When the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010, many corporate treasurers were satisfied that they had obtained an exemption from its derivatives provisions. Now, three years later, they have begun to reconcile with a different reality. They are engaging legal resources in evaluating their regulatory status, re-documenting their transactions, and working in new ways with their boards of directors. As they take these steps, treasurers are becoming increasingly aware that they are just beginning a journey that could extend for years.
Cross-border, margin, and Basel III regulations are not yet complete, which is creating uncertainty about their true regulatory impact. Additionally, it is becoming clear that navigating new regulations is not merely a compliance exercise. Corporate treasurers need to re-evaluate how regulations will impact their risk management strategies, operational processes, and systems. Rather than being outside of Dodd-Frank’s reach, corporate treasurers are finding themselves in the splash zone of the act’s enormous market changes.
Looming large among these uncertainties is cross-border regulation of swaps trading. Because of the global nature of the swaps market, end users in the United States regularly transact with European, Canadian, Asian, and Australian entities, just to name a few, and U.S. banks serve customers domiciled in every business center around the world. So far, neither Europe nor the United States has adopted final regulations governing the application of its rules to cross-border transactions. Early indications are creating concern about the potential for confusing, conflicting, and duplicative regulation.*
Rules proposed by the U.S. Commodity Futures Trading Commission (CFTC) hold that Dodd-Frank should apply whenever a “U.S. person” is party to a derivatives transaction. As of July 12, 2013, the CFTC’s definition of a “U.S. person” may become expansive unless the agency extends an exemptive order from December 2012. The legal implications of the expiration of the exemptive order, without a final rule to replace it, are complex. But in the absence of the clarity and relief that the exemptive order provided, many more entities—particularly those that are majority owned, directly or indirectly, by U.S. entities—may need to comply as U.S. persons.
Companies’ first order of business is to sort out which regulatory regimes apply to each of their various entities. Then they need to consider which regulations apply to each particular transaction, which involves determining the regulatory status of their counterparty in the transaction. There are a total of six different end-user statuses and eight different bank-entity status configurations that can alter which regulatory requirements apply to a transaction.
It’s likely that many transactions could be subject to oversight by multiple rule-making bodies. If the European Union adopts an approach similar to that proposed by the CFTC, any transaction between a U.S. entity and a European bank, or between a European entity and a U.S. bank, will be subject simultaneously to two different regulatory regimes. And a transaction might be subject to different rules depending on which bank wins a competitive auction. For example, the documentation, reporting, and other requirements that a European subsidiary of a U.S. parent company must comply with will vary depending on whether it’s working with a U.S. swaps dealer, a non-U.S. branch of a U.S. swaps dealer, or a non-U.S. affiliate of a U.S. swaps dealer.
This Rubik’s Cube of complexity is the source of international discomfort with the CFTC’s proposal, and it’s the basis for ongoing international dialogue about a system of mutual recognition that could simplify regulatory analyses. In a mutual-recognition system, one country could recognize another country’s regulatory regime as comparable to its own and so could deem any transaction that fully satisfies the regulatory requirements of the transaction’s host country as satisfying all requirements of both regulatory regimes.
The CFTC contemplated such a system, but its proposed cross-border guidance only compounded concerns about complexity because it applies the regulatory regime at a requirement-by-requirement level, rather than at a jurisdiction-by-jurisdiction level. If such an approach were finalized, a single transaction might be subject to the margin, reporting, and documentation rules of one country, while being subject to the clearing, recordkeeping, and portfolio reconciliation requirements of another country.
In a letter to U.S. Treasury Secretary Jack Lew on April 18, nine foreign finance ministers—including those from Germany, France, the U.K., and Japan—indicated that such an approach would challenge the efficient functioning of global derivatives markets. They noted: “An approach in which jurisdictions require that their own domestic regulatory rules be applied to their firms’ derivatives transactions taking place in broadly equivalent regulatory regimes abroad is not sustainable. Marketplaces where firms from all our respective jurisdictions can come together and do business will not be able to function under such burdensome regulatory conditions." While taking umbrage to the letter before a Senate panel, Treasury Secretary Lew noted that U.S. regulators were “making real progress” on the issue. And indeed, a recent proposal by the U.S. Securities and Exchange Commission (SEC) offers hints about the dimensions of that progress. While SEC rules will not apply to an end user’s interest rate, currency, and commodity swaps, its approach could influence the CFTC’s final rules.
