Corporates await final Dodd-Frank details as deadline approaches

On the surface, it might seem that corporate users of foreign exchange derivatives are not going to be significantly affected by the Dodd-Frank Act. At the asset class level, the first draft of the regulations, published in July 2010, provided an exemption from the clearing rules for vanilla FX forwards and swaps. Moreover, end-users who can prove to regulatory agencies that they engage in derivatives trading strictly to hedge or mitigate commercial risks, and can demonstrate board approval to do so, will not be subject to mandatory clearing for derivatives trades.

However, Dodd-Frank employs very specific definitions of FX forwards and swaps, which regulators have since clarified do not extend to non-deliverable forwards (NDFs), FX options or cross-currency interest rate swaps. These will all be subject to mandatory clearing. “If a corporate is trading an NDF, Dodd-Frank considers that product to be a swap that will be subject to the full panoply of swap regulations,” says Allison Lurton, a Dodd-Frank specialist at Washington DC law firm, Covington and Burling.

Moreover, in cases where corporate end-users are trading vanilla FX forwards that meet the swap exemption but are facing a swap dealer or major swap participant (MSP), they are subject to significant documentation and swap data repository (SDR) reporting requirements. “If a corporate is facing a dealer on a straight FX forward or swap transaction, it will still need to make representation to the dealer either via the International Swaps and Derivatives Association Dodd-Frank protocol, or a separately negotiated agreement, and make sure certain disclosures are made with respect to the trade,” Lurton says.

Dodd-Frank business conduct rules require dealers to have swap documentation in place with most counterparties from January this year. As part of that, the Isda Dodd-Frank protocol was established as a standard set of amendments to facilitate updating of existing Isda swap relationship documentation for Dodd-Frank compliance purposes.

For corporate treasurers, this is perhaps the simplest phase of the compliance process, and is typically achieved by engaging a swap dealer to sign a Dodd-Frank amendment to a standard Isda Credit Support Annex. Without this agreement, dealers are barred from trading uncleared swaps, and the end-user will be obliged to trade the swap via a derivatives clearing organisation or central counterparty.

So, after they have convinced the US Commodity Futures Trading Commission (CFTC) that they are not financial entities, and that any FX derivatives trading is hedging or mitigating commercial risk, end-users must establish swap documentation with all in-scope counterparties, report inter-affiliate swap trades to SDRs and reconcile hedge portfolios on a regular basis as of April. This is likely to require most companies to invest in new systems, connectivity and technology to meet compliance requirements.

According to a December 2012 poll of 386 corporate treasury professionals by Reval, a New York-based treasury and risk management technology vendor, while most US corporates have established swap documentation based on the Isda Dodd-Frank protocol or some other bilaterally negotiated agreement in line with the January 1, 2013 deadline, three quarters of the companies polled were not prepared for much of the end-user reporting requirements that become binding in April.

Furthermore, the survey found Dodd-Frank’s requirement for end-users to report inter-affiliate swaps to SDRs is of particular relevance to the FX hedging activities of most major corporates, with a quarter of all companies in the survey saying they enter into inter-affiliate swaps for FX transactions, and 10% use inter-affiliate structures for both FX and commodity transactions as referred to by the rules. “Corporates with foreign currency exposures typically consolidate risk on an enterprise-wide basis, but distribute it for various reasons, including allocation, accounting and cross-border tax purposes. With FX hedging, inter-affiliate structures are a very common format,” says Krishnan Iyengar, vice-president of global solutions at Reval in New York.

The ‘inter-affiliate’ concept in Dodd-Frank terminology refers to a hedging structure in which a corporate headquarters takes exposure to a swap dealer or MSP in a centralised manner, then trades ‘internal’ derivatives with subsidiaries, so there is no bank or MSP intermediating between the central entity and the subsidiaries. Under Dodd-Frank, the central treasury is responsible for the reporting obligations arising from the trade.

Consider the following scenario. The central treasury of an international consumer products manufacturer enters into a US$60 million vanilla FX forwards hedge with a swap dealer on behalf of its offshore affiliates, and parcels the notional hedge into three $20 million clips among its subsidiaries. Given the product’s Dodd-Frank treatment, the transaction is not cleared. In this situation, both the transaction between the swap dealer and the central treasury, and the three smaller inter-affiliate swaps, must be reported to an SDR. While the swap dealer carries the regulatory burden to report the $60 million trade, central treasury now carries an SDR reporting burden, albeit on a non-real time basis.

