President Obama was expected to sign into law in July the Dodd-Frank Act, the most extensive reform of financial services regulation since the Great Depression. The reforms look to be far more extensive than what Wall Street hoped for, including a substantial ban on proprietary trading by banks and tighter regulation of the derivatives market.

This column previously has noted how the extensive use of derivative instruments as a primary investment tool, rather than simply for hedging primary transactions, in concert with the securitization of pools of debt and their sale in different tranches of default risk profile, led to market opacity, higher leverage and loosening of credit standards that first fuelled the bull market of the 1990s and then led to the credit crisis of the last two years. The new legislation, while short of a reenactment of the Depression-era Glass-Steagall Act that required structural separation of commercial and investment banking activities, is intended to clamp down on the greatest of those excesses. All satellite industry executives and financial officers should know the key parts of the legislation.

Among Dodd-Frank’s provisions is a softened version of the so-called Volcker Rule to prohibit banks from proprietary trading — or betting their own capital. Banks will be prohibited from investing more than 3 percent of their own Tier One capital in private equity or hedge funds and will not be able to provide more than 3 percent of the target fund’s capital. (The original Volcker Rule would have prohibited such investment altogether.) In addition, the Dodd-Frank Act itself substantially defines proprietary trading, rather than leaving the parameters of the definition to regulators and the lobbyists that visit them, as earlier versions of the legislation proposed. Many financial institutions, therefore, may spin off proprietary trading activities. However, trading desks for true hedging operations, such as foreign exchange or interest rate swaps, may be maintained.

The Dodd-Frank Act will force banks to place other derivatives trading into separately capitalized subsidiaries, the intention being to protect taxpayers from bailout risk by isolating derivatives trading from depository institutions that have access to the Federal Reserve’s discount lending window. As with the Volcker Rule, the original proposal to ban all swaps trading was softened but not eliminated. Most over-the-counter derivatives trading also will be moved onto regulated exchanges, which should increase transactional margin costs but improve transparency. Most importantly for industry professionals, businesses (as opposed to financial institutions) that use derivative instruments for true hedging transactions related to business risk are exempt from Dodd-Frank’s reach.

Dodd-Frank also establishes the Financial Stability Oversight Council, a new regulatory body to supervise systemic risk and the “too big to fail” financial institutions. It can impose higher capital requirements, place institutions at risk into effective receivership and force divestitures. The act also contains increased capital requirements for banks, registration requirements for larger private equity and hedge funds (though not venture capital funds) and consumer protection provisions, among others, that are less relevant to industry in general and the satellite sector in particular.

Dodd-Frank, while falling short of some original financial regulatory reform proposals and certainly not a reenactment of Glass-Steagall, clearly is a major swing of the regulatory pendulum away from a hands-off, purely competition-based model of regulation. It should yield lessened interest in derivative instruments of Byzantine opacity whose very attraction was their lack of transparency; less volatile markets; less conflict of interest between financial institutions and their own clients; and, hopefully, an end of the “too big to fail” syndrome that undercut the critical principles of moral hazard and creative destruction so key to the U.S. economy. It should also go some way towards ending the insidious euphemism that those who profited in rigged markets in which they enjoyed superior access to information because they were insiders were merely operating in transparent, efficient markets and profiting because they were smarter than those on the other sides of their trades. If those projected effects take hold in whole or in part, Dodd-Frank will have played a vital role in restoring financial markets and the U.S. economy.

The satellite sector should expect continued tighter credit markets, less available leverage and a flight to quality.

Owen D. Kurtin is a founder and principal of private investment firm The Vinland Group LLC and a practising attorney in New York City. He may be reached by e-mail at [email protected].