By Anne Friberg
Two NeuGroups for FX managers look into the Dodd-Frank Act’s end-user rules, review hedge programs and delve into the intricacies of emerging markets.
When the two peer groups dedicated to FX risk management kicked off The NeuGroup’s second-half meeting season of 2012 in September, Dodd-Frank compliance as usual lately was high on the agenda, along with a look at the cumulative costs of regulations.
Sponsored by Standard Chartered and Chatham Financial, respectively, the FXMPG and FXMPG2 both met in California to dig deeper into these and other timely topics.
Dodd-Frank “making landfall”
The summer belatedly produced final language on the Dodd-Frank Act’s (DFA) end-user exception (EUE), and the timing was opportune for an update by the sponsors’ experts on the matter.
The Board (or appropriate committee of the Board) of an SEC filer must review and approve the decision to utilize the exception, which is required for all derivatives covered by the mandatory clearing requirement, effective August of 2013. The Board approval may be general rather than on a swap-by-swap basis but the EUE is legal-entity specific; it is not clear if the corporate Board (at the parent level) can pass resolutions concerning all relevant (derivative-using) affiliates.
Other sticky issues include the classification of treasury centers/in-house banks and which types of inter-affiliate trades qualify for the exception, which don’t, and how margin and reporting requirements apply (see illustration at bottom). These issues are further complicated by extraterritoriality concerns depending on their geographic location, and may be covered by regulations in other jurisdictions.
ISDA and CSA Updates
DFA compliance will require updates to ISDA agreements and those without CSAs will need them. To facilitate compliance with the DFA-specific ISDA updates, ISDA will have a series of “protocols” counterparties can sign onto, starting with the ISDA August 2012 Dodd-Frank Protocol.
The big concern of both FX groups: What does the hedge program achieve and how much does it cost?
Several more protocols are expected between now and next August as rules become finalized and the list of swaps required for clearing grows. ISDA has partnered with Markit to provide a tech-based solution—ISDA Amend—that will facilitate this process. It is expected that banks will insist that compliance-related ISDA updates be done via the Protocol and not bilaterally. Note that these ISDA updates will not affect the economic terms negotiated between counterparties.
Increased Cost of Regs
Increased costs resulting from derivatives regs and Basel III compliance, in combination with dwindling interest income and concerns about volatility raise questions about existing hedge programs.
Although tackled a little differently in each group’s meeting, the concern was shared: What does the hedge program achieve and how much does it cost? One member introduced the case for a re-evaluation of the hedge program in light of this new environment, and had even taken a stab at calculating the cost increases associated with Basel III and Dodd-Frank; the results were not encouraging.
Is hedging worth it when costs are so high and outcomes questionable?
Is hedging worth it when costs are so high and outcomes—e.g., reduced earnings volatility—sometimes questionable? Another way of looking at it: what steps can be taken to lessen the impact of collateral posting? Increase the use of purchased options. What would you rather have: cash-flow uncertainty due to margin calls or a budget for option premiums?
Emerging Markets
Supply-chain structure and market opportunities both contribute to growing exposures to China and members sought to learn more about the different renminbi markets: the onshore CNY, offshore CNH and the non-deliverable forward, NDF. At the end of 2011, the CNH market was about one percent of the CNY.
As CNH volumes grow, the different FX rate curves will converge and CNH hedging will edge out the NDF market; some market watchers expect the CNH hedge volume to overtake NDF hedging before the end of 2012.
Other topics
In addition to the agenda items above, members covered a range of other topics in their discussions. Standard Chartered’s European head of research Sarah Hewin gave an update on the eurozone. The bank predicts a euro-area recession in Q3 (and for the second half of 2012) and very low 2013 growth beyond that.
The forecast dovetailed nicely with a member’s observation, which highlighted the key aspects of his company’s euro contingency plan and action steps taken or planned if certain triggers are hit.
Systems are always subject to debate in the groups. Several members across the two groups are in the process of selecting or implementing new systems or versions. A couple of FXMPG2 members reviewed their systems infrastructure for the FX function and how they are integrated, which prompted questions and compare-and-contrast. Finally, a lively session dissected a member’s approach to educating non-treasury people in the company about FX.
Next up for the FX groups is the biennial “FX Summit” which will take place in March 2013.