As regulatory reform evolves on both sides of the Atlantic, end users still face the possibility of new rules negatively impacting their ability to use derivatives to hedge commercial risks. Chatham Financial’s Joe Siu offers a timely update on the specific risks end users face under Dodd-Frank and EMIR and specifically regarding entity classification, central clearing, margin requirements and higher capital requirements rules.
Introduction
The summer of 2011 marks an important milestone in the ongoing saga of derivatives regulation in the EU and the U.S. The one-year anniversary of the Dodd-Frank Wall Street Reform Act’s (Dodd-Frank) passage is fast approaching, followed shortly by the one-year anniversary of the publication of European Market Infrastructure Regulation (EMIR) by the EU Commission. Many months of hard work and vigorous debates presaged these anniversaries. Throughout this journey, end users – who use derivatives to hedge and manage risks – have played a crucial advocacy role. Yet, despite assurance from policy-makers that end users would be treated proportionately, significant risks remain for these legislations to negatively affect end users’ ability to hedge cost effectively. The current state of play indicates that what began as legislations to contain systemic risks and increase transparency have morphed into something more far-reaching than many market participants have realized.
Where are we in this journey?
By some estimates, the U.S. is a full year ahead of the EU on this journey, and is a perfect test case and the proverbial “canary in the coal mine” for other jurisdictions. Various U.S. regulatory agencies including the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), and the prudential bank regulators (e.g. the Fed), have spent the better part of the past year writing rules that would in theory add more clarity on top of the 848 pages of Dodd-Frank legislative text. A recent Wall Street Journal article put the total page count of legislative and rule text at 3,500 pages, with an equivalent word count of 16 copies of ‘Moby Dick’. Many more rules still need to be written over the next few months, adding to the tsunami of regulations end users and market participants have to navigate.
In the EU, Parliament and Council are close to finishing technical and political revisions to the text of EMIR proposed by the Commission. Trialogue between these three governing bodies likely will not occur until summer, and perhaps even delayed into the fall. This puts considerable pressure on European Securities and Markets Authority (ESMA), the new EU super-regulator, to promulgate rules quickly to meet the December 2012 implementation deadline set out by the G-20 leaders, or risk pushing the implementation date further out. Of course, the silver lining of the EU’s slower pace is that it allows the EU to learn from the mistakes of other jurisdictions and hopefully produce regulation that is more mindful of its real-economy impact on end users.
Significant risks to end users
Given the complexity and volume of legislative and rule text, it’s no wonder end users face significant direct and indirect regulatory risks. Three areas of risks worth highlighting include: 1) Entity Classification and Central Clearing, 2) Margin Requirements, 3) and Higher Capital Requirements.
Risk #1 Entity Classification and Central Clearing
Both the U.S. and EU regulations draw a bright line between financial and non-financial entities. Firms falling into the financial entity classification are presumed to have a more prominent role in causing systemic risks (regardless of whether they are hedging or speculating), and thus will face the bulk of the substantive regulatory requirements, especially the requirement to centrally clear their hedges, diverting precious working capital into margin accounts.
In light of the importance of entity classification, one would assume legislation will draw careful distinctions, taking care not to include firms into the financial entity definition inadvertently. The reality is less clearcut. In the U.S., some corporations are just beginning to discover they or their subsidiaries could be classified as financial entities through a reference to the Bank Holding Company Act, a piece of legislation that must have previously seemed inconsequential and obscure to non-bank corporations.
In the EU, large swaths of firms from micro finance entities to real estate companies are finding themselves corralled into the financial entity definition despite the obvious societal importance of these sectors and their links to the real-economy. The fact that many firms are “surprised” by such newfound regulatory labels suggests the need for companies large and small to raise their level of legislative engagement more proactively than they have done before.
Risk #2 Margin Requirements
While the financial entities will bear the brunt of regulatory requirements, non-financial firms do not necessarily have a “free pass”. Indeed, the U.S. regulators proposed a controversial rule on April 12th to impose margin requirements on financial and non-financial end users. The proposed rule will interpose regulators into every end user’s credit relationships with their derivatives dealers directly or indirectly. In doing so, all end users, including those without any margin posting requirements today, will face potential margin collection under the new regulatory regime. Moreover, the margin rule will impose initial margins on all OTC derivatives for the first time, further raising the potential cost of hedging for end users.
While the EU isn’t actively pursuing a similar course of action (EMIR calls for either appropriate dealer capital requirement or margin requirement), it is not clear whether this policy stance will hold true if the U.S. were to exert pressure to harmonize their derivatives regulations. Thus, margin requirement will be an important development to watch over the next year.
Risk #3 Higher Capital Requirements
But beyond the specific and easily identifiable costs associated with central clearing and margin requirements discussed above, there is also the inevitable adoption of new Basel III capital requirements, which when implemented will increase the amount of capital needed by dealers to offer derivatives to their customers. As a result, the credit spread paid by an end user on a typical interest rate swap could increase anywhere from two to eight times from their current levels.
Conclusions
Despite the dour outlook for end users and market participants caught up by legislation originally aimed at ending systemic risks, there are positive aspects that could benefit all participants including reporting requirements that would make the whole system more transparent to participants. The wholesale creation of a panoply of market utilities including data repositories, trade affirmation systems, central clearing houses, execution platforms, should in theory provide a stronger market structure for all participants. And perhaps the potential regulatory pain-points outlined above would provide the impetus for all end users to become more involved in future legislative processes, a necessary foundation for more well designed regulation in the future.
