Better late than never. Last week the CFTC provided a no-action letter recommending that the Commission does not enforce the requirement for inter-affiliate swap reporting under Part 45 governing Swap Data Repository (SDR) rules. Under these rules, a non-financial corporate that centralizes its hedging activity by consolidating its group needs into a larger dealer-facing swap is still required to report the subsequent back-to-back intra-group trades to an SDR. Opponents of this rule felt there would be a significant increase in regulatory costs with no perceived benefit in helping to reduce systemic risk or transparency as the grouped trade was being reported by the swap dealer.
The no-action letter means that the Division of Market Oversight and Division of Clearing and Risk will not enforce this reporting but the rule still stands. So I guess it’s like jaywalking, where in some states in the U.S. it’s against the law to cross the street in the middle of the road instead of at the cross walk, but you won’t get fined for it. Of course it would have been nice to have an exemptive order to make it clear and permanent, but perhaps that can come later.
So slowly, but surely, non-financial end-users are getting out of what should never have been in Dodd-Frank to begin with, such as the end-user clearing requirement. The main outstanding item impacting end-users is the margin requirement that still stands for un-cleared bilateral trades with swap dealers. This may largely fall out of the CFTC’s jurisdiction as the Fed or other prudential regulators govern the swap dealers that are banks, and they want to protect the financial system by having all swaps covered by margin either through exchanges, clearing or in the un-cleared world.
Robert Citron, the infamous former treasurer of Orange County, died last Wednesday at the age of 87. In 1994 he singlehandedly bankrupted the affluent county in sunny southern California by over leveraging his $20bn fund using repo markets and structured OTC derivatives with a $1.6bn paper loss…sound familiar?
As a municipal employee he did not reap personal gain from his actions, and some say he was motivated by ego. Whatever the motivation, his actions and behavior ultimately helped form some of the tenets of FAS 133 as, at the time, OTC derivatives were off balance sheet and not marked-to-market. Any of his speculative activity to create yield would have hit P&L and presumably would not have been kept under cover as long as it did. Depending on the controls around financial reporting at the time, it’s possible that with FAS 133 he either would not have entered into some of the OTC derivatives to begin with or maybe the extent of the losses associated with the speculative derivative positions could have been curtailed.
Also looking back, would Dodd-Frank have stopped this bankruptcy? As an active speculator to leverage his $20bn investment portfolio, Orange County would not have qualified for any end-user exemptions and most likely would have had to post margin against its derivative positions, which also may not have been easy to clear. However that leverage was reportedly only two times, which although surprising at the time for a municipality, is paltry compared to 2008 leverage ratios of thirty times. Presumably he would have been allowed some threshold on collateral agreements, and given the relative low leverage ratio, it’s hard to know if the extent of the loss could have been prevented by margining requirements alone.
During his grand jury hearing, Mr. Citron claimed he was an unsophisticated victim of banks selling him complex instruments and he didn’t understand the risks. Although probably not true, Merrill Lynch had to pay $400MM to settle with the county. Dodd Frank does have several business conduct rules that deal with knowing your client and explaining and documenting the risks. Some of the requirements were watered down in the final rules, for example transparency in the valuation methodology being only on request instead of being in the documentation sent to the client. However, by all accounts Mr. Citron was very sophisticated and it would be hard to see a Swap Dealer today that would not have had a problem meeting the Business Conduct rules.
Stringent accounting rules and Dodd Frank regulation would have gone a long way towards stemming the losses, but when you combine weak internal controls (Mr. Citron was able to deftly move money between accounts) with an individual intent on creating amazing market returns, a recipe for financial disaster is ready to be baked.
At long last, the U.S. Treasury Department on Friday came out with the final determination that FX swaps and FX forwards will be exempt from mandatory trading and clearing under Dodd-Frank.
As stated in the Treasury’s press release: This final determination is narrowly tailored. FX swaps and forwards will remain subject to the Dodd-Frank Act’s new requirement to report trades to repositories and rigorous business conduct standards. Additionally, the Dodd-Frank Act makes it illegal to use these instruments to evade other derivatives reforms. Importantly, the final determination does not extend to other FX derivatives, such as FX options, currency swaps, and non-deliverable forwards. These other FX derivatives will be subject to mandatory clearing and exchange-trading requirements.
Most corporate treasury departments have largely assumed that the exemption would be passed, but many are not aware or too concerned about the reporting requirements, which are not exempted. According to current reporting rules “all” swaps have to be reported to SDRs, so the question remains on inter-affiliate swap transactions that are currently required to be reported. In a recent survey we conducted, 36% of companies said they enter into back-to-back swaps for centralization of hedging and efficiency, so these companies would be required to report their inter-affiliate trades.
The determination does not exempt FX swaps and FX forwards from margining and makes a point that prudential regulators have done an effective job of minimizing risk through the use of capital and margin requirements. Therefore, corporates should not expect to avoid posting margin because of this Treasury exemption.
A global issue is also brewing as the European Securities and Markets Authority (ESMA) and other G-20 countries do not have this exemption of Fx swaps and Fx forwards. This lack of harmonization could drive plain vanilla FX business to the U.S., and if there is not harmonization on this “obvious” gap, then it’s hard to see how other less obvious gaps would be closed.
For now anyway, let’s take one of the few victories from Dodd-Frank and, on behalf of many beneficiaries of this exemption, thank Secretary Geithner for coming through with this farewell gift before he leaves office.