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Senators Dodd and Lincoln Clarify the End User Exemption in the Derivatives Title of Dodd-Frank

By Jim Hamilton

The Dodd-Frank Wall Street Reform and Consumer Protection Act does not authorize regulators to impose margin on end users that use derivatives to hedge or mitigate commercial risk, said Senator Chris Dodd and Senator Blanche Lincoln, who have instructed the SEC and CFTC not to make hedging so costly that it becomes prohibitively expensive for end users to manage their risks. In a letter to the Chairs of the House Financial Services and Agriculture Committees, the senators emphasized that Congress does not intend to regulate end users as major swap participants or swap dealers just because they use swaps to hedge or manage the commercial risks associated with their business. Just as Congress has heard the end user community, they said, regulators must carefully consider the impact of regulation and capital and margin on end users.

The letter emphasized that Congress clearly stated in the Dodd-Frank Act that margin and capital requirements are not to be imposed on end users, nor can the regulators require clearing for end user trades. If regulators raise the costs of end user transactions, they may create more risk. It is imperative that the regulators do not unnecessarily divert working capital from the economy into margin accounts in a way that would discourage hedging by end users or impair economic growth. Whether swaps are used by an airline hedging its fuel costs or a global manufacturing company hedging its interest rates, derivatives are an important toll that companies use to manage costs and market volatility.

The SEC and CFTC are charged with setting rules for capital and margin requirements for uncleared trades. But the senators cautioned that the rules may not be set in a way that requires the imposition of margin requirements on the end user side of a lawful transaction. In cases where a swap dealer enters into an uncleared swap with an end user, margin on the dealer side on the transaction should reflect the counterparty risk of the transaction.

Congress strongly encourages regulators to set margin rules for such swaps or security-based swaps in a manner that is consistent with the congressional intent to protect end users from burdensome costs. A consistent congressional directive throughout all the drafts of the Dodd-Frank Act, and in congressional debate, has been to protect end users from burdensome costs associated with margin requirements and mandatory clearing. Thus, changes made on the conference committee to the section of the bill regulating capital and margin requirements for swap dealers and major swap participants should not be construed as changing this important congressional intent to protect end users. Capital and margin standard should be set to mitigate risks in the financial system, not punish those who are trying to hedge their own commercial risk.

Congress recognized that the individualized credit arrangements worked out between counterparties in a bilateral transaction can be important components of business risk management. That is why Congress specifically mandates that regulators permit the use of non-cash collateral for counterparty arrangements with swap dealers and major swap participants to allow flexibility. Mitigating risk is one of the most important reasons for passing the Act.

Clearing is at the heart of the reform as it brings transactions and counterparties into a robust, conservative and transparent risk management framework. Congress also said that clearing may not be suitable for every transaction or every counterparty. End users who hedge their risks may find it challenging to use a standard derivative contract to exactly match their risks with counterparties willing to purchase their specific exposures. Standardized derivative contracts may not be suitable for every transaction. Congress recognized that imposing the clearing and exchange trading requirements on commercial end users could raise transaction costs where there is a public interest in keeping such costs low in order to provide consumers with stable process and promote investment.

Congress met these concerns by creating a robust end user exemption for those entities using swaps to hedge commercial risk. These entities range from car companies to airlines to energy companies to makers of farm machinery. The end user exemption may also apply to smaller financial entities, credit unions, community banks, farm credit institutions, who did not get the US into the crisis and should not be punished for Wall Street excesses. That is why Congress provided regulators the authority to exempt these institutions.

That is also why the Act narrows the scope of the swap dealer and major swap participant definitions. Firms that are properly managing their risks should not be inadvertently pulled in. When implementing these definitions, Congress expects the regulators to adopt rules maintaining that the definition of major swap participant does not capture companies simply because they use swaps to hedge risk in their ordinary course of business. For example, the definitions are not intended to include an electric utility that purchases commodities used either as a source of fuel to produce electricity and that uses swaps to hedge the commercial risks associated with its business. Congress incorporated a de minimis exception to the swap dealer definition to ensure that smaller institutions that are responsibly managing their commercial risk are not inadvertently pulled into more regulation.

Full post as published by Jim Hamilton's World of Securities Regulation on July 01, 2010 (boomark / email).