The US Midwest is suffering its worst drought in decades. The US Department of Agriculture (USDA) recently dropped its corn yield forecast from 166 bushels per acre, made earlier this year, to 123 bushels per acre. The expected shortage of corn is causing prices to surge.
Corn has multiple uses – it is used as fuel (ethanol), animal feed, or directly as food. Roughly 40% of US corn production goes towards ethanol, 36% towards feed, and the rest towards food.
There are several concerned groups that believe the Environmental Protection Agency (EPA) should relax the ethanol requirement under the Federal Renewable Fuels Standard act, which states that there must be 13.2 billion gallons of corn starch-derived biofuel produced in 2012. The UN has called for an immediate suspension of the US-mandated use of ethanol. In addition, a coalition of beef, pork, and poultry producer associations have called for a cessation of the ethanol requirement.
Whether the EPA will ease the ethanol requirement is not the most important question – the real question is how do we plan to deal with rising agricultural commodity prices and volatility in the long term? The corn shortage might be a one season event, but volatile agriculture and softs prices are here for the long term.
We have an expanding world population that is forecasted to grow from 7 billion to 10 billion in the next 35+ years. As part of this population growth, there is a rapidly growing middle class across China, India, and other parts of Asia. China and India alone are doubling their per capita incomes at approximately 10 times the rate and 200 times the scale achieved by Britain’s Industrial Revolution in the 1800s. This growing middle class wants to eat higher on the protein scale (more meat which needs more animal feed). And it appears we’ve hit a pattern of severe weather events including droughts, floods, extreme temperatures, etc. These long term trends will drive acute commodity price swings – which is, as we’ve said before, the new normal.
All companies in the food supply chain, from upstream to downstream, should be putting plans and commodity risk management systems in place to handle price volatility.
There have been several recent announcements from Delta Airlines related to jet fuel and oil trading.
According to Reuters, Delta Air Lines Inc. reported a second quarter loss because it took $561 million in charges for fuel hedges. Part of the loss was taken for mark-to-market adjustments on open hedge contracts.
It appears that Delta has chosen not to apply FAS commodity hedge accounting treatment. Many of the news reports called these derivative purchases “bets” when in fact they are hedges that reduce risk.
If Delta used hedge accounting it would match the loss of open fuel derivative contracts against future jet fuel purchases and not show the loss in the current period. Hedge accounting is extremely complex, and an advanced, auditable software system is required to support the adoption of these procedures.
Separately but related to managing fuel cost and risk, Delta announced that it completed its acquisition of the Trainer Refinery in Pennsylvania through its Monroe Energy subsidiary. Delta will move jet fuel from the refinery to its hub airports in the Northeast. Additional refined products such as gasoline and diesel fuels will be traded for jet fuel in other parts of the country. Delta spent about $12 billion on jet fuel in 2011 and expects to serve 80% of its domestic jet fuel needs from the Trainer refinery and related deals.
Delta is the first airline to own refining capacity. It will be interesting to observe if other airlines follow suit and move to vertically integrate their energy supply chains.
Supplying a refinery with crude oil and trading products requires sophisticated energy trading and risk management (ETRM) software. With volatility seemingly increasing daily in the commodity and crude oil markets, it seems prudent for Delta to invest in a hedge accounting and oil trading and risk management platform.
Four years ago Triple Point acquired INSSINC, the leading commodity hedge accounting software solution, and integrated it into its energy trading and risk management (ETRM) software solution. At that time, Triple Point recognized the need for an integrated commodity management platform that seamlessly integrates all key risk areas.
The new volatility reality demands that all industries with exposure to commodities and energy review their current risk systems to ensure they are appropriately protected.
In our circles, when we talk about the Dodd-Frank Act, we tend to gravitate our conversations to Title VII – Wall Street Transparency & Accountability. It is, of course, the most hotly disputed, high profile part of the legislation. So, it’s easy to forget some of the other sections of DFA that may concern corporations. One such section is 1502.
Section 1502 – Conflict Minerals
This section requires a disclosure that on the surface seems fairly well intended. Since Congress has determined that “the exploitation and trade of conflict minerals originating in the Democratic Republic of the Congo and adjoining countries is helping to finance conflict characterized by extreme levels of violence in the eastern Democratic Republic of the Congo, particularly sexual- and gender-based violence, and contributing to an emergency humanitarian situation”, corporations will be required to disclose their sources of “Conflict Minerals”. Conflict Minerals include columbite-tantalite (coltan, niobium, and tantalum), cassiterite (tin), gold and wolframite (tungsten) and their derivatives. The State Department can add new minerals when they determine it is necessary.
Who will be impacted?
The impact will be broad, and will encompass all publicly traded companies that source the listed minerals. If you think about it, that covers quite a cross-section of industries: automotive, communications, electronics – you name it. By the SEC’s own estimates, at least 6,000 companies will be impacted. They will be required to disclose in their 10-K, 20-F and 40-F filings the use of “Conflict Minerals” in their products. Even if the source of the material cannot be established, that will also require disclosure. Lacking a de minimis provision in the law, any sourced quantity will necessitate disclosure. The law also calls for due diligence, although that has not been entirely defined. In all likelihood the model of due diligence proposed by Organization for Economic Co-operation and Development (OECD), would serve as a template.
