Dodd Frank

It’s amazing how time flies. Can this really be our first newsletter in June 2013? Why, that means our favorite holiday is one short week away! Of course, we’re talking about World Derivatives Day! To answer your first question: no, this is not a joke! If you’ve been reading our newsletters for a while, you may recall that in 1997, we at Chatham decided to dedicate one day a year to celebrating the mighty derivative and its use in financial risk management: more predictable than a LIBOR-Fed Funds dislocation; more foreseeable than a black swan event; and able to fix the largest of variable interest rate exposures with a single “done”!

But this year, World Derivatives Day coincides with an important milestone in the now four-year-old realm of financial regulatory reform, and it is an inauspicious day for some. Beginning next Monday, June 10, 2013, certain interest rate swaps by “financial entities” (as described in the Dodd-Frank Act) become subject to mandatory clearing. This necessitates more than fully collateralizing these trades with cash or liquid securities and establishing financially and operationally intensive relationships with Futures Commission Merchants, or FCMs.

While this central clearing milestone ushers in the keystone of derivatives reform — containing and mitigating systemic risk — its arrival will not be welcomed by all market participants. With the imposition of new costs and responsibilities, many smaller financial entities are now considering whether they can afford central clearing and whether they can establish a relationship with an FCM in time to continue hedging without interruption. Such entities are finding that their hedging volumes may be insufficient to justify minimum monthly fees that most FCMs charge to their clients, they tend to execute idiosyncratic transactions that third party platforms are not always able to handle, and their lower transaction volumes dictate lower priority with infrastructure providers that are overwhelmed by a traffic jam of new clearing parties.

It’s the End of the World as We Know It

(and I Feel… Resigned… and Not Necessarily Ready)

By “smaller financial entities” (“SFEs” for short), we’re referring to companies like non-bank real estate lenders, microfinance funds, certain corporates, and community and regional banks, as opposed to large financial institutions. While their derivatives use is not sufficient to impose risk on the financial system, these SFEs nevertheless have been presented with a difficult decision: whether to continue hedging their interest rate exposure at greater cost. Many of those that have decided to enter into cleared swaps in the OTC market are at risk of not being ready for the June 10th deadline for a variety of reasons, including the following:

1 – It’s All New. Because SFEs never have cleared their OTC derivatives and because the clearing market for non-dealer banks itself is new, many SFEs have undertaken a significant and time-consuming FCM evaluation process, often seeking approval of boards of directors or risk committees. Compounding these delays, some of our SFE clients have received conflicting information from the front and back offices of clearing houses as to their ability to handle certain idiosyncratic features of their trades.

2 – Third-Party Backlogs. So close to the June 10th deadline, there is high demand for FCMs’ attention, and SFEs are relatively low priority to FCMs on account of their lower hedging volumes and consequent lesser profitability to FCMs. As a result, many SFEs have had to choose between accepting FCMs’ documents without negotiating terms and giving up interest rate hedging altogether.

If SFEs are not able to clear on June 10th, they will be left with another difficult decision: to hedge their interest rate exposure with products that do not adequately meet their risk management needs, or to give up interest rate hedging altogether. There are many potentially adverse consequences to this: for example, if regional banks opt not to hedge, they will not be able to manage the balance sheet risks they incur through the ordinary course of business and will not be able to offer swaps to their commercial customers in connection with offering loans.

The reality of these challenges raises questions about whether the clearing deadline should be extended for SFEs and whether this important feature of the financial reform agenda is focused on the right market participants in all cases. Indeed, we raised these very questions in a letter to the CFTC last week. Market participants and observers undoubtedly will be watching the CFTC this week to see if it opts to extend the clearing deadline in consideration of the needs of SFEs.

No matter what regulators choose to do, we’ll be helping our clients navigate their choices in a more complicated world, and we’ll continue celebrating World Derivatives Day year after year, decade after decade! Please do not hesitate to reach out to us for any last minute clearing-related inquiries or updates, and keep an eye out for next week’s newsletter, where we’ll tell you more about World Derivatives Day and how you can win prizes!