculate the amount of collateral a party needs to put up. For example, this
could be a percentage of the amount of the pay-out, while the capital requirement from
members could be based on a percentage of the party’s revenue.
Since clearinghouses are emerging as the next “too big to fail” entities, what
precautions can be taken in the event clearinghouses do actually fail? If a clearinghouse
fails, then numerous CDS agreements would be without protection or regulation. 157
Protection buyers will lose the guarantee of receiving their pay-outs via the clearinghouse
if the protection seller is unable to pay. Members looking to enter into new CDS agreements
will be without a clearing method and may have to scramble to become members of other
clearinghouses. The worst-case scenario is CDS agreements becoming a free-for-all,
returning to the essentially unregulated status they had before the Financial Crisis.
Unfortunately, the Dodd-Frank Act only has precautions to help clearinghouses if they are
failing and is silent on what steps to take if clearinghouses have already failed. 158 The Act
gives regulators authority to categorize clearinghouses as “systematically important,”
which subjects clearinghouses to more oversight. 159 The Dodd-Frank Act also allows the
Federal Reserve to give emergency funding to clearinghouses from the Federal Reserve’s
discount window. 160 The precautions in the Dodd-Frank Act regarding failing

150. Squam Lake Working Grp. on Fin. Regul., supra note 147, at 3–4.
151. Id.
152. Flight to Safety: Have Regulators Created a New Type of Financial Monster?, 431 ECONOMIST 63, 64
(2019).
153. Id.
154. Id.
155. Id.
156. Id.
157. David Skeel, What if a Clearinghouse Fails?, BROOKINGS (June 6, 2017), https://www.brookings.edu/
research/what-if-a-clearinghouse-fails/ [https://perma.cc/Q4GP-QAEM].
158. Id.
159. Id.
160. Id.
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clearinghouses pretty much end there. As of now, if clearinghouses not designated as

“systematically important” fail, they would be at the mercy of bankruptcy proceedings as
the only method of recovery available after failure. 161
Title II of the Dodd-Frank Act, the Orderly Liquidation Authority, authorizes
regulators to take control of troubled financial institutions whose failure could have
widespread ramifications potentially affecting the financial system. 162 However, it is
unclear whether clearinghouses would qualify as such a financial institution, and
clearinghouses are not specifically mentioned. To be covered under Title II, financial
institutions must be “predominantly engaged in activities that are financial in nature.” 163
However, the Federal Deposit Insurance Corporation (FDIC) does not include clearing
activities in any definition of “activities that are financial in nature.” 164 Clearinghouses are
clearly engaged in financial activities and their failure would have widespread
consequences affecting several areas of the financial system, so it would make sense for
them to be counted among the financial institutions covered under Title II. However,
ambiguous definitions in the Dodd-Frank Act leave uncertain whether clearinghouses
would be eligible to be taken over by regulators in case of failure. Amending Title II to
explicitly include clearinghouses would fix this problem; however, Title II would still only
apply to clearinghouses deemed systematically important. Title II also gives the FDIC the
power to take control of these financial institutions at risk of failing. 165 The SEC and the
CFTC would likely be better equipped to regulate clearinghouses, 166 rather than the FDIC,
so this would also need to be amended in the Dodd-Frank Act. Clearinghouses are essential
to the increased regulation of CDSs, so it is important to make sure they are well-regulated
and that precautions are taken to make sure there are protocols in place in case
clearinghouses fail.
To regulate CDSs, it is important to limit the regulation of the substance of a CDS
agreement. Limiting the terms of a CDS agreement would defeat the benefit of a CDS: its
ability to be customized. Instead, increased regulation of facets which can affect a CDS,
like funding sources for protection sellers, can act as a deterrent against speculative CDSs.
Furthermore, increased standardization of clearinghouses can mitigate the incentive of
making large profits, leading to decreased requirements from members. Expanding the
authority of clearinghouses—for example, allowing clearinghouses to require more
financial disclosures from members and impose stricter collateral requirements—can also
discourage members who are likely to default in their pay-out payments from entering into
CDS agreements in the first place. This would save the clearinghouse from having to step
in and fund the pay-out.

161. Id.
162. Skeel, supra note 157.
163. Id.
164. Id.
165. Id.
166. Id.
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262 The Journal of Corporation Law [Vol. 46:1

V. CONCLUSION: CDSS NEED MORE REGULATION BUT NOT AT THE COST OF

CUSTOMIZATION

The Dodd-Frank Act left a lot to be desired in terms of regulating CDSs. While the
Dodd-Frank Act did introduce sweeping regulations, it did not anticipate new
developments related to CDSs, such as narrowly tailored credit events. Mandating the use
of clearinghouses in CDS transactions was a major feat of the Dodd-Frank Act; however,
clearinghouses must be more standardized to make them efficient in reducing risk and
speculation. Today, clearinghouses are allowed discretion in determining requirements for
membership and required disclosures in CDS agreements between members. This gives
clearinghouses the power to, in effect, allow a potential “bad deal” to occur. A
clearinghouse does not mind doing this because the risk is spread to all of its members.
Increased standardization in these practices will take away the power of discretion from
clearinghouses. Furthermore, since clearinghouses play a large role in CDS transactions,
they should be afforded more authority to work to protect against risky speculation.
Increased standardization of clearinghouses will clear the path to giving them more
authority without having to worry about consolidation of too much power.
Another way to regulate CDS agreements without sacrificing their customizability is
to limit the amount of funding or loans that a protection seller can take out to use to fund a
default payment in the event of a negative credit event. This will help ensure that protection
sellers only take on CDS contracts that they can fund themselves, with their own financial
resources, in the event of a payout. It is important to preserve the customizable nature of
the Credit Default Swap because their ability to be customized is what makes them
desirable. Implementing increased restrictions on funding sources and loans to supplement
Dodd-Frank regulations will continue to preserve customizable Credit Default Swaps while
providing prudent oversight to protect the industry from another collapse.
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