The Dodd-Frank Wall Street Reform and Consumer Protection Act, most commonly referred to as Dodd-Frank, is a major piece of federal legislation established in response to the Great Recession of 2008-09. The crisis was primarily fueled by the housing bubble and under-regulated, risky trading in mortgage-back derivatives and related securities by many major financial services firms. The bill was named after U.S. Senator Christopher J. Dodd and U.S. Representative Barney Frank.
Dodd-Frank was signed into law by President Barack Obama on July 21, 2010, and is said to be the most extensive financial reform measure taken since the reforms enacted during the Great Depression of the 1930’s. The primary goal of the bill is to increase regulation in the financial sector by promoting financial stability, improving transparency and bolstering protections for consumers. All Dodd-Frank regulations are overseen by the Financial Stability Oversight Council, created via the reform act.
In whole, the bill has 16 provisions. Some of the more wide-ranging provisions are the regulation of advisors to hedge funds and other alternative investment firms, the push for more Wall Street transparency and accountability, the creation of the Consumer Financial Protection Bureau, and a major overhaul of the over-the-counter (OTC) derivatives trading industry.
Before Dodd-Frank, the Commodity Futures Modernization Act (CFMA) prohibited the SEC from regulating bilateral OTC derivatives transactions; poorly crafted OTC transactions such as mortgage-backed securities proved to be a major cause of the 2008-09 financial crisis when millions defaulted on their mortgages.
In order to address the issue of the under-regulated OTC industry, Dodd-Frank established a framework to monitor and regulate OTC trades. Now, the Commodity Futures Trading Commission (CFTC) and the SEC have greater oversight of OTC trading such as swaps and security-based swaps.
Several regulations have been put in place in order to monitor OTC trades, such as: rules prohibiting fraud, new requirements for trade reporting, new standards for clearing designated by the SEC and CFTC, and the execution of cleared swaps on a regulated exchange or swap execution facility (SEF). In addition, all swaps data will be sent to a trade repository or directly to the CFTC or SEC. Information regarding swap transaction and pricing must now be accessible to the public.
Aside from the individual regulations, Dodd-Frank’s other highlights include:
An Attempt to End ‘Too Big to Fail’ Bailouts—One of the more disturbing problems that became clear during the Great Recession was the fact that if some very large firms failed during the crisis, they would take down more participants than themselves because of the tightly connected nature of today’s global markets. Dodd-Frank hopes to mitigate this in the future by compelling failed firms to safely liquidate their assets, and urging ways to prevent the “too big to fail” status. In addition, the Federal Reserve’s power to support very large firms will be limited and standardized. The legislation also includes the widely debated “Volcker Rule,” which puts restrictions upon banks and their proprietary trading practices.
An advance Warning System—This aspect of Dodd-Frank creates a national council that will work to address industry-wide fiscal risks before they become a threat to the economy.
Transparency and Accountability for Exotic Instruments—This provision eliminates loopholes that have allowed people to participate in risky OTC derivative trades, among other formerly unregulated transactions.
Executive Compensation and Corporate Governance—This provision provides shareholders with the opportunity to vote on executive compensation and corporate affairs. This would also act as another means of monitoring the banks’ actions.
Investor Protections—These new rules for transparency are particularly aimed at credit rating agencies, which are seen as contributors to the financial crisis via tainted ratings of controversial mortgage-backed securities.
Dodd-Frank has been criticized by Republicans and Democrats with some saying that the law calls for intrusive regulation that restricts banks from exercising their abilities. Others, however, claim that Dodd-Frank will not adequately protect the U.S. from another crisis.