Debate On Derivatives Regulation Heats Up

As lawmakers hash out the details of new rules governing the over-the-counter derivatives market, business groups are stepping up their fight for an exemption from expected margin requirements for firms known as end-users.

Survey data released this week estimates that a 3 percent margin requirement on OTC derivatives could cut capital spending among corporate end-users, non-financial firms that use derivatives mainly to hedge risks, by $5.1 billion to $6.7 billion a year and cost 100,000 to 130,000 jobs. The study, conducted by Keybridge Research, was commissioned by the Coalition for Derivatives End-Users, a group whose members include the Business Roundtable, the U.S. Chamber of Commerce, and Financial Executives International.

Under Title VII of the Dodd-Frank Act, regulators, including the Commodity Futures Trading Commission, the Securities and Exchange Commission and the Federal Reserve, have to write new rules to bring OTC derivatives under the regulatory umbrella. As part of those regulations, rulemakers are weighing new capital and margin requirements on cleared and non-cleared transactions for swap dealers and major swap participants. Corporate end-users have been lobbying for an exemption, but it's still unclear how they'll be affected by the rules.

Having to post cash margin will hurt end-users' ability to manage their day-to-day biz risks, said David Hirschmann, president and CEO of the Chamber's Center for Capital Markets Competitiveness. Those firms will have to choose whether to tie up their working capital, to “go naked and simply not manage their risks” or try to find other jurisdictions to transact, he said during a Feb. 14 call with reporters.

Of the 74 BRT and U.S. Chamber companies responding to the survey, 97 percent (72 companies) reported the use of OTC derivatives. The companies report using 62 percent of their derivatives to manage interest rate risk; 27 percent to hedge foreign currencies; and 16 percent to hedge commodity prices.

The requirements could potentially shift some hedging activities overseas, Marie Hollein, President and CEO, Financial Executives International noted. Among those surveyed, 46 percent of respondents indicated that they would evaluate the ability to transact in foreign jurisdictions as result of U.S. OTC restrictions.

Most respondents (91 percent) said transactions costs associated with trading would likely increase due to higher margin and capital costs placed on counterparties. In response to higher costs, 68 percent of firms said they would likely reduce hedging, while less than a third would likely continue their current level of hedging. Roughly three-quarters of the firms (77 percent) said they would consider alternative means of managing risk, while 41 percent would increase pricing to end customers, and 23 percent would shift risk to customers or suppliers, according to the survey results.

Among 66 companies that provided data on the notional amounts of their OTC derivatives exposure, the total gross notional amount was $422.2 billion, or $6.4 billion per company, a median of $730 million. With no exemptions, a 3 percent margin requirement would result in aggregate collateral of $12.7 billion, or $191.9 million per firm on average, roughly 1 percent of revenue, according to the report.

Coalition members say it's still unclear whether the CFTC will exempt end-users from the requirements. In Feb. 10 written congressional testimony, CFTC chairman Gary Gensler said transactions involving non-financial entities don't present the same risk to the financial system as those solely between financial entities. Consistent with that, he said proposed rules on margin requirements “should focus only on transactions between financial entities rather than those transactions that involve non-financial end-users.” Although Gensler has indicated that the CFTC has the authority to exempt end-users, Hirschmann noted that the CFTC chairman “hasn't stated a commitment to do so.”

Coalition members say the ultimate impact on end-users of any exemption will depend largely on what the Federal Reserve does, since the Fed that sets margin rules for bank swap dealers, which account for the vast majority of hedging transactions done with end-users. It's also uncertain whether clearing charges imposed on financial institutions could be passed on to corporates in another way.

Among the group, 47 companies were non-financial firms with a combined total net market value of outstanding OTC derivatives of $6.3 billion, and a total notional value of $241.1 billion. They included five energy firms, nine healthcare firms, two insurance companies, nine manufacturing firms, and about a dozen real estate companies. The others were tech companies, telecommunications firms, and firms that identified themselves as multi-industry.

The issue has also caught the attention of several Senate lawmakers. In a Feb. 8 letter to the leaders of the Treasury, CFTC, SEC and the Federal Reserve, a group of 13 senators, including Sen. Mike Johanns, (R-Neb.), warned that imposing margin requirements on companies that engage in hedging of legitimate busyness risk would “not only blatantly disregard the end-user exemption and Congressional intent, but it could also have the effect of draining scarce working capital from the balance sheets of mainstream American companies.”