On July 14, 2011, the CFTC issued an Order providing relief from most provisions of Title VII of the Dodd-Frank Act that were slated to become effective July 16, 2011 to now expire upon the effective date of the final rules or December 31, 2011. This allows more time for comments and provisions that do not require a rulemaking but reference terms regarding swap entities or instruments that require further definition.
Besides the continued definition around what constitutes a swap and who is a swap dealer/major swap participant, the reporting requirements for transactions are still evolving. Organizations like DTCC and ICE are angling to become registered Swap Data Repositories (SDR), but terms and format must still be defined. It’s a start to have some terms in place, but a true “data dictionary” and certified format/technology is necessary.
In the proposed rule “Swap Data Recordkeeping and Reporting Requirements: Pre-enactment and Transition Swaps”; 76 Fed. Reg. 22833 (Apr. 25, 2011), Proposed Regulation 46.2 would require counterparties to keep records of a minimum set of primary economic data relating to such swaps. Of particular note are the open-ended terms for “Data elements necessary for a person to determine the market value”, “Other terms for determining settlement value, and “Any other primary economic terms(s) of the swap matched by the counterparties in verifying the swap.” While mandated, there is also currently no source for Universal Counterparty Identifiers (UCI), no standard format for electronic representation of master and credit support agreements (although some exploration with FpML and FIX), and no standard for reference data.
Companies that want to prepare for the new regulatory landscape need to automate their systems and create a centralized electronic system of record for counterparties, agreements, and trades to prepare for evolving SDR reporting requirements. The current reporting terms in the proposed rules are a good place to start, but the reporting framework should be flexible to include other terms as they become finalized. Having access to all of the required information NOW not only provides for efficient and effective conformance to the regulation when it is in place, it also allows time to analyze the data and make any appropriate changes to have the optimal netted exposure and liquidity positions when exposed to oversight.
There are any number of reasons why firms should take enterprise counterparty risk seriously, and manage it appropriately. A perceived failure will start investors, rating agencies and counterparties questioning an organization’s business processes and corporate governance procedures. The merest whiff of a rumor of default on a margin call, or over-exposure to a downgraded counterparty will start the wolf pack circling.
Failure to manage credit risk across the entire company can put organizations on a collision course with a market, that has shown little forgiveness for both real and perceived mis-steps, and regulators demanding greater transparency. It means that business decisions are being made on incomplete or inaccurate data. It severely blinkers a firm’s vision of the future, and hampers its ability to move forward. And, at a time when cash is king, it can have a very deleterious effect on liquidity.
Constellation – a firm with a previously strong reputation for sophisticated risk management – knows all about credit risk failure. In August 2008, the power producer shocked investors when it revealed that it had made an accounting error and underestimated its potential liabilities in case of a ratings downgrade. Both Standard & Poor’s and Fitch Ratings swiftly downgraded Constellation’s credit. Constellation was so large and appeared to be dependent on multiple lines of credit from various banks that were, at the time, either wobbly or are going under, that the perception developed that it was at risk.
Despite Constellation’s efforts to reassure investors of its excess liquidity, good balance sheet and solid commodities trading business, it got caught up in the spokes of Lehman Brothers’ death spiral.
Over three days in September 2008, Constellation’s stock lost nearly 60 per cent of its value as it was dragged into a world of plummeting share prices and eventual sell-offs.
And yet, post-Constellation, post-credit crunch, even post-Enron, when we know that the wrong numbers can do untold damage, many companies are still using a simple spreadsheet to stand between them and potential ruin. Instead of managing credit risk in a holistic fashion, based on consolidated, auditable data from across the organization, businesses rely on error-prone processes that perpetuate the stove-piping of data sets.
Worryingly, a CommodityPoint survey, sponsored by Triple Point Technology, of energy and commodity executives discovered that 70 per cent of companies are using spreadsheets or internally assembled systems to manage counterparty credit risk. While 60 per cent of the companies surveyed felt the need to upgrade their credit risk systems to manage counterparty risk effectively in the current business environment.
If companies do not wish to follow in the footsteps of Constellation, Lehman and Enron, they must grasp the central tenets of credit risk management which we call the five Cs: counterparty, contract, collateral, concentrations and credit analytics.
I am pleased to announce that recently Triple Point saw the fruition of its innovative credit research and development when our company was successfully granted US Patent #US007571138B2: “Method, System, and Program for Credit Risk Management Utilizing Credit Limits.”
Abstract: “Software aggregates and integrates credit exposure and credit data across accounting, trading, and operational systems within an organization and generates views of available credit in light of the exposure and credit limits.”
A comprehensive model of exposure to all counterparties, across all of their divisions and subsidiaries, is assembled, enabling the creation of a hierarchical view of each counterparty that models its real-world parent-child relationships.