The Worst of all Worlds
On May 1, the SEC offered a proposal on cross-border regulation that re-envisions how a mutual-recognition regime might work. Rather than evaluating whether each rule is equivalent between the U.S. and another regulatory regime, the new proposal focuses on the outcomes that the rules achieve. For example, if rules in one regime mandate that a given transaction be reported within one day, while comparable rules in another regime allow for three days, one could reasonably conclude that these rules achieve similar outcomes, even if they differ in the specifics. And rather than comparing regimes on a rule-by-rule basis, the SEC proposal groups regulations into four broad categories and evaluates whether those categories are broadly comparable between jurisdictions. In essence, it takes a half-step toward the jurisdiction-by-jurisdiction approach that foreign regulators have called for.
*Note that the CFTC and the EU have reached a tentative accord on the issue of cross-border swaps although, as the president of the Securities Industry and Financial Markets Association put it, "the devil's in the details."
As regulators labor toward harmonizing their approaches domestically and internationally, corporate treasurers must begin working through the practical implications of the current proposals. In the absence of clear and final guidance, many are assuming that their transactions will be subject to both U.S. and European laws, as well as rules in some other jurisdictions such as Singapore, Japan, Hong Kong, and Australia, which are largely lagging behind the U.S. and Europe. Such an approach dictates understanding the requirements imposed by each regime and, for every derivatives transaction, comparing the requirements in each rule category for the jurisdictions the transaction falls under. When treasurers identify which regime’s requirements have the highest standards and nearest-term compliance deadlines for each rule or rule category, they can prepare to comply with the most stringent demands in each category, a “worst of all worlds” scenario.
An inevitable conclusion when performing such an analysis is that life is simplest for companies that don’t cross borders—and this conclusion makes clear just what’s at stake with cross-border derivatives regulation. Some businesses will likely be overwhelmed by the complexity inherent in cross-border transactions, and few companies are going to subject themselves to a worst-of-all-worlds compliance regime without seriously considering the alternatives. Where possible, they’re likely to choose to transact with banks in their own jurisdictions.
For their part, large banks will not be satisfied with losing transactions because of jurisdictional considerations. They may have incentives to create subsidiaries in many new jurisdictions so that they can transact on a regulatory playing field that is level with that of domestic competitors. This may cause a proliferation of financial services entities and transaction documents for corporate end users—an effect some have called the “balkanization” of the derivatives market. It may also diminish the extent to which a company can net all of its global transactions with a given bank counterparty. Ultimately, rather than simplifying the lives of treasury professionals, Dodd-Frank may vastly increase the complexity of managing financial risk, especially for multinational businesses that frequently engage in cross-border derivatives transactions.
Cross-border swaps regulation is not the only piece of unfinished business looming over the derivatives market; capital and margin rules may also reshape the industry. Capital rules in the U.S. and Europe are likely to be finalized this summer.
Basel III derivatives rules require banks to set additional capital aside to cushion against losses across their derivatives portfolios. The amount of capital—and the prices banks will need to charge in order to be compensated for having to set it aside—is significant and driven by complex formulas that rely on stressed market rate and credit assumptions. The European Union is poised to finalize legislation that includes an exemption for European banks when they transact with non-financial end users that are using the derivatives to hedge commercial risks. U.S. banking regulators are not expected to adopt a similar exemption, which sets the stage for a significant competitive difference between U.S. and European banks. European banks will be required to hold less capital against their swaps with corporate counterparties than U.S. banks have to hold, allowing European banks to charge lower transaction prices to end users.
This discrepancy will reinforce the determination of European companies to transact with domestic banks and will increase incentives for U.S. businesses to transact with their European bank partners for risk management purposes. Of course, a U.S.-based organization may have to weigh the economic benefits of transacting with a European bank against the compliance burden created vis-à-vis cross-border regulations. The larger an entity is, or the more frequently it trades, the more likely it will choose to incur the cross-border compliance burden.
Meanwhile, margin rules for uncleared swaps are currently in the hands of a G-20 commissioned group, the Working Group on Margining Requirements (WGMR), which is tasked with creating a globally applicable margin framework. The rules the WGMR generates will dictate the volume and form of cash and/or liquid securities that companies will be required to post against their derivatives positions. Estimates for the total magnitude of margin postings worldwide, as dictated by the various margin proposals on the table, range from hundreds of billions to the low trillions of U.S. dollars. These figures suggest that the margin rules will have a substantial impact on the global economy and on corporate risk management decisions.
In February 2013, the WGMR undertook a second, “near-final” consultation, which sets the stage for completion of a final recommendation sometime this summer. Once the global framework is complete, national regulators—including U.S. banking regulators—will translate the final recommendations into national law. Among the key questions for corporate treasurers is whether U.S. banking regulators will relent on a proposed requirement for banks to establish credit support arrangements with all their counterparties. Specifically, under the rule proposed by banking regulators, non-financial companies would need to collateralize some portion of the market exposure their positions create, if the exposure exceeded a threshold set by their bank counterparties. For banks and their corporate counterparties that are already engaged in credit support arrangements, the new rules would represent, at a minimum, an additional documentation burden. For others, including those that rely on securitization financing or pledge physical assets to secure their swaps, new credit-exposure thresholds could substantially alter the way they finance assets, increasing their costs or reducing their flexibility.
