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 Commodity Management Blog has been closely following the top Commodity Management issues throughout the year. Not surprisingly, posts discussing Dodd-Frank top the list. Below is a complete list of the 10 most popular posts over the past 12 months based on views and shares. We thank you for following us and hope these posts have provided valuable tips on how to manage commodities smarter.
2. The Treasury Function and Commodity Risk
3. Life in a Dodd-Frank World
4. 4 Out of Top 6 Commodity Traders Use Triple Point
5. Can There be Good News in Men’s Underwear?
6. Triple Point’s Partnership with SAP
7. CTRM Checklist for Agriculture Companies
8. 5 New Rules for Credit Risk Management
9. Surviving Global Economic Uncertainty
10. Purchasing: The Impact of Risk and Volatile Raw Material Prices
We have some really great things in store for 2012, so here’s to a year of fresh ideas for Commodity Management!
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)
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.
So, here we are, one year later, and still trying to get our collective heads around the complexity introduced by the Dodd-Frank Act. So, how’s progress? Well, let’s take a quick look at the numbers. As of July 27th, the CFTC had finalized 11 out of the 47 rules required, only 23% of the way there. The SEC is fairing at about the same rate of finalization. Now it is important to note that we’re primarily talking about Title VII of the DFA; other sections of the law haven’t had a stellar rule adoption rate either. This raises the question, “Shouldn’t more of the key moving parts be in place by now?”
What Is Taking So Long, Anyway?
We’ve recently seen a level of Washington partisanship push us near to default status on our debt, so it should come as no surprise that legislation like the Dodd-Frank Act would inspire a predominantly divisive environment. There are many bills that were recently introduced in Congress that hope to redact sections of DFA, not to mention the budget cuts that are planned for the regulatory bodies. More with less seems to be the Congressional mantra.
To add to the legislative distress, President Obama is having a difficult time getting a new director to head up the Consumer Financial Protection Bureau. In mid July, he nominated former Ohio Attorney General Richard Cordray to the post. This nomination came when it was clear that Elizabeth Warren, the bureau’s acting director, was not going to get Senate approval to a permanent post. Senate Republicans are not likely to back Mr. Cordray’s nomination either. In fact, they don’t even want a director at all. They would rather have the bureau headed by a bipartisan five-member board. Without a director, the CFPB cannot enact any rules.
If you caught the Daily Show on Comedy Central last week, there was a segment spoofing the Schoolhouse Rock cartoon “I’m Just a Bill”, where John Oliver portrays a very battered Dodd-Frank Bill. Yeah, it’s funny, but sadly, it does illustrate some of the real problems that DFA faces, and quite possibly why we are witnessing such a slow rollout.
Hurry Up and Wait
With the CFTC and SEC both acknowledging the need to extend some deadlines along with their power to do so, it is apparent that we won’t see significant OTC regulation until the year end. We will also see much of the implementation moving in through calendar year 2012. CFTC Chairman Gary Gensler has stated on more than one occasion that it is important to get this right. Overall, I believe, that the CFTC has made reasonable attempts to acquire industry guidance and input throughout the rulemaking process. Perhaps this is a major contributing factor for some of the delays. I do, however, question the order in which the rules were proposed. I would have thought that the regulators would have tackled the bulk of the definitions first, but that’s just my view.
So, Happy First Birthday, DFA!
(What do you get a one-year old that needs everything?)
As part of my series of interviews with Triple Point clients, I recently had the chance to sit down with Thomas Harvey, CIO and VP of Information Technology at The Energy Authority, to discuss industry changes and how they use technology to operate effectively in the energy marketplace.
Q: What are some of the major trends driving your industry and how do you see it changing in the next few years?
Thomas: The Dodd-Frank Act and what’s happening with the CFTC is the hot topic. We’re looking at our business policies and technical systems across several areas–transaction and position reporting; audit-ability; credit management; and documentation–to ensure we’re ready to meet additional reporting requirements.
From an IT perspective, we see technology becoming less about automating routine tasks and processing data; it’s more about mining data for information we can act on. Some of what’s driving this is the world in which we live and our reliance on immediate information exchange. Technology enables us to capture and access huge amounts of data, and the ubiquitous presence of it in our lives means our workforce is increasingly more technically savvy and astute to analyzing the information available to them. Service providers that quickly provide actionable information to move businesses forward will be market leaders.
Q: What are some of the business issues that keep you up at night?
Thomas: Technology is an underpinning of TEA’s ability to operate effectively in the energy marketplace…so we’re always questioning where we should be investing our efforts and resources in terms of improving business processes. We are cognizant of how we can provide reliable, cost-effective competitive advantages to our traders, power managers, schedulers, and analysts.
