Derivatives: How Do They Impact Your Client?
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1 Derivatives: How Do They Impact Your Client? Dallas Bar Association Securities Section October 22, 2012 Craig Enochs Jackson Walker L.L.P.
2 Overview What are derivatives? How are derivatives documented? How are derivatives used? Why are derivatives used? Who uses derivatives? Regulatory impact of Dodd-Frank Act on derivative transactions. 2
3 What are Derivatives? Also referred to as swaps Basic Definition: Financial transaction no physical delivery involved The value of the transaction is derived from the price or value of some other source E.g., an index price, a currency rate, a commodity price or an interest rate 3
4 What are Derivatives? Physical Gas Deal Producer Gas Buyer $$$$ Gas Derivative Fixed Price Payor Fixed Price Gas Index Floating Price 4 Floating Buyer Price Payor
5 What are Derivatives? Commodity Price Swap: Characteristics No physical delivery occurs Each party agrees to pay a floating or a fixed price with respect to a notional quantity of a commodity No Seller or Buyer either party may be obligated to pay under the swap depending on whether fixed is greater than floating or floating is greater than fixed. 5
6 What are Derivatives? Commodity Price Swap: Example Fixed Price Payer ( A ) pays fixed gas price of $7/MMBtu Floating Price Payer ( B ) pays floating gas index price per MMBtu A Fixed Gas Price ($7) B Floating Gas Index Price If Index Price is $8: Party B pays Party A $1. If Index is $5: Party A pays Party B $2. 6
7 How are Derivatives Documented? Master Agreement published by the International Swaps and Derivatives Association ( ISDA ) 7
8 Why is the ISDA Important? Standardized termination rights for third party actions affecting the deal, such as increased taxes. Rights to unwind the transaction if a counterparty defaults. Protections if a counterparty becomes less creditworthy. Multiple transactions under the same terms and conditions. Cross-transactional netting Streamlines negotiations Large body of supporting documentation, including definitions, User s Guides, and explanatory memorandums. 8
9 How Are Derivatives Used? Various Industries: Banking Commodities Price Risk Management (end-users and producers) Examples: Manufacturers Agriculture Transportation Oil and gas producers 9
10 Why Are Derivatives Used? Commodity Price Swap: Timing Flexibility: swap can be entered into after a commodity purchase contract is already in place. Volume Flexibility: Can lock in total commodity volumes up front, or fix the prices for different portions of the total commodity volumes over time. Timing: a long-term fixed-price commodity contract creates risk as market prices shift. Instead, enter into swaps for shorter periods of time to lock in a fixed price. Market Liquidity: There may not be a market for a long-term fixed price commodity deal, or many buyers or sellers at a particular delivery point, but the swap market is more liquid. 10
11 Why Are Derivatives Used? Interest Rate Swap Variable rate bonds Swaps Cost Hospital System $69 Million, Ft. Worth Star- Telegram, December 24, 2010 Christus Health issued long-term variable rate bonds. To hedge such payments, Christus entered into 20 and 30 year interest rate swaps with Citibank and Merrill Lynch. Christus pays a fixed rate of 3.38% Citibank/ML pay a floating interest rate to cover Christus obligations to bondholders Notional amount is $1.22 billion. 11
12 Why Are Derivatives Used? Swaps Cost Hospital System $69 Million, Ft. Worth Star- Telegram, December 24, 2010 What if Christus did not enter into any swaps? A decrease in variable interest rates benefits Christus because they pay less to bondholders in interest expense An increase in variable interest rates means higher, unpredictable interest rate expenses payable to bondholders. No Swap = UNPREDICTABLE INTEREST RATE RISK 12
13 Why Are Derivatives Used? Swaps Cost Hospital System $69 Million, Ft. Worth Star- Telegram, December 24, 2010 How is Christus protected with the swaps? If variable rates decrease below the swap s fixed rate: Christus pays the variable payment to bondholders Christus pays the difference between the fixed and floating amounts to Citibank/ML In total, Christus pays no more than the fixed rate payment agreed to under the swap 13
14 Bondholders Christus Net effect Christus pays 3.38% Citi/ML 14
15 Why Are Derivatives Used? Swaps Cost Hospital System $69 Million, Ft. Worth Star- Telegram, December 24, 2010 How is Christus protected with the swaps? (cont.) If variable rates increase above the swap s fixed rate: Citibank/ML pays Christus the difference between the floating and fixed amounts Christus is fully protected in making higher variable rate payments to bondholders because of the swap payment it receives. Swap = PROTECTION AGAINST INTEREST RATE RISK 15
