What Obamacare and Dodd-Frank’s Swaps Rules Have in Common

The Affordable Care Act and the Dodd-Frank Act were passed during a four-and-a-half-month period when both houses of Congress and the White House were controlled by one party. When I roamed the halls of Congress with a proposed "Fix the Plumbing" amendment, Dodd-Frank was then known in conference as the Wall Street Reform and Consumer Protection Act. The clarion call of the reformers was "Just let's pass the damn thing – we'll fix it later!"

Well, now is later and at the detail level, especially where the rubber hits the technology road, things are failing. The politest comments now heard are that we are living in a transformational period of unintended consequences.

While the Obamacare fiasco has resonated for all Americans, the Dodd-Frank derivatives implementations are similarly problematic but not understood enough to touch the lives of everyday people … yet.

After all, it's just the "plumbing," the back end stuff, an afterthought. But back-end stuff is what (badly) powered healthcare.gov, and in the context of financial reform, it's what makes the American economy work. Most do not understand that today's diverse capital markets cannot work without equivalent risk-shifting markets.

Fixing the plumbing in the derivatives markets is not a simple issue that is easily and glibly stated in sound bites, as is the case of Obamacare, though there are exceptions. Warren Buffett's description of derivatives as "financial weapons of mass destruction," though not quite on point, was nonetheless catchy. Another rare case of pithiness was when Dennis Weatherstone, chairman of J.P. Morgan before it merged with Chase Manhattan, pronounced his daily 4:15 Report, summarizing his bank's Value at Risk, the leading indicator of a restful or restless night. This set a tone right up to the financial crisis suggesting that VaR embodied all he and other bankers needed to know about the safety and soundness of the banks they ran…. updated daily, just 15 minutes after the U.S. markets closed.

Second only to requiring more capital, the most significant change from Dodd-Frank was regulating the shadow financial markets, particularly over-the-counter derivatives. These derivatives were thought to be one of the main contributors to the financial crisis. They contributed to AIG's blowup and bailout, and produced securitized and synthetic fixed-income products which every bank held. Like a hot potato, they bounced from hand to hand until the trading stopped and the credit markets froze.

Derivatives regulation was troubled from the start when a Dodd-Frank creation, the Office of Financial Research, punted the technology data standardization of counterparty identification (who is trading with whom) to a global regulator, the Financial Stability Board. The board itself was a creation of the Group of 20 finance ministers and central bankers, reacting to the financial crisis by empowering a new international institution for stabilizing the global economy.

However, in the U.S., the Commodity Futures Trading Commission chose to proceed with its own version of counterparty identifiers even while the FSB was deciding on a global standard, still not finalized. The CFTC, in its haste to check off an "I implemented Dodd-Frank rules" box, stumbled badly. Passing framework rules and leaving technology implementation as an afterthought has proven disastrous. Like the website debacle of Obamacare, it has brought to the fore unresolved Big Data issues.

In March the CFTC asked 70 or more swaps dealers for data on the newly regulated derivatives markets. The agency was unprepared for the deluge that followed. Its systems were overwhelmed by non-standardized data, brought about by the CFTC's failing to provide guidance on data standards. As if this weren't bad enough, rather than waiting for the industry to settle on a data standard tested in the field and approved by the FSB, the CFTC went live prematurely. It asked other counterparties, the swap dealers' customers, to report data.

Now the problem has again been punted up to the Financial Stability Board, this time to resolve not only the counterparty identifier issue and nonstandard data in the U.S. but how data can be aggregated across the many new global derivatives infrastructure entities that have been put in place anticipating regulatory initiatives in their own countries.

The FSB has called for a coordinated approach to how newly mandated facilities like swap execution facilities (also called swaps exchanges) and swap data repositories will interoperate. Most important, these new facilities must be capable of providing a systemic view of their data to regulators across multiple sovereign regulatory jurisdictions. Without this capability, a technical issue of major importance, we have simply created another version of a shadow derivatives market, this one an electronic version that neither regulators nor industry members can observe transactions in.

The FSB study group's derivatives data aggregation rulemaking work is scheduled for completion in mid-2014. The Basel Committee's "principles for effective risk data aggregation and risk reporting" are due for implementation in 2016.

Lest we suffer again the lesson of unintended consequences, it would be best if regulators stop checking off nonsensical boxes that attest "I completed" this or that regulation. It only signifies the rule was written. Instead they need to check off the "I implemented the solution and it is working" box.

Allan D. Grody is the president of Financial InterGroup, a risk management advisory, training and research firm.