CFOs should see little change in their ability to use over-the-counter derivatives under the new regulatory regime mandated by the Dodd-Frank Act of 2010, some industry experts say. They may, however, pay more for the privilege. And contrary to the promise of Dodd-Frank supporters, they may see little benefit from the much-touted transparency the new regulations are designed to bring to the market.
For the past several months, regulators at the Securities & Exchange Commission and the Commodities Futures Trading Commission have been drafting regulations required by Dodd-Frank. Among other things, the law requires that “standardized” contracts for many market participants be cleared on an exchange or through a central counterparty. Contracts that cannot be cleared must be reported to newly created “swap information repositories.” Dealers will be subject to new capital and margin requirements. Regulators have a year from the date of Dodd-Frank’s signing–or until July of this year–to complete the bulk of their rulemaking activities.
Companies use over-the-counter derivatives — swaps, options and the like — for a wide range of hedging purposes, of course. Among the most common are exchanging floating-rate interest payments for fixed-rate payments, hedging foreign-currency risk and hedging commodity costs. In a typical transaction, an investment bank acts as the counterparty.
Other factors could drive costs for end-users higher, too.
While the new law exempts most corporate end-users from margin requirements if they are merely hedging risks–as opposed to speculating–it is widely expected that the dealers will pass their own marginal costs onto their customers.
“With the additional regulation creating more barriers to entry to this market, the banks are going to charge higher prices and find new ways to make money on these transactions,” predicts derivatives veteran Reuben Daniels, who recently co-founded independent capital markets advisory firm EA Markets LLC, after serving as managing director and co-head of U.S. investment banking at Barclays Capital in New York.
[President Obama’s new budget also includes measures by which taxpayers will help pay for policing derivatives.]
Will Enough Detailed Reporting Be Required?
That’s not been the message from advocates of Dodd-Frank, who argue that the increased transparency generated by the new regulations–by moving trades to exchanges and creating information repositories–will make the market more efficient and minimize counterparty risk. Both, they say, should help to drive trading costs down.
But Daniels and some other industry veterans aren’t convinced.
“Although there is all this talk about transparency, it will do little to change things for regular corporate end-users of the OTC derivatives markets,” says veteran banker Joyce Frost, who served as head of marketing for Chase Manhattan Bank’s credit derivatives business in the mid-1990s and later in similar capacities for a number of other banks. Today she is a partner with Riverside Risk Advisors LLC, a boutique derivatives consultancy headquartered in New York City.
The problem, Frost argues, is that regulators are unlikely to require swap dealers to report sufficient detail about OTC derivatives transactions to be useful in benchmarking pricing.
A False Sense of Comfort
“I can’t imagine that regulators will require the disclosure of the actual names of buyers, or, in the case of interest rate swaps, who’s receiving fixed and who’s paying floating rates,” Frost says. “In addition, credit is an important part of pricing, and many corporate end-users don’t have credit ratings. So simply having a bank report that a corporation paid a fixed rate of, say, 2.5% on a five-year deal, won’t tell you much. In terms of the economics of deals and price transparency, the new rules are going to be a little meaningless.”
So much focus has been put on Dodd-Frank as a cure for making the market more transparent, Frost says, that she worries end-users will get a false sense of comfort that they’re actually going to be given everything they need to understand how swaps are really priced. “It’s just not going to happen,” says Frost. “Dodd-Frank is not going to illuminate the methods and practices banks use to price swaps with counterparties.”
In fact, Frost warns, companies could find it harder than ever to figure out fair pricing, since the new capital requirements mandated by Dodd-Frank, plus the new capital requirements expected under next year’s Basel III international bank accords, will add a new layer of complexity to pricing calculations.
“There will still be a very asymmetrical level of experience between swap dealers and end users,” Frost predicts. “Even the capital markets pros at some of the larger, more active companies, if they are not derivatives savvy, will find it hard to catch that extra basis point in their transactions. And we have worked on transactions where one basis point could be worth a quarter-million dollars.”
“In a derivatives transaction, the fee is totally embedded and highly opaque,” agrees Craig Orchant, co-founder and chief advisory officer for EA Markets, and formerly managing director and head of corporate finance and risk management at Barclays Capital in New York.
Orchant isn’t totally disenchanted with Dodd-Frank, however. Over the long term, he says, its rules and regulations could be good for corporate America. “Initially they may have little impact, and may even scare off some end-users if they object to doing greater reporting of their transactions or subjecting themselves to greater regulatory review,” he says. “But over time, I think there will be sufficient additional transparency that it helps to reduce bid-offer spreads, and that, along with the reduced counterparty risk that comes from clearing, will bring in a greater number of marginal participants into the market.”
Randy Myers is a business and finance journalist based in Dover, Pa.