By Pam Brown, Chatham Financial
A massive (and possibly chaotic) reconfiguration of the derivatives market is on the way. Here’s what companies can do to prepare.
It’s clear that the over-the-counter (OTC) derivatives market will undergo a massive reconfiguration over the coming years, but it’s far less clear exactly when the changes resulting from passage of the Dodd-Frank Act will occur and which market segments and market participants will have to adapt first.
The official effective date of Title VII of the Dodd-Frank Act—the part of the new law that concerns the OTC derivatives market—is July 16, 2011, but the two regulatory agencies charged with implementing the lion’s share of Title VII, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), have indicated that they will not come close to meeting that deadline. Moreover, many key provisions in Title VII permit the regulators to specify the actual effective dates and compliance deadlines.
As recent news reports can attest, this has created chaos among end-users as now the laws will change but the mechanisms and rules supporting those laws will be delayed. There is speculation that a flood of legal issues will bring the market to a standstill. For their part the CFTC and SEC have issued statements suggesting they will clarify the issue before the deadline. Nonetheless, companies are worried.
And no wonder. With a little more than a months left before the deadline for finalizing rules under Title VII, the Commissions have only announced general “concepts” with respect to phasing in implementation. This uncertainty poses a challenge for market participants: those that choose to charge ahead with preparations risk deploying scarce resources too early—or worse, may find that steps they’ve taken have been invalidated in the ongoing rule-making process; those that choose to wait for more clarity risk starting too late, and could find themselves in one of many bottlenecks that are almost certain to result from imposing regulations on the massive OTC market for the first time.
While it’s certainly tempting to adopt a wait-and-see approach, we recommend that any participant should get started with certain preparations now. At the very least, companies should assess how they would be classified under Title VII, identify the requirements that could affect their business, and develop a plan for how they will meet these requirements.
Below is an overview of where we are in the rule-making process and presents a list of questions to ask and recommended steps to take to help companies get started on this process.
A Phase-In Approach
While no dates have been specified, the CFTC and SEC have indicated that they are considering a phased implementation, as opposed to a “big bang” approach where all requirements go into effect for all participants at the same time. In early May, the Commissions presented a paper proposing that implementation be phased-in according to the following concepts:
- General reporting and clearing requirements would go into effect before real-time reporting and trading requirements;
- Dealers and large market participants would be required to comply before other market participants; and,
- Vanilla credit and interest rate trades would be subject to compliance deadlines before other customized or less liquid trades.
With only these broad concepts to go by, many firms are estimating that they would not need to comply with new rules until sometime in 2012 and possibly 2013. Given the uncertainty, many corporate treasurers are wondering what they should do right now to prepare for the upcoming regulatory sea change. While it’s certainly too early to take actions, companies can take steps to prepare. Doing so will make the transition to the post-Dodd-Frank world much easier in the long run.
Questions to Ask
A first step that a company can take is to ask two key questions regarding its business:
1. What is (or could be) your company’s entity classification? The regulatory burden under Title VII is largely determined by how a firm is classified, which is contingent upon the firm’s use of derivatives. There are four broad categories of entities, and these classifications are subject to some change due to ongoing rule-making:
- Swap dealer (SD): Generally speaking, a swap dealer is any entity who holds itself out as a dealer or makes a market to accommodate customer demand for swaps.
- Major swap participant (MSP): Broadly speaking, an MSP is an entity whose book of uncollateralized derivatives is so large that its default could potentially harm the financial system. The proposed rule sets specific exposure thresholds above which a firm would be required to register as an MSP.
- Financial entity: This category captures all SDs, MSPs, commodity pools, private funds, employee benefit plans, and any entity predominantly engaged in activities that “are in the business of banking or…are financial in nature.”
- Non-financial end user: This category, not explicitly defined in Dodd-Frank, captures entities that do not fall into the previously mentioned categories.
2. Which parts of Title VII are the most likely ones to have an impact on your business? Once a firm knows its classification or potential classification, the next step is to identify the requirements that apply to that classification. The table below identifies the major regulatory requirements based on entity classification.
Note that this list is not exhaustive and that some of the requirements will apply differently to different types of entities, due to jurisdictional issues. For example, the current proposed rule on margin requirements for trades done with bank swap dealers, which is set by the prudential regulators, is different from the proposed rule on margin requirements that applies to trades done with non-bank swap dealers, which is set by the CFTC. After identifying the key provisions that could have an impact on your business, the next step is to develop a compliance plan.
Developing a Compliance Plan
One thing companies can do in developing a compliance plan is to identify stakeholders and key decision makers within the company and involve them in the planning process.
It is important to identify the key stakeholders within a company to ensure that they are aware of the impact of pending changes. If the group is large or dispersed among different business units, then consider developing a plan for how you would communicate and coordinate implementation across the organization. A small investment of time in setting up the right communication strategy will pay large dividends in the long run. Other actions to take include appointing a person or team responsible for regulatory compliance (see first sidebar below) and assessing current capacity (see second sidebar below).
Put One person in charge
The critical part of the Dodd-Frank legislation is of course Title VII, which deals with OTC derivatives. The rules will now require lots of preparation — particularly in terms of compliance. Therefore any company that uses derivatives should appoint a person or team responsible for compliance. This person or team will serve as the central hub for all Title VII implementation activity and will communicate and coordinate across different business units.
Until the rules are finalized, this person or team could be responsible for tracking the regulatory process and making sure stakeholders are aware of major developments. Once the rules are finalized and the requirements for compliance are clear, this person or team could oversee the process for delegating tasks to ensure compliance with the new rules.
Assess current capacity
Part of the long list of preparing for Dodd-Frank rules includes making an assessment of the resources and capacity available to meet them. In this, start with the areas that are somewhat certain to apply to your firm. For example, it may be certain that your company will be required to report to a swap data repository, so there’s no point in waiting to get set up.
Similarly, companies subject to the clearing requirement may want to start comparing different clearing houses as well as clearing members, The process for getting set up with a clearing member could take a few months; your firm should try to avoid the potential bottleneck of firms trying to get set up for clearing once the rules are finalized.
With the July 16 deadline just around the corner, a lot of uncertainty regarding the rule-making process remains. This uncertainty, however, is no excuse for getting caught off-guard by the regulatory changes that are sure to come.
Pam Brown is a Senior Advisor at Chatham Financial (chathamfinancial.com). She can be reached at +1-484-731-0414 or [email protected].