The Shape of Swaps to Come

Corporate users of derivatives brace for coming regulations.

Regulators are expected to crank up output of Dodd-Frank Act rules in the months ahead, leaving corporate end users of derivatives waiting to see how the regulations will affect their use of over-the-counter swaps.

Two of the most controversial issues that regulators will tackle—whether end users will have to post margin and whether their inter-affiliate swaps will be exempted from new requirements—may also be addressed by Congress. In late July, Rep. Michael Grimm (R-NY) introduced legislation that seeks to clarify that swap end users are exempt from margin requirements. And Rep. Steve Stivers (R-OH) introduced a bill in August that would ensure that companies using swaps internally among affiliates were exempted from Dodd-Frank rules.

Pat Ryder, director of financial risk management at Eastman Chemical, says his company fought hard for the end-user exemption from margin requirements when the Dodd-Frank legislation was being written. The exemption was included in the legislation, along with an exemption from clearing the transactions. Since the legislation became law, however, the FDIC has proposed giving prudential regulators the authority to require banks to post margin on swaps and collect margin from their clients.

Whether regulators ultimately approve that back door approach to margining is something end users will be watching.

“Our first concern is margining, tying up that cash and setting up the infrastructure to monitor positions” and put up margin if appropriate, Ryder says, adding that currently Eastman has no margining obligations.

Companies use inter-affiliate swaps to balance their books, often to net out their exposures to more efficiently hedge their risk, says Tom Deas, treasurer and vice president at FMC Corp. and president of the National Association of Corporate Treasurers (NACT). Regulators, however, have suggested companies must report those transactions to still-to-be-built swap data repositories in real-time.

NACT has supported more transparency and suggested that banks, which already have the necessary back-office systems, report the swap transactions they engage in with corporate customers, Deas says. Inter-affiliate swaps are not market transactions, however, and unlike banks acting as swap counterparties as a business, companies typically lack the systems to report the data. “We don’t have the back-office systems in place to fulfill this requirement,” Deas says.

Jiro Okochi, CEO and co-founder of Reval, a provider of financial risk management solutions, says that if margin requirements and the documentation rules are imposed on companies, banks and other dealers will require corporate customers to enter into credit support annexes (CSAs), which legally regulate bilateral swap agreements. Most swap market participants use the International Swaps and Derivatives Association’s CSA template. But companies must be sure their law firms are familiar with negotiating CSAs, Okochi said, and they should make sure they get in the documentation queue with banks sooner rather than later, since if the requirement is put in place, banks may become backlogged.

Both Deas and Ryder say their companies are waiting for further developments before tackling the CSA issue.

The regulators’ swaps proposal would establish thresholds, around which counterparties would shift collateral back and forth, depending on the values of the swap sides. Companies that have put on hundreds of swaps with a dealer may have to reconcile valuations as often as daily. Firms such as Reval and Chatham Financial provide automated swap valuation services, but that’s an additional cost.

Ryder says Eastman has the technology and processes in place to do daily valuations. However, the company doesn’t want to “ship cash” when it holds the “exact opposite physical position” the swap is hedging, he says, adding that Eastman would have to develop the ability to monitor positions and determine when to pay or collect margin.

In addition, margin requirements would force companies to set aside cash to ensure they can meet margin calls when they arise.

“If a corporate treasury is called to meet margin requirements and it doesn’t, then it’s in default. So we would have to hold credit to meet that potential margin call,” Deas says. “Holding aside that amount of credit, with a cushion required [to cover unexpected margin calls], would be a significant subtraction from the credit we use to run our business.”

A study undertaken by the Coalition for Derivatives End-Users estimated that the average nonfinancial member of the Business Roundtable would have $120 million of cash or committed credit tied up to meet daily derivatives margin requirements.


For a discussion of the CBOE’s exchange-traded CDS, see Credit Default Swaps Makeover. And for a look at possible changes to hedge accounting, see Hedging Inflation and Other Risks.



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