Investing and Pretending

One of the more prominent components of Dodd-Frank’s regulatory changes was Title VII, providing for the regulation of the over-the-counter derivatives known as swaps. Although there was much ado about that regulation immediately after Dodd-Frank’s enactment, the same cannot be said of the many rules that the Commodity Futures Trading Commission (“CFTC”) has subsequently adopted pursuant to its authority under Title VII. This Article is the first scholarly work to critically evaluate the CFTC’s “swap rules” and to identify the regulatory vision that they reflect. Based on that evaluation, it argues that the swap rules are grounded in a notable distinction between swaps and another financial market instrument — namely, securities. In particular, whereas “investing” is the hallmark of securities transactions, swap transactions fall under the rubric of “pretending,” a concept that this Article employs to elucidate the function and structure of swaps. After all, the value of a swap is based on an asset — the “reference asset” — that is wholly unrelated to the swap itself. Each party to a swap pretends that it holds either a long position or a short position in the reference asset, making payments to (or receiving payments from) the other party based on the performance of that position. Yet, as the Article further contends, although the distinction between investing and pretending is vividly reflected in the CFTC’s approach to crafting the swap rules, the distinction is irrelevant for regulatory purposes. Moreover, the substantial regulatory costs arising from the CFTC’s pretense-based approach to swap regulation are likely to excessively hinder swap use, as firms seeking to mitigate risk turn to other types of hedging strategies in situations in which using swaps would otherwise be more socially beneficial. With the goal of efficient and coherent regulation in mind, the Article proposes that a substantially better approach to the CFTC’s swap rules would be to predicate them not on pretending, as the counterpoint to investing but, rather, on something that swap transactions and securities transactions have in common — and on which securities regulation, too, is based: the risks arising from speculation.