Swaps Users Up in Arms

Terry Flanagan

Rules could hinder ability to hedge financial risk.

The ability of corporate end users to use derivatives as hedging tools would be severely restricted under proposed rules by the CFTC.

The Commodity Futures Trading Commission has proposed a rule under Dodd-Frank that would establish margin requirements for uncleared swaps for swap dealers and major swap participants that are not banks.

Under the proposed rules, both the CFTC and the prudential regulators would permit swap entities to use models approved by the applicable regulator in calculating the amount of initial variation margin required to be collected from their counterparties.

Both the CFTC and prudential regulators would require the models to cover 99% of price changes over a 10-day liquidation window, as opposed to the typical three to five day requirement used by swap clearinghouses.

“Banks need to use derivatives for many different reasons and in many cases as insurance or a hedge against an exposure,” Zohar Hod, vice president and head of the America at SuperDerivatives, told Markets Media. “If the regulators impose these margin and collateral rules they will kill a section of the markets that allowed non- speculative participants to responsibly hedge their exposures.”

Under the CFTC’s proposed rules, a nonbank swap entity would be required to have credit support arrangements in place with all of its counterparties.

A great majority of end users don’t have ISDA Credit Support Annexes (CSAs) in place today. In a poll conducted by Reval, 68% of end users don’t have any kind of collateral arrangement with their swap dealers.

For those that do have a CSA in place, the variation margin above the threshold is typically bilateral where either the swap dealer or the end user can post or collect collateral depending on the net position of the portfolio with respect to the threshold set in the CSA.

Therefore, all end users will incur costs for negotiating new or existing CSAs, the intent of which may be to have a high enough threshold that would never go into effect.

“There have been many attempts in the past to pit the uncleared instruments to ISDA type contracts and they all failed because of the vast variations between bilateral contracts,” said Hod.

“Not all cleared products can be used to hedge specific positions and imposing a large cost to keep these products on the books will eventually lead to institutions not hedging correctly and that could lead to other market risks,” he said.

Particularly rankling is a proposed rule from the CFTC that would require that a minimum of 85 percent of trading in any contract listed on a designated contract market (DCM) must occur on the centralized market. If a contract fails to meet this test, the DCM is required to delist the contract and transfer the open positions in the contract to a swap execution facility (SEF).

CME and other participants argue that the 85 percent threshold is arbitrary, and runs counter to the intended result of FinReg to promote transparency in markets.

“Following the Enron debacle, CME created the Clearport clearing system to try and mitigate the risk in energy trading,” Hod said.

“Funnily enough, the new liquidity requirement mentioned below or the 85/15 rule actually will take many of products off the Clearport system as they mostly don’t comply with the liquidity rule,” he said. “This is just an example of how the regulation can take something that is working well and make it worse.”

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