Credit limits are set across the enterprise, supporting the organization’s unique methodology and business process — and on a granular basis — incorporating factors such as external credit ratings, internal credit scores, commodity, geographic region, deal duration, and security instruments.
Credit, transactions, and risk are then determined at any level in the hierarchy. After aggregating exposure and credit limit information, the system presents a comprehensive, detailed, real-time, enterprise-wide view of current exposure, collateral requirements and available credit for both a company and its counterparties. This makes it easy for users to identify trouble spots by counterparty, geography, industry, and credit rating and to manage the company’s liquidity.”
The sweeping Dodd-Frank Act changes in the US for market participant classification, clearing, and margining are being closely watched and emulated internationally. The dangers/opportunities between national regulations, adoption, and timelines can be significant.
In September of last year, the European Commission proposed a framework to regulate OTC derivatives, central clearing counterparties, and trade repositories. In December, the Commission also published a consultation paper on the Markets in Financial Instruments Directive (MiFID) to “improve the regulation, functioning and transparency of the financial and commodity markets to address excessive commodity price volatility.” In a joint statement from EU Commissioner, Michel Barnier and CFTC Chairman, Gary Gensler, Barnier stated, “It’s essential –across the board on all financial regulation–that the United States and Europe move in parallel and that we don’t create new space for regulatory arbitrage.”
It still remains to be seen how significant the differences will evolve, and which countries and companies will be most affected or take the most advantage (China stands out as a likely recipient of business fleeing costly or time-consuming regulations.) Below is a table with some of the key similarities/differences. Also of note is that some of the regulations at the bottom that are US-centric may be applied to US-listed companies or those operating in the US (e.g. Canada.)
|Clearing||Mandatory for standardised OTC contracts (unless end-user exempted)||X||X|
|Hedging for non-financial entities||X||X|
|Uncleared swaps to SDR (US) or trade repository (EU)||All|| Specified
|Volker Rule||Prohibiting bank proprietary trading||X|
|Swap Push Out||Banks to establish separate trading entity (“too big to fail”)||X|
|Timeline||Deadlines for most major provisions to be published||9/2011||12/2012|
|Regulatory bodies that are responsible for enforcement|| Many
|Reporting on payments to non-US governments (provinces and municipalities)||X|
|Executive compensation drawbacks||X|
|Companies operating mines in the US||X|
|Up to 30% >$1M in damages||X|
|Independent review of minerals being conflict free (e.g. Congo)||X|
Credit departments manage billions of dollars of capital and provide a system of checks and balances on company risk, but are chronically under funded and lack regulatory support to provide proper oversight. In the rush to make a quick buck, organizations often fail to invest the time and energy they should to constantly re-evaluate the strength of their policies and procedures and ultimately conduct business in a way that ensures long-term prudence and prosperity. Even with recent financial reform regulatory actions under the Dodd-Frank act, no person, department or governmental compliance effort can totally prevent all errors, misrepresentations, or deceptions. It is essential that organizations have their own enterprise credit risk management policies in place to provide transparency and to help ensure compliance. This market perspective presents a number of timely approaches for potential improvements to the regulation and administration of credit risk management issues.
Automated Collateralization / Margining
The International Swaps and Derivatives Association, Inc. (ISDA) recently conducted its 2010 ISDA Margin Survey. Over the last ten years, the number of executed collateral agreements has grown from 12,000 to over 170,000, with the estimated amount of collateral in circulation growing from $200 billion to over $3.2 trillion, and 83% are bilateral. Much of the tracking and application of collateral (and its expiration) is still conducted in spreadsheets, with the potential for manual error and/or incorrect calculation. This can lead to the belief that credit reserves are adequate when they’re not, or increased trading that is not supported by accurate and enforceable risk-mitigation provisions. Automation and audit-ability of the recording, maintenance, and calculation of collateral and margining is critical to meet the growing demand. Under Dodd-Frank, evolving requirements for minimums, timeliness, and collateral type will likely increase. Investments in this area support the business and help to avoid the next company going down because it couldn’t meet liquidity demands.
Credit Rating Agency Independence
Similar to auditing, paying a company to review your own business and provide a rating can represent a potential conflict of interest. And yet, critical decisions on billions of dollars of investments and contingent collateral requirements are based on those same ratings. If you look to the consumer sector, where credit bureaus like TransUnion, Equifax, and Experian provide FICO credit scores, revenue comes from the requestor of the score—individuals do not pay for their own evaluation. Even with the 2006 Credit Rating Agency Reform Act and the SEC implementation in 2007 of the Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organization, NRSRO’s still rely on an “issuer-pays” business model. These ratings are too important to take a chance– a subscription-based model would provide significant independence. Recent reforms mandated by the Dodd-Frank act (Title IX, Subtitle C) look to address the oversight and regulation of rating agencies, but it is still unclear how far and deep the changes will go. Market leading organizations will pay close attention and provide comments to the rule making process to ensure reform delivers comprehensive, sustained results.