Q: What were the major business drivers in moving to Triple Point’s Enterprise Solution?
Thomas: Having trading, scheduling, and risk management functionality on a common platform was key. Triple Point enables us to manage both transaction and decision-making information in one solution: physical and financial transactions for power, gas, and oil; scheduling; and credit risk management.
Q: In addition to your current business, how do you see Triple Point supporting TEA’s future expansion?
Thomas: TEA represents 46 Public Power Utilities throughout the United States, and we wear multiple hats to support our partners. Triple Point truly understand the complexities of our business, and this provides great peace-of-mind. With Triple Point, we have the infrastructures in place to support our business strategically, now and in the future. If you really look at what TEA offers, a cornerstone of our business is risk management. The value that Triple Point provides in our risk management practice will continue to be a contributor to our success.
Q: What have been the biggest benefits of implementing the Triple Point Solution?
Thomas: I’d be remiss in not mentioning the exceptional Triple Point staff we work with. Our success with the implementation of Triple Point’s commodity management and credit risk platform is built upon the dedication of some very smart, hard-working individuals. Triple Point provides an outstanding implementation team and superior customer support. They’ve been invaluable in educating our team on the inner working of the Commodity XL product and have been fully engaged in helping craft solutions for our unique requests. It’s really the whole package, Triple Point’s software and people, which brings benefit.
Turbulent economic conditions combined with stringent and uncertain regulatory reform are bringing dramatic changes to the face of energy and commodity credit risk. Don’t just cross your fingers and hope a catastrophe won’t happen to your organization.
Triple Point recently hosted a webinar on The New Rules of Counterparty Credit Risk and how you can prepare for potential economic & regulatory pitfalls with a flexible and transparent credit risk system.
In case you missed the live webinar, here is a link to download the webinar and view at your convenience.
In this webinar, Triple Point’s Vice President, Credit Risk Division, Dan Reid, discussed how Triple Point’s Commodity XL for Credit Risk™ will safeguard against counterparty credit risk failure and growing regulatory demands. Attendees learned how our solution will deliver an ROI to their business through liquidity savings and business expansion, how to reduce reliance on credit rating agencies, the impact of Dodd-Frank, Markets in Financial Instruments Directive (MiFID) and Market Abuse Directive (MAD) on credit risk management, and more.
To learn about the implications of market volatility and financial reform on credit risk, and how you can safeguard against counterparty credit risk failure, download the webinar below.
House of Representatives Bill, H.R. 87, introduced by Rep. Michele Bachmann, R-Minn. back in January, called for the full repeal of the Dodd-Frank Act (DFA). As one would expect a repeal to be worded, the bill’s text simply states, “The Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111–203) is repealed and the provisions of law amended by such Act are revived or restored as if such Act had not been enacted.”
Oddly, even with Republican leadership in the House, the bill seemed to lack any serious momentum. There are, however, two nearly identical Senate bills, S. 712 and S. 746, introduced by Sen. Jim DeMint [R-SC] and Sen. Richard Shelby [R-AL], respectively, that have really started to gain support. In fact both bills have the backing of the entire Republican Senate. But will it be enough? Right now – not likely. Remember that in the Senate, the Republicans are still the Minority party – just ask Senate Minority Leader Mitch McConnell, whose title serves as a daily reminder.
Without winning over any Senate Democrats, neither bill will likely see the light of day. But, let’s just say they do indeed pick up some votes from the Democrats, and the bill passes – they still need to get it through the House. This is fun! Ok, now let’s pretend that by some stroke of luck the bill squeaks past the House and now sits on the President’s desk. Come on – you know it’s veto time! There is absolutely no way that President Obama will let this go, and if you remember your civics lessons (Do they still teach that?), both Houses would need to pass it with a two-thirds majority to make it stick. Now, with that, we are stretching the boundaries of reality.
What’s likely is Congress will not increase the CFTC’s and SEC’s budgets. In the current economic climate, that really shouldn’t be a surprise. In fact, Congress intends to slash the agencies’ budgets (see my March 23rd article). This will effectively hamper rule making and regulatory oversight as CFTC Chairman Gary Gensler has pointed out while relentlessly pleading for more funding.
As I see it, the killing off of DFA is not going to happen. As the DFA deadlines draw near, we may see some amendments to the legislation. I believe that Congress will be receptive to revise disputed sections of the Act, but to a wholesale repeal – no way.
So, for now, don’t go dumping any plans relating to compliance. Remember, a bill is just a bill, but right now, Dodd-Frank is law.
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|