getting ready for changes in the regulation of derivatives under the dodd- frank act
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Getting Ready for Changes In the Regulation of Derivatives Under The Dodd- Frank Act. NEPOOL Meeting Boston, MA. Matthew Picardi Vice President. DISCLAIMER. - PowerPoint PPT PresentationTRANSCRIPT
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GETTING READY FOR CHANGES IN THE REGULATION OF DERIVATIVES UNDER THE DODD- FRANK ACT NEPOOL Meeting
Boston, MA
Matthew Picardi
Vice President
September 16, 2011
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DISCLAIMER
Shell Energy North America (U.S.), L.P. and its affiliates make no representation as to the accuracy or completeness of the information contained herein or otherwise provided by Shell Energy North America (U.S.), L.P., its affiliates or third parties, and accept no responsibility or liability, in contract, in tort, in negligence, or otherwise, should the information be found to be inaccurate or incomplete in any respect. Shell Energy North America (U.S.), L.P., and its affiliates are not acting as an advisor to the recipient of this information, and the ultimate decision to proceed with any transaction rests solely with the recipient of this information. Therefore, prior to entering into any proposed transaction, the recipient of this information should determine, without reliance upon Shell Energy North America (U.S.), L.P., or its affiliates, the economic risks and merits, as well as the legal, tax, and accounting characterizations and consequences, of the transaction and that it is able to assume these risks. This information is neither an offer to sell nor the solicitation of an offer to enter into a transaction. Shell Energy North America (U.S.), L.P., and its affiliates may act as principal or agent in similar transactions or in transactions with respect to instruments underlying a proposed transaction. This document and its contents are proprietary information and products, and contains the view of Shell Energy North America (U.S.), L.P., its affiliates or third parties and may not be reproduced or otherwise disseminated in whole or in part without written consent.
September 16, 2011
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AGENDA
Key Definitions
To Clear or not to Clear? – The End-User Exception
Proposed Margin Requirements For Market Participants
Positions Limits
Market Implications
Schedule For Implementation of Rules
September 16, 2011
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CRITICAL DEFINITIONS
Swap – includes exchange-traded swaps, bilateral swaps (like those done under ISDA agreements) and puts, calls, caps, floors, collars or other options that are based on the value of interest rates, commodities, currencies, securities, etc., but does not include transactions intended to go to physical delivery
Swap Dealer – regularly enters into bilateral swaps for purposes other than hedging, in particular entering into swaps as a regular business activity
Major Swap Participant (MSP) – holds a substantial position in swaps other than positions used for hedging
End-User – not a MSP or swap dealer, only uses swaps to hedge
September 16, 2011
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KEY ISSUES RELATED TO CFTC’S PROPOSED DEFINITIONS
Definition of swap is broad, includes any financially settled options.
CFTC developing understanding of physical option products.
Under its proposed definition of swap, CFTC makes the following assessment to determine if option embedded in a physical transaction should be excluded:
It should just impact price, not overall nature of contract
It should not impact delivery terms
Cannot be severed from the contract*
* Further Definition of “Swap,” “Security-Based Swap” and “Security-Based Swap Agreement;”
Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 76 Fed. Reg. 29,818 (May 23, 2011).
September 16, 2011
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KEY DEFINITION ISSUES CON’T.
Definition of Swap Dealer is broad and could pick-up commercial energy firms not historically engaged in dealing activity.
Remember, Swap Dealers will be required to clear their swaps and will face a number of additional obligations.
CFTC rulemaking considerations:
“accommodating demand”
de minimis exception
Dodd-Lincoln Letter clarifying intent of Congress not to include gas utilities
September 16, 2011
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UNDERSTAND YOUR TRANSACTION
Financial products allow for efficient hedging but:
Discrepancies can create open positions – make sure intent is to hedge or mitigate commercial risk.
Rules create new players – know your counterparties.
Understand how options in a physical forward contract work.
September 16, 2011
TO CLEAR OR NOT TO CLEAR ?-END-USER EXCEPTION
Section 2(h)(1) of the Commodity Exchange Act (“CEA”) requires swaps to be cleared though a derivatives clearing organization if they are of the type the CFTC determines must be cleared.
Section 2(h)(7) of the CEA provides an exception if one party to the swap is (i) not a financial entity, (ii) using swaps to hedge or mitigate commercial risk, and (iii) notifies the CFTC how it generally meets its financial obligations for non-cleared swaps.
CFTC proposed rules for taking advantage of the End-User Exception require that the “reporting counterparty” provide certain information to a Swap Data Repository (“SDR”), or if none is available to the CFTC.
. 8September 16, 2011Source: www.cftc.gov/LawRegulation/DoddFrankAct
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TO CLEAR OR NOT TO CLEAR? -END-USER EXCEPTION (CONT.)
Reporting counterparty is the financial entity, but if both counterparties are End-Users, they must choose
Information required by the CFTC to qualify for End-User Hedge Exception
Identity of electing counterparty and whether it is a financial entity.
