Synthesis and Conclusion

This chapter begins with a synthesis of key themes, covering derivatives, debt instruments, and structured notes. It considers the case study Securities and Exchange Commission v. Goldman, Sachs & Co. & Fabrice Tourre. It then describes the Erlanger “cotton” bonds issued by the Confederate States of America to raise money during the Civil War. This is followed by discussions on range notes, internal leverage and market risk, and risks (interest rate risk, liquidity risk, reinvestment risk). The chapter concludes by describing the bulletin issued by the Office of the Comptroller of the Currency on May 22, 2002, to all national bank CEOs and all federal branches and agencies in regard to risky “yield-chasing” strategies that were returning to the markets.

Securities Regulation

Prior to the 2007 financial crisis, financial regulation was compartmentalized along lines of segmented financial instruments. With the exception of the regulation of swaps as described in chapter 14, post-crisis regulatory reform maintains this bifurcation of regulation along product lines between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC and the CFTC have begun to issue rules establishing a coordinated approach to regulating certain derivatives under the Wall Street Reform and Consumer Protection Act (widely known as the Dodd-Frank Act) in particular as they relate to swaps. This chapter discusses the jurisdiction of the SEC, what constitutes a security, sellers’ representations, consequences of securities, hedge funds, and derivatives regulation.

Regulation of Swaps

Former Federal Reserve Chairman Ben S. Bernanke classified derivatives as a “vulnerability” of the financial system that led to the financial crisis. He explained that derivatives concentrated risk within particular financial institutions and markets without sufficient regulatory oversight. The Wall Street Reform and Consumer Protection Act—Dodd-Frank—constituted a seismic shift in the regulation of financial institutions and markets in a massive effort to address regulatory shortcomings in derivatives markets. This chapter discusses the Dodd-Frank regulatory regime. Topics covered include the Dodd-Frank and derivatives trading; jurisdiction and registration; clearing, exchange, capital and margin, and reporting requirements; analysis of the provisions of Dodd-Frank on derivatives trading; rationale behind the exemptions and exclusions; the Lincoln Rule; Futures Commission Merchants; and criticisms of Dodd-Frank's derivatives trading provisions.

Debt Securities

Debt instruments obligate an issuer to make interest payments and repay principal to the buyer according to the terms of an agreement between the lender and the borrower. The yield, or market price of these debt securities is related to the yield on U.S. Treasury securities. Treasuries remain the benchmark for risk-free credit investing, and other yields are related to the risk-free return Treasuries offer. Also known as bonds, debt instruments are attractive to investors because they can provide a reliable stream of cash flows in the form of interest payments and also might provide for the repayment of principal upon maturity. This chapter discusses the features of bonds, types of bonds, bond-rating agencies, special types of debt instruments, and the Securities Act.

Financial Instruments and the Capital Markets

This chapter begins with a discussion on the capital markets. It compares primary and secondary markets, and long-term versus short-term marketplaces. This is followed by a case study on the auction rate securities (ARS) market. The second section discusses financial instruments, covering the types of financial instruments (equity-based financial instruments, debt-based financial instruments, derivatives, cryptocurrency and digital assets), and the distinction between debt and equity, and federal regulation. The final section deals with the role of the attorney. It discusses competent representation, the duty to advise the client, drafting financial instruments, regulatory compliance, and the issuance of opinion letters to clients regarding the implications of financial transactions.

Using Financial Instruments

Capital markets provide enterprises with the opportunity to access capital to maintain their level of business activity. Therefore, ensuring the stability of the capital markets and preventing systemic failure are paramount concerns of the Federal Reserve and other financial market regulators. Access to capital markets is facilitated through the use of financial instruments that allow risk to be negotiated among market participants. When using financial instruments to achieve goals, a corporation must be aware of several considerations: the value of the asset underlying the financial instrument, duties or obligations the corporation owes to the other party to the contract, the implications and “worst case scenario” of the performance of the financial instrument, the risk of the transaction, and how the specific transaction can achieve the corporation's goals. This chapter discusses goal-oriented investing, achieving investment goals, and managing risk.

Dodd-Frank and the Regulation of Depository Institutions Capital Requirements

This chapter continues the discussion of the previous chapter on the Dodd-Frank Act. In the years since its passage, the legislation has had dramatic effects on the operation and stability of the financial markets, and will continue to play a vital role in the capital markets. In addition to establishing new capital and leverage requirements for banks, bank holding companies, and systemically significant nonbanks, Dodd-Frank also mandates that these requirements be “countercyclical, so that the amount of capital required to be maintained by a company increases in times of economic expansion and decreases in times of economic contraction.” The remainder of the chapter covers the Volcker Rule; living wills, credit exposure reports, and concentration limits; and other prudential standards.

The Financial Crisis

This chapter discusses the origins of the 2007 financial crisis, subprime lending, and government-sponsored entities. It argues that the events driving financial markets to the precipice of collapse during the global financial meltdown gave rise to a regulatory framework that may have been a rational response to a market in free fall, but need to be reassessed in an era of recovery. In 2018, the U.S. economy may be, by many measures, viewed as wholly recovered from the economic impact of the crisis. The stock market is trading at record highs, having erased all the losses of the crisis period and then some. With this recovery, the Trump administration seeks to restrain the regulatory burden imposed during the crisis.

Suitability

This chapter begins with a discussion of the suitability doctrine. The duty owed by broker-dealers is one of suitability when doing business with the general public; this was added to the Exchange Act with the adoption of the Securities Act of 1993. The duty owed by broker-dealers is not a fiduciary duty: it is the duty to make recommendations that are suitable to their client based on their personal situation. The suitability doctrine requires that the broker must have a reasonable basis for believing the recommendation to have been suitable for the customer, in light of the customer's financial condition and understanding of the investment and its risks. The Government Securities Act of 1993, which amended the Exchange Act, is the impetus for the suitability rule. The remainder of the chapter deals with suitability as it relates to futures and options.

Derivatives

Derivatives provide a means for shifting risk from one party to a counterparty that is more willing or better able to assume that risk. The counterparty's motivation for assuming that risk might be to manage its own risk or to enhance yield (make money). Derivatives transactions may be based on the value of foreign currency, U.S. Treasury bonds, stock indexes, or interest rates. There are four types of derivatives contracts: forwards, futures, swaps, and options. This chapter discusses the following: counterparty credit risk, over-the-counter versus exchange-traded derivatives, shifting risk, types of derivatives, reduction of counterparty risk, suitability as hedging instruments, distinction between forwards and futures, foreign exchange forwards and futures, options, characteristics of swaps, and credit derivatives.