NOTE CONTENTS INTRODUCTION I. THE EFFECTS OF INCONSISTENT SWAPS REGULATION A. The 2008 Recession and Tide VII of Dodd-Frank B. Inconsistencies in Rules Governing Swap Reporting C. Inconsistencies in Rules Governing SEFs D. Failure To Consider the Costs of Inconsistent Swaps Regulations II. REGULATORY HARMONIZATION THROUGH COST-BENEFIT MANDATES AND THE APA A. APA Requirements B. Cost-Benefit Mandates III. HOW JUDICIAL REVIEW CAN FOSTER INTERAGENCY COLLABORATION A. Interagency Collaboration B. Why Judges? C. Models for SEC and CFTC Swap Harmonization CONCLUSION INTRODUCTION
In early April 2012, just two years after Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), (1) a sense of deja vu paralyzed financial markets. On April 6, the press reported that J.P. Morgan had suffered significant losses because of trades executed in its London office. (2) A week later, CEO Jamie Dimon dismissed these reports as a mere "tempest in a teapot." (3) But the loss turned out to be more than that. One month later, J.P. Morgan disclosed that its losses had ballooned from $415 million to $2 billion. (4) By the end of the year, transactions executed by a single J.P. Morgan trader named Bruno Iksill--more commonly known as the "London Whale"--led to a $6.2 billion trading loss. (5) In other words, barely two years after the most consequential financial regulatory reform in decades, a major financial institution took risky bets that once again roiled global credit markets. And--even more troubling--it did so right under the nose of its regulators.
A year-long Senate investigation followed. The investigation concluded that the American financial system would be less vulnerable to systemic shocks if federal regulators required more comprehensive financial reporting, (6) used more accurate risk models, (7) and finalized rules prohibiting banks from using money held in federally insured deposit accounts to make speculative investments that did not benefit their customers. (8)
The usefulness of the Senate Report, however, was undermined by the fact that existing regulations rendered many of its recommendations superfluous. Dodd-Frank already required that data on swaps, (9) the financial instruments traded by the London Whale, (10) be reported on publicly accessible exchanges. (11) The Commodity Futures Trading Commission (CFTC), one of the agencies charged with monitoring swaps and detecting destabilizing financial positions, had finalized swap-reporting rules in March 2012. Those rules went into effect at the beginning of 2013. (12)
Nor did the Report mention that banks had already begun to report swap data in anticipation of the CFTC's rules. In the aftermath of the London Whale incident, Michael Bodson, the chief executive of a company that collected swap data, acknowledged that data on the London Whale's trades had been reported to swap data repositories. (13) The problem was that although CFTC rules specify what data must be reported, the rules do not explain how data repositories should report information. (14) According to Bodson, regulators failed to detect the London Whale's position not because the data was unavailable, but because formatting incompatibilities rendered it unusable. (15)
Significantly, however, Title VII of Dodd-Frank does not grant regulatory authority over swaps solely to the CFTC, but divides oversight between the Securities and Exchange Commission (SEC) and the CFTC. (16) Title VII grants the SEC the authority to regulate security-based swaps and the CFTC the authority to regulate all other swaps. (17) In accordance with its own statutory mandate, the SEC issued its final rule on the reporting and public dissemination of security-based swap information over three years after the CFTC's rules went into effect. (18) Dodd-Frank split oversight between the two agencies in order to avoid alienating members of Congress who served on the agricultural committees, (19) who had made it clear that they would vote against any bill that removed the CFTC from their jurisdiction. (20)
In abandoning regulatory consolidation, Title VII permitted the SEC and CFTC to create a fragmented reporting regime that has raised the costs of complying with Dodd-Frank while making it more difficult for regulators to supervise the swaps market. There is no question that the SEC and CFTC are each statutorily required to issue swaps regulations. (21) Nonetheless, the effectiveness of the SEC's and CFTC's rules depends in large part on whether their rules are compatible. (22) This Note analyzes recent D.C. Circuit cost-benefit cases in order to argue that the Administrative Procedure Act (APA) and the cost-benefit mandates in the agencies' organic statutes, both individually and in tandem, require that the SEC and CFTC either justify the costs of regulatory inconsistencies or harmonize their regulations. Thus, in addition to offering a possible solution to the SEC's and CFTC's unwillingness to promulgate consistent swaps rules, this Note offers a new, albeit limited, defense of cost-benefit analysis. Recently, a number of academics have criticized "judicially reviewed, quantified" (23) cost-benefit requirements as an exercise in futility and a judicially sanctioned attempt to quantify the unquantifiable. (24) By forcing agencies to harmonize their rules when they cannot offer a reasonable justification for an inconsistency, I show that cost-benefit requirements can discipline agency action in cases involving overlapping agency jurisdiction.
