A Summary of the Dodd Frank Act and How it Affects Hedge Funds


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This presentation serves as study notes for the e-learning material titled: "South African Hedge funds and international developments"

These notes focus on Dodd Frank and its Impact on the Hedge Fund Industry.


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A Summary of the Dodd Frank Act and How it Affects Hedge Funds

  1. 1. Dodd Frank Act Summary Study Notes
  2. 2. Brief Overview • Dodd Frank Act: – Its full name is the Dodd Frank Wall Street Reform and Consumer Protection Act – Reaction to the Housing Crisis in 2008 – Implemented in 2010 – It was created by Senator Christopher J. Dodd and of Connecticut and US Representative Barney Frank of Massachusetts
  3. 3. Brief Overview • Dodd Frank Act: – What Does it do? • Dodd Frank places many new regulations on financial institutions while attempting to keep accountable the companies who fell during the crisis. • Adds over 90 provisions that require SEC rulemaking, and gives the SEC additional discretionary power. – Not every rule that was involved with Dodd Frank has been implemented yet, but many will be initiated over time.
  4. 4. How does Dodd Frank affect Consumers? • Dodd Frank helped create the Consumer Financial Protection Bureau (CFPB) as a committee to help protect consumers. – The committee’s duties are to make sure the regulations are followed to protect consumers – It will be run by an independent director who is chosen by the president and voted upon by the senate – CFPB will be funded by the Federal Reserve
  5. 5. How does Dodd Frank affect Consumers? • Dodd Frank helped create the Consumer Financial Protection Bureau (CFPB) as a committee to help protect consumers. – The CFPB will be allowed to create new rules for consumer protection – Banks and credit unions with more than $10 billion in assets will be examined through proper regulations – The committee will consolidate work which was performed previously by several other departments.
  6. 6. How does Dodd Frank affect Consumers? • The Federal Reserve also has a new oversight committee. – Its goal is to end bailouts for too-big-to-fail companies and eliminates bailouts for large corporations that would require taxpayer money which could potentially harm the economy – It would create regulations to make it unattractive to become too large of a company, and safeguards would be set in the case that a large company decided to make a decision which could endanger the status of the economy
  7. 7. How does Dodd Frank affect Consumers? • Transparency and accountability for exotic investment vehicles. – Vehicles being referred to are • Hedge funds • Asset-backed securities • Mortgage brokers • OTC derivatives • Payday lenders – This could protect investors from potential harm of investing in these riskier vehicles, but also impact revenue for the institutions negatively
  8. 8. How does Dodd Frank affect Consumers? • Regulations on bookkeeping will be more heavily enforce to reduce fraud, manipulation of the system and conflicts of interest.
  9. 9. How does Dodd Frank affect Banks? • Banking was a large factor in why Dodd Frank was created. • The Financial Stability Oversight Council – Was created for assisting with the breaking up of too- big-to-fail companies. – Made up of the head chair who is the Treasury Secretary, and nine others from departments consisting of: • SEC • CFTC • OCC
  10. 10. How does Dodd Frank affect Banks? • Banking was a large factor in why Dodd Frank was created. • The Financial Stability Oversight Council – Made up of the head chair who is the Treasury Secretary, and nine others from departments consisting of: • FHFA • NCUA • FDIC • CFPB
  11. 11. How does Dodd Frank affect Banks? • Banking was a large factor in why Dodd Frank was created. • The Financial Stability Oversight Council – Non-bank entities that may become too large can be taken control of by the federal reserve if there is risk of the entity endangering the financial system • All banks are required to have set an emergency shut down plan in the event or threat of bankruptcy
  12. 12. Volcker Rule • What is the Volcker Rule? – Volcker Rule was created to prohibit banks from using riskier investment vehicles – Was originally planned to be initiated in July of 2012, but has been postponed for disagreements in constructing the rule for the time being. – Created by Paul Volcker – Would require banks from removing investments in private equity, hedge funds, and proprietary trading.
  13. 13. Volcker Rule • What is the Volcker Rule? – Entities required to follow Volcker would be • Credit Unions • Traditional Banks • Investment Banks – Short term trading strategies would be prohibited once Volcker Rule is passed – Internal compliance departments would be required to set up, and larger banks would need to report to the appropriate agencies
  14. 14. Volcker Rule • What is the Volcker Rule? – Any investments put into a fund may not supply a source of revenue over 3 percent overall – Entities would be allowed to participate in holding of foreign currencies to offset risk
  15. 15. Volcker Rule • How would Volcker Rule be implemented? – Banks would be required to exit out of their positions in the specified investments once the final draft has been published and a deadline is set – Since progress for Volcker Rule seems to have hit a wall for the time being, banks may want to continue with their previous investment strategies that have been successful.
