The CFTC releases the final details of its end-user exemption from mandatory central clearing; the question is whether corporates should clear anyway.
The Commodity Futures Trading Commission today released the final version of who is and who isn’t required to clear their swaps in accordance with the Dodd-Frank Act. But should non-financial companies that use swaps to mitigate risk make use of the exemption? Are the costs of not clearing worth it?
That was part of the discussion of a NeuGroup conference call with members of several NeuGroup peer groups and consultancy Chatham Financial. The call was to help companies better understand US and European derivatives regulations and the impact they may have on your corporate hedge activities.
CFTC issues final rule.
Today’s Federal-Register publication of the final rule – which will become effective September 17, 2012 – bright-lines the issue for users. It outlines that it’s now against the law “for any person to engage in a swap unless that person submits such swap for clearing.”
Then offers the key clause. “However, Section 2(h)(7)(A) of the [Commodity Exchange Act (CEA)] provides that the clearing requirement of Section 2(h)(1)(A) shall not apply to a swap if one of the counterparties to the swap: ‘(i) Is not a financial entity; (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-cleared swaps’” It adds that “any swap that is required to be cleared by the Commission pursuant to Section 2(h)(2) of the CEA must be submitted to a DCO for clearing by the parties thereto unless the conditions of Section 2(h)(7)(A) and § 39.6 are satisfied.”
However Chatham Financial suggests that perhaps using the exemption is not the best way to go. Citing quotes from Treasury Secretary Tim Geithner and other regulators, all of whom in one way or another said end-users (exempt or not) should be pushed (given incentives) toward central clearing. This would be done by making it more costly. “…[M]arket participants will pay for the costs of their contributions to systemic risk and will have the proper incentives to move toward standardized and clearable derivatives products that carry less systemic risk…,” the Financial Stability Board was quoted as saying.
Mitigating the impact.
To mitigate the impact of these “incentives” (costs), Chatham suggested companies could do a number of things, including:
- Reducing the transaction term (tenor)
- Purchasing options
- Entering into to CSAs
- Lowering CSA thresholds
- Including credit breaks
In taking these measures, Chatham said financial and non-financial end users will need to develop :
- Capabilities for analyzing the relative merits of uncleared swaps vs. cleared swaps vs. futures as regards:
- Transaction pricing
- Collateral
- Economic & accounting effectiveness
- Credit cost
- Operational capabilities outside of those required for the uncleared OTC derivatives market
- Transaction execution
- Reporting
- Accounting
- Collateral management
With the originally stated regulatory goal of reducing risk and increasing transparency in the swaps market shining through in the final rules, opting out of the clearing requirement using the end-user exemption comes at a price. As always, the choice comes down to cost-benefit analysis, weighing the increased cost of continuing to do what you used to do vs. the cost and hassle of developing procedures to comply with the new framework. Regardless, reporting of transactions will be an increased burden, including those between affiliates.