Uncertainty in Derivatives Legislation Looms Large

As financial institutions brace for legislative overhaul of their derivatives business, companies that enter into derivative contracts as part of a hedging strategy are wondering what the impending new regime will mean for them, too.

But thanks to a final burst of political intrigue in Washington last week that has plunged derivatives oversight back into uncertainty, right now nobody knows.

At issue is one section of the regulatory reform bill pending in Congress, which will require financial firms trading in derivatives to post more cash as collateral. Its intention is to prevent a major derivatives trader from going broke suddenly and leaving its counter-parties in the lurch; that is what happened to AIG in 2008, which prompted the government’s $180 billion bailout.

In theory, non-financial companies using derivatives will be exempt from that collateral requirement. But banking lobbyists opposed to tough regulation of derivatives are sounding alarms that fine print in the regulatory reform bill actually could sweep non-financial companies into its reach, costing Corporate America hundreds of billions of dollars. The argument may just be a stalling tactic to let the bill’s opponents round up more votes in the Senate—but it’s an effective one, that has spurred a flurry of buzz in risk-management and financial reporting circles.

The International Swaps and Derivatives Association says its research suggests that regulatory reform (known as the Dodd-Frank bill) will spawn new capital and liquidity requirements for companies that trade in the affected derivatives. Under the bill’s current language, the ISDA says, companies would collectively need to post about $400 billion in collateral with their dealer counter-parties to cover the current exposure of their derivatives transactions.

In addition, companies would need to maintain some $370 billion in additional credit capacity to cover potential future exposure of those transactions. If markets ever return to the pre-crisis levels seen in late 2008, those requirements could surpass $1 trillion, the ISDA says.

The association says the Dodd-Frank bill originally did contain an exemption from margin requirements for corporate end-users of derivatives, but that exemption was dropped in later language. “If the bill is passed without this exemption, regulators could significantly increase the costs of hedging exposures,” the ISDA said in a statement.

The House approved that final language of the Dodd-Frank bill last week; Democratic leaders in the Senate hope that chamber can approve the bill by mid-July, although they are two votes short of enough support to avoid a Republican filibuster.

Derivatives experts analyzing the bill aren’t as convinced that the bill will result in dramatic new costs or collateral requirements directly imposed on corporations. Jim Hamilton, principal federal securities analyst for CCH/Wolters Kluwer, says the new regulatory regime for derivatives wasn’t intended to create a burden on companies that use derivatives contracts for hedging purposes.

“The intent was that they wouldn’t see any change from this,” he says. “The non-financial companies weren’t part of the problem they were trying to deal with.”

But …

Indirectly, however, Corporate America may end up paying part of the solution. Under the Dodd-Frank bill, most derivatives will be traded through a clearinghouse, much like stocks are traded on stock exchanges. That derivatives clearinghouse will bear the risk of one party defaulting on another, rather than the counter-party carrying that risk itself. But that means the clearinghouse will need high capital reserves to offset those risks—and somebody must pay for that higher cost somehow.

“[W]ithout the hedge accounting, you can get lots of earnings volatility. The [proposed ASU] would make it easier to qualify for hedge accounting.”

—Faye Miller,

Director of Audit and Accounting,

McGladrey & Pullen

Could that higher incremental cost be passed along to corporations, the ultimate consumers of derivative contracts? Maybe. “You can’t really tell until you set up the regime and see how it works,” he says. “People are concerned about this, but I don’t think anyone really knows right now if it will be more costly. I don’t think anyone can answer that right now.”

Strait

Karl Strait, a partner with law firm McGuireWoods, says companies would be wise at least to begin taking inventory of their existing derivative contracts, to get a sense for whether their risks will change under a new regulatory approach.

Another wrinkle: Financial institutions will be required to push out their current dealings in credit-based derivatives (credit default swaps, collateralized debt obligations, and the like) to their subsidiary businesses. If banks that are insured by the Federal Deposit Insurance Corp. push their derivatives business onto uninsured subsidiaries or affiliates, that would change the counterparty on an existing agreement, Strait says.

“What’s the credit strength of the affiliate?” he says. “How does that have an impact on me? There are some questions about how much those will be worth when you exclude the assets of an FDIC-insured institution from a bank holding company.”

Strait said companies should evaluate those existing agreements to see whether any modifications might be in order as a result of the bill. “Who is the counterparty?” he says. “What is their strength? And whose credit strength are they relying on?”

Holding Patterns

Beyond inventorying existing agreements, it’s difficult to take any further precautions until the final legislation goes into effect and subsequent regulations are adopted, Strait says. In particular, the Securities and Exchange Commission and the Commodities Futures Trading Commission will have mountains of rules and guidance to write once the Dodd-Frank bill becomes law, he says.