  16. 16. Volcker Rule • Procrastination of the Bill – Agencies involved with writing the bill are: • The Federal Reserve • The Office of the Comptroller • SEC • FDIC • CFTC – The way all of the separate agencies are intertwined is not helpful in constructing the bill. – Progress has not been seen yet, and Volcker Rule should be ignored for the time being
  17. 17. Volcker Rule There is an exception to the rule which allows banks to hedge assets on speculative trading if attempting to protect assets. • Room for Improvement – The exception is a large loophole for Volcker Rule that could eliminate the rule all together. – Some ask, “ how should an employee be compensated if one wanted to reduce risk?”
  18. 18. Volcker Rule • What others think – Banks believe this will reduce incoming revenue from investing activities – Traders think this will bring smaller bonuses – Some believe the loophole is too lenient and that other requirements will need to be stricter as well.
  19. 19. Reforming the Federal Reserve • New limits on emergency lending and controlled by the Secretary of the Treasury • GAO is now allowed to audit the Federal Reserve on any issues involving: – Emergency lending – Open market transactions – Discount window lending
  20. 20. Reforming the Federal Reserve • Disclosures for lending transparency is now required with information about the terms, conditions, and amounts that are loaned. • A Vice Chairman for Supervision has been created as well, and will be selected by the President.
  21. 21. How are Derivatives Affected? • Dodd Frank’s goal for derivatives is to regulate more risk derivatives, like credit default swaps. • Riskier derivatives would now be regulated by the SEC and CFTC. • Clearing houses would be required to be constructed to make derivatives more transparent to the public for trading.
  22. 22. How are Derivatives Affected? • What are Swaps? – Swaps can be represented in the form of interest rates, equity and commodity pricing, and foreign exchange rates. – Traded on the OTC market – Dodd Frank decided to broadly regulate the OTC market.
  23. 23. How are Derivatives Affected? • Derivatives Registration – Registration requirements depend upon the size of the swap – Quantitative and circumstantial analysis will be used to determine the margin and capital requirements – If certain criteria is met, participants involved are required to register with the necessary US authorities. – The SEC and CFTC has made some hedge funds, banks, and energy companies exempt from derivative registration.
  24. 24. How are Derivatives Affected? • Clearing of Swaps – The US and other G-20 countries are starting to require clearing of swap transactions • This will be performed through clearing houses – Title VII of Dodd Frank details the requirements demanded of derivative transactions – Costs may be substantial in implementing the changes – The CFTC is able to add categories to swaps that are transacted under the policies
  25. 25. How are Derivatives Affected? • Clearing of Swaps – The exception to the rule is called the “End User Clearing Exception” • The exception can be used for those using derivatives as hedging or diversifying risk. • Financial institutions, asset managers, and investment vehicles are excluded from the exception – Cleared swaps are subject to margin requirements for collateral before they can pass through a clearing house
  26. 26. How are Derivatives Affected? • Clearing of Swaps – Swaps under exemptions may also need to follow margin requirements for future rule changes – Final drafts of the clearing requirements for swaps have not been written yet – G-20 countries will work with Dodd Frank on the requirements between countries, but there will most likely be confusion about how everything will be delegated.
  27. 27. How are Derivatives Affected? • Exchanges and Electronic trading – G-20 countries believe exchanges should be set up for transparency of derivative transactions, and that an electronic platform should be made as well to act as a market surveillance system – Trading strategies will vary by jurisdiction – All cleared swaps will be traded through an exchange as decided upon by the drafting of Dodd Frank
  28. 28. How are Derivatives Affected? • What is an SEF – An SEF is a swap execution facility – SEFs act as a market place for participants to perform derivative transactions – Developed by Dodd Frank, this will assist in transparency and accountability.
