Derivatives: sour grapes or Dodd-Frank victims?

While claims the Dodd-Frank Act will make the derivatives market prohibitively expensive could be seen as a case of sour grapes from a market unregulated until now, a committee reviewing the Act has asserted that end-users of derivatives, including pension funds, will bear the brunt of the new laws.

Frank Iacono, a derivatives practitioner and partner at New York-based Riverside Risk Advisors, an independent derivatives advisory firm, claimed the Act potentially placed undue burden on so-called end-users, such as corporations, some banks, and pension funds that increasingly rely on the derivatives market.

“With the best intentions, Dodd-Frank was designed to reduce the risk of a systemic meltdown similar to 2008. The problem is that the Bill over-reaches in some regards and is still inadequate in others,” he said.

Iacono presented his suggestions for amending the legislation in a letter to the US House of Representatives financial services committee, which held a hearing on the aspects of the Dodd-Frank Act, including implementation of the derivatives provisions of the law on February 15.

They proposed a broader end-user exemption, which they believe would in effect limit margin and clearing requirements to those end-users who are deemed large enough to pose a meaningful risk to the financial system, what the Act refers to as the “major participants”.

“Making the derivatives market affordable is good for everyone,” Iacono said.

“Unfortunately, the derivatives market could dry up for some parties if access to it is made prohibitively expensive.”

Riverside Risk has also suggested that Congress consider alternative measures to address counterparty risk, including updated capital reserve requirements for federally-insured banks and more meaningful disclosure in financial reports.

The committee’s chairman, Spencer Bachus, asserted end-users of derivatives did not cause the financial crisis at the hearing.

“Let’s be clear up front right at the beginning of this hearing: end-users of derivatives did not cause the financial crisis. They were among its victims,” he said.  “Although the 2,300 page Dodd-Frank Act was promoted as being directed at Wall Street, we are coming to understand more clearly, it is the end-users of derivatives who will bear so much of the regulatory brunt of this law.”

The Bill’s Title VII – Wall Street Transparency and Accountability – has three critical reforms for the derivatives market.

First, the bill aims to lower risk through comprehensive regulation of swap dealers, with the law providing the US Commodities Future Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC) with far-reaching new authority and imposes significant requirements on these agencies to regulate the OTC derivatives market, products and market participants.

Second, the Bill moves the bulk of the swaps marketplace onto transparent trade facilities – either exchange or swap execution facilities (SEFs).

Third, the Bill requires clearing of standardised or “clearable” swaps by regulated clearing houses to lower risk in the marketplace. Under the new law, the CFTC and SEC are required to circulate rules and regulations to provide for the mandatory clearing of such swaps.

Under the Act, it will be illegal to engage in a swap that is required to be cleared without submitting it first to a clearing house.

The law provides an exemption to this as long as one of the counterparties to the swap is not a financial entity; is using swaps to hedge or mitigate commercial risk; and notifies the regulator (CFTC or SEC) how it generally meets its financial obligations associated with entering into non-cleared swaps.

As a final security measure, companies will be required to post some form of collateral, generally in the form of margin or extra capital.

Regulators will set minimum capital requirements and initial and variation margin requirements for swap dealers and for the major participants. While the Act permits the use of non-cash collateral, non-cleared swaps requires swap dealers and the major participants to hold their counterparties’ initial margin, upon request, in a segregated account at an independent third-party custodian.

The Act does not provide an exemption for these margin requirements for commercial end users.