Will the Dodd-Frank Act actually create more too-big-to-fail financial firms? - SmartBrief

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Will the Dodd-Frank Act actually create more too-big-to-fail financial firms?

3 min read

Modern Money

An oft-repeated refrain by then-Treasury Secretary Henry Paulson as he tried to deal with the financial crisis was that the government had neither the authority nor the necessary tools to wind down a so-called Systemically Important Financial Institution. When it comes to SIFIs, policymakers have precious few choices. They can:

  1. Do nothing and let the markets sort things out when a SIFI collapses.
  2. Do nothing and rescue/bailout a SIFI once it is on the brink of collapse.
  3. Identify SIFIs and break them up (thus making them no longer a SIFI).
  4. Identify SIFIs before a crisis, then devise an orderly process for winding them down when a crisis hits.

The policymakers who wrote the Dodd-Frank Act chose the fourth option, giving birth to the Financial Stability Oversight Council. The Treasury Department’s website states, “The Council is charged with identifying threats to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States financial system.” So one of the goals of Dodd-Frank was to better regulate, if not reduce, the number of firms deemed systemically important. But what if Dodd-Frank actually creates SIFIs?

Enter the Dodd-Frank provision mandating most swaps be guaranteed by clearinghouses and traded on exchanges and electronic trading platforms known as swap execution facilities (SEFs). Exchange operators and clearing houses initially welcomed this provision because the fees associated with it put dollar signs in their eyes. But as the Financial Times recently reported, some exchanges and clearing houses may be starting to second-guess that initial excitement.

The details and costs associated with the provision are such that some experts believe firms will come to see clearing as merely a client service, rather than a valuable revenue stream. Some of the major exchanges that have voiced an interest in setting up SEFs have done so with the caveat that they will wait to see how the specific Dodd-Frank rules are written and implemented.

The Commodity Futures Trading Commission expects a few dozen SEFs to be created as a result of Dodd-Frank. Given the wait-and-see approach some firms are taking, that CFTC prediction seems a bit optimistic. Some firms may weigh the costs associated with setting up a SEF and opt not to do so. Firms that initially offer clearing as a client service could one day decide to get out of the game. And mergers and acquisitions, which are sure to take place over time, would reduce the number of SEFs even further.

Sooner or later, regulators may have to answer a difficult question: What if the number of SEFs — entities that would have never existed if not for Dodd-Frank — shrinks to a point whereby the precious few left standing are inherently too-big-to-fail?

Tell us what you think.