From the November 2010 issue of Treasury & Risk magazine

Corporate End Users in Jeopardy

As a global company, Eastman Chemical's earnings can be impacted significantly by swings in interest and foreign exchange rates, as well as in the prices of commodities, especially natural gas and propane. To mitigate that volatility, the $5 billion manufacturer of chemicals and plastics projects its propane needs, for example, over the coming year and purchases the commodity using forward contracts to lock in a price over that period. That allows executives figuring out their budgets for the next year to more effectively price products and analyze profitability.

"By taking some of the volatility out of the price of raw materials, we're able to provide customers with some pricing certainty so they can better manage their businesses," says Mary Hall, treasurer and vice president of Eastman Chemical. "Without derivatives, we wouldn't be able to do that."

Concerns are mounting, however, that new regulations may make over-the-counter (OTC) derivatives, which multinationals employ to hedge a wide range of risks, too costly for them to use effectively.

The new rules--still in the early stages of development in the U.S. and Europe--have been driven by the role credit default swaps and other mortgage-related derivatives played in the financial crisis. Then last spring, the use of cross-currency swaps by Greece, unbeknown to its European Union regulators, put the country in financial jeopardy.

In the U.S., regulators are acting on the tenets set out in the Dodd-Frank financial reform law enacted this summer. These include increasing the transparency of OTC derivative transactions, including swaps and forwards, in part by verifying and settling them through central clearinghouses, and collecting data on derivative transactions in regulated repositories. Dodd-Frank also imposes new margin and capital requirements on dealers of OTC derivatives, as well as on major market participants.

Given the importance of OTC derivatives in commercial hedging strategies, Dodd-Frank exempts nonfinancial companies that use OTC derivatives to hedge such risk from clearing requirements, although in most cases their dealers must report data to the repositories. The law also appears to exempt nonfinancials from the requirement to post margin--collateral backing transactions--that it imposes on derivatives dealers and the biggest market participants.

Now that treasurers have studied the law, however, they are voicing concerns that despite the clearing exemption, the initiatives to increase transparency may result in significant cost burdens for derivative end users. And a top regulator's recent statements suggest that the exemption from margin requirements may not be there at all.

"What we're all waking up to is a back door to margining," says Thomas Deas, treasurer at FMC Corp. and president of the National Association of Corporate Treasurers (NACT).

Deas is referring to recent statements by Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), including his comments on Sept. 21 at a public meeting in Washington hosted by the U.S. Chamber of Commerce.

In the question-and-answer period following his speech, Gensler said that the Federal Reserve will have the authority to set margin for most end-user transactions, since it has oversight of bank derivative dealers, while the CFTC will decide the issue for non-bank dealers. Gensler said he believes the statute provides the CFTC the authority to set margin for end-user transactions, but he doesn't yet know what the CFTC will do.

That leaves open the possibility that the CFTC could require non-bank swap dealers to collect margin from end users. Since the Fed and the CFTC are working jointly on the new regulations, rules applying to non-bank dealers will likely be paralleled in those for banks.

Although neither Gensler nor other CFTC staffers have explicitly expressed support for margin requirements for end users, neither have they nixed the possibility. "We haven't gotten any assurances that regulators will not apply margining requirements directly on end users," says Michael Bopp, co-chair of the public policy practice group at Gibson Dunn & Crutcher. The CFTC did not return calls seeking a comment on its stance on margin requirements for end users.

Should such requirements be imposed, the impact on end users could be significant. In a panel discussion following Gensler's presentation, Tammy Evans, director of global funding for investments and foreign exchange at IBM, said the notional value of IBM's derivatives portfolio at the end of the second quarter was between $40 billion and $45 billion. "Depending on where the market shifts, you could potentially have upwards of $5 billion in capital that's held up in margin requirements," Evans said, adding that for IBM, that equates to a year's worth of acquisitions.

Deas notes that a Business Roundtable study estimated its members would have to hold $269 million, on average, to meet margin requirements, impeding their investment in plant and equipment and research and development. "We've extended that estimate to the S&P 500, and that effect would result in the loss of 120,000 to 125,000 jobs," he says.

The challenge of putting in place the systems and staff to handle margin requirements could discourage some companies from using derivatives.

"We're neither staffed for nor do we have the systems to accommodate the kind of daily, and perhaps intraday, mark-to-market analysis that would be required in order to post margin," says Eastman's Hall, adding that such new requirements would "probably preclude us from participating in the [derivatives] market."

The CFTC, the Securities and Exchange Commission and banking regulators are on a tight schedule to finish the multitude of new rules stemming from Dodd-Frank, which mandates such regulations be in place within 360 days of the bill's signing. If CFTC officials do not clarify the margin issue soon, corporations will see the agency's intent in black and white when it issues draft rules for public comment, expected in November or December.

Even if corporate end users are not subject to margin requirements, imposing those requirements on dealers will most likely make using OTC derivatives more costly for end users.

Sam Peterson, a senior adviser in Chatham Financial's regulatory advisory services group, says Chatham analyzed the impact of requiring a bank dealer to post 2.5% initial margin and full-variation margin on a 10-year, $100 million notional interest-rate swap.

The Kennett Square, Pa., derivatives adviser and technology provider estimates it would cost the bank $1 million over the 10 years. "That's not to say all of that cost would be passed on to end users," Peterson says. "But even if it's 10%, that $100,000 is important to a commercial end user."

