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.
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)
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?)
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|
George Carlin once told a great story about how he “put a dollar in one of those change machines and nothing changed.” Wouldn’t it be nice if we could control change. In today’s volatile world we never know when to expect it, where it will come from or what it will bring - we just know it’s coming.
The Dodd-Frank Act, the most sweeping financial reform since the 1930’s, is coming and it will bring dramatic changes to the face of energy and commodity credit risk. New rules on central clearing, position limits and margining have the potential to significantly increase the cost of hedging and reduce the availability of credit. Many of the details are still uncertain, but the 5 simple rules below will help you prepare for the Dodd-Frank Act and other inevitable changes.
- Internal Scoring. Don’t rely solely on credit rating agencies. Your own internal model can be more accurate.
- Monitoring. Monitor your cash flow risk and exposure. Increasing capital requirements make it more important than ever to mitigate risk and seize opportunity.
- Margining. Do not use spreadsheets for collateral management. Robust collateral management is now a necessity. If you have a significant number of counterparties, it is time to eliminate spreadsheets. With the proliferation of margining they are no longer adequate and cannot provide active and accurate cash management.
- Reporting. Build flexible reporting infrastructure that prepares for today’s uncertain fiscal and regulatory environment.
- Analytics. Perform liquidity analysis with analytics. Companies who understand the impact of capital and margin requirements on their liquidity will have a competitive advantage.
We can’t control change, but proactive companies with a flexible trading and risk infrastructure will be best prepared to avoid the pitfalls and take advantage of the new opportunities that come with change. Is reporting cash exposure a piece of cake? Do you know without a doubt your IT systems will meet new regulations? Is your margining process working great for you? If not, maybe now is the time for change.
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.