The Four Phases of Regulatory Engagement (aka the “LaRCO” Framework)

End users of derivatives have had to consider a multi-faceted approach for engaging withderivatives regulation. This approach includes four phases: Legislation, Regulation, Compliance and Optimization (“LRCO” or “LaRCO”). Each phase requires different competencies, has different objectives and different action steps. This framework is described as follows.

Chatham Regulatory Engagement


Legislation

Key Objective: Establish end user exemption and preserve efficiency of OTC derivatives market.

AIG’s synthetic bets (via derivatives) on the housing market contributed to its failure and government-funded bailout. In response, many policy makers questioned whether all derivatives should be forced into clearinghouses and exchanges or even banned altogether. Chatham, working together with numerous companies and the Coalition for Derivatives End-Users – a group of trade associations in Washington that represents the business community on derivatives policy issues – sought to tell how companies use derivatives to reduce, rather than increase risk. We emphasized that end users and the economy at large would be hurt by margin requirements. And we advocated for improvements to the law that would support end-users’ continued and efficient use of the OTC derivatives market. While the final law did not perfectly reflect the needs of end users – especially non-financial end users – policy makers did conclude that an end-user exemption would benefit the economy without undermining the core policy objectives of the Act.

Regulation

Key Objective: Preserve end user exemption and preserve efficiency of the OTC derivatives market.

While the Dodd-Frank Act did include an end-user exemption, it also gave regulators substantial authority – authority that could have served to substantially undermine the end-user exemption and the efficiency of the OTC derivatives market. Chatham, numerous companies, and the Coalition for Derivatives End-Users actively engaged through the regulatory process to ensure regulators understood how their actions would affect companies and the broader market. We wrote hundreds of pages of comment letters and met with regulators at the CFTC, SEC, Fed, FDIC, Treasury, White House and other regulatory agencies in dozens of meetings. The regulatory process is not complete, and while regulators have made great effort to understand andrespond to end-user concerns in many cases, the final outcome of the regulatory process on end-users is still difficult to assess. The ultimate outcome will substantially be determined by final decisions by bank regulators on capital and margin rules.

Compliance

Key Objective: Understand and meet legal requirements.

Even while legislative and regulatory initiatives continue, compliance deadlines are requiring companies to take action now. During this phase, it is essential for companies to understand the regulatory requirements that apply to them, to understand key timing deadlines and to take all necessary actions to comply with the law. Chatham has been working to educate clients and to design services that allow them to efficiently and effectively meet their legal requirements.

Optimization

Key Objective: Reassess hedging strategies in light of new regulatory requirements in order to make sure hedging strategies are optimized.

After clients have done what they need to do in order to meet their legal obligations, it will be time for them to focus on what they should do to ensure their hedging strategies are optimized. The need to optimize will be driven by changes in capital and margin requirements that create regulatory incentives to consider using cleared swaps, futures transactions, or hybrids thereof. These regulatory incentives may conflict with competing business incentives, such as the desire to preserve liquidity or obtain hedge accounting treatment. In order to assess the best hedging alternatives, companies will need to develop capabilities that allow them to compare alternative hedging options across six factors: transaction price, collateral, credit risk, economic fit, accounting effectiveness and portfolio effects. Chatham has been working to enable clients to analyze these factors in order to make wise hedging decisions during the optimization phase.

If you have questions about how Chatham can help you through these four stages or any of them individually, please contact your Chatham advisor.