A new era of swaps regulations is dawning, and most companies aren't prepared.
Non-financial companies are just starting to awaken to the complexities that will entangle all users of derivatives, and with some key regulations still not finalized, uncertainty is adding to the struggle.
For many companies, the wake-up call comes when they are approached by banks or other counter-parties to update documentation as required for those dealers under the Dodd-Frank Act. “Companies that use derivatives to hedge normal business risks, like long-term debt or fluctuations in interest rates, are playing catch up,” says Gail Bernstein, special counsel at law firm Wilmer Hale. “They have time, but if they are not getting up to speed, it will bite them.”
Under the Dodd-Frank Act, all derivatives trading must be done through a new clearing process meant to bring greater transparency to the swaps market. Financial institutions have been gearing up for the new clearing requirements for some time, says Bernstein. Non-financial companies that are heavy end users of derivatives also have been engaged from the beginning, she says. That typically includes companies that are heavily dependent on commodities, such as fuel or food, where price fluctuations are hedged with swaps, or companies that are heavily subject to foreign currency risk.
A large number of operating companies that make up a small portion of the derivatives market, however, are well behind on compliance with new rules, says Christina Crooks, senior manager of government affairs for Financial Executives International. They make up only about 10 percent of the over-the-counter market, she says, but it's common practice for companies across all sectors to at least occasionally trade in interest rate swaps or credit default swaps, for example.
“There is significant reason for concern,” says James Schwartz, an attorney of counsel to law firm Morrison & Foerster. “In the old world, a non-financial end user of derivatives had a bilateral relationship with a dealer, so in a contractual sense it was fairly simple,” he says. “Now, by imposing conditions on that bilateral relationship, and in certain cases requiring trades to be cleared by a central counter-party, Dodd-Frank significantly complicates life for those end users.”
The good news, says Crooks, is lobbying groups were successful in winning an exemption from clearing for non-financial end users when they are hedging business risk, so they won't be subject to the full scope of swaps regulation for those transactions as it rolls into place this year. However, she and other legal experts point out, the exemption isn't necessarily straightforward or easy to get. That's where the difficulties begin.
The exemption only applies to non-financial end users who use derivatives specifically to hedge business risk, not for other purposes, like speculation or trading, says Anna Dodson, a partner with law firm Goodwin Procter. A non-financial company might also fail to qualify for the exemption if it fits any of the criteria for a “financial entity” as spelled out in banking rules, such as swap dealers, commodity pools, private funds, or employee benefit plans. Companies that have an affiliate that fits the criteria may also have trouble gaining the exemption. It also gets dicey when a non-financial company centralizes its swaps through its treasury department or another non-operating company, a situation that could qualify a company as a financial entity. “It's narrow, so you have to tick and tie through that carefully to make sure you are not a financial entity,” she says.
“Companies that use derivatives to hedge normal business risks, like long-term debt or fluctuations in interest rates, are playing catch up.”
Records and Documentation
If a company doesn't qualify for the exemption or qualifies only for certain of its swaps, there's a mountain of documentation required when clearing takes effect this year. If a public company determines it qualifies for the non-financial end-user exemption, then it needs the approval of its board of directors or a designated committee of the board to enter into uncleared swaps. “Non-financial companies need to get a move on that,” says Crooks. “Most boards only meet quarterly, and you need the board or a committee that oversees swaps to approve you to not clear and continue to use over-the-counter swaps.”
Even when the end-user exemption applies, new recordkeeping procedures on swaps will be required, says Dodson. “Every counter-party is required to keep full, complete, systematic records of swaps for five years, and they have to be retrievable within five days,” she says. “For historical swaps, there are transition rules, and it gets very granular very fast.”
NON-FINANCIAL END-USER EXCEPTION
Below, Wilmer Hale provides details on how to tell if your company qualifies for the non-financial end-user exception.
Does your company qualify for the non-financial end-user exception?
