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PwC 10 Minutes on Derivatives Reform Services Companies


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Regulatory reform doesn't only affect financial institutions. If your business uses derivatives, you might want to look at your options and consider new funding strategies, as you'll pay more for …

Regulatory reform doesn't only affect financial institutions. If your business uses derivatives, you might want to look at your options and consider new funding strategies, as you'll pay more for over-the-counter derivatives. And you’ll need to follow new rules for trading, reporting and record-keeping. More info:

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  • 1. Home At a glance 01 02 03 04 Upcoming 10Minutes     How PwC can help 10Minutes on derivatives reform for non-financial services companies December 2012 Beyond the banks: What derivatives regulation means for the corporate world Highlights Regulatory reform is going to change the market for over-the-counter derivatives. Hedging will be pricier due to increased costs of using derivatives and new compliance expenses. All companies must meet new recordkeeping and reporting requirements. Corporate finance leaders will need to weigh their choices and consider new derivative and funding strategies. Regulatory reform through the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) and Basel III is all about transparency, making the derivatives world less opaque and more standardized. While the end goal of the derivatives provisions is less risk and greater stability in the market, these new standards come at a considerable cost for all derivatives users—not just dealers and financial services companies. Corporate users will pay more for over-the-counter (OTC) derivatives as banks pass along the increased cost of their own compliance to customers, and corporates will likely need to comply with new trading regulations and increased reporting and recordkeeping requirements. OTC derivatives are executed between a bank and a corporate entity, as opposed to exchange-traded futures, which are already regulated and are not impacted by these new rules. These OTC derivatives can be used to manage future uncertainty, including currency and interest rate risks. Since corporates most frequently use OTC derivatives to manage risks, this reform has broad reach: These trades make up 95% of the derivative marketplace.1 This reform isn’t simply a compliance issue, and it isn’t limited to large, multinational companies—it’s going to impact every corporate that holds a derivative. Where reform will hit hardest 1. Business strategy: The increased cost of OTC derivatives will lead companies to consider alternatives to manage their risk, including exchange-traded derivatives or more strategic OTC use. Not all derivatives will cost the same or have the same hedging power as they did before. 2. Funding: Financial institutions are expected to pass along increased costs to corporate hedgers, and companies will be asked to post more collateral. Companies must look at their debt and working capital profiles to consider how much collateral they’ll need and have the ability to post, especially as markets shift. 3. Operations: Processes must be updated to accommodate new types of derivative transactions. Additionally, IT will need to update systems to accommodate complex recordkeeping requirements. Finance managers must ensure that margin and collateral are posted daily. 4. Accounting: It may become more difficult to obtain and maintain hedge accounting, which could result in increased earnings volatility. 1 “OTC Derivatives Regulation,” Regulatory Briefing. International Centre for Financial Regulation, July 2012.
  • 2. Home At a glance 01 02 03 04 Upcoming 10Minutes     How PwC can help At a glance Regulation is increasing costs... ...and increasing demands on available cash. Collateral requirements will go up under the new rules. Looking at the total derivative liability positions of 225 non-FS companies on December 31, 2011, if they were required to post full collateral on their open positions, the impact could be significant. DoddFrank Volcker Rule Basel III Direct increased costs Banks $39.49 billion Increased costs passed along Nonfinancial services firms Total derivative liability positions Represents 3.9% 2.2% 8.3% of working capital of total debt of net working capital Source: Data based on public year and financial statement data for the S&P 500, excluding financial institutions and entities in the energy industry
  • 3. Home At a glance 02 03 04 Upcoming 10Minutes How PwC can help     01 Bracing the business for significant change Do you qualify for exemption? When compared to exchange-traded futures, key benefits of OTC derivatives include easier customization to risk and lower collateral and daily margin requirements. But soon, if a company does not qualify for or elect the end-user exemption, the Act requires swaps to be traded on an exchange through a central clearinghouse. YES NO 2. Are you using derivatives to hedge or mitigate commercial risk? NO YES 3. Have you obtained the approval of your board of directors to apply for the end-user exemption? NO By forcing a portion of swap transactions into these regulated clearing institutions, the Act concentrates risks into one location and ensures both parties honor their trade obligations. Regulators will monitor the exchanges and clearinghouses for increased standardization, greater transparency, and collateral requirements. YES 4. Have the appropriate regulators (i.e., CFTC or SEC) been notified of your plans to use the end-user exemption? NO YES End-user exemption may be permitted. Entities will still need to consider other recordkeeping, reporting, and business conduct rules and requirements. End users may be able to bypass some complexities of the Act by applying for exemptions, notably from trading on an exchange and using a clearinghouse so they can continue to trade OTC derivatives. Still, they’ll be impacted by increased costs and increased margin requirements, and they’ll have to meet the reporting, recordkeeping, and business conduct rules applicable to all users, plus annually file their end-user election with regulators. Navigating the end-user pros and cons Ask yourself... 