Hedging commercial risk continues to be important to companies across the globe. This proves to be especially true in the United States where, according to one poll, 80 percent of financial executives said they would continue to enter into derivative hedges despite the increase in costs expected from regulation provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act. Still, as companies continue to hedge, they need to understand the requirements Dodd Frank RIP imposes on corporate end users as many are under the assumption that Dodd-Frank is solely a compliance regulation for financial institutions.
Namely, there are four major areas of compliance that companies need to be aware of and prepare for if they enter into derivative hedges: swap documentation; end-user clearing exception, proofs and reporting; SDR [swap data repository] reporting for inter-affiliate swaps; and portfolio reconciliation.
Swap Documentation. To illustrate how these areas of compliance affect companies, consider the following common scenario where XYZ Corp. enters into an over-the-counter interest rate swap with a swap dealer. Upon entering into the swap, XYZ Corp. decides that the particular interest rate swap it has executed with the swap dealer will be an uncleared trade. In most cases, Dodd-Frank requires those institutions deemed to be swap dealers (SDs) or non-swap dealer financial institutions to have a Dodd-Frank amendment in place with their counterparties prior to executing transactions.
Although the impact to corporates is minimal from a documentation standpoint, most corporates still need their counsel to review these forms and to ensure that these are executed prior to engaging in trading activity with their counterparties.
End-User Clearing Exception Proofs and Reporting. A more direct impact to corporates is the end-user clearing exception proofs and reporting. The intent of Dodd-Frank is to push as many classes of derivatives toward clearing, in which case end users will be forced to clear their swaps, unless they claim the end-user exception. In order to qualify for this exception, corporates must prove that they are actually hedging commercial risk. A company may use the documentation it used to prove that it qualifies for hedge accounting under the Financial Accounting Standards Board (FASB) ASC 815.
While a company may not actually take hedge accounting, it may use regression analysis or a similar type of analysis (critical...