Court of Public Opinion
There are problems with distilling the complex problems of the Democratic Republic of the Congo to a sourcing disclosure and expecting it to be the solution. There are legitimate tribal mining operations that are likely to suffer as a result of this requirement. Regions of the DRC are not in conflict, but they are already witnessing the impact of the proposed rulemaking. According to a recent New York Times article, many mining operations in Eastern Congo have been damped or halted completely. And so the SEC struggles – delaying its final rulemaking yet again. With no established SEC guidelines, I would anticipate more mining operations to close. The concern among manufacturers is also heightened, and it is not just a cost of compliance issue. The fear is that the public’s perception will drive investment or product purchase decisions based solely on a DRC tag or a lack of traceability. Keep in mind, the legislation does not make it illegal to source Conflict Minerals, it just requires the disclosure of that information. I’m all for doing the right thing here, but I’m just not entirely convinced that this is the right thing. Not for the people of the DRC or the corporate world.
The 2,000 page Dodd-Frank Act is the US government’s response to the financial crisis. While it was signed into law well over a year ago, the finer points are still being negotiated, clarified by lawyers, and challenged by Wall Street players.
For energy and commodity firms operating in Europe, this is a cautionary tale – the European Union (EU) is introducing an alphabet soup of directives and legislation affecting the financial and commodity markets including the Regulation of Energy Market Integrity and Transparency (REMIT), the Market Abuse Directive (MAD), the second Market in Financial Instruments Directive (MiFID II), the European Market Infrastructure Regulation (EMIR), and the Capital Requirements Directive (CRD).
The EU’s objective is to have all legislation in force by the end of 2013. The exact provisions aren’t fully baked, but it’s clear that all companies trading over-the-counter derivatives will be impacted across the whole value chain from front office sales through to back office reporting and all points in between.
Not sure how to prepare your company for the impending regulatory avalanche? Mike Zadoroznyj, Triple Point’s Vice President, Treasury and Regulatory Compliance, has written an article for FX-MM magazine about what you need to do in order to ensure that your systems are compliant. Read it now
If you get the feeling that we’ve been here before, you’re right. I’m talking about the convergence efforts of the two accounting standards organizations – FASB and IASB. After all, they have been at it for nearly ten years, so the probability of my addressing it at one time or another are quite high. Well, at the end of January the two boards renewed their efforts to find common ground in the development of standards and disclosure requirements. “The boards have been urged to converge their standards on financial instruments. Today’s decision to work together on key differences—which represent the most significant remaining differences between the decisions reached to date—is responsive to stakeholders in the US and abroad”, said FASB Chairman Leslie Seidman. A commitment with a rhyme – what could go wrong?
As an optimist, I want to believe that it can happen, and there certainly are signs that indicate that it just might come to fruition. Of course, if you’re a pessimist, you are just as likely to find many signs to indicate that it won’t happen. If the renewed talks aren’t enough evidence for you, then you may want to consider a staff paper that the SEC issued back in May, 2011, titled “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers”. That paper explores the incorporation of IFRS, and is essentially an approach combining elements of convergence and endorsement, thus coining the now popular phrase, “Condorsement”. With an endorsement approach, jurisdictions would simply incorporate an individual IFRS standard into their standards, while a convergence approach keeps local standard and attempts converge them with IFRS. The condorsment approach suggests a phased one, where the scheduled convergence projects continue to move forward while seeking areas where endorsements of individual IFRS make sense.
The concept of allowing corporations to adopt IFRS reporting is not that new. It was first pitched in 2008 by then SEC Chairman Christopher Cox, and there now seems to be some serious momentum behind the proposal. Even though the SEC recently delayed its decision on the topic, IASB Chairman Hans Hoogervorst remains confident that SEC will ultimately decide to go with IFRS. In a recent speech given at an Ernst & Young IFRS seminar in Moscow, Hoogervorst stated, “The US already has developed a sophisticated set of financial reporting standards over many decades. Transitional concerns have to be carefully considered. That is why I have supported the general approach for the endorsement of IFRSs described by the SEC staff’s work plan. It is also important to note that the US is committed to supporting global accounting standards. It is SEC policy, it is US Government policy and it is the policy of the G20, in which the US is a key player. “
Most of the G20 member countries currently require the use of IFRS. Also, more than a hundred countries globally currently allow or require IFRS reporting. Detractors call IFRS Euro-centric. I find that interesting, since much of the seeding for the standards in IFRS were a result of groundwork laid out by FASB. In a global economy, it is essential that we end up with a uniform approach. So let’s keep it moving along – make it international and rational. I love rhymes.
Research and consultancy firm, Finadium, published an interesting report last week on the challenges that new regulations (MiFID and Dodd-Frank) are set to bring collateral management for OTC trading. The report highlights how dramatic the changes are going to be, and according to the market participants they interviewed, how technology is the only viable solution to effectively manage collateral in a post regulation world.
