By Joseph Neu
Poll most corporate treasurers about the impact of Dodd-Frank-initiated derivatives reform and the majority will respond that it will do little to change business as usual. Such is their faith in the exemptions from central clearing mandates for corporate end-users that won the day in the legislative process. It will probably be months before they will know if this faith has been well placed. And faith alone will not keep them exempt—they are going to have to continue to work hard to keep the market environment from changing as non-exempt end-users are migrated to central clearing.
End-user margining
While there are multiple cracks forming in the wall shielding corporate end-users from derivatives reforms, the most visible involves end-user margining and collateral. This has been the case ever since it came to light that language in the final legislation did not fully extend the corporate end-user exemption to margin requirements (see ”What Comes After Dodd-Frank Regarding Rulemaking and Derivative Exemptions?” IT, August 2010). There is, of course, the famous Dodd-Lincoln side-letter, where the Senators tried to make clear that a corporate exemption from margining requirements was indeed the intent of the legislation. However, CFTC Chairman Gensler still indicates his desire and belief in his authority to impose margining on end-users.
Despite the intent of margining exemption, “the Act also says that, ‘to offset the greater risk to the swap dealer… and the financial system from the use of swaps that are not cleared,’ regulators shall ‘help ensure the safety and soundness of the swap dealer’ and set capital and margin requirements that are ‘appropriate for the risk associated with the non-cleared swaps,’” as Chairman Gensler noted in a November 9 speech.
His position was also underscored by representatives from Chatham Financial involved in supporting the advisory firm’s corporate advocacy efforts when speaking to The NeuGroup’s Tech20 Treasurers’ Peer Group last month. They noted that protecting dealers and the financial system via collateralizing and margining makes it an open question as to whether corporate end-users will continue to be allowed to trade derivatives without such loss mitigation. Indeed, the regulatory sentiment against margining exemptions is strong enough that there is also a possibility that existing derivatives contracts, even if grandfathered from central clearing requirements, may not be exempted from margining. Regulatory efforts to swath the entire derivatives market with collateral protection are also coming on the banking side.
For instance, Chatham Financial is concerned about proposals coming out of the Financial Stability Board (FSB) and the Basel Committee, both affiliated with the Bank for International Settlements bringing forth the new Basel rules for capital adequacy and liquidity. Both are advocates for increasing capital requirements substantially so that market participants have an incentive to use standardized contracts subject to central clearing. End users will be subject to higher costs that compensate the dealer for setting aside substantial sums of capital.
If the Basel Committee and FSB have their way, these requirements would be in place regardless of whether the end-user is exempt. Thus, depending on how local regulators, such as the Fed in the US, implement the Basel Committee’s guidelines, OTC derivatives could end up becoming too expensive to use—at least without bilateral margining and collateral. Such an outcome would effectively obviate the exemption end users fought so hard for during the legislative debate on financial reform.
A MARKET OPPORTUNITY
In the end, among the likely impacts of the derivatives rules will be market responses to counterparties’ need for working capital set asides, including margin lending facilities and other forms of dedicated credit facilities. These will join the post-trade processing and collateral management solutions that banks are rolling out for non-exempt end-users.
Since credit still tends to be a loss leader for banks seeking other business, specialized facilities may appear cheaper to the desired corporate end-users that a bank wants to have frequent its derivatives desk (aka business as usual), but more costly to others.
Thus, as the margining issue helps to point out, any exemption will only go so far in sheltering corporates from reform.