DJ CFTC Derivatives Disclosure Rules May Lift Transaction Costs

By Katy Burne


Corporate end-users of derivatives may face higher transaction costs for large hedges under new regulatory proposals that will require post-trade reporting of swaps. 

End users are companies entering hedges to mitigate commercial risks rather than to speculate on market prices. Examples include airlines who are hedging the costs of jet fuel or exporters hedging against lower revenues from overseas sales because of currency fluctuations. 

As part of its efforts to write new rules for OTC derivatives under the Dodd-Frank Act, the Commodity Futures Trading Commission said Friday it wants to see over-the-counter derivatives executed on registered trading platforms publicly reported in real-time. The rules are out for public comment for 60 days after they are entered into the Federal Register and must be completed before a July 15, 2011, deadline. 

Critics say that if these proposals are adopted after a series of regulatory votes, end users could be subject to higher prices on big, market-moving swaps as dealers pass the extra costs to account for the risks of having trade data out in the open. 

Having asset managers and pension funds pay more for hedges, and generating lower returns for Main Street, could be an unintended consequence of Dodd-Frank, these critics add. 

"This is a very delicate calibration exercise we need to undertake since as a policy decision we want to ensure that we have not moved the risk to the party that was not intended to take the risk," Athanassios Diplas, head of systemic risk management for global credit trading at Deutsche Bank, told Dow Jones Newswires. 

Dealers taking on a trade with a client have to hedge their own risk, typically with other dealers, and the public reporting requirement would give other dealers on the Street real-time information about the risk that the original dealer needs to offset. 

"On large trades, if the dealer cannot liquidate that risk in the shortest amount of time, the dealer has to charge a wider bid/offer spread to take the risk," said Diplas. "The cost is borne by either the original client or by the dealer--and the beneficiary would be a third party." 

The Dodd-Frank Act forces OTC derivatives with standardized terms to be traded on exchanges and other designated contract markets, or alternative venues called swap execution facilities, or SEFs, and then be processed by central clearinghouses that will guarantee the trades. 

The aim of forcing the majority of swaps onto registered platforms and having post-trade reporting is to bring more price transparency to the market. 

Customized, bilaterally negotiated trades would still be allowed to trade privately and remain outside that mandatory execution rule "off-facility," as the CFTC calls it. When trading on exchanges and other platforms, the parties involved would remain anonymous to protect their business interests. 

All swaps and security-based swaps must be reported, regardless of how they are executed, with trades over $250 million posted as "$250 million+" whether they are $260 million or $3 billion. "This will protect anonymity and promote the liquidity of these large trades," CFTC Chairman Gary Gensler said at a hearing on the rules Friday. 

Gensler added that while dealers may complain they are more at risk because of the new reporting requirements, he feels "to the core" that the CFTC is helping liquidity so that small municipalities and other end users will achieve better pricing on swaps. 

"[Dealers] will tell us why they need days or weeks, and I would say that information advantage would stay with Wall Street," said Gensler. 

Price and volume information on the majority of trades would need to be reported "as soon as technologically practicable" potentially in milliseconds but certainly before the 15-minute cut off. 

Similar swap reporting proposals are also being prepared for Monday by the Securities and Exchange Commission, which along with the CFTC was charged with implementing Dodd-Frank. The SEC rules are expected to be more lenient in some respects, allowing the notional sizes on block trades to be reported within 24 hours. 

Block trades and big, market-moving trades that are executed on trading platforms will have an exemption to the immediate reporting requirement, having a 15-minute delay to protect dealers. By comparison, the futures market has a five-minute delay for block trades and the equity market has an even shorter delay, said Gensler. 

The CFTC has not yet decided on the delay for large, customized trades that are not executed on swap execution facilities. Gensler said the Commission is seeking feedback as to whether a 15-minute reporting delay should be applied to, say, interest rate and currency hedges, with perhaps other rules applied to large physical commodities trades. 

Some market participants wanted to see voice-brokered or hybrid trades--swaps executed partly over the phone and then entered on screen by a broker--given a longer delay to account for the time it takes to enter trade details on screen, but that was not outlined on Friday and may be the subject of later rulemaking. 

Jamie Cawley, CEO of Javelin Capital Markets and co-founder of the Swap & Derivatives Market Association, said in a recent letter to regulators that giving voice-brokered trades extra time to disclose might create a "race to the slowest" because customers will want to keep their trades in the dark as long as possible. 

Writing rules for block trading of derivatives is devilishly complex, starting with the lack of a consensus on how to define block trades. The size at which a swap becomes a block trade is to be calculated by data repositories using data over the prior year, taking the greater of the largest 5% of similar swaps by asset class, or five times the average, or mean, transaction size, the CFTC said. 

Only dealers and major swaps participants essentially non-dealers who hold it out as a core business function to regularly engage in swaps would be required to report trades to swap data repositories after execution, so long as at least one counterparty to every trade reports. 

Execution is defined as the point of agreement by both parties, be it verbally or in writing, to the "primary economic terms" of the swap, making the trade legally binding. 

End users were given an exemption so that dealers would report on their behalf, but on the rare instances where trades are conducted between two end users and executed over the phone, Gensler said reporting would be as "prompt" as possible, noting that timely reporting in their case "might mean something very different." 

Moreover, end users are required to confirm trades before they are given over to clearinghouses, which guarantee trades. That's an extra administrative and cost burden end users were not banking on. 

"The dealer would report it and the end user would have to somehow confirm the accuracy of the report, possibly having to go to some website, review the details and assert that the details are accurate," said Luke Zubrod, director of Chatham Financial's regulatory services group. "Maybe it's not overly burdensome but it certainly adds a step people they have to do today." 

Records must be kept by data repositories for five years after the swap expires or is terminated. A user can hire a third party to handle reporting, but that entity would then take full responsibility for reporting and counterparties wouldn't be considered to have complied with the rules until that has happened. Swap data repositories would then disseminate that information to the public.