Many companies, both large and small, enter into over-the-counter (OTC) derivatives transactions with a bank or other dealer in order to hedge commercial risks. For example, a company can use an interest rate swap in order to lock in a favorable fixed interest rate; it can enter into an FX forward in order to fix the currency exchange rate at a specified future date; or it can enter into an OTC commodity option in order to establish the maximum price that it will be required to pay for a commodity (e.g., steel or gasoline) that it needs to operate its business.
The Dodd-Frank Act will have a major impact on the regulation of the markets in the United States for OTC derivatives and of the participants in those markets. Although the Dodd-Frank Act was adopted in July 2010, many of the rules needed to implement the Act only recently were adopted by the Commodity Futures Trading Commission (CFTC), and other rules are expected to be adopted later in 2013.1
This Client Update uses a question and answer format to highlight those aspects of the Dodd-Frank Act that will have the greatest impact on end-users of derivatives, and it explains what end-users will need to do in order to comply with the Act and implementing regulations.
- General Aspects of Dodd-Frank Regulation
- Is my company an eligible contract participant (ECP)?
Under the Dodd-Frank Act, an end-user must be an ECP in order to enter into an OTC derivatives transaction. End-users typically qualify as ECPs in one of two different ways: as either a “large entity” or a “hedging entity.” Your company is a “large entity” if it has assets of $10 million or more. Your company is a “hedging entity” if it has a net worth exceeding $1 million and is entering into the transaction in order to manage a risk associated with an asset or liability owned or incurred by the company in the conduct of its business.
- Will my company be required to register with the CFTC?
The Dodd-Frank Act requires certain types of market participants known as a “swap dealer” and a “major swap participant” (MSP) to register with the CFTC. A swap dealer is an entity that holds itself out as a dealer in swaps, makes a market in swaps, or regularly enters into swaps in the ordinary course of its business (subject to a de minimis activity dealing threshold and other exceptions). An MSP is an entity that maintains a “substantial position” in swaps (i.e., it maintains a daily average aggregate uncollateralized current exposure of $1 billion or more in any major swap category). A typical end-user will not be deemed to be either a swap dealer or an MSP.
- Mandatory Clearing Requirement
- What is the mandatory clearing requirement?
One of the main goals of the Dodd-Frank Act is to cause certain types of OTC derivatives to move to an environment where they will be cleared by a regulated central counterparty—i.e., a clearinghouse. The Act requires the clearing of all swaps that the CFTC determines should be cleared. Thus far, the CFTC has determined that certain interest rate and credit default swaps are subject to mandatory clearing. The implementation date for this requirement varies depending on the nature of the counterparties. For interest rate and credit default swaps involving end-users, the requirement to clear those swaps becomes mandatory on September 9, 2013. The CFTC has not yet made any determination for the mandatory clearing of other types of swaps.
When enacting the Dodd-Frank Act, Congress was aware that imposing a clearing requirement on end-users of swaps would impose certain costs and other burdens on American businesses. With central clearing, persons holding positions in swaps must deposit initial margin in the form of specified liquid assets and must be prepared to make variation margin payments in cash as their positions are marked to the market on a daily basis. Accordingly, the Act contains an exception (known as the end-user exception) from the clearing requirement. This exception is discussed below.
- Can my company use the end-user exception?
To qualify for the end-user exception, your company needs to meet three requirements: (1) your company must not be a financial entity, (2) it must be using the swap to hedge or mitigate commercial risk, and (3) it must notify the CFTC how it plans to meet the financial obligations related to uncleared derivatives.
The end-user exception applies on a swap-by-swap basis, and these requirements must be met for each uncleared swap that is subject to the mandatory clearing requirement. You should carefully determine whether use of the end-user exception is appropriate because abuse of the exception can involve heavy penalties. The Dodd-Frank Act makes it a felony punishable by a fine of not more than $1 million, a prison sentence not to exceed 10 years in prison, or both, for abusing this exception.
The elements of the end-user exception are described below:
- Not a financial entity.
Generally, financial entities cannot use the end-user exception. Swap dealers, MSPs, private funds, commodity pools, and certain employee benefit plans are financial entities. Also, any business primarily engaged in banking or other financial activities is a financial entity.
In the following situations, a financial entity is deemed not to be a financial entity for purposes of the first requirement of the end-user exception: (a) a depository institution with less than $10 billion in total assets; (b) a captive finance company that primarily provides financing and uses derivatives to hedge commercial risk related to foreign currency and interest rate exposures, at least 90% of which are from providing financing for purchasing or leasing products that are manufactured by its parent company; and (c) a financial entity acting as an agent for a company that is eligible for the end-user exception.
- Swap used to hedge or mitigate commercial risk.
