In response to reports of a letter sent to lawmakers by Commodity Futures Trading Commission (CFTC) chairman, Gary Gensler, asking for even stricter reform of the over-the-counter (OTC) derivatives market, Jiro Okochi, chief executive of Reval, warns US corporations not to sit back and assume that the exemptions of some OTC derivatives in proposed legislation delivered just last week by the US Treasury Department will make it through legislation by year end.
“Before we have even had a chance to applaud the Administration for putting in motion the fair reform of the OTC derivative markets, campaigning has already begun to remove important language that contains key exemptions for corporations using these instruments to hedge business risk,” said Okochi. “Hopefully fair reasoning will prevail as hedgers were not the cause of the financial crisis and the total notional volume of corporate derivatives pales in comparison to swap dealer and major swap participant activity. Companies now have to do everything they can to help pass the parts of this legislation that supports these exemptions and avoids penalising the corporate end-user.”
According to Okochi, large US companies using OTC derivatives will not be as impacted as originally thought. The proposed legislation from the US Treasury Department, Title VII of the US Code, amends the Commodities Exchange Act and the Securities Exchange Act to incorporate the changes proposed by the Administration in June.
Okochi outlines the top five reasons why corporate end-users who use OTC derivatives to hedge business risk will want to write Congress to preserve the Administration’s legislative language:
- Foreign exchange (FX) forwards and swaps are exempt: these instruments are exempt from the definition of a swap and therefore exempt from the proposed regulation. As these instruments are the most widely used by non-financial corporations, and it was seen as unlikely that there would be any exemptions, this is a major victory should this exemption remain intact.
- Effective hedges are exempt: other swaps, such as interest rate, cross currency and commodity hedges, although not exempt from either being classified as a standard derivative with clearing and margining or non-standard without clearing but with a capital charge, may be exempt from margin requirements if these hedges are effective under US GAAP (FAS 133) and bought from swap dealers regulated by prudential regulators (the Federal Reserve, FDIC, OCC, etc).
- Physically settled commodity derivatives are exempt: procurement departments or producers who settle for physical settlement at the location point have a benefit.
- Better price transparency: the regulation requires clearing firms to disclose all fees generated from the sale of the swaps, and the business conduct requirements for swap dealers requires the following disclosure: “The source and amount of any fees or other material remuneration that the swap dealer or major swap participant would directly or indirectly expect to receive in connection with the swap.”
- Swaps associated with underwriting securities may also be exempt: while legislative language is murky, it may be that fixed to floating swaps associated with the issuance of debt or Treasury locks or forward starting swaps associated with a future issuance may be exempt or may simply be suggesting that a ‘when issued’ security not be classified as a derivative.
Okochi notes that there are still trouble areas with the reform. The two main areas of concern for end-users are:
- Costs for standardised trades: although more transparent, costs are sure to increase from clearing firm members having to recoup their costs to clear and become a member. The number of clearing firms may be limited as currently non-US firms are typically not accepted as members because they can avoid US bankruptcy laws, and only healthy firms will be able to post the capital and keep up with the regulations to stay a member. Additionally, becoming a registered swap dealer will involve capital costs as well as significant regulatory requirements and may inhibit many of the Tier 2 or 3 banks from pursuing registration. Fewer dealers and higher clearing costs will mean more cost to the end-user, although they will benefit by having eliminated bank counterparty credit risk.
- Major swap participants must now register and follow the same rules as a swap dealer: although probably intended for insurance companies and finance companies who were active in swaps, it could mean large swap users who cannot prove effective hedging under GAAP or certain sectors like airlines may be unintentionally forced into classification as a major swap participant.
“Many of these issues will become clearer after the lawmakers return from summer recess. Until then,” Okochi says, “corporations should continue to write their Senators and Congressmen to make their voices heard until final legislation is passed.”