16 Bondholders Christus Net effect Christus pays 3.38% Citi/ML 16
17 Why Are Derivatives Used? Swaps Cost Hospital System $69 Million, Ft. Worth Star- Telegram, December 24, 2010 Christus has had to pay as much as $1 million a month in additional interest costs, money that otherwise might have gone to its 30-plus healthcare facilities in Texas, six other states and Mexico. What if interest rates had skyrocketed instead and swaps saved Christus millions of dollars in unforeseen expenses? How would rate uncertainty involving this much money impact Christus financial strategy and planning? 17
18 Why Are Derivatives Used? Swaps Cost Hospital System $69 Million, Ft. Worth Star- Telegram, December 24, 2010 The value of the swaps changes daily, depending on what interest rates do and the length of the swap. The Christus swaps are for 20 and 30 year terms. Even if Christus pays today, they may experience substantial savings in the long run. It is impossible to judge whether the interest rate lock was better than floating with the market until the swap ends. Certainty of the rate and limitation of the volatility is captured on day 1. 18
19 Why Are Derivatives Used? Managing Price Risk: Commodity End User Plant owner purchases electricity to manufacture aluminum Under an existing Power Purchase Agreement (PPA), manufacturer buys 1,000 MWh of electricity at a floating price. Month 1: the floating price for electricity is $50/MWh, and manufacturer enters into a fixed-floating commodity swap with counterparty. Manufacturer pays fixed price of $50/MWh Counterparty pays floating price. Notional quantity = 1,000 MWh 19
20 Why Are Derivatives Used? Managing Price Risk: Commodity End User Month 2: Floating price increases from $50/MWh to $60/MWh Under the PPA: Manufacturer owes $60,000 to power seller Under the Swap: Manufacturer owes $50,000 to counterparty, and counterparty owes $60,000 to manufacturer. Net Effect: Counterparty pays $10,000 to manufacturer. Under the PPA and the Swap: Manufacturer pays $50,000 ($60,000 under PPA offset by $10,000 receivable under the swap). Practical Effect: Manufacturer pays a fixed price of $50/MWh for electricity, even though prices increase. 20
21 Why Are Derivatives Used? Managing Price Risk: Commodity End User Month 3: Floating price decreases from $50/MWh to $40/MWh Under the PPA: Manufacturer owes $40,000 to power seller Under the Swap: Manufacturer owes $50,000 to counterparty, and counterparty owes $40,000 to manufacturer. Net Effect: Manufacturer pays $10,000 to counterparty. Under the PPA and the Swap: Manufacturer pays $50,000 ($40,000 under the PPA and $10,000 under the swap). Practical Effect: Manufacturer pays a fixed price of $50/MWh for electricity, even if prices decrease. 21
22 Who Uses Derivatives? CLIENTS MAY INCLUDE: Banks Municipalities Large retailers Private equity Mineral producers Commercial real estate owners Pension funds Manufacturers Corporate borrowers Energy companies Healthcare systems Corporate debt issuers 22
23 Impact of Dodd-Frank In the past, over-the-counter derivative transactions have not been regulated by the CFTC Over-the-counter : Bilateral trades between two persons (i.e., not traded on an exchange like NYMEX). In such case, certain exemptions applied under the Commodity Exchange Act. The Dodd-Frank Act changes this dramatically. 23
24 Impact of Dodd-Frank Dodd-Frank applies to most swaps: (interest rate, currency, forex, commodity, etc.) NOTE: Dodd-Frank does NOT apply to forward contracts where physical delivery is anticipated unless certain elements of optionality are present. Dodd-Frank applies broadly to Swap Dealers : Anyone who regularly enters into swaps with counterparties as an ordinary course of business for its own account. 24
25 Impact of Dodd-Frank New Requirements: Registration and reporting requirements Mandatory clearing Position limits Capital and margin requirements Restrictions on transactions and documentation requirements Rules remain unclear CFTC still working to finalize the rules even though compliance is now required for many rules. No discussion by CFTC as to how most of these requirements relate to or would avert another financial crisis, nor how the CFTC will sort through the information it receives Preliminary estimate are that around $400 billion has been spent to date trying to comply with Dodd-Frank Not clear if this will send swaps to friendlier jurisdictions with less scrutiny 25
26 Key Points to Take Away Derivatives are documented under the ISDA Though ISDA may be presented as standard, it always can and should be negotiated. Derivatives can help clients across a variety of practice areas and industries. Major changes are coming to OTC derivative transactions. Derivative users include most clients. 26
27 Craig R. Enochs Jackson Walker L.L.P McKinney, Suite 1900 Houston, Texas Ph: (713)
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