When, Not If

Participants in the CFTC's October 9 meeting commented on how an NDF clearing mandate should be implemented, rather than whether it's necessary. CFTC Commissioner Mark Wetjen stated that a clearing mandate for NDFs would improve market structure and stability. There seemed to be consensus among the Commissioners that an NDF clearing mandate is inevitable. 

Commissioners did express concern that international regulators should act in unison, and expressed interest in aligning the CFTC clearing mandate with comparable European proposals. By the time of the CFTC meeting, the European Securities and Markets Authority (ESMA) had already proposed rules mandating clearing of certain NDFs. ESMA's proposed clearing mandate covers roughly the same currencies under consideration by the CFTC; they are either considered non-convertible currencies, or they are currencies that have only recently become convertible. The ESMA rules also focus on NDFs that are settled in U.S. dollars. 

One difference between the CFTC and ESMA proposals is that imposition of a CFTC clearing mandate may ultimately also result in the imposition of a mandate that NDFs be traded on a regulated exchange or swap execution facility (SEF). The ESMA announcement does not include this requirement. Participants in the October 9 meeting expressed concern over the possibility that the U.S. may impose both clearing and SEF-trading requirements while ESMA imposes only a clearing mandate. Such disharmony could be highly disruptive for market participants and could result in decreased liquidity, as the market is split up between the United States and Europe. In addition, market participants at the CFTC meeting questioned whether the current SEF infrastructure could handle the heightened traffic that would follow from any mandate that NDFs be traded on SEFs.

The CFTC has not yet formally proposed NDF clearing, so even if the change is inevitable, it is not yet imminent. When the regulations do ultimately go into effect, they will require the parties to an affected NDF to submit their trades to a clearinghouse through CFTC-registered brokers, instead of transacting on a bilateral basis. To mitigate counterparty risk, the clearinghouse will require the parties to exchange initial margin and daily mark-to-market variation margin. The brokers may also require additional margin. This means cleared NDFs are likely to become more costly for corporate end users than trading non-cleared, customized, bilateral NDFs with a dealer.

Another significant challenge of moving NDFs to clearing is that cleared swaps must have a higher degree of standardization, compared with bilateral swaps, in order to provide adequate liquidity. This presents a challenge to corporate treasurers, who are accustomed to very precisely designing NDFs to match expected cash flows. The inability to customize NDFs could result in less effective risk mitigation. It could also result in the loss of favorable accounting treatment for the NDFs.

Cleared transactions do mitigate the risk of dealer insolvency. Still, many companies would prefer to continue crafting bilateral transactions. Some companies that use NDFs to hedge business risks, and not for speculation, will continue to have that option.

Corporate Exemptions

The CFTC's "commercial end-user exception" from Dodd-Frank clearing rules for other types of swaps will apply in the same way to NDFs. Companies that are not financial entities, as defined by the CFTC (e.g., companies that are not "predominately engaged in activities that are financial in nature") would not be required to clear swaps through clearinghouses, nor would they be required to trade on a SEF. (Note that if the commercial entity is a public company, or is controlled by a public company, an appropriate committee of the board of directors of the entity or its parent must approve of the decision to elect the commercial exemption and adopt a policy for oversight of decisions on whether to clear swaps.)

In this environment, centralized treasury affiliates present a challenge for regulators. Although it may manage risk and provide other financial services only for a corporate group that, on an overall basis, would qualify as a non-financial entity, a centralized treasury entity may meet the definition of a financial entity because its predominant activities are financial in nature. However, the CFTC has provided a special "treasury affiliate exemption." To qualify: 

