June 2011...Financial Executive Magazine
The Obama administration's implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act’s provisions on derivatives has set off a political slugfest, with U.S. Treasury Secretary Timothy Geithner and other federal regulators in one corner and business financial executives in the other. What is surprising, and maybe ultimately the knock-out blow, is that despite the sharply partisan atmosphere
on Capitol Hill on many other issues, for this one both Republicans and many Democrats appear to be in the corporate corner.
Sen. Richard Shelby (R-Ala.) highlighted the bout on April 12 at hearings in the Senate Banking Committee when he asked Thomas C. Deas Jr., vice president and treasurer of FMC Corp., a hearing witness that day, whether he agreed with Geithner that derivatives “only benefit Wall Street, not Main Street.”
“No, sir, I don't,” Deas responded. “We are manufacturing goods consumed in theU.S. and derivatives help us offset risks we couldn't otherwise control.” Deas was representing the National Association of Corporate Treasurers and has been a leading lobbyist for the Coalition of Derivatives End-Users, of which Financial Executives International is also a member.
The Obama administration's implementation of Dodd-Frank's exemption for clearing and margin requirements for nonfinancial users of derivatives is a major sticking point with business, especially the margin requirements. The Federal Reserve, Federal Deposit Insurance Corp. and other banking regulators proposed a rule on margins on April 12. It was roundly criticized within the business community.
A week prior to the Senate Banking hearing, Sen. Tim Johnson (D-S.D.) and another Democratic Senate committee chairman had written to Geithner, Federal Reserve Chairman Ben Bernanke and other federal banking regulators pleading with them to prohibit margin set-asides for commercial end users of derivatives who are hedging business risks. But that plea fell on deaf ears.
“The letter sent by Sen. Johnson and others reaffirmed congressional intent and admonished regulators to ensure that end users were not subject to such requirements,” explains Deas. “However, the prudential regulators' proposal indeed subjects virtually all end users to margin requirements.”
The Obama administration, however, did pull its punch on one issue. In late April, the Treasury Department
announced its decision to exempt foreign exchange (FX) swaps and forwards from the definition of “swaps”—meaning they do not have to be cleared, nor is margin an issue. This was welcomed by the mostly large multinationals that do extensive exporting, or that have business units overseas. But according to Luke Zubrod, director of Derivatives Regulatory Advisory service for Chatham Financial, FX swaps and forwards constitute less than 10 percent of the hedging done by most major U.S. companies. Interest rate swaps account for perhaps 80 percent of commercial hedging, with commodities somewhere near FX swaps in terms of percentages. Moreover, FX options, cross-currency swaps, non-deliverable forwards and other FX products will still have to be cleared, and even forwards and swaps remain subject to Dodd-Frank reporting and business conduct requirements.
Congress Listens, Rulemakers
The Treasury decision to exempt FX swaps and forwards does nothing to erase business concerns about having to post margins on interest rate and commodity swaps, one of the issues that
dominated the April 12 Senate hearing. It was the committee's first oversight hearing on the controversial, far-reaching Dodd-Frank act, which requires agencies such as the Commodity Futures Trading Commission, U.S. Securities and Exchange Commission and the federal banking regulators, including the Federal
Reserve Board, to finalize numerous rules by July 2011.
For companies represented by the Coalition on Derivatives End-Users, there are two key rulemakings. The first involves the CFTC and SEC definition of “swap dealers” and “major swap participants.”
Companies that fit those definitions must register with the government and clear their swaps through a central
clearinghouse — two requirements that will add considerably to corporate costs. Commercial end users of swaps —those that are not market makers looking to make a profit but multinationals hedging
the risks arising from price swings in commodities, interest rates and foreign exchange rates — can qualify for an exemption from that clearing requirement. If they do, they would then be subject to margin requirements — if their risk threshold exceeds a certain level — set by the Federal Reserve Board, FDIC, Comptroller of the Currency and other financial agencies.
The second key rulemaking is really the more important of the two, since it affects many more companies, was published by the banking regulators on April 12. It describes how banks should set their risk thresholds below which no margins would be required. Most U.S. companies will not be swept into the “swap dealer” or “major swap participant” definitions, so they will not have to clear swap contracts where they hedge commercial risk. Very large companies such as Kraft Foods Inc. and Phillip Morris International Inc. that
use captive “centralized hedging centers” to hedge foreign commodity, interest rate and currency prices could, under certain conditions, have to work through the new swap clearinghouses, meaning systems and record-keeping costs.
However, the majority of U.S. companies that contract with their commercial lenders to hedge commodities,
foreign currency and interest rates — those are the “Big Three,” although sometimes companies even go so far as to hedge the weather — will not have to clear their swaps. If companies are exempt from clearing for commercial swaps, then the next question is whether their banks should have to collect “margin”
on those contracts. According to Ann Marie Svoboda, author of Actual Cash Flow and member of FEI’s Committee on Corporate Treasury, companies currently with strong credit histories do not have to
post margin on derivatives they buy from their commercial banks. This could change under
the “margin” proposed rule.
