A Derivative in Need: Rescuing U.S. Security-Based Swaps from the Race to the Bottom

Over the past 30 years, the development and proliferation of new financial instruments has provided investors with fresh and innovative methods to gain exposure to foreign markets, hedge investments, and capitalize on speculation opportunities. These “derivatives” have increased the interconnectedness of investors all over the globe, and in particular, the derivative known as the “security-based swap” has facilitated cross-border investments that were previously impracticable, yet greatly sought after. These financial advancements came at a price, however, and in 2007 and 2008, a lack of regulation over derivatives that led to a global financial crisis and spurred a widespread public desire for increased scrutiny over derivatives and those who use them. The United States responded by enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act, which, among other things, established a new regulatory framework for derivatives, including security-based swaps. In the United States today, developments in both the legislative and judicial arenas following Dodd-Frank have come to a head, and the synergy between the two has resulted in an environment that is hostile to investors in security-based swaps. The result is a shift of these investments out of the United States and into foreign, less regulated markets, which thereby preserves the type of risks that Dodd-Frank was intended to mitigate. This note explains the benefits of security-based swaps while tracking these legislative and judicial developments, and it suggests a two-pronged solution for encouraging security-based swap investment within the United States while guarding against systemic financial risk. First, it calls for the abandonment of the economic reality test used by a court in the Southern District of New York as a means of evaluating the applicability of U.S. securities laws to actions involving derivatives. Second, it urges global coordination of financial regulatory regimes. Together these changes will afford U.S. security-based swap investors the ability to avail themselves of U.S. securities laws without the need for governmental intervention, while also establishing a baseline, blanket level of global financial regulation that will safeguard against systemic risk