Investing and Pretending

• Author: Anita K. Krug
• Position: Associate Dean for Research and Faculty Development and Associate Professor, University of Washington School of Law
• Pages: 1559-1618

1559

Investing and Pretending

Anita K. Krug

ABSTRACT: One of the more prominent components of Dodd–Frank’s

regulatory changes was Title VII, providing for the regulation of the over-the-

counter derivatives known as “swaps.” A swap is a financial instrument

whose value is based on an asset—the “reference asset”—that is wholly

unrelated to the swap itself. Although there was much ado about swap

regulation immediately after Dodd–Frank’s enactment, the same cannot be

said of the many rules that the Commodity Futures Trading Commission

(“CFTC”) has subsequently adopted pursuant to its authority under Title

VII.

This Article critically evaluates the CFTC’s “swap rules” and identifies the

regulatory vision that they reflect. Based on that evaluation, it argues that

the swap rules are grounded in a notable distinction between swaps and

another financial market instrument—namely, securities. In particular,

whereas “investing” is the hallmark of securities transactions, swap

transactions fall under the rubric of “pretending,” a concept that this Article

employs to elucidate the function and structure of swaps. Each party to a swap

pretends that it holds either a long position or a short position in the reference

asset, making payments to (or receiving payments from) the other party based

on the performance of that position.

Although the distinction between investing and pretending is vividly reflected

in the CFTC’s approach to crafting the swap rules, this Article contends that

the distinction is irrelevant for regulatory purposes. Moreover, the substantial

regulatory costs arising from the CFTC’s pretense-based approach to swap

regulation are likely to excessively hinder swap use, as firms seeking to

mitigate risk turn to other types of hedging strategies in situations in which

using swaps might otherwise be more socially beneficial. With the goal of

efficient and coherent regulation in mind, this Article proposes that a

substantially better approach to the CFTC’s swap rules would be to predicate

them not on pretending, as the counterpoint to investing but, rather, on

 Associate Dean for Research and Faculty Development and Associate Professor,

University of Washington School of Law. The author thanks participants at the 2014 National

Business Law Scholars Conference and the 2014 Annual Meetings of the Midwest Law and

Economics Association and the Canadian Law and Economics Association for helpful comments

on presentations and earlier drafts of this Article.

1560 IOWA LAW REVIEW [Vol. 100:1559

something that swap transactions and securities transactions have in

common—and on which securities regulation, too, is based: the risks arising

from speculation.

I. INTRODUCTION ........................................................................... 1560

II. THE DERIVATIVES KNOWN AS SWAPS ........................................... 1566

A. SWAPS ................................................................................... 1568

1. Their Nature ................................................................ 1568

2. Their Purpose .............................................................. 1571

B. SWAPS AND THE FINANCIAL CRISIS ......................................... 1573

C. CHALLENGE TO REGULATION ................................................. 1577

D. TITLE VII OF DODD–FRANK ................................................... 1581

III. THE SWAP RULES ........................................................................ 1587

A. THE SWAP DEALER RULES ..................................................... 1588

B. THE CROSS-BORDER RULES .................................................... 1596

1. Regulatory Approach .................................................. 1597

2. U.S. Person Definition ................................................ 1599

3. Extraterritorial Application ........................................ 1602

IV. RETHINKING SWAP REGULATION’S FOUNDATIONS ..................... 1605

A. PRETENDING V. INVESTING ..................................................... 1605

B. SPECULATION ........................................................................ 1610

V. CONCLUSION .............................................................................. 1617

I. INTRODUCTION

Although it may seem as though the financial crisis was only yesterday, it

began almost seven years ago, and Congress finalized the statute intended to

prevent its recurrence, the Dodd–Frank Act of 2010 (“Dodd–Frank”),1 more

than four years ago. Since that time, those most affected by the financial crisis

have made substantial strides to rebuild and move on (though, to be sure, for

those most severely affected, progress has often been painfully slow). Of

course, a substantial subset of those emerging from the crisis—namely, those

comprising that vaguely defined group known as “Wall Street”—have also had

to face adjusting to the new regulatory world that Dodd–Frank created. Still,

commentary and debates about the new regulation and its proper focus and

tools have largely faded, as firms have accepted and settled into their new

obligations.

1. Dodd–Frank Wall Street Reform and Consumer Protection (Dodd–Frank) Act, Pub. L.

No. 111-203, 124 Stat. 1376 (2010) (codified as amended in scattered sections of 7, 12, 15 U.S.C.).

2015] INVESTING AND PRETENDING 1561

Or so it might seem. Despite the apparent return to calm and the

emergence of other events to draw our attention—new securities statutes such

as the Jumpstart Our Business Startups (“JOBS”) Act2 and controversial

Supreme Court decisions, such as those in the McCutcheon3 and Hobby Lobby4

cases—much remains unsettled and problematic regarding one of the most

critical components of Dodd–Frank. That component is Title VII of the

statute, which sets forth a comprehensive and entirely new regulatory regime

governing swaps.

“Swaps” are a type of derivative financial instrument, meaning that their

value is derived from the value (including the expected future value) of some

other financial instrument.5 They are just one of several types of instruments

falling within the derivative category. Others are options and warrants, the

value of which is derived from the value of particular securities, and futures

contracts, whose values are derived from the value of particular commodities

or securities.6 Swaps, moreover, are a derivative of the “over-the-counter,” or

“OTC,” variety, meaning that, at least traditionally, parties enter into them

privately, outside of any formal exchange mechanism.

Swaps were the anointed culprits behind much of the financial crisis’s

worst assaults on asset values. Recall AIG’s near-bankruptcy, the product of

the firm’s extensive transactions in a certain type of swap—namely, “credit

default” swaps.7 AIG, moreover, was not alone. Many financial institutions

served as willing counterparties for credit default swaps at the time, given the

robust demand for them—but then defaulted on them (or risked defaulting

on them) as the housing bubble burst, thereby feeding the systemic contagion

that produced the crisis. Still, the rationale for financial and commercial

firms’ extensive swap participation was clear: They sought to hedge risks, such

as the risk of default on mortgage-related or other liabilities,8 and viewed

using swaps as a cost-effective way to do that.9 Swap transactions, after all, were

not regulated.10 In 1999 Congress effectively forbade both the Securities and

2. Jumpstart Our Business Startups (JOBS) Act, Pub. L. No. 112-106, 126 Stat. 306 (2012)

(codified as amended in scattered sections of 15 U.S.C.).

3. McCutcheon v. Fed. Election Comm’n, 134 S. Ct. 1434 (2014).

4. Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014).

5. See infra note 36 and accompanying text (defining “derivative”).

6. See infra notes 33–42 and accompanying text (describing different types of derivatives).

7. See infra notes 78–91 and accompanying text (describing AIG’s activities in the swap markets).

8. See Kimberly D. Krawiec, Derivatives, Corporate Hedging, and Shareholder Wealth: Modigliani–

Miller Forty Years Later, 1998 U. ILL. L. REV. 1039, 1040 (“Corporate America considers risk

management vitally important and considers derivative financial products an indispensable tool

for managing many types of financial risk regularly faced by today’s corporations.”).

9. See Complaint at 49, Sec. Indus. & Fin. Mkts. Ass’n v. U.S. Commodity Futures Trading

Comm’n, No. 13-CV-1916 (D.D.C. Dec. 4, 2013) (noting that swaps have been a “cost-efficient[]”

hedging tool).

10. See infra notes 126–31 and accompanying text (discussing swaps’ historically

unregulated status).