June 27, 2013
A deadline looms for compliance with a Dodd-Frank protocol.
With a deadline for adopting the March 2013 DF Protocol due on July 1, recent conversations among corporate end users of derivatives in NeuGroup online forums have centered on whether or not they should adopt Schedule 3 (risk valuations) and Schedule 4 (portfolio reconciliation).
According to Marc Horwitz of DLA Piper, Schedule 3 is optional for corporate end-users. Schedule 4, meanwhile, will likely be required by dealers. See further detail in the table below with input from Mr. Horwitz and Chatham Financial’s Luke Zubrod.
Schedule 3: Yes’s and No’s.
Among NeuGroup members who have reported in on whether they plan to adopt these schedules, one’s rationale for adopting Schedule 3 was that the company does not have CSAs yet, but another – with CSAs in place – said his company would adopt, possibly for the reasons cited by Messrs. Horwitz and Zubrod: they might find the information useful.
Schedule 4: No preferred but yes by coercion?
The picture is also mixed on Schedule 4 adherence. Several members note that they would prefer not to adopt it but they are facing pressure from their swap dealers to do so, and that trading may become affected, and eventually halted, if they don’t.
One member said the rationale for declining Schedule 4 is the already existing CSAs with all counterparties and in the daily CSA management market valuations are effectively agreed on within immaterial margins on a daily basis, rendering Schedule 4 “unnecessary.” However, he said, “at least one bank contacted us today to say that they ‘need’ us to say yes to schedule 4 or agree to a bilateral annex agreement.”
Said another member: “We were comfortable saying no to Schedule 4 based on our confirmation process, our internal system reconciliation and annual audit confirmation process.” But, faced with pressure, this member is now working on bilateral agreements and/or potentially adhering to Schedule 4 to agree on a reconciliation process, and said: “We are trying to learn the CTFC thresholds to hopefully reduce the frequency of reconciliation to once or twice a year.”
Outlook.
What is optional and mandatory for end users seems to be in the eye of the beholder and requirements on swap dealers appear to have a real “trickle-down” effect on end users in that they apply pressure on their swap clients to adhere to requirements the clients feel are adequately “covered” by existing procedures and documents, and have to yield to maintain trading relationships. It’s safe to say that end users may expect more such standoffs in the future.
Information about March 2013 DF Protocol adherence status by counterparty is available here.
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Schedule 3 – Risk Valuations
― Calculation of risk valuations
― Dispute resolution
― Relationship to other valuations |
Schedule 4 – Portfolio Reconciliation
― Required reconciliation dates
― One-way delivery of portfolio data
― Exchange of portfolio data
― Other portfolio reconciliation procedures |
| DLA Piper |
- Schedule 3 is optional for corporate end-users. Corporates can elect it if they want to receive daily marks of each trade, and if elected, the corporate can dispute the valuation in a manner similar to how it disputes a valuation under the CSA. Many large corporates may not elect Schedule 3 as they can obtain this information from dealers in any case and they do not want their inboxes clogged.
- We have seen a few who have elected it as they might find the information more useful than intrusive, and in any case, they can change their mind by amending this Questionnaire response if the information does not prove useful.
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- Dealers likely will require corporates to elect Schedule 4, as CFTC Regulation 23.502(b) requires swap dealers to agree in writing with their counterparties on the terms of portfolio reconciliation. If elected, corporates have the choice of “One-Way Delivery” and “Exchange”. Since “One-Way Delivery” involves only the dealer providing portfolio data, we are generally finding corporate end-users prefer this less onerous election.
- We are also finding that corporate are not electing reconciliation against SDR data as this would also require action by the corporate in obtaining the SDR data and reconciling against that data.
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| Chatham Financial |
- This schedule is only mandatory for financial entities. Since some corporates may be non-financial, they have the option of whether or not to agree to this schedule.
- Schedule 3 outlines the process for (i) determining the value of a swap solely for the purpose of a swap dealer’s internal risk management requirements under 4(s)(j), and (ii) provides a valuation dispute resolution. This is different from what a CSA accomplishes, which is calculating value for the purpose of collateral exchange.
- Bottom line, if non-financial corporates feel these valuations would be a useful additional data point, they should agree to Schedule 3. Furthermore, the corporate would still need to actively request these values from the swap dealer in order to receive them; they are not automatically sent.
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- This schedule deals with portfolio reconciliation and for the time being, our recommendation has been that corporate end-users say “no”.
- If a client really wishes to engage in portfolio reconciliation at this time (e.g., because they think this would be additive to their process/controls), they can answer “yes” and we generally recommend the “exchange” method rather than “review” where discrepancies might be inadvertently overlooked and both parties are responsible for identifying them. However, the “exchange” method does require the parties to exchange valuations. As a result, some companies who wish to maintain the confidentiality of their internal valuations, or who do not have the infrastructure to exchange data, may prefer to “review.”
- Note that for end users who transact with European banks, these banks may require an agreement with respect to portfolio reconciliation prior to trading after September 15, 2013. Additional market infrastructure as well as other documentation options are expected to develop in the intervening time.
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