A raft of new regulations mandated by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) are just coming into effect and will substantially restructure the swaps and derivatives markets, with implications even for end users exempt from some major provisions.
The principal burden of implementing these regulations falls upon the class of institutions that qualify as major swap participants (MSPs) and swap dealers under the regulations. Nevertheless, corporations that use even the simplest of swaps to hedge commercial risks (end-users) are discovering that they are being drawn into the regulatory web as well. Even where exemptions may be available to such end-users, Dodd-Frank and its progeny create compliance hurdles to be surmounted, and the end-users of swaps may require a deeper acquaintance with these instruments.
Swaps, broadly speaking, are contracts in which parties agree to exchange (or swap) payments that are based upon specified rates or prices (or related indices) to manage the risks associated with movements in those rates and prices. For example, companies often enter into interest-rate swaps when they borrow funds at a floating rate of interest to cap their payments in a rising interest-rate environment.
In such swaps, the company/borrower will pay a fixed interest rate and a bank will pay a floating rate, both multiplied by the same principal or “notional” amount. This swapping of payments effectively locks the borrower’s interest payments on the floating rate borrowings at the swap’s fixed rate. If the floating rate referenced in the swap (and the related loan) exceeds that fixed rate, that excess will be paid by the bank counterparty.
Similarly, companied that receive payments for their products or services in the currency but have expenses payable in another currency will often enter into currency swaps to mitigate the effects of currency fluctuations on their businesses. Like interest rate swaps, currency swaps call for the parties to exchange payments, which may involve exchanges of principal, interest or both in the relevant currencies.
Commodity swaps are commonly employed by companies to manage their exposure to changes in commodity prices. In one form of commodity swap, a company that uses a commodity in its business – oil, for example – makes periodic payments based on a fixed price and receives payments based on actual market prices. In this way, the company pays only the fixed price for oil, and the actual market price above the fixed price is covered by payments received under the swap.
Dodd-Frank and its implementing regulations will require companies using these instruments to reexamine the documentation and compliance procedures they employ for hedging internal risks. Swap counterparties will have ongoing reporting and recordkeeping requirements. The new regulations will also create standardized collateralization or “margin” rules and impose position limits that may affect hedging costs and practices. Over the next few months, the average, casual user of swaps will need to address the following regulatory changes:
- Since swaps with end-users are generally exempt from the mandatory clearing requirements of the new rules, a company that would like to rely upon the exemption will have to determine whether it qualifies as an end-user. An end-user is an entity that: (i) is not a “financial entity” under the regulations; (ii) is using the swap for hedging or to mitigate commercial risks; and (iii) has provided certain information to the Commodity Futures Trading Commission (CFTC), including a description of how it intends to meet its financial obligations with respect to its non-cleared swaps. An end-user that is an SEC reporting company must approve the election to use the exemption through action by its board of directors or an appropriate committee thereof, and this election will need to be ratified in the same manner at least annually. Companies should review their use of swaps carefully and consider whether they qualify as anend0user and, if they do, whether using the end-user exemption makes sense for their future swap transactions.
- In connection with new “know your customer” and external business conduct rules, companies may be requested to sign on or adhere to the ISDA 2012 DF Protocol (DF Protocol). The DF Protocol is a tool for amending and supplementing existing swap documentation for Dodd-Frank compliance purposes by incorporating (among other things) a standard set of representations, agreements and information.
The ISDA has developed a website that is designed to streamline the process of executing and delivering the DF Protocol. A Party digitally execute an adherence letter in which it agrees to be bound by the DF Protocol (the letter will be publicly available) and then completes a questionnaire that provides certain required information about that party that has signed an adherence letter, it directs (via the website) that the completed questionnaire be delivered to that other party. The DF Protocol and questionnaire should be carefully reviewed with counsel.
- Even though end-users will not be required to clear their swaps on a regulated exchange and are not subject to some of the more rigorous “know your customer” and external business conduct rules, they will be required to make periodic filing with the Commodities Futures Trading Commission (CFTC) regarding their swap transactions, most likely through a check-the-box type of report. End-users also will be required to maintain records of every swap until five years after the swap has terminated; these records will need to include information relating to the satisfaction of the conditions for the end-user exemption.
- Finally, since the new regulations will create standardized margin requirements (including for swaps subject to the end-user exemption), parties may be required to post margin for swaps for the first time. Margin arrangements are generally documented using a Credit Support Annex, which provides a standardized framework for posting collateral, although the particular terms of the annex are negotiated. Initial margin is typically posted to the swap dealer or MSP upon entering into each swap, and additional (or variation) margin is required to be delivered or returned (most commonly on a daily basis) based on changes in the market value of the swap. The most common, acceptable collateral types for margin are cash and U.S. Treasury securities, so companies will have to source these types of assets to have them available for posting.
Dodd-Frank gives counterparties the right to require segregation of initial margin collateral with a third-party custodian. Parties will have to determine whether the reduction of counterparty risk afforded by segregation justifies the upfront and ongoing costs. If a company requests segregation, it will need to select a third-party custodian and enter into both a custodial agreement and a tri-party control agreement.
As discussed above, the implementation of the new regulations under Dodd-Frank has made the use of swaps as part of a corporate hedging strategy a more complicated undertaking. Companies that use swaps (or anticipate doing so in the future) should pay close attention to the rules and seek expert advice to ensure compliance with the new regulations and assess the impact of the rules on present and future transactions.