MiFID and Dodd-Frank central clearing mandates are going to change OTC trading forever. The increase in cash collateral requirements and daily margin calls will have a large impact. According to a recent Bloomberg article the cost of central clearing could setback Europe’s electricity market by up to $93bn.
While decreasing counterparty credit risk, central clearing will bring huge operational risk. Daily margin calls will make position and liquidity management impossible on a manual basis. Additionally, firms with non-standard trades that cannot be centrally cleared, or who are exempt from clearing, need to manage a ‘mixed’ collateral environment which only adds to the complexity and need for automation.
Effective collateral management needs to become a key feature in pre-trade decision making, where costs of collateral may affect where, whether and how to engage in a trade. So, not only is effective collateral management required from an operational point of view but it will be vital to drive the best trading decisions.
In its conclusion the report highlights that the majority of participants have started to look for collateral management solutions now, rather than wait until the regulations have taken effect. Have you started to think about this? With changes this far reaching can you afford not to?
The full report can be downloaded from here: www.omgeo.com/reportswhitepapers
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)
The global financial crisis has sparked a rethinking of the reporting of fair value disclosures and given rise to concern about counterparty credit risk inherent in derivative portfolios. The credit position of an organization and their counterparties is critical to the transparent valuation of earnings and compliance with changing regulatory requirements.
With auditors, shareholders and regulators insisting on transparency, verifiability and validity of accounting figures, getting the credit haircut or credit value adjustment (CVA) wrong, or excluding it from earnings statements, will raise serious concerns. Organizations cannot afford to ignore this issue, doing so risks the reputation of the firm and the confidence of stakeholders which could ultimately lead to potential business failure.
Triple Point has been helping companies optimize, value and manage their derivative portfolios for over 18 years. By taking into consideration counterparty risk, we enable organizations to provide consistent fair value measurements and disclosures which give all stakeholders confidence in the valuations of assets and liabilities.
Below is a list of 4 ‘must-have’ features that will enable organizations to make accurate credit value adjustments in their fair value disclosures:
- 360 View of all Counterparties – A single, automated view of each counterparty, showing the asset and liability position which indicates the basis for the credit adjustment.
- Collateral Management – Ability to analyse all collateral within master netting agreements, ensuring a contractually accurate view of exposure and liquidity obligations.
- Credit Rating Assessment – Assessing the credit rating of the counterparty or your internal rating in conjunction with the maturity of each transaction will determine the credit adjustment, typically based on credit default swap (CDS) rates to the valuation.
- Transparent Accounting for CVA – Separate accounting entries for each CVA, showing the methodology for each credit adjusted Mark-to-Market
All of the above functionality is available within Triple Point’s Commodity XL for Fair Value Disclosure, a Software Assisted Compliance (SAC) solution which ensures organizations are able to optimize their portfolios, disclose accurate valuations, comply with regulations (IFRS 7, ASC 820) and maintain stakeholder confidence. Counterparty credit risk should also be considered when applying hedge accounting and calculating hedge effectiveness. If you would like to learn more click here.
There has been a lot of discussion recently about how the credit function will undergo revolutionary changes in the next few years. This highlights what Triple Point has been saying for the last 12 months, “Uncertain regulations in both the US and Europe will significantly increase the cost of trading and require the credit department to take a strategic position in optimizing portfolios.”
Rather than a revolution, we talk about the ‘New Rules for Credit Risk’. By following these rules organizations can be ready today for whatever regulatory or economic changes occur in the future (revolution or not), safe in the knowledge that they don’t have to overhaul their IT systems.
‘New Rules for Credit Risk’
- Margining: The impact of clearing OTC swap transactions is huge. According to Richard McMahon, Vice-President, Energy Supply and Finance at the Edison Electric Institute, the annual cashflow impact could be between $250 million and $400 million per company. A credit department’s primary focus will need to shift from counterparty assessment to margining and collateral. This can only be achieved with robust collateral management.
- Reporting: Enterprise-wide analysis and reporting to both the company and regulator will need to be a key priority, and with the ability to be performed within minutes of a transaction. Flexible reporting will prepare for today’s uncertain fiscal and regulatory environment.
- Exposure Monitoring & Management: Monitoring cash flow risk and exposure is critical. Increasing capital requirements make it more important than ever to mitigate risk and seize opportunity. Rather than monitoring positive exposures (amounts owed to the company by counterparties), the credit function will need to monitor negative exposures (what the company owes exchanges and clearing houses).
- Analytics: Changing and uncertain times have proved that many of the basic risk analysis and measurement techniques are not adequate and companies need access to more forward looking information. Credit analytics does just that. It provides a consistent framework to forecast, evaluate, and respond to future credit events.
- Internal Scoring Don’t rely solely on credit rating agencies. Collating and managing counterparty information, and applying custom scoring techniques, is critical for any organization that wishes to protect itself from defaulting counterparties.
Don’t just cross your fingers and hope catastrophe won’t happen. Start following the rules today and safeguard your organization against credit risk failure.
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.