This Note proceeds in three parts. Part I provides a brief overview of Dodd-Frank and examines existing rules governing swap reporting and swap execution facilities (SEFs). This Part shows that the SEC's and CFTC's failure to collaborate has created unnecessary costs, made the American financial system less transparent, and introduced unjustified risk into the market. Part II analyzes the cost-benefit and APA requirements that govern SEC and CFTC rulemakings. I argue that the two agencies are legally required to consider how their swaps regulations interact. Although practitioners and scholars have argued that it is desirable for the two agencies to collaborate, (25) almost no one has suggested that collaboration is legally required. (26) Part III describes my model of judicial review and considers how the SEC and CFTC might respond if this model were put into practice. (27) In addition, Part III examines cases in which other agencies have collaborated voluntarily and argues that the form of judicial oversight I endorse would grant the SEC and CFTC broad discretion to choose the most effective method of harmonizing their rules.
My argument applies not only to swaps, but also to other areas in which the APA and cost-benefit requirements could reduce some of the inefficiencies that occur when Congress requires agencies to administer regulatory initiatives jointly. New regulations are not written on a blank slate; they interact with a complicated and dynamic administrative apparatus. Agencies must therefore consider how their rules will interact and whether these interactions undermine the effectiveness of new rules.
THE EFFECTS OF INCONSISTENT SWAPS REGULATION
Congress enacted Dodd-Frank in the wake of the 2008 recession to reduce risk in U.S. financial markets. In this part, I explain how Title VII of Dodd-Frank seeks to accomplish this goal. I then identify two elements of Dodd-Frank--swap-reporting rules and SEF rules--in which inconsistencies between the SEC's rules and the CFTC's rules impose unnecessary costs without providing any identifiable benefit. I further argue that these conflicting rules ultimately compromise Dodd-Frank's goal of controlling systemic risk.
The 2008 Recession and Title VII of Dodd-Frank
The Great Recession of 2008 is widely considered to be the worst economic crisis since the Great Depression. (28) Despite aggressive and unprecedented efforts by the Department of Treasury and the Federal Reserve, unemployment rose to ten percent--a thirty-year high (29)--and housing prices fell thirty-three percent, (30) costing Americans $16.4 trillion in household wealth. (31)
Although the causes of the financial crisis continue to be debated, (32) it is clear that swaps--in particular, credit default swaps--played a critical role in allowing individual companies to accrue risk sufficient to cause the global economy to collapse. (33) Credit default swaps are akin to insurance on bonds. When a bank buys a bond, say from General Electric (GE), the bank expects to receive a steady stream of payments from GE over the life of the bond. However, if GE were to go bankrupt, the bank would stop receiving those payments. To hedge against that possibility, the bank might buy a credit default swap from another company. The credit default swap would require the bank to pay a premium at regular intervals. In exchange, the company that sold the credit default swap would agree to pay a large sum if the entity that borrowed funds from the bank cannot afford to pay the interest on its bond. As long as GE can afford to pay its interest payments, the bank loses its premium payments. But if GE were to go bankrupt, then the bank would receive money from the party that sold the bank the credit default swap. In this way, credit default swaps allow companies to insure against the possibility that a counterparty will not be able to honor its obligations.
At the end of 2007, the credit default swaps market was worth $60 trillion. (34) Companies used credit default swaps to protect against nearly every possible contingency, from changes in bonds and stocks to fluctuations in interest rates and housing prices. (35) The portfolio of one credit default swap seller, AIG, covered bonds worth more than $440 billion. (36) AIG did not have sufficient funds to honor all of its obligations. As a result, Moody's Investor Service, a credit rating agency, downgraded...