  29. 29. How are Derivatives Affected? • International Effects – Because Dodd Frank and all of the other regulations that developed out of the crash in 2008 are so different, there will most definitely be confusion with implementation of each law – Basel III increases collateral much higher than any other laws that have been enacted – With these margin requirements, higher grade collateral will be in short supply
  30. 30. How are Derivatives Affected? • International Effects – Different options for collateral may be needed to shift the demand for required assets – The majority of all derivative trades would be required to be pre-funded – Operations would become very complex on an international basis, and strategies would still be supervised – Someone would need to manage the assets that were being held as collateral for the derivatives that are being developed
  31. 31. How are Derivatives Affected? • Reporting – Swap transactions would need to be reported for accountability and transparency, and then recorded in a database – Reporting would vary by jurisdiction, and integrating with risk, compliance, and back office teams can become very intricate – There will be differences in reporting between cleared and uncleared swap transactions – For US citizens who participate in trading derivatives, reporting will fall upon the predetermined entity
  32. 32. How is Mortgage Reform affected? • New lender requirements are being put into place to assure the borrower is qualified to make the payments • There is now more transparency in making sure the borrower understands the conditions of the information set before them – This would require the lender to inform the borrower if the interest rate is fixed or not, and set a cap on the interest rate if it is not fixed.
  33. 33. How is Mortgage Reform affected? • An Office of Housing Counseling has been started within HUD to boost homeownership and rental housing.
  34. 34. What will happen to Hedge Funds and Private Equity • Hedge funds and Private Equity funds are now required to register with the SEC as an investment advisor • They will also be required to release information on the contents of portfolios and information on trading activities
  35. 35. How will Credit Rating Agencies be affected? • The Office of Credit Ratings is responsible for the compliance of credit rating agencies – Agencies are audited annually, and findings are publicized • The SEC is looking deeper into the methods of how companies are rated, and how they use third party information • Other outside sources that are considered credible through previous due diligence of agencies and rating them can be used by the SEC
  36. 36. How will Credit Rating Agencies be affected? • A conflict of interest clause was also added • Agencies are now liable if they have knowledge that information is inaccurate and do not respond immediately • The SEC has authority to delist agencies that are inaccurate with their ratings over time
  37. 37. Executive Compensation and Corporate Control • Executive compensation is now controlled by the shareholders – This is supposed to keep executives accountable for their actions • Compensation will be affected by deceptive practices and changing of financial records to appeal to shareholders • Shareholders have the power to nominate directors to shift goals to long term strategies
  38. 38. How is Insurance Affected? • A Federal Insurance Office (FIO) was created and is operating out of the federal government – It is the first federal department that specializes in insurance • Its purpose is to gather information to help supply lower and middle class individuals and families with more affordable insurance • The department also focuses assuring that small businesses are treated fairly with fees
  39. 39. Credit Score Protection • This allows consumers to now check their credit score when negatively affected by a missed opportunity or declined for a financial transaction.
  40. 40. How is the SEC affected and are Investors better protected? • The SEC has authority to impose fiduciary duties upon brokers who give investment advice • Whistleblowers are being encouraged with large incentives for uncovering corruption • An external audit of the SEC will be performed annually, and a GAO review will look at the management in the SEC • Dodd Frank created an Investment Advisory Committee to supervise the SEC on regulatory practices. – This will assist investors who have complaints about the SEC and assure that the complaints are received
  41. 41. Reducing Risks Posed by Securities • Dodd Frank wanted to reduce risk on mortgage backed securities by requiring issuers to hold a minimum of 5% credit risk • Additional information about securities is now required to allow investors to know what they are partaking in
  42. 42. Oversight of Municipal Securities Industry • Municipal advisors are now obligated to register with the SEC and follow the rules mandated by MSRB • Investors interests will be put first by having a majority of independent members • Municipal advisors must follow a fiduciary duty
  43. 43. Congo Conflict Materials • Mineral manufacturers in the Democratic Republic of Congo who are registered with the SEC are required to disclose materials gathered and products manufactured • The Act also requires links between manufacturers and armed groups to be disclosed for strategies of illicit minerals traded
  44. 44. Congo Conflict Materials • Deposit insurance is also discussed and raises the limit to $250,000 • Projected loans by IMF to middle income countries are curbed if the country’s debt is greater than annual GDP
  45. 45. Conclusion • There are mixed views about Dodd Frank – Those who are against it believe there are too many regulations that will negatively affect the industry – Those who are for it consider it to be an asset in making investment entities more accountable • If boundaries had not been tested previously, Dodd Frank may never have come to be
  46. 46. Conclusion • The Act has been enacted for over three years now, but not all additional rules have been implemented yet • Outcomes of Dodd Frank will be evaluated to be positive or negative in time