This month’s question
“Understandably, there has been a great deal in the financial press recently surrounding the Dodd-Frank Act in the US. I am not entirely clear though on how this will affect treasury and the wider finance function. Also, are there any less well-publicised aspects of the Act that companies need to consider?”
Jiro Okochi, CEO and Co-founder, Reval, responded:
The Dodd-Frank bill exempted most non-financial corporations from the requirement to trade derivatives on an exchange or be forced into clearing, which would then require the cost of margining. So, on the surface, most corporate treasury departments will not be as impacted as others, like non-dealer banks who are also hedging risk with derivatives.
What is not yet clear is how the impact will affect a swap dealer’s pricing and willingness to offer corporations derivative products that won’t clear. Without a doubt, swap dealer costs will be rising in the form of higher capital requirements and reporting costs. These costs will most likely be passed on to end-users through either wider bid-offer spreads or additional service fees. Some have argued that a wider bid-offer spread is more reflective of how the market has, for decades, underpriced the true cost to manage the processing and credit risk of these OTC derivatives, but at the end of the day nobody wants to pay more.
Depending on how much higher capital charges will be for uncleared trades than for cleared trades, some swap dealers may be either driven out of the business of selling to corporates who won’t clear their trades, or they may ask for collateral to reduce the credit risk (and therefore the capital charge). So despite the exemption from clearing under the reform, some corporates may ultimately have to fund margining costs through collateralised swap agreements being forced on them.
In addition to the capital requirements that may ultimately affect corporates, there are over a hundred rules that the regulators have to first define. These activities are ongoing right now, with many closed-door meetings and public roundtables to discuss approaches. One key rule that has yet to be openly discussed is how the regulators will define commercial risk and how it can be hedged or reduced. This definition can make the difference between whether a corporate can qualify for clearing exemption or whether it actually has a large net position, which would then deem it a major swap participant subject to rules similar to a swap dealer.
It is incumbent upon participants in the swap market, whether they are in the US or Europe, to stay actively involved as the outcome of the Dodd-Frank bill is being shaped as we speak and will ultimately determine how the bill is implemented and regulated.
Next month’s question
“What is hybrid cash pooling and how does it actually work? Also, what are the major legal and regulatory restrictions surrounding this form of pooling?”
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