Strait, like Hamilton, says companies may see increased costs as a result of the new regulatory environment, but it’s too soon to say for sure. “Some of that will flow from the regulations themselves, and some of it will flow from the financial institutions as they make business decisions,” he says. “But it’s not at all clear how that’s going to develop. Right now it’s a lot of guessing and wondering.”

DERIVATIVE VALUES

Below is an excerpt of a statement from the International Swaps and Derivatives Association raising alarms about the possible cost of regulating the derivatives trade.

A change in the wording of the financial reform bill now being finalized in the US Congress could cost US companies as much as $1 trillion in capital and liquidity requirements, according to research by the International Swaps and Derivatives Association. About $400 billion would be needed as collateral that corporations could be required to post with their dealer counterparties to cover the current exposure of their OTC derivatives transactions. ISDA estimates that $370 billion represents the additional credit capacity that companies could need to maintain to cover potential future exposure of those transactions. If markets return to levels prevailing at the end of 2008, additional collateral needs would bring the total to $1 trillion.

The Dodd-Frank Wall Street Reform and Consumer Protection Act could lead to a requirement of initial and variation margin (also referred to as collateral posting) for all over-the-counter (OTC) derivatives that are not cleared, including those involving an end-user. The legislation presented to the conference committee would have explicitly exempted corporate end-users from margin requirements on such transactions. This exemption is no longer in the bill. If the bill is passed without this exemption, regulators could significantly increase the costs of hedging exposures.

To assess the impact of this provision, ISDA’s research team analyzed year-end 2009 data available from the Office of the Comptroller of the Currency regarding derivatives exposure and margining. The association’s analysis is based in part on this data and also includes assumptions and estimates regarding corporate end-user exposure, required margin levels and other factors.

At year-end 2009, the notional value of derivatives held by US commercial banks totaled $213 trillion according to the OCC. Assuming 10 percent of this amount reflects corporate end-user activity, and that the initial margin requirement would be 1% (a typical level) of the notional amount, then US companies would face a $213 billion collateral requirement.

In addition to initial margin, US companies could also face variation margin requirements under the bill. According to the OCC, the net current credit exposure (NCCE) of U.S. banks at year-end 2009 was $398 billion. Of this amount, 41 percent or $163 billion was related to corporate users of OTC derivatives. Approximately 31 percent of this amount was collateralized and 69 percent or $112 billion was not collateralized.

In addition to the approximately $325 billion in initial ($213 billion) and variation ($112 billion) margin that U.S. companies could face related to their OTC derivatives transactions with U.S. banks, they would also be required to post margin for their transactions with non-U.S. banks. Using a conservative estimate of non-U.S. banks’ share of the US corporate derivatives market, ISDA’s analysis indicates that the cash and liquidity requirements of US companies might increase by about another $81 billion to $406 billion.

Source

ISDA (June 29, 2010)

As for the accounting implications, Tom Omberg, a partner with Deloitte & Touche, says the legislation itself should not have significant effect on accounting requirements. But companies can expect far greater accounting upheaval with a proposal from the Financial Accounting Standards Board to change the way companies account for their financial instruments.

FASB published an exposure draft in May for an Accounting Standards Update that would overhaul the manner in which companies, especially financial institutions, account for their financial instruments. Included in the proposal is a provision to simplify hedge accounting by giving companies a qualitative rather than quantitative formula for determining whether a hedge is effective and therefore should qualify for hedge accounting treatment.

Omberg says the proposal would do away with the strict criteria for establishing that a hedge is effective and for the detailed testing that companies must complete each quarter. Instead, companies would be able to document under a qualitative basis that a hedge would be reasonably effective, he says. “That should make some of the difficult operational issues go away. You will still be required to report any ineffectiveness through the income statement, but you won’t be required to do the granular, detailed testing.”

Faye Miller, director of the national office of audit and accounting for McGladrey & Pullen, agrees that the FASB proposal ultimately will have a greater impact on corporate hedging activities than the regulatory reform emerging from Congress. The Dodd-Frank bill will upend how banks operate, she says, but the accounting standard will upend how companies achieve effective hedging and how those effects flow through the income statement.

“If a company is unable to use hedge accounting, it is sometimes stuck with recording derivatives at fair value through the income statement, without the benefit of recording the item they’re hedging at fair value through the income statement to offset it,” she says. “So without the hedge accounting, you can get lots of earnings volatility. The [proposed standard] would make it easier to qualify for hedge accounting.”