Whether you work in the front, middle or back office of a company that trades derivatives, life will be changing for you in a big way. Well, that may be a bit dramatic, but really, your current work-flow will certainly be changing. To what degree largely depends on how your company gets branded – swap dealer, major swap participant or end user.
Regardless of your company’s Dodd-Frank branding, its approach to derivative trading will most certainly be impacted. Your business processes may need to be adapted to keep records throughout a swap’s existence and for five years following final termination or expiration of the swap. In addition all swap data must be readily accessible throughout the life of a swap and for two years following its final termination. Daily trading records for swaps must be identifiable by counter party. The CFTC has the authority to request ad-hoc reporting from an entity. Your systems will need to support such requests.
If your company happens to fall into the category of swap dealer or major swap participant, you will likely be faced with additional trading room challenges. Your entire transaction history is to be tracked – from the moment of initiation onward. All of the correspondence related to transaction activity – phone, email, text messaging – is subject to examination at the CFTC’s request. Swap dealers and major swap participants also must maintain a “complete audit trail for conducting comprehensive and accurate trade reconstructions.”
The real-time reporting requirement will no doubt spawn the need to capture information that would not typically be captured in smaller trading operations. Don’t count on the on a status of end-user to exempt you from these requirements. Even if you qualify for end-user exception, depending on your counter party, you’ll need to assert who in fact will ultimately be responsible for reporting the transaction to a swap data repository (SDR).
Risk and Credit
Since the CFTC introduces two tests of substantial position as a daily requirement, you can bet that your risk and credit department will be busy. The first test of substantial position is based on an entity’s current uncollateralized exposure, and the CFTC’s proposed rule sets the threshold at a daily average of $1bn for credit, equity, or commodity swaps, and $3bn for interest rate swaps. The second test is based on an entity’s (PFE) potential future exposure, and is set at a daily average of $2bn for credit, equity, or commodity swaps, and $6bn for interest rate swaps. Moving beyond the thresholds dictated by these tests can push your company into being categorized as an MSP within a particular swap category. It is important to note that the substantial position tests exclude those trades that are used for hedging or mitigating commercial risk.
In addition, your risk and credit groups will need to prepare a substantial counterparty exposure test. This test raises the thresholds for current uncollateralized exposure and potential future exposure to $5bn and $8bn, respectively, without any exclusion for positions held for hedging or mitigating commercial risk.
Since the requirement is that all swaps that can be cleared must be cleared, unless exempted, margining becomes a concern. The credit group will need to carefully assess and project margin requirements. Liquidity management, as important as it has been in the past, will now take on a role in the spotlight.
Your hedge accounting group will need to maintain accurate records to substantiate your company’s hedging program. This will be important if you wish to establish an end user exception for these transactions. Business processes must assure that the proper documentation and tracking of hedging activity is in place from intent to inception.
In a Dodd-Frank world, a successful implementation of compliance depends on an escalated level of communication and coordination between the various groups and systems within an organization. You must consider it an enterprise deployment – trading, legal, risk, credit, finance, and IT – all must be part of the process and the solution. Only by evaluating the implications of Dodd-Frank across all these areas will you be able to develop solid compliance plans.
Although, the rules are still in the making, it’s never too early to start planning and assessing your potential problem areas.
 Commodities Exchange Act – Section 4s(g)(4)