The road to reform. Helping commercial end users of OTC derivatives comply with Dodd-Frank s Title VII

Transcription

1 The road to reform Helping commercial end users of OTC derivatives comply with Dodd-Frank s Title VII

2 Wide-ranging impact A survey conducted by the International Swaps & Derivatives Association (ISDA) shows that well over 90% of organizations in the Global Fortune 500 use derivatives to manage risk. And the Commodity Futures Trading Commission (CFTC) estimates that there are approximately 30,000 end users of over-the-counter (OTC) derivatives. Given the tremendous growth over the past 30 years in the use of OTC derivatives for risk management, the number of end users could easily be higher. If your organization uses OTC derivatives or plans to in the future, Title VII applies to you. Dodd-Frank Title VII compliance for end users

3 Deadlines are being set finally Dodd-Frank is broadly understood to affect financial institutions. But Title VII applies to any entity trading OTC derivatives even nonfinancial end users. And for many, compliance is required as early as the beginning of Many treasurers struggled to understand and prepare for new derivatives regulations while federal regulators agreed to delay many compliance deadlines. But with the release of several key final rules, the timeline for compliance is taking shape. Organizations using various OTC derivatives need to take steps now to further understand Title VII s impact and address required changes. We can help. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 reaches far beyond financial institutions. In particular, Title VII establishes a robust regulatory framework governing derivatives traded over the counter. But more than two years after its passage, many organizations are sharpening their focus on the implementation of Title VII. Still, many treasurers are surprised to learn of the variety of ways in which the new rules could affect their businesses. The recent approval and publication of the foundational entity and product definitions, as well as the timeframe for compliance, mean that organizations must begin preparing for compliance now. Does Title VII apply to you? If you trade derivatives over the counter, the answer is yes. How much time do you have? That depends. End users will be required to update existing documentation in Q3 and Q4 of this year due to a number of rules imposed on their swap dealer counterparties. The rule that finalizes the so-called commercial end-user exception for nonfinancial entities is effective on September 17, 2012 and nonfinancial companies wanting to avail themselves of it must meet the specific conditions of this exception by as early as summer of Need to get ready? You re not alone. Thousands of nonfinancial companies are affected by the new rules, ranging from manufacturers and consumer product companies to pharmaceutical companies, from energy and utility companies to mining companies and commodities trading firms, from real estate companies to agricultural producers and more. Many organizations engage in derivatives trading to address market risk related to fluctuating interest rates, foreign currency exchange rates or commodity prices. All types of organizations now face rigorous new requirements that affect how they trade. Title VII grants the US Commodity Futures Trading Commission broad oversight and enforcement powers, including the power to impose stiff penalties for noncompliance. Deadlines for compliance are just around the corner for some and on the horizon for others. OTC derivatives now regulated Title VII defines swap broadly to include all OTC derivatives, with very few exceptions. 1

4 Clearing hurdles, achieving compliance Dodd-Frank Title VII presents compliance challenges and has longer-term market impact for end users. Title VII: where do you fit? Any entity that intends to continue to trade various OTC interest-rate, FX or commodity derivatives now must comply with Title VII. Your entity s classification determines the level of impact and effort necessary for compliance: Swap dealers (SD) Entities that deal in swaps or make markets in swaps Major swap participants (MSP) Non-SDs with swaps exposures significant enough to pose a risk to the financial system Financial entities Banks, insurers, private funds, commodity pools, pension plans and all other entities predominantly engaged in financial activities Nonfinancial or commercial end users Entities that are not SDs, MSPs, or other financial entities, but that generally engage in derivatives trades to hedge or mitigate commercial risk Any company entering into OTC swap agreements will fall into at least one of these designations, and the volume and type of swap activity they are engaged in also helps to determine the appropriate designation. Title VII fundamentally changes the OTC derivatives market, affecting how swap trades are executed, documented, processed, and settled. Many derivatives once traded almost exclusively over the counter must now trade on regulated exchanges or electronic trading platforms; many derivative contracts that existed previously as bilateral contracts must now be centrally cleared after execution. Title VII also creates new entity designations, establishes new registration requirements for certain market participants, and imposes new capital and margin requirements, which in turn will affect working capital and liquidity at many companies. It mandates substantially more formal recordkeeping, reporting and governance responsibilities than companies have ever had to face. And its governance requirements extend all the way up to the Board of Directors. The impact of Title VII cuts across multiple functions, from treasury and risk management to legal and information technology. Other consequences could include: Impact on employee benefit plans Considered financial entities under the Act, pension plans do not qualify for the commercial end-user exception and may face increased collateral requirements for uncleared swaps. Plan administrators should assess the collateral requirements associated with central clearing and the proposed bilateral margin rules. Constraints on captive finance units and centralized treasury functions These business units, even if housed under the umbrella of a nonfinancial parent company, could be considered financial entities under Dodd-Frank, subject to clearing and trading requirements. Inter-affiliate trades are subject to reporting requirements that can be quite burdensome. Impact on working capital and liquidity The end-user exception offers a limited exemption from clearing and trading requirements, but uncleared trades are still governed by Title VII. Bank regulators have proposed rules that would impose collateral requirements on all OTC contracts entered into bilaterally with bank swap dealers. So non-financial end users that have successfully exempted their contracts from the central clearing requirements will likely still feel the impact of Title VII on their available working capital. Market participants need to examine the regulations, the types of trades executed, and the entities executing the trades, and must consider the implications for their business model and their risk management objectives. But the impact of new derivatives regulation goes beyond the near-term need to meet compliance deadlines. Inevitably, Title VII and other new regulations will have the effect of hastening transformational changes already underway in the derivatives market. End users swap dealer counterparties will face significant increases in capital and collateral (i.e, margin) requirements. These capital and margin costs will likely be passed on to end users. In particular, customized, uncleared swaps could be much more expensive than cleared and exchangetraded swaps. As a result, end users that have never considered cleared or exchangetraded derivatives may need to consider these alternatives in the future. 2 Dodd-Frank Title VII compliance for end users