Consequently, companies working through the Coalition for Derivatives End-Users are encouraging the U.S. Congress to pass legislation that would preclude regulators from imposing margin requirements on derivatives transactions executed by non-financial end users. On June 12, the House of Representatives voted by a margin of 411-12 for a bill (H.R. 634) focused on the needs of non-financial end users. A significant question is whether the Senate will take up the same legislation in a body that has heretofore been highly resistant to Dodd-Frank legislative changes of any kind. A companion bill (S. 888) was introduced by a bipartisan group of Senators on May 7.
Motivated to Find Alternatives
Until these major elements of derivatives reform are finalized, corporate treasurers will have difficulty assessing the overall impact of Dodd-Frank on their risk management strategies. However, looking at the existing proposals may help treasurers predict how derivatives markets will be reshaped in the coming years.
For example, it is now widely understood that the cost of using uncleared over-the-counter (OTC) derivatives will increase, substantially in some cases. Factors driving this cost increase include Basel III, the administrative costs associated with Dodd-Frank, and funding charges associated with banks’ posting initial margin on their hedge positions. How will companies respond to these higher costs? Will the cost increase cause them to look for alternative means of managing their risks? These questions cannot be answered monolithically because companies will respond in a variety of ways.
Almost all alternative hedging products, such as exchange traded futures and swap futures, require a company to fully margin its derivatives positions to obtain favorable transaction pricing. For many companies, including those that are highly leveraged, those with a high cost of capital, and those without access to liquid resources, collateral is a gateway issue. If these organizations were required to post collateral, many would usually opt not to hedge. For such companies, the question is not whether to use exchange-traded futures or swap futures, but rather whether their uncleared OTC swaps can be structured in a more efficient manner or whether they can manage their risks using a tool other than derivatives.
Companies that are willing and able to post cash or cash-equivalent collateral—a category of companies that we might refer to in shorthand as “cash-rich corporates”—may consider alternative hedging products. Their principal motivation for considering these products would be to lower transaction costs. Among these alternatives, a company might use CME swap futures to pre-hedge bond issuances and use Eris Flexes and Eurodollar futures to hedge LIBOR-based loans. Companies may also elect to bilaterally margin or clear their OTC transactions; some large, investment-grade companies are already choosing to use margin to gain more control over their counterparty risk in derivatives trades.
A key question for companies considering these alternatives is how they would affect hedge accounting. Public companies generally place a high priority on ensuring that their derivatives qualify for hedge accounting treatment, lest they jeopardize their ability to demonstrate consistent and stable earnings to investors. Many alternative hedging products allow for hedge accounting, but the “hedge ineffectiveness” that results from subtle differences between the hedged item and the hedging instrument may have a small impact on earnings. This may be tolerable for some companies, but for others, even a small degree of ineffectiveness might make these products unattractive.
Aside from the theoretical question about whether hedge accounting is possible with a particular instrument, companies considering alternative hedging products need to ensure they have the operational capability required to carry out the accounting treatment. For example, does their staff have the tools and expertise to perform regression testing on exchange-traded futures to demonstrate the hedge effectiveness relative to the hypothetically perfect derivative? These questions may lead some companies to invest in new systems and operational capabilities.
Has Regulation Gone Too Far?
Corporate treasurers are increasingly seeing themselves at the beginning of a long journey. Even as they prepare to move forward, they are asking themselves, their trade associations in Washington, and policy makers whether the pendulum has swung too far.
Thomas Deas Jr., vice president and treasurer of Philadelphia-based FMC Corporation and chairman of the National Association of Corporate Treasurers, expressed this sentiment succinctly in April, when he testified before the House Financial Services Committee: “[A]t this point, over two and a half years after passage of the Dodd‐Frank Act, there are several areas where continuing regulatory uncertainty compels end users to appeal for legislative relief from actions we believe will raise costs unnecessarily and hamper our ability to manage business risks with properly structured OTC derivatives.”
This sentiment is animating companies to remain engaged with policy makers to ensure that derivatives regulation serves the interests of those that have long relied on these markets to promote certainty and predictability in their businesses.
Luke Zubrod is director of risk and regulatory advisory for public and private companies on OTC regulations at Chatham Financial. In this role, he provides policy and technical advice to businesses and organizations around the world, as well as to Congressional staff and many U.S. regulatory agencies. Zubrod has authored numerous comment letters, white papers, and articles; testified before Congress; and spoken to government and business groups on the impact of derivatives regulation on end users.