Luke Zubrod:  They basically create four categories of market participants, and the margin rules apply differently for companies in the different categories. The categories are: first, 'covered swap entities,' which are basically swaps dealers and major swap participants; second, financial end users with 'material swaps exposure'; third, financial end users without material swaps exposure; and then a fourth category, 'other counterparties,' which includes both non-financial end users and sovereigns.

The proposed regulations include two basic kinds of margin requirements. One is variation margin, which backs the mark-to-market value of a portfolio of trades by requiring counterparties to increase posted margin as market shifts increase their exposure. Companies in the first three categories—covered swap entities and all financial end users—are required to post variation margin under the proposed rules, but those in the 'other counterparties' group are not.

The other type of margin is initial margin, which is designed to create a buffer so counterparties are covered in the event that the market moves and a company that owes more collateral doesn't provide it. I call that a 'close-out scenario.' If one party doesn't post the required variation margin, the counterparty can cite the default. There will be a cure period, but if the party in default doesn't cure the situation in time, the counterparty can terminate its position. At this point, enough time may have passed since the party in default posted collateral that the counterparty may have become under-collateralized. Initial margin is intended to provide enough excess collateral to cover 10 days of that process working. With respect to the proposed rule, initial margin applies to the first two categories of swaps-market participants, but not to financial end users without material swaps exposure or non-financial end users.

The key outcome of this process for non-financial end users and corporates is that they are not subject to the margin requirements. That was unexpected. In the 2011 proposal that this proposal amended, corporate end users were subject to margin requirements. The requirements were lighter for non-financial end users than for everyone else, but still they were subject to them. In this proposal, they are not.

T&R:  What would the fallout be if margin were required from a company that uses derivatives to hedge foreign exchange, interest rate, or commodity risks?

LZ:  The operational burden they would have had to undertake to prepare for the regime put forth in the 2011 proposal would have been quite substantial. They would have had to spend the better part of a year renegotiating every one of their ISDA agreements with swap counterparties. They may well have also had to evaluate technology platforms that would allow them to closely monitor and track collateral postings. But as it is, since they're scoped out of the margin requirements, the burden of this proposal on non-financial derivatives end users is much lighter.
 

T&R:  That said, where is the line between a financial end user and a non-financial end user? Is it possible some companies that are not primarily in the financial services sector will find their treasury functions caught up in the definition of a 'financial end user'?

LZ:  That's one of the questions we're studying closely. And it's a good question, because the stakes are significant around where that line is drawn. If you're on the non-financial side of the line, you can continue with the status quo. If you're on the financial side, the requirements could be fairly substantial.

T&R:  Does that mean some corporates are likely to fall into the 'financial end user' category?

LZ:  The definition of a financial end user is very detailed in the Fed's margin proposal. It has about 15 bullet points, and each of those has a listing of various kinds of entities within it. So the Fed has tried to very specifically identify the kinds of legal classifications that it deems to be 'financial.'

Nevertheless, the rule requires careful study around its impact on organizations with treasury affiliates, treasury centers that centralize intercompany lending and hedging activities for a corporate group. Under Dodd-Frank, these are 'financial entities' because they're predominantly engaged in activities that are financial in nature. They're legal entities focused on financial activities—except they're not undertaking those activities as part of an externally facing business; they're centralizing them as an efficiency mechanism, as a result of a structuring decision within a non-financial company.

Regulators know these entities exist, and they're generally sympathetic to the notion that these entities don't give rise to any notable degree of systemic risk. The challenge is that the Dodd-Frank legislative text doesn't adequately contemplate treasury centers as legal entities.

For Dodd-Frank clearing and reporting regulations, U.S. legislators tried to create an exemption, but the language in the exemption is so muddled that it doesn't cover most treasury centers. The Coalition for Derivatives End-Users engaged with the CFTC about this problem, and they were pretty responsive. They created a no-action letter so that centralized corporate treasuries wouldn't be subject to Dodd-Frank clearing and reporting requirements. However, the no-action letter is highly conditioned; you have to jump through a lot of hoops to fit within the tight box of the exemption. Also, it's a no-action letter. It doesn't modify the rules, it just says CFTC staff won't prosecute organizations that are violating the rules as long as the organizations meet the stringent requirements.

The new margin proposal references the muddled treasury affiliate exclusion from Dodd-Frank clearing section, and it seems to indicate that the margin exemption will track the clearing exemption and its implementing regulations. The problem is that no-action letters aren't themselves implementing regulations, so it's not clear whether the language of the no-action letter will actually be effective in scoping corporate treasury centers out of the margin rule. 

T&R:  Would you say, then, that the margin proposal was a victory for corporate derivatives end users?

LZ:  Yes, I think corporates really feel this rule was a victory. It was representative of a lot of hard work by companies involved with the Coalition for Derivatives End-Users. Corporate treasurers have been instrumental in meeting with regulators, making their case in comment letters, and actively participating in the processes around global standard-setting, and it certainly appears as though bank regulators listened. But there's still anxiety remaining around whether the rules have adequately contemplated treasury centers in drawing the line between financial and non-financial.

T&R:  When does the public comment period for this rule end?

LZ:  I expect it to end in November.

T&R:  What should corporate treasurers do if they use derivatives to hedge risks and are concerned about their centralized treasury organization getting caught in the margin rules?

LZ:  Well, clearly this is a very technical issue. I think the first order of business is for a number of experts to study the regulation and get as clear a view as possible into the size and nature of the problem. For now, I recommend staying plugged into the Coalition for Derivatives End-Users. They were a significant force in working with the CFTC to draft the no-action letter, and they've been pushing a bill in Congress to more clearly exempt centralized treasury centers from many of the regulations. The Coalition is highly attuned to this issue, and staying engaged with them is a good way to track its progress and make sure it's adequately addressed.