In response to reports of a letter sent to lawmakers by Commodity Futures Trading Commission chairman Gary Gensler asking for even stricter reform of the OTC derivatives market , Jiro Okochi, ceo of Reval warns U.S. corporations not to sit back and assume that the exemptions of some OTC derivatives in proposed legislation delivered just last week by the U.S. 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,” Okochi says. “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 penalizing the corporate end-user.”
Okochi’s company, Reval , helps corporations comply with the stringent regulations governing the use and accounting for interest rate, foreign exchange and commodities derivatives.
According to Okochi, large U.S. companies using OTC derivatives will not be as impacted as originally thought. The proposed legislation from the U.S. Treasury Department, Title VII of the U.S. 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 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 unlikely that there would be any exemptions, this is a major victory should this exemption remain intact.
•Effective hedges are exempt: Other swaps like 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 (Fed, FDIC, OCC).
•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.
In June, Okochi launched www.savemyswaps.com to aid corporate end-users and the Administration reach a fair reform of the OTC derivatives market. Reval’s own position has been that OTC derivatives that qualify for hedge accounting treatment under FAS 133 (or IAS 39 outside the U.S.) should be classified as non-standard derivatives and exempt from any additional capital requirements since the burden of proof companies have to go through to prove hedge effectiveness is rigorous, well documented, and available in a trade repository for access by regulators.
A hedge generates ineffectiveness when the gains and losses of a derivative do not exactly offset the gains and losses of its underlying exposure. Additionally, if the imperfectly matched gains and losses are too great, then followers of U.S. Generally Accepted Accounting Principles would be ineligible for the accounting offset afforded by hedge accounting under Financial Accounting Standard No. 133.
Okochi notes that there are still trouble areas with the reform. The two main areas of concern for end-users are:
•Costs for standardized 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-U.S. firms are typically not accepted as members because they can avoid U.S. 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 two or tier three 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.”