If your company is a non-financial entity, it may elect to use the end user exception from mandatory
clearing for swaps that it uses to hedge or mitigate its commercial risk and not for speculative trading purposes. The purpose determination is made on a transaction-by-transaction basis. A company will not
be allowed to use the exception for non-hedging swaps even if it otherwise qualifies for the exception.
If your company qualifies, how does it elect the exception from clearing?
All end users (public and nonpublic) that rely on the end user exception to elect not to clear qualifying
swaps must provide the following information to a swap data repository (SDR), if available, or to the
- Whether your company is a financial entity and, if so, which exception to the definition of
“financial entity” it is using (e.g., is it a small bank or a captive finance company?);
- Whether the swap for which the election is being made hedges or mitigates commercial risk. To
satisfy this requirement, the company need only state that it will only elect the end user exception
for swaps that meet the hedging or risk mitigation standard;
- How the company generally expects to meet its financial obligations with respect to entering into
uncleared swaps. The company will need to indicate (in a check-the-box format) all the following
—a written credit support agreement;
—pledged or segregated assets (including posting or receiving margin pursuant to a credit
support agreement or otherwise);
—a written third-party guarantee;
—its available financial resources; or
—other means; and
- Whether it is a public company and, if so, confirmation that it has obtained appropriate approvals from its board of directors. Nonpublic companies are not required to obtain board approval.
These items may be reported on an annual basis (in anticipation of making the election and valid for 365
days from the report) rather than at the time a swap is entered into. However, the election of the
exception and the identity of the end user must be reported on a swap-by-swap basis at the time the
swap is entered into. While all swaps will ultimately need to be reported, the obligation to report will
largely be borne by swap dealers, MSPs, and larger private funds and not by non-financial end users.
These requirements only apply to swaps entered into on or after the compliance date.
An inter-affiliate reporting requirement could be especially burdensome for large non-financial companies that have centralized swap booking entities, so they are trading with global affiliates internally, says Evan Koster, a partner at law firm Hogan Lovells. Even if such trades might escape clearing, which isn't fully clear yet, those centralized booking entities may still be required to meet the reporting obligations. “When you think of a large company with operations globally, they could be doing many foreign trades daily,” he says. “They may not have the systems to report those to each other in the manner required by the rules. This is going to be a money issue for them.”
Even as the clearing process is nearly getting under way, there's still a cloud of uncertainty over many aspects of it, says Bernstein. The U.S. Commodity Futures Trading Commission has jurisdiction over most swaps, but the Securities and Exchange Commission will be responsible for overseeing securities-based swaps, she says. The CFTC still has some major rules pending, and the SEC is much further behind in finalizing its rules, she says.
Most significant among the unresolved questions, Bernstein says, is how much margin or collateral companies will be required to post for swaps that are not cleared. Dodd-Frank requires margin and capital to be imposed on uncleared swaps that would be at least as much, if not greater, than for cleared swaps, she says. There's plenty of debate over the extent to which Congress intended for that margin requirement to be imposed on uncleared swaps, and lobbying groups are still hoping to get Congress to amend that requirement. In the meantime, however, regulatory agencies are adhering to it and planning to enforce it, she says.
Peter Vinella, director at the Berkeley Research Group, says implementation of the clearing process is going to be difficult. “It's going to be a nightmare for companies to comply with this, even if they wanted to,” he says. “This was like Sarbanes-Oxley, where everyone threw everything at the wall.” It will take time for the system to develop, he says, and in the meantime he believes companies may look for ways to take their derivatives trades offshore to avoid the U.S. regulatory regime.
Even the effective dates are "surprisingly complicated," says Schwartz. Many of the important external business rules are scheduled to go into effect on May 1, he says, while mandatory clearing for those who do not qualify for or elect the end-user exception begins Sept. 9. According to Crooks, the reporting and recordkeeping requirements for end users begin on April 10. The margin rules are still in development.
“Non-financial companies can't wait for this to get sorted out,” says John Alan James, executive director for the Center for Global Governance, Reporting and Regulation at Pace University. “For non-banks, there is still a lot that is up in the air.”