By Joseph Neu
Ever since the Dodd-Frank Act (DFA) took aim at OTC derivatives markets, non-financial corporates have been lobbying to be exempted. The CFTC granted them an exception from the DFA swap-clearing requirement under most circumstances in a final rule published on July 19 (see “Swap Clearing Nears Lift-Off“). However, it does not exempt them from DFA margin requirements. So the lobbying effort continues for an exception extended to margin requirements. Next, they will have to lobby regulators of financial institutions to recognize these exceptions in exempting FIs from countless capital and liquidity set asides and other rules.
It is nice to have options—and no one should begrudge corporate treasurers for not submitting to regulatory requirements without a fight. Yet at some point they need to stop banking on exemptions and start exploring how to best transact in rapidly evolving markets for cleared derivatives with margin. Here are a few reasons why.
- Not exempted from new market norms. An exemption from clearing and even margining will not exempt corporates from the economics of the new market conditions for derivatives confronting all other non-exempt counterparties. Rules covering banks and broker-dealers will incent clearing and posting margin for derivatives transactions with added costs for those that are not. These will eventually get passed on in some way. Corporates surely cannot expect to win an exception to every element of OTC derivatives reform.
Further, the majority of market participants will be non-exempt, and market norms for trade pricing, risk management, settlement and processing of transactions will evolve to serve cleared trades. Do corporates really want to stay in the kiddie pool?
- Costs of exempt OTC transactions need to be recalculated in line with new norms. Since the financial crisis, numerous corporates have looked at collateral-supported derivatives trades incorporated in CSAs as a means of getting better pricing, especially on long-term swaps. The results, after offsetting the administrative hassles of implementing CSAs and managing collateral, have been mixed.
As the above-mentioned market norms evolve, however, it is likely that the cost equation will change. Particularly when viewed on a risk-adjusted basis, the pricing benefits of secured transactions will only grow larger and the administrative costs smaller as systems and processes catering to the larger pool of counterparties evolve. It gets harder and harder, therefore, to argue against the notion that corporate treasurers who do not explore cleared derivatives and margin alternatives will leave money (or risk) on the table, exemption or no. Cash will get tied up in collateral instead, that’s true, but what is that cash earning sitting on corporate balance sheets today?
- Pricing exempt derivatives is going to get trickier. In connection with the cost analysis, corporate treasurers should also reflect on pricing challenges. OTC derivatives, even those close to the plain vanilla spectrum, are already being described by dealer banks as uniquely priced based on the relative credit risk (and wallet) of the counterparties, the quality of the collateral and the procedures for margin involved. This is only going to get worse as the market moves further in the direction of fully secured and centrally cleared trades. Just as Libor suffered when banks no longer lent to each other on an unsecured basis, attempts at unsecured OTC derivatives pricing will become less and less reflective of the market.
- Exception does not eliminate reporting and documentation requirements. Also worthy of consideration is that the end-user exception does not eliminate reporting requirements by corporates and their financial counterparties. This includes reporting on inter-affiliate transactions plus documentation that exceptions are only applied to hedges mitigating commercial risk. If these don’t qualify for hedge accounting, then you’ve opened the door for further documentation and scrutiny, which discourages hedging that does not comply with accounting rules. Plus, if a corporation hedges from a treasury special purpose entity, such as an in-house bank, it may find that the exception unravels more than just reporting. And you can be sure that more unraveling of the exemptions will come in time.