A Perfect Storm: Rules, Rules and More Rules
Corporate treasurers are being bombarded with rules which affect how they conduct their business, circulate cash and hedge risk. Recent additions to these rules include the US Congress enacted the Dodd-Frank Act of 2010, the major elements of which came into force this quarter. Dodd-Frank’s key objective is to reduce risk, increase transparency and promote the market integrity of the over-the-counter (OTC) derivatives market, among other things, by forcing financial market participants to clear their trades via central counterparty (CCP) clearinghouses.
Treasurers using derivatives to hedge and as part of their risk programmes would be well advised to take note of the changing market conditions and norms under the impact of these new regulations. The G20 is insisting that the changes are introduced worldwide too, with Europe, Asia and elsewhere also introducing CCP clearing for OTC derivatives, centralised repositories and more transparency demands as well, in accordance with governmental wishes following the 2008 financial crisis. More information and initiatives like the standardised legal entity identifier (LEI) drive are also part of this global post-crash effort, with Dodd-Frank in the US leading the way.
It is important to remember that there are costs associated with all these changes, however, some of which are bound to be passed on to corporate treasurers and other business or retail end users. Centralised clearing, for instance, and the beefed-up collateral that needs to be held to enable it, is bound to be expensive to implement.
Lobby groups have, however, ensured that it was recognised that corporates which use swaps for hedging or mitigating commercial risks would not generally be required to clear their trades, so there is some leeway here for treasurers to resist price rises if banks or others try to pass on increased infrastructure costs to them. Only Swap Dealers (SDs) and Major Swap Participants (MSPs) will need to register with the Commodities Futures Trading Commission (CFTC) in the US under Dodd-Frank and comply with specific requirements. There are some exceptions of course – for example if an oil corporates’ hedging is actually profit-seeking – but on balance I would say that it appears as if Dodd-Frank will not have the catastrophic impact that many people initially predicted. As ever, there is another side to the story though, and that is primarily based around the fear that increased infrastructure and regulatory compliance costs will inevitably be passed on to corporate users in some way or other, so I’d like to consider this next.
Will Increased Infrastructure and Regulatory Compliance Costs be Passed On?
There are still many people who argue that, despite the exemption from centralised clearing obligations that hedging corporations have won, the costs for using OTC derivatives will still rise under Dodd-Frank, and these costs will ultimately be borne by corporate end users.
The new global regulatory framework on bank capital requirements, Basel III, will also add to the collective corporate treasury headache surrounding regulatory costs and procedures. The Basel III capital adequacy regime will require banks to allocate more capital for uncleared trades – for instance, swaps they trade with their corporate clients – and they will do this by increasing the swap transaction price. The question remains as to whether this will happen in reality, and if so then what affect it will have on corporate behaviour in this area?
Getting back to Dodd-Frank in the US for a second, I’d like to look at the regulatory avalanche from a global perspective and point out that there is much interaction between the regional legislative initiatives. Although Dodd-Frank is a US Act, the US and European Union (EU) have stated bluntly they intend to work together to follow similar paths for centralised, more transparent OTC derivative trades. The G2O remember is the guiding hand in this effort.
Currently, the US scope combines much of the European Market Infrastructure Regulation (EMIR) which proposes moving trades to CCPs as well, and also requires extended transaction reporting, with increased trading platform transparency covered in the revised Markets in Financial Instruments Directive (MiFID) II also coming in across the EU. MiFID was initially designed a few years ago to regulate the new electronic communication networks (ECNs) as they were known in the US – multilateral trading facilities (MTFs) in Europe – and is now being revised to improve its best execution requirements and to cover any opaque trading venues that it missed the first time around. A new designation of organised trading facilities (OTFs) has been created in the EU especially for this purpose and to minimise unlit dark pools of liquidity.
So what are the likely impacts for corporates of this raft of global regulations? From a purely cost viewpoint Dodd-Frank in the US will have a major impact on companies where a large portion of the spend will be on achieving compliance with the regulations. In a 2012 survey carried out by Accenture and entitled ‘Coming to Terms With Dodd-Frank’, 70% of companies responding said that they believed the proposed regulatory reforms – and their effect on revenue streams – will cause them to revise their long term business strategies.
On the positive side many respondents (64%) believe that the Dodd-Frank Act will strengthen their competitive position in the long run. Firms that are engaged in derivatives trading may well enjoy benefits from the Act’s goal to establish more open and transparent derivatives trading. Whether this proves to be true is anyone’s guess and there is a long way to go with this, but in many corporates minds things are just getting more and more complicated.