5 Exception? The commercial end user The exemption may not be as simple to claim as one might think. While not specifically defined in Dodd-Frank, the term commercial end user has come to mean a nonfinancial or commercial organization that executes derivatives to hedge or mitigate commercial risk. Title VII does allow an exception to mandatory clearing and trading regulations for nonfinancial entities that enter into derivatives to hedge or mitigate commercial risk. But this socalled commercial end-user exception is neither a free pass nor is it automatic and it is limited in scope. Even qualifying organizations must meet certain conditions to be exempt from clearing and trading requirements, and must keep records and ensure that all OTC trades are reported. The type and purpose of the products traded is not the only issue that must be addressed; absent a clearing function, the The compliance timeframe entity will need to report how it meets its financial obligations for swaps. Also, if the entity files with the SEC, it must receive approval at least annually to enter into non-cleared or OTC swaps from an appropriate committee of the board of directors a function far different than the typical monitoring and oversight role of many of today s board committees. Asking a board of directors or its audit or finance committee to approve claiming the end-user exception will likely involve significant preparation, including educating board members on Title VII and gathering information supporting management s position. Finally, any company with substantial volumes of swaps will need to perform certain notional and exposure calculations to determine whether registration and regulation as a major swap participant (MSP) is applicable. Q4 Q1 Q2 Q3 and beyond Where to start? Key questions Complying with Title VII can have a significant effect on your existing hedging strategies, as well as on your processes and policies, systems and controls, and documentation. The following questions can help your organization begin planning and better anticipate the scope of required changes required: Has our organization fully assessed the potential impact of Title VII s new derivatives regulations? Have we determined how all our relevant legal entities and derivative products will be classified? Have we initiated a sustainable program and governance structure to manage multiple types of contracts and hedges? What modifications might we need to make to existing infrastructure, systems, and transaction workflow? What s our roadmap for complying with the proposed requirements and for managing a compliance effort on multiple tracks? What action steps and deadlines must we attend to immediately? What are the longer-term implications? Should we be thinking differently about hedging and product selection? Reporting and recordkeeping for non-swap Dealers/non-MSPs for all swap categories (240 days after publication of product definitions) (April 2013) Annual end-user exception potentially reviewed and approved by appropriate committee (no earlier than December 2012) End-user exception from mandatory clearing of initial category swaps subject to CFTC determination (expected Summer 2013) * Based on CFTC estimates as described in 17CFR Part 39 End-User Exception to the Clearing Requirement for Swaps; Final Rule (July 19, 2012) CFTC s timetable for finalizing compliance end users 3

6 Addressing impact: the way forward We can rapidly assess your compliance needs, helping evaluate applicable entity and product classifications, providing template materials and implementing new processes and controls. Ernst & Young LLP s Financial Accounting Advisory Services practice includes a dedicated team focused on Title VII compliance for commercial end users. Our professionals have deep knowledge of Title VII s provisions and are deeply versed in best practices for Title VII compliance programs across a range of industries. In addition, we have a solid track record working with board of directors on key issues that impact businesses such as Title VII. We can customize our services to suit your organization s specific circumstances: End-User Training Suite Two distinct modules to educate treasury departments and boards of directors respectively on the regulations and potential impacts. End-User Compliance Toolkit A package of training, documentation templates, and hands-on assistance from our professionals. End-User Readiness Assessment An analysis of the potential gaps between your company s compliance preparations thus far and the applicable new requirements, along with a fixed amount of assistance from our specialists. End-User Assessment and Compliance Plan A comprehensive Title VII readiness assessment and implementation, with assistance from our specialists throughout the project, including: Assessing Title VII s impact, reviewing your hedging portfolio, helping you establish which trading entity designation is applicable to relevant business units, and helping you classify derivatives contracts Advising on what changes must be made to processes, infrastructure, and systems to achieve compliance and adapt to the evolving derivatives market Reviewing alternative systems and platforms for executing and capturing trades, modeling, and risk management Documenting functional and reporting requirements, to determine what technology changes may be needed Recommending appropriate implementation plans and a project roadmap, in line with expected mandates for compliance Helping educate the board of directors regarding their accountability for reviewing and approving management s decision to enter into non-cleared swaps. Providing an in-depth analysis of your organization s systems, policies, processes, risk models and controls as impacted by Title VII regulatory changes, and working alongside you to design and implement necessary improvements. 4 Dodd-Frank Title VII compliance for end users

7 Contact us To learn more, please contact one of the professionals in Ernst & Young LLP s Financial Accounting Advisory Services practice: Talib Dhanji, Partner Markets Leader Commodities talib.dhanji@ey.com Robert Royall, Partner Markets Leader Derivatives & Financial Instruments robert.royall@ey.com 5

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