Skip to content
Contact Us Client Area

The Dodd-Frank End-User Experience: What's Happening April 10

| FinReg

By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.

Originally published on Tabb Forum 


When it comes to trade reporting, Dodd-Frank cuts some slack for end users, or non-financial companies using swaps to hedge business risks. But inter-affiliate swaps are not exempt from reporting requirements, and firms need to be prepared now.


One of the areas where the Dodd-Frank Act (DFA) and the ensuing regulations appear to cut some slack is for end users, defined as non-financial companies (a category that oddly includes small banks) using swaps to hedge business risks. The DFA and the regulations exempt end-user trades from mandatory clearing and SEF trading (whenever SEFs actually come into existence).


However, one area where end users are not exempt is in trade reporting. Granted, most market-facing end-user trades will be done with a swap dealer (SD); and for those trades, the SD has the reporting responsibility. There is, though, one other kind of trade that end users will have to report on: inter-affiliate trades.


This turns out to be a big deal for end users, because of the popular practice of doing financial market trades in a trading subsidiary and apportioning them internally to the various operating companies. This practice allows the end user to manage all its trading relationships through one entity -- for example, executing one trading agreement per counterparty as opposed to executing a separate agreement between each operating entity and each counterparty.


On April 1, 2013, the CFTC released a final rule exempting inter-affiliate trades from certain clearing requirements, but not from these reporting requirements. In fact, the rule says that the reporting party “shall provide or cause to be provided the following information to a registered swap data repository or, if no registered swap data repository is available to receive the information from the reporting counterparty, to the Commission, in the form and manner specified by the Commission,” and then lists a set of information to be provided for uncleared trades in addition to the regular reporting.


The reporting requirement is made worse by the fact that deliverable FX forwards are swaps for reporting and business conduct purposes. Although there may be a limited number of commercial companies that use traditional swaps, virtually any company that operates internationally uses FX forwards. Whether you are buying raw materials overseas, selling your product overseas, meeting an overseas payroll or borrowing in another currency, forward FX trades are part of almost every company’s daily business. And every time a company channels these trades through a market-facing subsidiary, it creates a DFA reporting requirement.


On the surface, this may look like overkill. After all, what difference do transactions between wholly owned affiliates make to overall market risk? That is the argument the Coalition for Derivatives End Users made in its February 26, 2013, comment letter to the CFTC, and in a January 29, 2013, presentation given on its behalf to the House Agriculture Committee staff by the law firm Gibson Dunn. In the letter, the Coalition points out, “Because end users use inter-affiliate swaps to manage the internal risks of the commercial enterprise and, hence, are able to net swaps on an enterprise basis, the number of inter-affiliate transactions can significantly exceed the company’s market-facing swaps, which adds to the reporting burdens on end users.”


There is no indication that the CFTC is planning to weaken the end-user reporting requirement for inter-affiliate trades (although they certainly could), so perhaps we should take a look at the actual impact of these trades on market risk. The first thing to understand is the impact of bankruptcy rules on counterparty exposure. History is full of examples in which one affiliate of a company filed bankruptcy while other affiliates did not, leaving counterparties to the bankrupt affiliate unable to access other resources. So anyone doing business with a market-facing affiliate would, one supposes, have a good understanding on that affiliate’s financial condition and resources. Otherwise, a counterparty might find itself holding the obligation of a thinly capitalized trading subsidiary that has defaulted while better capitalized operating subsidiaries operated behind a corporate wall. The CFTC may be mindful of this possibility in requiring the reporting of inter-affiliate trades.


We should also be aware of the global jurisdictional issues involved in derivatives trading. If a market-facing affiliate is in one jurisdiction -- say the US -- and the internal counterparties are in others -- say Europe and Japan -- the inter-affiliate trades do have an impact on the regulators. If the US’s rules on, or definition of, end-user exempt trades are different from the rules in Europe or Japan, and if they are different again between market-facing and inter-affiliate trades, then the inter-affiliate trades are important to the regulators.


And, finally, we shouldn’t be too trusting in the assurances that end-users only do swaps to hedge their risks, so that inter-affiliate trades are just tidying up a perfectly benign use of these products. The reporting rules aren’t made for the benign situations, but to catch the trades, or end users, that have run amok. And before we pooh-pooh that possibility, we should remember that Enron would probably have qualified as an end user at the time it blew up.


In the meanwhile, April 10 is literally just around the corner, so end users need to be just about ready to report their inter-affiliate trades. Fortunately, the CFTC has specifically allowed reporting through third parties, so end users that have an FCM can probably arrange their reporting through that relationship. And, also fortunately, this reporting requirement isn’t real time, because these trades aren’t available to the public. But relying on the CFTC to delay the requirement or water it down is very much a long shot. Your horse might come in, but you really need to be prepared if it doesn’t.