The extent to which costs rise for end users will depend on how regulators define the categories laid out in Dodd-Frank. For example, the law divides OTC derivatives users into four types: swap dealers, major swap participants (MSPs), financial entities and nonfinancial end users. The first two will be highly regulated; the latter two to a lesser degree.

Nonfinancial firms making markets in OTC derivatives could be labeled dealers, while other companies with enough derivatives on their books to pose systemic risk would be labeled MSPs, Peterson says. Nonfinancials potentially in the dealer category--mainly large energy companies--are probably already anticipating the new requirements. Dodd-Frank mandates that dealers centrally clear their OTC derivatives trades, or trade certain derivatives over an exchange or yet-to-be-developed swap execution facilities, and it also imposes a slew of business conduct, record-keeping and reporting rules.

MSPs will face the same rules as dealers, but it's much less clear which companies will fall into that category. Peterson says some nonfinancial end users may be labeled MSPs if they have very large volumes of swaps on their books. Dodd-Frank creates a link between the MSP category and a company's potential to pose systemic risk, he says, but adds, "We don't know where they will draw that line."

Gibson Dunn's Bopp says that no regulator has recommended a limit yet, but $50 billion in notional value has been discussed as the threshold over which a company could be considered systemically significant.

Deas points out two important distinctions between the U.S. and the EU's regulation of OTC derivatives. First, the EU clearly links central clearing and margining. If an end user is exempt from clearing, it is also exempt from margining. Under Dodd-Frank, however, while all end users are exempt from central clearing, some--as Gensler has suggested--may have to post cash collateral as margin for their derivative positions.

Second, in the EU, an end user's hedging of underlying business exposures with OTC derivatives does not count in measuring the level of derivatives activity that triggers additional regulation. Instead, the EU will consider only what is left over after the derivatives and underlying exposures are netted, and the systemic risk that poses, an approach supported by NACT and the Coalition for Derivatives End-Users.

The EU regulators have set two thresholds, based on a netted number, that apply to all market participants. Breaching the first "information threshold" will require reporting marked-to-market positions to the regulators, while crossing the "clearing threshold" will require centrally clearing the transactions.

Under Dodd-Frank, the notional value of an end user's derivatives, including those used for hedging commercial risk, appears to be the preferred measure when determining whether it fits into the MSP category.

Dodd-Frank encourages U.S. regulators to harmonize regulations with non-U.S. regulators. Its netting language, however, was removed at the eleventh hour, leading to concerns that U.S. regulators may adopt the threshold concept using notional instead of netted value. While companies classified as end users will remain exempt from clearing, if the MSP category is tied to a predefined notional value, a number of companies could fall into that category, even though their derivatives books show little risk after netting.

Although Dodd-Frank does not link notional value to the MSP category, says Bopp, "We're worried about whether the agencies will keep them separate."

Some U.S. companies support a different threshold concept based on netted derivative positions. In a comment letter, mutual fund giant Vanguard recommended companies become MSPs if they exceed a $1 billion threshold of aggregated, netted exposure across all major swap categories, or $500 million in any single category. The asset management group of the Securities Industry and Financial Markets Association suggested an aggregate netted-exposure threshold of $2.5 billion.

Also in the works is the definition of commercial risk. Bopp questions whether that definition will be broad enough to include the various risks end users employ derivatives to hedge. "Or will the CFTC and SEC limit the definition to such a degree that legitimate hedges won't be seen as hedging commercial risk but rather financial or balance sheet risk?" he asks.

That's problematic because corporate end users are exempted from margin requirements only for hedging commercial risk. Should regulators define commercial risk narrowly, companies with very large derivatives books may find themselves labeled MSPs. In addition, all end users will likely have to take new measures to document their hedges.

Jiro Okochi, CEO and founder of Reval, a provider of hedge accounting solutions, says that a corporate end user must declare to its swap dealer that it is hedging commercial risk, rather than clearing derivative trades, to get the exemption. "The corporation is going to have to document that the exemption applies," he says, adding that documentation will create an additional cost.

In fact, end users--whether prolific hedgers with OTC derivatives or not--are likely to see increased costs in several areas. For example, says Okochi, OTC derivative trades that aren't cleared will require banks to hold additional capital. That may not impact how the largest banks, with plenty of scale, deal with their clients. But regional banks may require corporate customers to clear all derivatives trades or post collateral against uncleared trades to lower the banks' capital requirements.

Okochi says posting collateral will typically be more cost-effective for end users than posting initial and variation margin to a clearing firm, and end users' dealer counterparties will ask them to enter into credit support annexes (CSAs)--legal documents stipulating collateral support. "It will be better to have CSAs in place [instead of clearing trades], but most corporates don't even know what a CSA is," Okochi says.

Deas notes that Dodd-Frank requires the Fed to specify capital requirements for bank dealers. The Coalition for Derivatives End-Users, of which NACT is a part, has requested that regulators base those requirements on derivatives' historical losses. The losses have been relatively minor in the case of interest rate, foreign exchange and other "plain vanilla" derivatives typically used by corporates.

Instead, says Deas, regulators appear to view unmargined, uncleared derivatives--no matter their hedging benefits--as riskier. Consequently, they are likely to require banks to hold more capital against those positions, further increasing costs for end users.

"It may no longer be cost-effective to hedge," Deas says, adding that U.S.-based manufacturers could end up moving more factories offshore in search of a natural hedge in which FX risk is eliminated by producing products in the countries where they will be sold.

Hall says that inhibiting corporations' use of derivatives creates "capital deployment issues, where we'll have to hold resources and capital to cushion volatility."

For more on this topic, see "Backdoor Margins Ahead?"

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