Backdoor Margins Ahead?

Nonfinancial companies may be the over-the-counter derivative users least impacted by Dodd-Frank, but they're also the group that's least prepared to comply with the new requirements almost certain to come their way.

The final form of the regulations regarding OTC derivatives is still conjecture, because government agencies including the Commodity Futures Trading Commission, the Securities and Exchange Commission, and banking regulators are just starting the process of hammering them out ahead of a July 2011 deadline. Dodd-Frank exempts corporate end users from having to clear OTC derivative transactions or post margin against them, although concerns have emerged recently that the CFTC may have the authority to impose a margin requirement. (See Corporate End Users in Jeopardy.)

Even if the concerns about margin requirements from the CFTC evaporate, companies may find such requirements coming at them from another direction. Dodd-Frank mandates that banks hold more capital against their assets, especially OTC derivatives. To limit the amount of their regulatory capital, some banks are likely to require end-user customers to enter into credit support annexes (CSA), which stipulate collateral support between counterparties.

That will be a big change from current practice. Jiro Okochi, CEO and founder of Reval, a provider of financial risk management solutions, says that currently "less than 10% of corporates have collateralized swap agreements with counterparties."

Whether margin requirements are imposed by the CFTC or individual banks, they will carry new burdens and costs for end users, including the need for systems that manage the process of posting and monitoring collateral.

"For corporate end users that haven't been posting collateral, they're probably not cut out from an operations perspective to post or receive the collateral," says Sam Peterson, a senior adviser in Chatham Financial's regulatory services group. "So they must either hire someone to do it for them or use an outsourced collateral management system."

Several vendors, including Chatham and Reval, provide those services, typically as a part of a broader package of derivatives services. Okochi notes that collateral reporting systems must be able to value the derivative as well as the collateral and must adhere to CSA provisions that often differ. For example, some CSAs may require a company to post the full amount by which the mark-to-market value exceeds the stipulated threshold limit, while some require that companies post only half that amount.

In addition, collateral reporting systems must be able to determine the mark-to-market values of the derivatives, as well as the underlying asset, to post collateral against the netted value.

"These collateral agreements are not a piece of cake to monitor,"Okochi says. "You want to work with an experienced vendor that not only has the functionality, but also the understanding of the business of collateral management."

Peterson points out that when the changing value of a derivative or the underlying assets prompts a collateral readjustment under the ISDA Credit Support Annex, those changes do not occur automatically but rather on demand.

"So the end user is going to want to stay on top of those price moves and, when appropriate, request collateral as soon as possible, because if the counterparty goes under, the corporate may lose the excess amount that it could have requested back," he says.

Dodd-Frank only exempts end users from clearing OTC derivatives if they are hedging commercial risk. Regulators have yet to determine how to enforce that requirement, but whatever they decide is likely to impact end users.

"Will the end user have to demonstrate this in some way, or will it be purely an audit requirement?" asks Peterson. He notes that audits could be triggered by regulators that spot suspicious activity in the swap data repositories to which dealers must send all OTC derivative data, under Dodd-Frank.

Peterson also notes that a public company's board must approve if it decides to opt out of clearing a derivative transaction, a requirement that could prove burdensome if mandated on per-transaction basis. Chatham is promoting a one-time, "simple statement of fact" that would apply to all the transactions the corporation's dealer transmits to a swaps data repository, Peterson says.