Almost four years after the financial crisis and over two years after the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), the overhaul of the US derivatives market is rapidly shifting into the implementation phase. Many of the key elements of Dodd-Frank relating to OTC derivatives will begin to take effect on October 12, 2012, although the CFTC has delayed implementation of some requirements until the beginning of 2013.
Under Dodd-Frank, Swap Dealers, Security-Based Swap Dealers, Major Swap Participants (“MSPs”) and Major Security-Based Swap Participants must register with the CFTC or SEC, as appropriate, and thereafter will be subject to strict regulation. Swap Dealers and MSPs will be required to comply with, among other things, regulations governing minimum margin and capital requirements, mandatory clearing and exchange trading of swaps and security-based swaps, swap reporting and recordkeeping requirements, internal and external business conduct standards and position limits. Even for companies that are not Swap Dealers or MSPs, are predominantly engaged in non-financial activity, and are using swaps or security-based swaps to hedge or mitigate commercial risk (“End-Users”), compliance with Dodd-Frank presents a significant challenge.
Dodd-Frank divided the OTC derivatives market into swaps and security-based swaps, to be regulated by the CFTC and SEC, respectively. Generally, swaps are defined to include contracts based upon interest rates, foreign exchange rates, commodities, and broad-based security or credit indices, among other financial instruments. Security-based swaps, on the other hand, include transactions based on a narrow-based index, a single security or loan or the occurrence, nonoccurrence of an event relating to a single issuer of a security, among other things. The regulation of mixed swaps falls under the joint jurisdiction of both Commissions.
Notably, certain F/X derivatives may be carved out of the definition of swap for certain purposes. Dodd-Frank permits the Secretary of the Treasury to exclude F/X swaps and forwards from the definition of swap. The Secretary of the Treasury has proposed such a determination, but this proposal has not yet been adopted and the scope of the proposed exclusion would only cover physically settled transactions involving the physical exchange of two different currencies.2 As a result, many commonly used F/X derivatives, including foreign currency options, currency swaps and non-deliverable forwards, would be swaps.
This handbook provides an overview of the key requirements and issues that End-Users need to consider as they enter the implementation phase of Dodd Frank. As a reference tool, we have provided a table summarizing the required compliance timeline for the various elements of Dodd-Frank that End-Users may need to comply with, including recordkeeping and reporting requirements, adopting board resolutions to take advantage of the clearing exception offered to End-Users and amending swap documentation as appropriate.
II. Commercial End-User Exception from Clearing
(a) Mandatory Clearing
Dodd-Frank’s key aim is to reduce risk, increase transparency and promote market integrity by, among other things, mandating clearing and exchange trading of certain swaps and security-based swaps. However, there are substantial costs associated with clearing and Congress recognized that these costs create disincentives for End-Users to hedge their commercial risk. As a result, Dodd-Frank contains an exception from the clearing requirement that is intended to be available to End-Users. End-Users using swaps to hedge or mitigate commercial risk will generally not be required to clear their swaps. End-Users may, however, elect to clear if they wish, and may in fact be required to clear under certain circumstances. If an End-User is going to clear a swap, then the trade must be submitted for clearing by or through a registered futures commission merchant (“FCM”) to a registered Derivatives Clearing Organization (“DCO”) in accordance with its rules.
Mandatory clearing determinations for swaps, security-based swaps and mixed swaps are made by the CFTC and/or the SEC, as appropriate. Clearing determinations will be made following submissions from DCOs or by the CFTC following a review on its own initiative. The CFTC has finalized a phased-in compliance timeline for complying with the clearing requirements. Generally, the phased-in compliance schedule grants End-Users more time than active market participants, such as hedge funds, to come into compliance with the clearing requirement (to the extent it applies). The CFTC’s phased-in compliance schedule provides that End-Users that are subject to the clearing requirement will be required to clear a particular product within 270 days following publication of the final clearing determination in the Federal Register unless an election to use the End-User Exception is made. The CFTC has proposed its first determination for “plain vanilla” fixed-for-floating interest rate swaps, forward rate agreements and basis swaps in US dollars, Euro, Sterling or Yen, and CDX and iTraxx index credit default swaps.
