Will credit be the end-user exemption’s first domino?
Bank regulators want corporates to be subject to margin on uncleared derivatives if their credit deteriorates past a threshold. If they win on this point, there’s little to stop them from asking for more.
Congress intended commercial end-users to be exempt from Dodd-Frank’s derivatives clearing and margin requirements. This is explicitly stated in the Dodd-Lincoln side letter to the Act (see related story here). Nonetheless, US prudential bank regulators led by the Federal Deposit Insurance Corp. (FDIC) Tuesday proposed that end-users be subject to margin if their credit deteriorates.
If that happens, the regulators’ proposal would require commercial end-users to post initial and variation margin to their counterparties. A competing proposal from the Commodity Futures Trading Commission (CFTC) requires no margin, only a credit support agreement between the parties.
At first glance, the FDIC-backed argument appears somewhat innocuous. Banks, its backers note, already acknowledge credit risk in the pricing of OTC derivatives sold to corporates. In fact, CFTC Commissioner Scott O’Malia, speaking out against the FDIC approach, warned that there is little to keep banks from increasing the pricing on derivatives to make up for the extra capital they need to hold against uncleared transactions with commercial end-users.
Also, the prudential regulators’ focus on credit risk skirts one of the end-user lobby’s strongest cases against including commercial hedgers in the Dodd-Frank regime: the observation that a decline in the value of a commercial end-user’s hedge is offset by an increase in the value of the hedged asset.
So, unlike a decline in a speculator’s derivatives position, a fall in the price of a commercial end-user’s derivatives does not mean the company has necessarily lost money. It would therefore make no sense to increase its margin or collateral requirements based on a price decline.
But that’s a market risk argument. FDIC and its regulatory counterparts are focused on credit risk, and only above an as-yet unspecified threshold. That argument’s merits will be harder for the end-user lobby to counter. After all, despite the value of its hedged assets, a company that cannot service its contracts due to a decline in, say, cash flow represents a real risk to its financial counterparty – which the FDIC or the other regulators could be on the hook to bail out. Both the FDIC and the CFTC proposals are now out for comment.
If the credit risk exception only threatens zombie companies, why should corporates worry? Mainly because it would represent a breach in the airtight exclusion envisioned in the Act and the Dodd-Lincoln side letter. Regulators could be emboldened to whittle back the exemption even more. Once a dromedary’s snout pokes under a tent flap, it often proves difficult to keep the rest of the beast out.