The proposed rule says each bank must establish “credit exposure limits” for each customer or counterparty,
based on a computation using a standardized “lookup” table that specifies the minimum initial margin that
must be collected, expressed as a percentage of the notional amount of the swap or security-based swap.
These percentages depend on the broad asset class of the swap or securitybased swap. If a company's risk exposure is below that threshold, the bank would not have to collect margin, as long as the threshold was established under appropriate credit processes and standards.
Zubrod notes that proposed margin
rules allow for margin amounts to reflect
the credit strength of each company.
Although all companies will be
subject to margin requirements, highlyrated
companies may post less collateral
than companies with questionable
Margins could be doubly troublesome
for companies that ordinarily secure
derivatives transactions with
physical assets — like real estate and
utilities. Such hard assets cannot be
used to satisfy margin requirements under the proposed rule.
Again, the prudential regulators do
not propose a standard method for setting
collateral thresholds. So banks have
some leeway to set thresholds but, because
regulators will be looking over
their shoulders, they could be very conservative
in their approach.
Moreover, Zubrod questions how
regulators will use their supervisory authority.
He notes that “the regulations
require that margin thresholds be ‘appropriate.’
We worry that regulators will require
banks to lower thresholds
during times of market stress —
when preserving liquidity is
most critical for end users.”
Even if regulators exercise
their authority judiciously,
banks may feel limited ability
to negotiate thresholds with
their corporate customers. They
may rebuff corporate efforts to
negotiate more favorable
thresholds, saying, “Sorry, I
can't give you a better deal
because I have the Fed breathing down
Where banks will set risk thresholds
for margin requirements is the big
issue for U.S. companies that use commercial
swaps. Diana Preston, vice
president and senior counsel, Center
for Securities, Trust & Investments for
the American Bankers Association, says
it is too early for ABA to comment. The
comment period for the proposed rule
closed after press time.
Pressing for Changes
While a broad swath of the business
community is pressing the banking agencies
to change some of the language in
the proposed rule on margins, a narrower
group of mostly large companies want
the SEC and CFTC to clarify their definitions
of swap dealers or major swap participants.
The battleground there is a proposed
rule issued on Dec. 9, 2010 by the
two agencies that defines an “end user
exemption” from clearing for companies
that otherwise might qualify as swap
dealers or major swap participants.
That exemption rests on whether the companies use swaps for commercial
operations hedging and whether they are
not a bona fide “financial entity.” Those
two agencies issued proposed rules on
the same day, but in some instances they
define the exemptions in slightly different
ways, which has added to the confusion
over who, in the end, will have to
This fog covers a number of corporate
entities. Companies such as Kraft
Foods are concerned that their centralized
hedging centers (CHC) could be pulled into both the swap dealer and
major swap participant definitions. Those
two CHCs are Kraft Foods Finance Europe
(KFFE), which acts as in-house
treasury and centralizes global cash
management, and Taloca GmbH, a centralized
procurement unit for globally
Philip Morris hedges foreign currency
risk through Philip Morris Finance
SA (PMF), a wholly-owned treasury subsidiary
of the parent company. Marco
Kuepfer, vice president finance and
treasurer of Philip Morris, says the company
“is concerned that swap transactions
entered into by PMF and other
wholly-owned treasury subsidiaries of
large nonfinancial companies, with their
affiliates on the one hand and
traditional swap dealers on the other,
will not be considered 'hedging or mitigating
commercial risk' under the proposed
Companies that might otherwise fit
the definition of swap dealer or major
swap participant but that use swaps for
“hedging or mitigating commercial risk”
are exempt from clearing. While some large multinationals
worry that their foreign financing arms
will be caught up in the new swaps
clearing regime, other Fortune 500 companies
are concerned about their domestic
captive financing arms. The proposed
rule says captive financing arms will be
exempt from clearing if they use derivatives
to hedge “underlying commercial
risk related to interest rate and foreign
exchange exposures, 90 percent or more
of which arise from financing that facility’s
purchase or lease of products, 90
percent or more of which are
manufactured by the parent
company or another subsidiary
of the parent company.”
In a letter to CFTC at the
end of February, the top executives
of Caterpillar Financial
Services Corp. and counterparts
at Nissan Corp., Toyota
Motor Corp., John Deere Corp.
and American Honda Corp.
wrote: “We do not have a clear
understanding of how this provision
works in practice.”
These concerns over the SEC and
CFTC definitions and the prudential regulators
margin requirements have led Republican
members of the House to
introduce legislation prohibiting the agencies
from issuing implementation dates
for final rules prior to Dec. 31, 2012.
However, the bill, even if it passes
the House, probably would not pass
the Senate, especially since CFTC
Chairman Gensler went to great
lengths at the April 12 Senate Banking
hearings to take the wind out of the
bill's sails. Gensler proclaimed his
openness to a staggered, flexible derivatives
implementation schedule — one
coordinated with international regulators,
and said his agency was conducting
additional outreach hearings.
So readers are advised to stay informed
of current developments that
might impact their businesses.
Stephen Barlas (firstname.lastname@example.org)
is a freelance writer who has covered
Washington, D.C., since 1981 and frequently
writes for Financial Executive.