(b) Commercial End-User Exception from Clearing
The requirement to clear and the attendant obligation to exchange trade and post margin presents a significant cost and operational challenge for End-Users. In recognition of these significant burdens, Congress provided End-Users with an optional exception from the mandatory clearing and trading requirement (“End-User Exception”) when the following conditions are satisfied:
- (i) End-User is not a Financial Entity;
- (ii) Swap is hedging or mitigating commercial risk; and
- (iii) End-User satisfies its reporting obligations to the CFTC, including how it generally meets its financial obligations for non-cleared swaps.
End-Users will want to perform a thorough analysis of their hedging operations, including a review of any inter-affiliate swap activity and any activity undertaken by a captive finance subsidiary, in order to determine if these activities could preclude use of an affiliate or captive finance subsidiary from claiming the End-User Exception. End-Users will also want to carefully analyze and monitor which entities are ultimately liable for swaps entered into by affiliates or captive finance subsidiaries, because the CFTC’s recently adopted definition of “swap” defines the term to include guarantees of swaps.
(c) What Does it Mean to “Hedge or Mitigate Commercial Risk”?
The CFTC has adopted an expansive definition of hedging or mitigating commercial risk that is substantially similar to the guidance it provided for the same phrase as used within the MSP definition. Generally, the definition requires that the swap be economically appropriate to the reduction or mitigation of a commercial risk. Commercial risk has been interpreted broadly by the CFTC, which acknowledges that commercial risks can arise from financial activities such as interest rate risk on a non-financial entity’s debt incurred for commercial business operations. However, the use of the End-User Exception by non-financial entities for financial risk hedging or mitigation must be an incidental part of (i.e., not central to) the electing counterparty’s business. In addition, the swap must not be entered into for speculative purposes. The CFTC emphasized that determining whether a swap hedges or mitigates a commercial risk will require a facts and circumstances analysis, to be performed at the time the swap is entered into and the overall purpose of the swap is the driving factor in what will determine whether it is eligible for the End-User Exception. As part of their recordkeeping requirements, End-Users are required to maintain records justifying their reliance on the End-User Exception and will need to develop (or update existing) policies and procedures for making and documenting this determination.
Several commenters raised concerns over dynamic and portfolio hedging and whether these more sophisticated hedging techniques could still meet the test for hedging or mitigating commercial risk. The CFTC determined that a swap that facilitates this type of hedging program may be eligible for the End-User Exception if it hedges or mitigates a commercial risk. Commenters also raised concerns over hedge effectiveness testing, but the CFTC determined that parties will not be required to demonstrate hedge effectiveness or engage in periodic hedge effectiveness testing, nor will parties be required to document and report the risk being hedged. These clarifications from the CFTC should offer End-Users welcome flexibility in designing their hedging operations.
(d) Who Is a Financial Entity?
The definition of Financial Entity is sufficiently narrow and precise that most End-Users will not meet that definition, provided that their level and type of swap activity does not qualify them as a Swap Dealer or MSP. “Financial Entities” include Swap Dealers, MSPs, private funds, commodity pools, certain employee benefit plans and persons predominately engaged in the business of banking or in activities that are financial in nature, except depositary institutions with less than $10 billion in total assets. Financial Entities are generally not entitled to the End-User Exception, except when the Financial Entity is a captive finance subsidiary or is an affiliate entering into the swaps as agent on behalf of an End-User hedging a commercial risk of that End-User.
(e) Captive Finance Subsidiary — “90/90 Test”
A captive finance entity or subsidiary generally refers to an entity that provides purchase or lease financing to customers for the purchase or lease of products or other goods manufactured or assembled by a parent or affiliate. Dodd-Frank provides that captive finance companies are not Financial Entities if they satisfy the following requirements:
- (i) primary business is providing financing;
- (ii) use derivatives for hedging commercial risks related to foreign currency (F/X) and interest rate exposures;
- (iii) at least 90% of exposures arise from financing that facilitates the purchase or lease of products; and
- (iv) at least 90% of such products are manufactured by the parent company or a parent’s subsidiary.
