By Luke Zubrod, Chatham Financial
Corporate hedgers are pleased with latest regulatory rule but still wary of costs, capital and margin.
The Commodity Futures Trading Commission and the Securities and Exchange Commission on Wednesday finally nailed down the definitions on key swap entity definitions. This was the most important rule to be finalized to date, as it allows market participants to determine the scope of regulatory requirements that apply to them and will have a big impact on shaping the scope of regulation for the market. It’s an important step in adding certainty for corporate end-users, however many questions remain, particularly those regarding hedging costs.
In a 4-1 vote the CFTC and the SEC approved the final rule defining the terms major swap participant (MSP), and swap dealer (SD). Commissioner Scott O’Malia dissented.
Following the legislative debate on Dodd-Frank in 2010, corporates were concerned about whether they might be major swap participants or swap dealers and whether their swaps would be deemed hedges of commercial risk. In each case, those concerns were substantially diminished by the final rule.
Major swap participants. Corporates were concerned that regulatory agencies would expansively define the term “major swap participant” to include broad swathes of end users. The MSP definition brings with it more than 1500 regulatory requirements, so it was essential for corporates to be excluded from this definition. In fact, the CFTC and SEC seemed to honor Congressional intent to focus this definition on entities whose derivatives use was so material that its failure could undermine financial stability.
Now with the rule in place, a corporation’s swaps exposure (i.e., current and/or potential future exposure) must exceed thresholds ranging from $1 billion to $8 billion in order for it to be deemed an MSP. The exact thresholds that apply depend on factors such as asset class (e.g., interest rates vs. commodities) and transaction purpose (i.e., hedge vs. non-hedge). Importantly, posted collateral and transaction netting are taken into account when assessing whether a party is an MSP. Thus, corporates could put in place credit support annexes or lower the thresholds therein to ensure they fall below the relevant thresholds.
Swap dealer. Also a concern was Dodd-Frank’s SD definition, which was broadly worded and included a phrase that conceivably could have been interpreted to include end-user hedging activity. Specifically, the definition included a person who “regularly enters into swaps with counterparties as an ordinary course of business for its own account.” However, the CFTC focused the SD definition on those who offer swaps to satisfy customer demand. And, it excluded those whose swap dealing activity falls below thresholds that range from $3bn to $8bn. Additionally, the CFTC opted to exclude a company’s inter-affiliate swaps when considering whether that company is a swap dealer. These and other changes make it likely that the vast majority of corporates – perhaps save certain participants in the energy and agriculture space – will not be subject to the swap dealer definition and the extraordinary regulatory burden that applies thereto.
Commercial risk hedges.
In order to be exempt from clearing requirements, end users must be hedging a commercial risk. Corporates were concerned that the definition of commercial risk could be narrowly tailored to exclude financial or balance sheet risk. Instead, the CFTC and SEC defined this term expansively to include (1) trades that qualify as bona fide hedges under the Commodity Exchange Act, (2) trades that qualify for hedge accounting treatment and (3) other trades that meet a broadly worded definition of commercial risk. Although the specific context of this definition is focused on determining whether a participant is an MSP, it is widely expected that the definition used in this rule will also track the definition to be used in the pending end user exception rule.
Questions remain. Although this rule represents an important step for increasing certainty for corporate end users, many questions remain. Chief among them is the cost of hedging, the answer to which will largely be a product of capital and margin rules. Capital costs will be driven by prudential regulators’ rules to implement Basel III, anticipated sometime this year. Margin rules will also be finally determined by prudential regulators, as early as late summer. This has been a particularly hot topic for the US Fed Governor Daniel Tarullo, who last week talked about the need to introduce “minimum margin requirements for certain derivatives transactions that are not cleared with a central counterparty.” In the meantime, most end users will likely be pleased to see that regulatory agencies listened to their concerns as they finalized the entity definitions rule.
Luke Zubrod is a director at risk management advisor Chatham Financial, an advisor to over 1,000 end users of derivatives in Asia, Europe, and the US.