Derivatives After Dodd-Frank

On June 28, 2011, in derivatives, Dodd-Frank, by Jon Lewis

The New Financial Deal: Understanding The Dodd-Frank Act and Its (Unintended) Consequences. David Skeel. John Wiley & Sons, Inc. 2011, pp. 220, $34.95 For those individuals who work in financial services, understanding the basic provisions of Dodd-Frank is a necessity. Love it or hate it, no other legislation passed in recent years will have such [...]

The New Financial Deal: Understanding The Dodd-Frank Act and Its (Unintended) Consequences. David Skeel. John Wiley & Sons, Inc. 2011, pp. 220, $34.95

For those individuals who work in financial services, understanding the basic provisions of Dodd-Frank is a necessity. Love it or hate it, no other legislation passed in recent years will have such an indelible impact on the regulation of America’s financial services industry. In The New Financial Deal, David Skeel provides both an overview and a critique of the Dodd-Frank Act and suggests ways in which the legislation could be improved. Skeel, a professor at the University of Pennsylvania Law School with an academic expertise in bankruptcy law, argues that two themes emerge from Dodd-Frank; namely, a corporatist European-style, partnership between the federal government and America’s largest, too-big-to-fail financial institutions and “a system of ad hoc interventions by regulators that are divorced from basic rule-of-law constraints.” Among Skeel’s worries is his assessment that the legislation “invites the government to channel political policy through the big financial institutions by giving regulators sweeping discretion in the enforcement of nearly every aspect of the legislation.” Indeed, government regulators will play an increasingly important role in the financial services industry in the years ahead.


Skeel argues that Dodd-Frank was falsely premised on what he calls “the Lehman myth,” the notion that Lehman Brothers’ bankruptcy caused the financial crisis and that, because of this, regulators needed more tools at their disposal to intervene when a large financial institution fell into distress. Through a judicious use of charts (including one indicating the LIBOR-OIS spread reaction to the Fall 2008 crisis) and persuasive argumentation, he aptly demonstrates that Lehman’s bankruptcy did not precipitate the worst of the financial crisis of 2008. Most significantly, however, is his discussion of the conditions under which Lehman filed for bankruptcy. Skeel contends that, because CEO Richard Fuld and Lehman expected a government bailout, they did not prepare for bankruptcy proceedings. “Given the expectation of a bailout, Fuld and Lehman had little reason to start making plans for an orderly bankruptcy, as they might be expected to do if they viewed bankruptcy as a plausible option.” Skeel is generally correct that Lehman may have misperceived that it would be a recipient of a bailout. Nevertheless, Lehman’s leadership – well paid executives, all – clearly dropped the ball. His argument that, despite the dire circumstances, Lehman’s bankruptcy process has been a general success needs to be counterbalanced by the fact that Harvey R. Miller, the lead bankruptcy attorney for Lehman, wrote the book’s foreword. Miller writes that Skeel’s work “is mandatory reading for all those interested in the financial markets and the global economy.” A reader will have to make up his own mind as to whether Skeel’s analysis of Lehman’s bankruptcy process could have been more objective.


While very critical of the corporatist aspect of Dodd-Frank, Skeel is not unthinkingly critical. He acknowledges that Dodd-Frank has positive attributes. One is in its treatment of derivatives, what he succinctly defines as “simply a contract between two parties whose value is based on changes in an interest rate, a currency, or almost anything else, or the occurrence of a specified event.” Dodd-Frank institutes a framework wherein swaps are to be cleared and traded on an exchange. According to Skeel, the most important innovation in Dodd-Frank with regard to derivatives regulation is the “new clearing requirement that gives the CFTC and SEC the power to require that any category of swaps be cleared.” This means that a third party clearinghouse will “stand behind both parties, guaranteeing each party’s performance to the other.”


For those interested in how best to regulate financial institutions, Skeel’s discussion of how a clearinghouse could itself become a source of systemic risk merits particular attention. Because a clearinghouse failure would be catastrophic, Dodd-Frank gives the Federal Reserve the power to lend to clearinghouses, making the largest clearinghouses entities that they themselves are too-big-to-fail. This raises a significant question that policymakers will need to wrestle with in the years ahead; namely, should the United States allow financial institutions – be they bank holding companies, insurance companies, or clearinghouses – to become so big that their failure poses systemic risk to the national economy? Although Dodd-Frank emphatically does not break up the largest financial institutions into smaller components, a future clearinghouse failure, in which taxpayers would be on the hook for billions or trillions, could reopen a debate on this subject that Dodd-Frank seems to have legislatively settled – for now.


Skeel, who has written a history of American bankruptcy law, not surprisingly, is biased in favor of the bankruptcy process as an alternative to the Dodd-Frank resolution regime. Premising his argument on the notion that Dodd-Frank is here to stay and is unlikely to be legislatively repealed, Skeel makes the case for removing the protections that derivatives and other financial innovations are given in bankruptcy proceedings, wherein they are protected from the automatic stay. He contends that “the special treatment of derivatives is a mistake” and that “[t]reating derivatives the same way as other contracts would give the managers of troubled financial institutions much greater incentives to make adequate preparation for insolvency proceedings, and to use bankruptcy rather than the Dodd-Frank resolution regime.” This proposal, which has been opposed by the International Swaps and Derivatives Association, if implemented, would diminish “the bias towards derivatives-based and repo financing.” It would also be a boon for the bankruptcy bar, particularly those attorneys who would then be able to bill hours for their efforts in winding down failing financial institutions through the court system.


In conclusion, The New Financial Deal is worth reading and ample consideration. Students and those interested in bankruptcy law would particularly benefit from reading Skeel’s work. The greatest weakness of the work is that, at times, the author seems too close to the events of 2008-2009 to be impartial to the personalities who were involved in both implementing the bailouts and drafting Dodd-Frank. His reference to Paulson, Geithner, and Bernanke as “[t]he three musketeers of the financial crisis” seems gratuitous. That said, Skeel has written an engaging study of Dodd-Frank and of the likely future of financial services regulation in the United States.

Jon Lewis (c) 2011

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