Derivatives in Secured Lending: The Impact of Dodd-Frank

Derivative products can be used in various ways, often to hedge interest rate or foreign exchange risks. Over the past decade, derivatives have become an integral part of secured lending transactions, commonly required by lenders to mitigate the risk that a borrower's credit may be adversely affected due to fluctuations in currency or interest rates. The Dodd-Frank Wall Street Reform and Consumer Protection Act¹ amended the Commodity Exchange Act (CEA),² which is implemented, administered and enforced by the Commodities Future Trading Commission (CFTC) through regulations,³ and introduced major changes to many aspects of the financial system in the United States, especially swaps and other derivatives. Congress passed Dodd-Frank's derivatives provisions largely to bring stability and transparency to the largely unregulated swaps market in the wake of the 2008 financial crisis. The new rules change in fundamental ways who can enter derivatives, how they go about it, and how much derivatives cost. Today we discuss how these rules have changed the ways in which derivatives can be used in secured transactions and what new issues they have introduced.

Background

The most common forms of derivatives in secured lending transactions are interest rate swaps, since most commercial loans bear interest based on a floating rate. In floating rate-based loans, a rise in interest rates increases the amount of the borrower's interest payment obligations and, accordingly, may adversely affect the borrower's liquidity. A swap addresses this credit risk to borrowers and their lenders through a structure in which a counterparty (typically one of the financial institution lenders or its affiliates) agrees to pay a floating rate of interest to the borrower matched to the loan's floating rate, based on a "notional amount" that is usually the principal amount of the loan, in exchange for a fixed interest rate payment by the borrower on the same notional amount. This form of swap is referred to as a fixed-to-floating interest rate swap, and its effect is to have the counterparty bear the risk of changes in interest rates rather than the end-user (i.e., the borrower).