• the entity must be directly, wholly owned by a non-financial entity or another eligible treasury affiliate, and must not be indirectly majority-owned by a financial entity;
• the entity's ultimate parent must be a non-financial entity, and a majority of the ultimate parent's affiliates must qualify for the commercial exemption;
• the entity must meet the definition of a "financial entity" solely as a result of acting as a principal to swaps with, or on behalf of, one of more of its affiliates, or providing services that are financial in nature to such affiliates;
• each swap the entity elects not to clear via its reliance on the CFTC's treasury affiliate exemption must be entered into for the sole purpose of hedging or mitigating a commercial risk of one or more of its affiliates that was transferred to the treasury affiliate by operation of one or more swaps with such affiliates (i.e., via back-to-back inter-affiliate swaps);
• the payment obligations of the treasury affiliate for its exempted swaps must be guaranteed by the entity's non-financial parent, an entity that wholly owns (or is wholly owned by) its non-financial parent, or the related affiliates for which the swap hedges or mitigates commercial risk; and
• the treasury affiliate may not enter into swaps other than for the purpose of hedging or mitigating the commercial risk of one or more of its affiliates. 

Any company that relies on the treasury affiliate exemption must make an annual filing with a swap data repository (SDR) detailing how it is meeting its financial obligations associated with entering into non-cleared swaps. Possibilities include a credit support agreement, a written third-party guarantee, availability of the company's own resources, pledged or segregated assets, or other means.

Swaps entered into by two affiliates that are under common majority ownership and that share consolidated financial statements may also be exempted from the clearing requirement, even if the parent company doesn't qualify for the commercial exemption. To qualify for the CFTC's "inter-affiliate exemption," swaps must be appropriately documented; the organization must have a centralized swaps risk management program; and any swaps the affiliates enter into with third parties must comply with the CFTC's mandatory clearing requirement or an exemption or exclusion, or with foreign requirements that the CFTC has determined to be comparable. Companies claiming the inter-affiliate exemption must also file with an SDR a report that includes a board certification and a description of how the affiliates are meeting their financial obligations.

Proposed Margin Requirements for Non-cleared Swaps

In September 2014, the CFTC proposed margin requirements for non-cleared swap transactions. The CFTC's proposed application of these margin requirements depends on how the corporate counterparty to the swap is classified. Companies classified as "non-financial end users" would not be required to post either initial or variation margin under the CFTC's proposal, although counterparties would be permitted to negotiate margin requirements bilaterally.

It is worth noting that the definition of "financial end user" in the CFTC's margin proposals differs from the definition of "financial entity" used in connection with the mandatory clearing rules. The proposed definition of "financial end user" does not include a catch-all for entities "predominately engaged in activities that are financial in nature," as the definition of "financial entity" does.

Many treasury affiliates and other entities that do not consider themselves to be financial firms, but are nevertheless captured in the definition of "financial entity," will welcome the proposed definition of "financial end user," which relies on an objective "laundry list" approach, targeting specific categories of specifically regulated entities. However, the incongruity in the definitions raises a potentially troubling gap between the CFTC's margin rules for non-cleared swaps and its mandatory clearing rules. A company that could not escape mandatory clearing for those swaps that are subject to mandatory clearing might nevertheless be able to escape mandatory margin for those swaps that are not subject to mandatory clearing. Similarly, a company could escape mandatory clearing only to be subject to mandatory margin requirements for the uncleared swaps.

There appears to be no regulatory rationale for retaining this disparity between the two sets of rules, and this is likely to be a fertile area for industry comment on the proposed margin rules. The comment period for the CFTC's margin proposal runs through December 2, 2014.

—————————————–

Nathan Howell is a partner in the Chicago office of international law firm Sidley Austin LLP. He advises a broad range of financial services clients on regulatory and transactional matters, with a particular focus on issues arising under the Dodd-Frank Act. Howell represents major investment advisory firms, futures commission merchants, derivatives clearing organizations, clearing agencies, commodity pool operators, commodity trading advisors, exchanges, and other financial companies in a variety of matters relating to derivatives.

Michael Sackheim is a partner in the New York office of international law firm Sidley Austin LLP. He focuses on futures and derivatives regulatory, transactional, and enforcement matters. Sackheim concentrates on advising end users on compliance with the new derivatives financial reform laws and regulations.

Kunal Malhotra is an associate in the Investment Funds, Advisers, and Derivatives practice group in the Chicago office of international law firm Sidley Austin LLP. He assisted in preparing this article.