Similarly, while swap dealers carry the CFTC reporting burden for non-cleared trades transacted with end-users, corporates will be required to reconcile the fair value of their hedge portfolio on a regular basis, with frequency to be determined by the number of swaps they have with a particular swap dealer. For end-users that have more than 500 swaps with a specific dealer, reconciliation must be done on a daily basis, falling to weekly reporting for 50–500 swaps and quarterly if the total number of swaps is less than 50. “Portfolio reconciliation needs both counterparties to a trade to play, which means end-users are going to have to communicate and interact regularly with dealers around portfolio valuations,” Iyengar says.

With compliance needs in swap documentation set-up, proof of end-user status, SDR reporting of inter-affiliate swaps and portfolio reconciliation, corporate treasurers are currently wrangling with significant levels of detail, and are still waiting for final rules in a number of material areas. As the Reval poll suggests, while end-users are generally compliant with respect to swap documentation, few are advanced in developing strategies for compliance with the other more systems-intensive reporting requirements.

“What we see from corporate treasuries right now is an effort to understand the extent to which their derivatives hedging is in the scope of Dodd-Frank. End-users are evaluating the regulations and some are hiring consultants to help them understand what new compliance processes should be,” he adds.

In Europe, the largest companies could be impacted by both Dodd-Frank and European Market Infrastructure Regulation (Emir) reporting requirements. Most, however, direct US dollar cashflows to domestically domiciled treasuries, which they trade with banks in London or Frankfurt. Like Dodd-Frank, Emir offers a broad exemption from clearing and margin-posting obligations for end-users hedging commercial risk, but requires them to be able to value and report derivatives trades. European regulators expect Emir’s reporting requirements to become binding until the second half of 2013, starting with interest rate and credit derivatives, with FX and commodity reporting standards phased in a year later.

Roland Kern, vice-president and head of treasury at Lufthansa in Frankfurt, says the airline’s use of hedge accounting has prepared the treasury to operate under closer regulatory scrutiny. “Under Emir, we will be obliged to provide transaction data to trade repositories, and be able to mark-to-market our portfolios. Our treasury system is already able to provide a lot of the necessary information,” he says. Lufthansa subsidiaries transfer currencies to central treasuries in London and Frankfurt, through which they transact hedges centrally.

Kern says Basel III-related credit valuation adjustment (CVA) charges are likely to have a more profound impact on market pricing for European corporates than Dodd-Frank or Emir. “The biggest impact on pricing in all this is going to come from the CVA charges, especially for complex long-dated derivatives,” he says.

While Lufthansa treasury systems are largely ready to accommodate Emir reporting and valuation requirements, Kern warns that banks may need to improve response rates under new reporting rules. “Confirmation for the hedges we trade online is fast, but complex hedges like cross-currency swaps take much longer to confirm. Banks will have to improve their workflow and efficiency around trade confirmation under the new rules,” he says.

Corporate treasuries with less extensive FX hedging programmes, or a strategic bias towards vanilla products, may see the regulatory burden rise to potentially uneconomic levels versus the hedging benefit, says Brian Kalish, director of the finance practice at the Association for Financial Professionals, in Maryland. “While the Fortune 50 and 100 companies are no doubt looking at how to keep their hedging programs compliant, it’s probably a second-tier concern for many of the companies in our network. For most corporate treasury professionals, it is still confusing as to what the final rules for end-users will be,” he says.

Kalish notes that for smaller corporates with foreign currency exposure, many companies do not actively hedge FX risk using financial products, but pass the risk through the supply chain as the price of doing business. “Once you get past the blue-chip titans into the nuts and bolts of corporate America and Europe, a major decision to hedge FX will be the outright cost. For those companies that do one hedge a year, it’s not clear that it makes sense to invest in all the processes and open themselves up to audit and regulatory concerns,” he adds.

The potential impact of Dodd-Frank compliance has mobilised the Washington lobby industry like no other legislation before. According to the Center for Responsive Politics, financial services firms have spent more than $400 million on lobbying to roll back regulations and delay final rule implementation since 2010. As such, a key strategy for corporate America has been to push for further exemptions from financial regulations as compliance deadlines loom.

In addition to the potential impact of Title VII of Dodd-Frank, which concerns derivatives regulation on corporate treasurers’ hedging activities, Title I addresses money market funds, another subject close to the heart of corporate treasurers. While they might not have the financial fire-power of the swap dealers and MSPs, non-financial industry associations are also seeking regulatory roll-back. “As long as the issue is live, there will be people in Washington talking to anyone pertinent. Even if a rule gets passed, it does not mean the game is over,” Kalish notes.