Regulation Through Substitution as Policy Tool: Swap Futurization Under Dodd-Frank

Abstract

Recently, significant market and regulatory attention has focused on a new trend known as “futurization”—the recasting of economic arrangements previously transacted as swaps to trade as futures. This trend results from new regulations governing swap markets under the Dodd-Frank Act, which increase the cost of transacting in swaps. Given the magnitude of the business and economic interests at stake—the swap market is estimated at $633 trillion and the futures market is estimated to be $24 trillion—the futurization trend has significant implications for the success of the Dodd-Frank Act’s swap market reforms and can provide important insights to the Commodity Futures Trading Commission (“CFTC”) and other regulatory agencies as they seek to protect financial markets in the post-financial crisis environment. This Article is the first to provide an academic treatment of this trend and its implications for regulatory policymaking. We develop a simple economic model to explain how regulators can “regulate through substitution” by encouraging market participants to subject themselves to one regulatory regime versus another through the imposition of differential regulatory costs. By applying this model to three critical areas of CFTC swap rulemaking—margin requirements, protection of customer collateral, and public dissemination of swap trading data—we predict the futurization effects of these regulations, which are in some cases contrary to what might be expected or desired. In doing so, we demonstrate how the common view of futurization as a trend affecting the swap markets in a uniform manner is overly simplistic and obscures the important lessons of futurization. Armed with this predictive tool, we believe that the CFTC can apply the regulation through substitution analysis to better design regulations, to achieve its policy goals, and to assess the costs and benefits of proposed regulations. This same tool can be used by other regulators that similarly oversee multiple related regulatory regimes to better implement their policy concerns in similar contexts.