What Is the End Game for the “End User” Exemption?
February 5, 2010
The Obama administration has stated that over-the-counter (OTC) derivative regulatory reform is a priority. On August 11, 2009, the U.S. Department of the Treasury delivered legislative language to Congress. The House of Representatives used the Treasury draft as a starting point and passed the Derivative Markets Transparency and Accountability Act of 2009 on December 11, 2009 (Act). At the time of publication, two Senate committees are crafting separate pieces of OTC derivatives legislation that are expected to be introduced into the Senate in the next few weeks.
A hot topic of debate in this process is the so-called “end user” exemption, which would exempt companies who are “end users” of derivative products from the definitions and obligations of “swap dealers,” “major swap participants,” “security-based swap dealers” and “major security-based swap participants” and the Act’s clearing requirements. This would allow certain companies, such as airlines, energy utilities and other consumers or producers of commodities to pursue hedging and risk management strategies without being subject to the potentially expensive new swap requirements.
However, regulators and legislators, some of whom equate energy derivatives with the credit default derivatives that spiked the financial crisis, want mandatory, regulated central clearing of all “standardized” derivatives. Both Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler and the U.S. Treasury oppose the end user exemption. The bills being drafted in the Senate by Banking Committee Chairman Dodd and Agriculture Committee Chairman Lincoln may use the House-passed bill but not necessarily to mirror it, and may even create additional categories of trading entities and exemptions. The future of end user derivative hedging strategies could hang in the balance, depending on the Senate bills’ provisions.
Under the Act as passed by the House, “swap dealers,” “security-based swap dealers,” “major swap participants” and “major security-based swap participants” would be required to adhere to the likely expensive new swap requirements, such as mandatory clearing of standardized swaps, registration and increased capital and margin costs. Exempted from the substantial net position calculation of the Act’s dealer and major participant definitions is any person with “positions held primarily for hedging, reducing or otherwise mitigating its commercial risk.”
The clearing requirement of the Act would not apply to a swap if one of the counterparties to the swap (i) is not a dealer or major participant, (ii) is using swaps to hedge or mitigate commercial risk, including operating or balance sheet risk, and (iii) notifies the CFTC or SEC how it generally meets financial obligations associated with entering into non-cleared swaps. The devil is always in the details, and the CFTC and Security Exchange Commission (SEC) regulation promulgated under the legislation would have to provide the granularity necessary to assess whether an entity meets the definitions or exemptions.
Chairman Gensler has explained his opposition to the end user exemption from clearing in recent speeches. For example, Chairman Gensler stated in a January speech, “When a corporation or another end-user wants to hedge a risk, they go to their bank and get a price quote. When they enter into transactions, those transactions largely stay on the books with their banks. The price is not discovered on transparent trading venues, such as exchanges, and the risk is not transferred from the dealer’s books to a central clearinghouse. This leaves significant risk in the system.” Chairman Gensler contends that most such end user hedging transactions are or could be standardized, making centralized clearing more feasible and giving all market participants increased transparency. The CFTC Chairman also contends that all standard contracts should be brought to transparent trade execution facilities.
