Passed as a response to the biggest financial crisis since the Great Depression, it is hardly surprising that the Wall Street Reform and Consumer Protection Act (CPA), more widely recognised as Dodd-Frank, has a wide-ranging remit. Nor is it surprising that one of its many provisions is aimed at clearing up and regulating the derivatives market, given that disgrace has been heaped on these assets since the world became aware of the damage an ill-considered collateralised debt obligation (CDO) could do.
The volume of derivative instruments trading on unregulated or over-the-counter (OTC) markets has expanded dramatically in the past few years, with some estimates putting the rate of growth at around 400% since 2006.1 The Dodd-Frank act gives the Commodity Futures Trading Commission (CFTC) – the federal government regulator of commodity futures/swaps markets in the US – the authority to oversee the US$600 trillion unregulated swaps market, and will require all organisations to centrally clear their OTC derivative trades.
And so it is immediately clear that the impact of Dodd-Frank will be felt far beyond the institutions of Wall Street. Once trades are centrally cleared, as the regulations demands, there is immediately an increased margining and collateral requirement. This attempt to mitigate the credit and counterparty risk faced by market participants will thus tie up valuable resources, limit the availability of working capital and could effectively hobble the risk management efforts of many energy and commodity companies.
However, as Jill Sommers, commissioner, Commodity Futures Trading Commission (CFTC) acknowledged: “Requiring them [end users] to divert scarce capital to margin would likely increase risk, rather than reduce it, by making hedging more expensive and thus less likely to occur.” In recognition that not all derivatives are what Warren Buffet describes as financial weapons of mass destruction, and that futures, swaps and options are a critical element in risk management, the new regulations also allow for an end-user exemption in very specific circumstances.
The first of these is that companies who trade derivatives to hedge against price volatility or mitigate commercial risk will not be obliged to meet the Dodd-Frank Act’s clearing and collateral requirements. Second, at least one party to the swap must be a ‘non-financial entity’, which, although vague in its definition, essentially excludes from exemption any derivative transaction between two banks. And finally, notice must be provided on how the firm generally meets the financial obligations associated with entering into a non-cleared swap.
Provided all these conditions are met, an organisation can apply for the end-user exemption which is granted on a hedge-by-hedge basis. The exemption provision therefore clearly benefits commodity organisations who use swaps as part of their hedging strategy, and enables them to escape the central clearing and margin requirements of the Dodd-Frank Act.
There is, however, a caveat. Organisations must demonstrate to the regulators’ satisfaction that they have a bona fide hedging strategy, and that the strategy is being followed in each instance. They must have watertight records and audit trails that demonstrate who their counterparties were, and when the trade took place. And they must be able to provide that information on a hedge-by-hedge basis. The regulators will not provide a blanket exemption that covers a firm for a given time period and then leave it to get on with business.
The implications for accurate record-keeping and accounting are therefore huge. Perhaps more than any other piece of recent legislation, Dodd-Frank demands the implementation of appropriate systems and procedures to ensure that firms stay on the right side of law. Handling the mountains of paperwork that compliance requires without the right tools would almost certainly wipe out the advantages that end-user exemption offers, and any extra working capital would soon disappear into an administrative black hole.
And so firms need the tools that at a minimum provide a complete, automated audit trail of all hedging activity, by creating the documentation for each hedge that tracks the derivative and risk relationship constructed. They need a solution that uses approved methods, including regression analysis, to test the effectiveness of each proposed hedging transaction. They need technology that offers automated documentation and disclosure management, including hedge objective, type of hedge, description of hedge, type of risk, length of hedge, and prospective and retrospective assessment to be used. The solution will also have standard operating procedures to maintain exemptions, and will enable firms to manage their OTC derivatives on a common platform to eliminate local data stores that hinder auditability.
Any technology has to do all this without disrupting hard-won straight-through processing (STP)or requiring an unsustainable workflow. Transparency and flexibility will assure both adaptability and adoptability: too complex and it will be side-stepped, too rigid and it will be obsolete in a few years. Because, although much of the Dodd-Frank Act is still open to interpretation, there is one thing we can be sure of: regulation is on the political agenda and it’s only going to become more onerous over time.
1 Source: Petroleum Marketers Association of America
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