Whether hedge is used for “hedging or mitigating commercial risk”
To qualify must be “economically appropriate” to the reduction of risks in the conduct or management of a commercial enterprise; and
CFTC will look at totality of circumstances and where the risks to be hedged arise from.
Might not include risk reducing transactions associated with speculation or trading transactions – all hedges are not equal!
September 16, 2011Source: www.cftc.gov/LawRegulation/DoddFrankAct
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PROPOSED MARGIN REQUIREMENTS – UNCLEARED SWAPS
September 16, 2011
Does this entity have to collect
margin ?When it transacts with:
Swap Dealer
FinancialEnd-User
Non-Financial End-User
Bank Swap Dealer Yes High Risk – YesLow Risk – Yes* Yes*
Non-Bank Swap Dealer Yes High Risk – Yes
Low Risk – Yes* No
End User No No No
*For exposures above thresholds
Note: Margins must be cash or government-backed instruments and are to be calculated in the form of initial and variation margin, with initial margin held by third party custodian.
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TO CLEAR OR NOT TO CLEAR? -END-USER EXCEPTION (CONT.)
Indentify if End-User will meet financial obligations using (i) credit support agreement, (ii), pledged or segregated assets, (iii) third party guarantee, (iv) own financial resources, (v) other.
If an SEC filer, proposed rules say Board of Directors or committee of board approval for every swap being entered into under the End-User Exception is required.
Source: www.cftc.gov/LawRegulation/DoddFrankAct September 16, 2011
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KEY ISSUES—MARGIN REQUIREMENTS
Margin requirements on cleared swaps
Collateral on non-cleared swaps
Greater need for working capital?
Inability to use unsecured lines of credit to support swap positions?
Inability of some parties to transact?
Use of non-cash collateral with exchanges?
Shift towards physical transactions?
Imbed financial features in physical contracts?
September 16, 2011
Issue
SomePossible
Responses
Potential Consequenc
es
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MARGIN REQUIREMENTS PROPOSAL---CONCERNS
Disregards letters of credit and liens on physical resources
End –User transactions with bank Swap Dealers will require margin
Imposes “exchange concepts” on bilateral credit arrangements
Initial margin
Variation margin
Requirement for third party custodian adds costs
Reliance on models to determine creditworthiness
September 16, 2011
KEY ISSUES—POSITION LIMITS
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September 16, 2011
Issue
Potential Consequenc
es
Aggregate Position Limits -- across exchanges and OTC transactions(Applied to 4 types of energy contracts: WTI, Henry Hub, RBOB and Heating Oil)
Uncertainties about Hedge Exemptions Reduced capability to hedge physical
positions? Loss of liquidity (especially in out months)? Less speculative activity? Shift in activity to foreign boards of trade?
Potential Consequenc
es
Related Issues and Concerns
Overall complexity – compliance risk Systems to link physical positions with hedges Systems to track swap and futures positions
intraday
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BONA-FIDE HEDGE LIMITATIONS
The definition of bona-fide hedge has been narrowed under Proposed Position Limit Rule
CFTC may not maintain a flexible process to allow market participants to obtain exemptions for unforeseen bona-fide hedging strategies and daily reporting of cash positions will be burdensome
It may not include certain risk reducing transactions for which market participants applied and obtained exemptions, a/k/a “non-enumerated hedges”
September 16, 2011
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BONA-FIDE HEDGE LIMITATIONS (CONT.)
Hedges on the value of services may no longer be covered
A bona-fide hedge exemption may no longer apply to the following transaction:
LDC wants to enter into a basis hedge to protect the value of a proposed purchase of firm transportation for $.30/mmbtu
LDC enters into a $4.00/mmbtu swap at receipt point and sells a strip of NYMEX gas futures at the delivery point at for $4.33/mmbtu
Not actually purchasing or selling gas at the time it enters into two separate transactions
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OTHER END-USER ISSUES
Reporting and Recordkeeping Obligations
Existing Swaps
Swaps entered into after rule implementation date
Potential obligation via SEF/DCM membership to keep records of telephone, voicemail, IM, electronic mail, etc… communications that lead to the execution of transactions in a commodity interest or cash commodity
Documentation Requirements—Credit Support Agreements?
Complications for “Special Entities”
New provisions on market manipulation and disruptive trading practices
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POTENTIAL MARKET IMPLICATIONS FOR END-USERS
Higher costs to hedge?
Inability of some parties to enter into swaps?
Smaller market –less liquidity?
Shift towards physical transactions?
More regulatory requirements and compliance risk?
Uncertainty about regulation of related markets such as power, carbon and environmental product markets.
September 16, 2011
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THE SCHEDULE FOR IMPLEMENTATION
Few rules were final by the July 16, 2011 deadline
Deadline now targeted for December 31, 2011
CFTC has finalized some rules, such as those covering market manipulation, SDRs, whistleblowers, and large trader position reporting but the rules critical to overall implementation are still pending.
Proposed legislation to delay Dodd-Frank Act implementation is unlikely to be passed.
Attention is being given to sequencing implementation and on workable compliance deadlines.
Implementation expected to occur through the end of 2011 and into 2012.
September 16, 2011
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Q & A
September 16, 2011