1. Are you a financial entity? The majority of non-financial services companies that use OTC derivatives to hedge and mitigate commercial risks are likely to be defined by the Act as end users—about 30,000 firms.2 End-user exemption is not applicable. Corporates eligible for exemption must decide: Should we move to exchanges and/or centrally cleared trades to save on some of the increasing 2 “U.S. regulator finally defines a swap, starts reform countdown,” Alexandra Alper., July 10, 2012. costs of using derivatives, or should we continue to trade bilaterally to better manage risk while paying more for derivative positions? In either case, companies will likely post more collateral than before. Centrally cleared derivatives will need daily postings, while counterparties to bilateral trades will also ask for more collateral to help offset their increased costs. The scope of swap regulation for corporates In July 2012, the Commodity Futures Trading Commission and the Securities and Exchange Commission released final definitions of “swaps,” a.k.a. contracts that fall under the scope of the Act. This clarified which derivatives were impacted by the Act and which types were excluded from certain requirements. For instance, deliverable forward contracts (which deliver/exchange the underlying currencies rather than net settling) may be excluded from the scope.3 But non-deliverable forwards (when settlements are combined into one net payment between the company and bank) are included, as well as foreign currency options. This implies that companies that use only plainvanilla, deliverable-forward foreign currency derivatives could be spared from the new rules. But they won’t be entirely off the hook: They’ll likely still be hit with increased costs from banks and higher margin requirements due to Basel III and other regulatory requirements impacting the banks. 3 The Treasury proposed that deliverable foreign exchange forward contracts be exempted from all aspects of the Act, but that exclusion has not been finalized.
  • 4. Home At a glance 01 02 03 04 Upcoming 10Minutes     How PwC can help 02 The new costs for corporates Standardizing the swaps If a company does not qualify for or elect the end-user exemption, he t Act requires swaps to be traded on an exchange and executed through a central clearinghouse. Before reform Corporate Corporate Bank Bank After reform Corporate Corporate Corporate Corporate Corporate Corporate Exchange/ Exchange/ ClearingClearinghouse house Bank Bank Bank Bank Bank Bank Financial institutions will now feel the effects of increased capital requirements for all their derivatives activities. And corporates who continue to trade OTC will see higher bid-and-ask spreads, greater transaction costs, and increased requests for higher collateral postings. These greater total costs for high-volume or dynamic hedging may begin to diminish the benefits of derivatives altogether. Even if you don’t believe the Act will have a big impact on your company, the elevated-risk environment makes it a good time to reevaluate your hedging program. Three choices to explore in light of cost increases Consolidate derivatives: Instead of hedging with high volumes of derivatives for independent risks, corporates may consider ensuring that they are hedging only consolidated net positions to limit the number of trades needed. This is a good time to take a look at the company holistically and see if financial risks in one area offset activities in another. For example, if one subsidiary conducts its sales in euros while another purchases goods in euros, the company may be able to aggregate those offsetting exposures rather than using foreign currency derivatives to manage the gross inflow and outflow risk. Use standardized swaps: Companies may also look at using centrally cleared derivatives instead of OTC trades. Standardized swaps will cost less, but they may negatively affect an organization’s ability to hedge effectively. Standardized swaps are just that—standardized—meaning terms like interest rates and settlement dates are not customizable as they are with OTC trades. So companies won’t be able to precisely align terms to match their risk exposure. This mismatch also affects hedge accounting by making it more difficult to apply, which can lead to reported earnings volatility. Opt out of derivatives: Companies may also want to reconsider purchase-and-sale agreements to see if changing the terms of contracts would allow them to manage risks without derivatives. For example, a firm might currently use derivatives to manage commodity price exposure for inventory purchases. Instead, under the new rules it might change its contract terms to fix its purchase price to eliminate the risk exposure. Margin and collateral costs are going up Before the Act, OTC swaps typically required little or no collateral. If positions became too large, then banks sometimes required credit support annexes (CSAs), which are legal documents that regulate collateral for derivative transactions. Now, CSAs or other similar credit support agreements are likely to be required for all OTC derivative trades, and they’ll require more collateral posting. Previous regulations had less stringent capital requirements, so banks were less restricted to take on bigger credit exposures embedded in OTC derivatives. And recently, we’ve seen collateral requests grow as banks lower requirements—from 2001 to 2011, the total collateral posted against OTC trades increased 24%.4 This exponential demand comes at the same time there is a shrinking range of perceived “safe” assets. Now, companies will be forced to manage cash and other very liquid, highly rated investments more proactively, as competing demand for these assets is likely. 4 International Swaps and Derivatives Association, Inc., ISDA Margin Survey 2012.