The two 90% calculations are interpreted separately, so that in order to be a captive finance company, first, at least 90% of the interest rate and F/X exposure that is being hedged must arise from financing that facilitates the purchase or lease of products (as calculated on a consolidated basis that includes the entity’s consolidated subsidiaries) and second, of the products that are being purchased or leased using financing, at least 90% must be manufactured by the parent company or parent’s subsidiary. Captive finance companies can take an expansive view of “products” and “facilitates” when performing both 90% calculations.
(f) Affiliated Agents
The hedging activities engaged in by End-Users can vary significantly as can the corporate structures that End-Users employ to enter into these hedging transactions. Many End-Users are part of a larger corporate organization that employs centralized hedging and may make use of, among other strategies, a central booking entity, which may use a series of inter-affiliate risk transfers completed by back-to-back transactions. Dodd-Frank allows affiliates of an End-User (including captive finance subsidiaries) to rely on the End-User Exception when entering into the swap as agent on behalf of the End-User if an End-User could enter into the same swap and rely on the End-User Exception, unless the affiliate is a type of entity that is specifically not permitted to rely on this provision. Entities that are predominantly engaged in activities that are financial in nature are not prohibited from acting as agent on behalf of End-Users, even though such entities would otherwise be unable to rely on the exception for hedging their own commercial risk.
The CFTC declined to exempt swaps entered into by End-User hedging affiliates on a principal basis from the clearing requirement where the hedging affiliates are Financial Entities, even if the hedging affiliate is hedging or mitigating the commercial risk of the End-User. The CFTC states that the statute leaves no room for them to provide relief on this point. This position will disproportionally affect certain hedging structures. For example, the End-User Exception would be available if the treasury function of an entire corporate group is undertaken by the parent or other corporate entity that engages in non-financial activity. However, for those End-Users with a treasury affiliate that operates as a separate legal entity, because the treasury affiliate would likely be a Financial Entity, the End-User could not take advantage of the End-User Exception if it acts as principal in conducting hedging. As a result, many End-Users may need to restructure their business and risk management techniques, thereby potentially losing many benefits of their current centralized hedging operations.
(g) Reporting Requirement for End-User Exception
Dodd-Frank imposes a reporting requirement when an End-User relies on the End-User Exception. The required information must be reported to a Swap Data Repository (“SDR”). The CFTC has responded to commenters’ concerns regarding the amount of information that the proposed rulemaking required by allowing End-Users to comply with most of the reporting requirements with a single annual filing that will primarily employ a check-the-box approach. However, for each swap for which the End-User elects to rely on the End-User Exception, the reporting counterparty, as determined by CFTC’s swap data reporting rules (see discussion in section IV below), is required to provide notice of the election and the identity of the electing counterparty. The annual filing contains basic information about the entity and the basis for relying on the End-User Exception and requires the End-User to inform the CFTC how it generally meets its financial obligations associated with entering into non-cleared swaps. There is an ongoing reporting obligation, which requires that the filing be updated with any material changes. There is no exception from the requirement to report use of the End-User Exception for inter-affiliate swaps and consequently End-Users with centralized hedging arrangements will need to develop policies and procedures designed to ensure that such reporting requirements are complied with.
The reporting counterparty, as determined by the CFTC’s swap data reporting rules, will typically be a Swap Dealer. The CFTC is requiring that the reporting counterparty have a “reasonable basis to believe” that the End-User that is electing to rely on the End-User Exception meets the requirements necessary to make such election. As a result, the Swap Dealer will likely require the End-User to provide certain representations regarding its eligibility to make the election.