Generally, if the swap is economically appropriate to reduce your company’s business risks, even financial risk, it is being used to hedge or mitigate commercial risk. The overall reason your company engages in the swap is also important. Swaps that are entered into for speculative purposes will not qualify for the end-user exception.
- Notify the CFTC how your company will meet its financial obligations associated with the swap.
If your company chooses not to clear swaps by relying on the end-user exception, it will have to provide certain information about its eligibility for the exception to a swap data repository (SDR). Your company should indicate how it plans to meet its financial obligations regarding the swap by checking off applicable items from a list of choices. This information should be reported annually and updated if any of the information changes materially.
- What internal approvals does my company need to use the end-user exception?
If your company is a publicly traded company, the decision to use the end-user exception should be reviewed and approved by the board of directors or a committee of the board. The board or committee should set appropriate policies governing the use of swaps subject to the end-user exception and should review such policies annually or whenever there is a material change in the company’s hedging strategy. If your company is not a publicly traded company, its normal approval process is sufficient.
- May my company choose to clear its swaps even though it could use the end-user exception?
Yes. The end-user exception is at the option of the end-user. If the end-user chooses not to exercise the exception, then the swap must be cleared.
- Does mandatory clearing apply to inter-affiliate swaps?
Generally, no. The CFTC adopted a rule that exempts swaps between affiliated entities within a corporate group (whose financial statements are consolidated) from the mandatory clearing requirement, provided that certain conditions are met. As with the end-user exception, each affiliate must indicate how it plans to meet its financial obligations regarding the uncleared swaps. If an affiliate is publicly traded, it must satisfy the approval process discussed above in Question 5.
- Reporting and Recordkeeping Requirements
- What are my company’s new reporting obligations, and how does it prepare for them?
For reporting purposes, corporate end-users must obtain a legal entity identifier (LEI), which is a unique number that identifies each entity that enters into swap transactions. Obtaining an LEI, also known as a CICI (CFTC Interim Compliant Identifier), is relatively easy. You can either register your company yourself by completing the application at https://www.ciciutility.org/, or you can have a third party, such as an attorney, register your company and obtain the CICI for you. The deadline for obtaining your CICI is April 10, 2013.
Under the CFTC’s rules, only the “reporting party” is required to report specified information about swap transactions. When only one counterparty to a swap is a U.S. person, the U.S. person shall be the reporting party. When both counterparties to the swap are U.S. persons, the reporting party is determined as follows:
- If one counterparty to the swap is a swap dealer or MSP, that party shall be the reporting party.
- If neither counterparty is a swap party or MSP, but one counterparty is a financial entity, then the financial entity shall be the reporting party.
- If neither counterparty is a swap dealer, MSP, or financial entity, then the counterparties to the swap shall decide which of them will be the reporting party.
The Dodd-Frank Act imposes additional reporting and documentation requirements and business conduct standards for swap dealers and MSPs that require them to gather additional information from their counterparties. MSPs and swap dealers may require their counterparties to amend their existing ISDA master agreements. In response to these requirements, ISDA created the Dodd-Frank Frank Protocol, an online protocol that allows a swap user to update all of its existing agreements easily. If your company chooses to use the Protocol, you will need to submit an adherence letter to ISDA, pay an adherence fee, and complete a detailed questionnaire outlining various information about your company, such as corporate status and your CICI number.
You should be aware that there is no regulatory requirement to follow the Dodd-Frank Protocol. Instead, your company may choose to provide the new information to each of its swap counterparties separately. However, because the Protocol makes meeting the new reporting requirements so much easier for MSPs and swap dealers, they may require your company to comply with the Protocol before they will do business with you.
- What are my company’s new recordkeeping obligations, and how does it comply with them?
As of April 10, 2013, your company must comply with new recordkeeping requirements regarding the type of information that must be maintained for each swap and the manner in which it is kept. All swap records must be kept for five years after the termination of the swap, and must be retrievable within five business days.
The type of information your company must keep about its swaps depends on whether the swaps are “historical” swaps or “new” swaps. Historical swaps include so-called “preenactment” and “transition” swaps. Pre-enactment swaps are swaps entered into before and still in existence on July 21, 2010. Transition swaps are swaps entered into on or after that date, but before April 10, 2013. New swaps are swaps entered into on or after the April 10, 2013, compliance date.
For any pre-enactment swap that ended before April 25, 2011, your company must keep all information and documents regarding the swap that it had on or before October 14, 2010. For transition swaps that ended before April 25, 2011, your company must keep all information and documents it had on or after December 17, 2010. For any swap in existence after April 25, 2011, your company must keep records of all the primary economic terms specified in the CFTC’s rules. These terms will vary depending on the type of swap.
For all new swaps, your company must keep full, complete and systematic records, including those demonstrating how a swap is eligible for the end-user exception if your company used that exception.