ECONOMIC REPORT OF THE PRESIDENT

Prior to the financial crisis, one category of derivatives, swaps, was not
standardized and was traded over-the-counter.18 The trading volume and
outstanding notional value of these swaps, particularly the type known as a
credit default swap, grew rapidly prior to the financial crisis and formed a
complex network of exposures among large financial institutions.19 , 20 Only
the two parties to the transaction were typically aware that the transaction
had occurred, resulting in an opaque market in which there was little
transparency around either prices or exposures. The lack of transparency
in exposures could result in a concentration of risk in particular financial
institutions as occurred with AIG just prior to the financial crisis. As Figure
6-20 shows the rapid growth in several types of OTC derivatives in the years
leading up to the financial crisis.21
The Dodd-Frank Act took a number of steps to reform the OTC
market in derivatives, including the reporting of all swap trades to a trade
repository, the public reporting of certain trade information, the posting of
margin against possible losses resulting from counterparty default, the mandatory
clearing of standardized swap contracts through registered central
counterparties, trading on exchange-like trading facilities, and registration
and regulation of swap dealers and certain large market participants. These
steps were intended, among other purposes, to reduce the opaque nature
of the derivatives market, to improve price transparency and to reduce
systemic risk.
Under Dodd-Frank, swap and security-based swap dealers and major
swap and security-based swap participants are required to register with and
be subject to supervision by the CFTC and SEC. As of November 2016,
more than 100 swap dealers were provisionally registered with the CFTC.
The SEC estimates that as many as 50 security-based swap dealers, many of
18 A swap is an agreement between two parties to exchange sequences of cash flows for a set
period of time. Types of swaps include interest rate, foreign exchange, and credit default. For
example, in an interest rate swap one party pays a fixed amount and the counterparty pays an
amount determined by a variable interest rate such as LIBOR.
19 A credit default swap (CDS) is a particular type of swap designed to transfer the credit
exposure of a fixed income security from the buyer to the seller. The CDS buyer makes
periodic payments to the seller, who, in the event of default, pays the buyer the difference
between the face value and the defaulted value of the security. CDS are often used by buyers
to hedge the credit risk of bond positions and by sellers to create positions that are similar to
holding the underlying bond. Dodd-Frank reforms have ensured that most such transactions
are required to have collateral posted to insure performance of the contract.
20 The notional value of a swap contract is the nominal or face value and is used to calculate
payments made on the instrument. With respect to CDS, the notional value represents the face
value of the debt security whose credit risk is transferred from buyer to seller of the CDS.
21 It is important to look at global trading activity for several reasons. These include the fact
that a sizeable fraction of these transactions are between parties in different jurisdictions and
many participants in these transactions, particularly dealers, have a global presence and the
jurisdiction in which they book the transaction is often a matter of choice.
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