If an End-User is a publicly-traded company, then that End-User’s board or an “appropriate committee” thereof must approve the End-User’s election to rely on the End-User Exception. The annual filing requires the End-Users relying on the End-User Exception to confirm that board approval has been obtained within the last year. The CFTC noted that board approval must be obtained from an appropriate committee with sufficient authority and may be required more frequently than annually if there is a triggering event such as implementation of a new hedging strategy. Both the SEC and CFTC have determined that End-Users controlled by public companies will also be required to obtain such approval before they can rely on the End-User Exception. For End-Users that will require board approval to make use of the End-User Exception, the board or committee must maintain policies and procedures governing the use of swaps subject to the End-User Exception and review those policies at least annually and, as appropriate, more often upon a triggering event (e.g., a new hedging strategy is to be implemented that was not contemplated in the original board approval).
(h) Costs and Benefits of Clearing OTC Derivatives
Even if an End-User is entitled to rely on the End-User Exception, it may still elect to clear certain swap transactions. There are a multitude of factors that may impact this decision for any given swap, but three principal considerations will be cost, liquidity, and counterparty risk.
Cost. Without the End-User Exception, an End-User may be subject to substantial additional costs in connection with their cleared derivatives by way of margin requirements set by a particular DCO. Historically, many End-Users have avoided posting initial and variation margin in cash or liquid securities to their dealers in connection with their OTC swaps, but this may change going forward. For cleared swaps, End-Users will be required to post initial and variation margin, as determined by the clearinghouse, together with any additional margin required by the clearing broker above clearinghouse minimums. It is also expected that additional margin requirements will be imposed for uncleared swaps entered into with a Swap Dealer if the End-User meets certain criteria discussed in greater detail below. After the CFTC and banking regulators finalize rules relating to margin requirements for uncleared swaps, a complete cost-benefit analysis of trading a cleared or uncleared product will include the amount of margin, if any, that End-Users will need to post in connection with each transaction type.
Liquidity. Two of the oft-touted benefits of OTC clearing are enhanced liquidity and transparency, both of which may enhance an End-User’s ability to enter into transactions and may also have the potential to lower the costs associated with cleared swaps. In particular, a more liquid and transparent market may result in a narrowing of bid-offer spreads. As the cleared OTC markets deepen and liquidity increases, End-Users may develop a preference for clearing certain products. On the other hand, splitting the market between cleared and uncleared swaps may have an adverse effect on liquidity, particularly in the short run as clearing (and particularly mandatory clearing) is implemented.
Counterparty Risk. A key benefit of central clearing is the reduction of counterparty credit risk. With the DCO standing in the middle of each cleared transaction, there is a reduced likelihood of loss from a counterparty default. However, End-Users will face certain risks associated with their clearing brokers. A discussion of some of these risks, including the limitations of the customer asset protections offered by the central clearing model, follows in section III.
The full publication is available here. A summary of the compliance timeline is available below.
Timeline for End-User Dodd-Frank Compliance
|Dodd-Frank Requirement||Compliance Date||Compliance Obligation|
|Segregation for Cleared Swaps||11/2012||FCMs and DCOs must comply with rules on treatment of cleared swaps customer contracts and collateral.|
|Clearing Requirement||270 days from each CFTC determination||After the CFTC makes a clearing requirement determination, clearing is required by non-SD/MSP and
non-financial entities 270 days after this determination is published in the Federal Register (likely July/August 2013).
|Real-time Reporting of Credit and Interest Rate Swaps||12/31/2012||SDs and MSPs must report credit and interest rate swaps to SDRs and comply with applicable recordkeeping requirements.|
|Swap Data Reporting||12/31/2012||Trades with SDs must be reported, but trades with non-SD/MSPs only need to be reported beginning on 4/10/12|
|Internal CFTC Business Conduct Rules||12/31/2012||SDs and MSPs are required to comply with reportingand recordkeeping requirements.|
|External CFTC Business Conduct Rules||1/1/2012||SDs and MSPs must comply with the external business conduct rules. End-User Note: Expect DF Protocol document inadvance.|
|Internal CFTC Business Conduct Rules||1/2013||Under proposed exemptive order, US SDs and MSPs may defer compliance with entity-level requirements (including risk management requirements and CCO
requirements) until this date.
|Real-time Reporting for all Swaps for other Market Participants||4/10/2013||All other market participants (if required) must commence reporting swaps to SDRs.|