  • 5. Home At a glance 01 02 03 04 Upcoming 10Minutes     How PwC can help 03 The Act mandates rigorous recordkeeping and reporting, and for many companies that means new systems and processes. Prior to the Act, there were no significant recordkeeping measures beyond basic contract law. Now, all derivatives users—even end users—must comply. Compliance will trigger operational challenges Gathering and maintaining the right data The data that companies need to collect includes: • A report on the date of execution for any clearingexempt transactions • Hedge documentation for exemptions and position limits • A regular report on the reconciliation of swap portfolios with counterparties Who’s ready for reform? Survey question: Have you done an assessment of the potential impact of the changing regulations on your derivative transactions? • Disclosures of derivative collateral 29 (60%) Yes 19 (40%) No 0 5 10 15 Reporting responsibilities 20 25 30 Survey question: Have you had conversations with the banks you execute derivatives with regarding the potential impact of the changing regulations on your derivative transactions? Yes 23 (50%) No 23 (50%) 0 5 10 15 • Up to 50 different data fields for each derivative, maintained internally for five years past maturity 20 25 30 Source: “Dodd-Frank: T7 Minus 60 Webcast: Countdown to regulation of swap dealers and swaps” follow-up polling of non-financial services entities. PwC, August 2012 For every swap, information must be submitted to a swap data repository (SDR). SDRs are newly created central locations for data reporting and recordkeeping that intend to reduce risk through transparency. Some of this information will be publicly published in real-time to lend the market more transparency on timing, prices, and volumes of transactions, without revealing party identities. Otherwise, regulators will track derivative activity through confidential reporting. For a corporate trading with a financial institution, the reporting requirements will likely be the financial counterparty’s responsibility. Be aware that corporates doing internal trading—interaffiliate trades—will be responsible for real-time reporting for those trades, too. To simplify the reporting complexities, the International Swaps and Derivatives Association released a Dodd-Frank Documentation Initiative with a standardized protocol. This lets corporates submit required information in a set format to their counterparties just once, instead of separately to each. The protocol also updates existing trading documentation to decrease trading disruptions and negotiations. Recordkeeping requirements All swap counterparties, including end users, will be required to maintain a full set of data related to each of their derivative positions. These rules apply to all derivatives with expiration dates after July 21, 2010. And it’s not just active swaps that need to be recorded; all swap records must be maintained for five years after the transactions are terminated, and two years’ worth must be readily accessible. With this much data needed, companies might want to invest in new software. While spreadsheets can manage large volumes of information, companies that deal with a sizeable derivatives portfolio should consider a more practical approach that runs less risk of data entry mistakes or formula errors. Finance, compliance, and IT leaders can work together to design these new systems. Expect long lead times on the software enhancements—start budgeting now.
  • 6. Home At a glance 01 02 03 04 Upcoming 10Minutes     How PwC can help 04 Six ways to be ready for reform—before the deadlines Identify what’s regulated in your portfolio Understand new collateral demands Figure out which instruments meet the official definition of a “swap” or “security-based swap” and thus fall under the scope of the Act. If the company elects the end-user exemption, or if dealing with foreign currency derivatives, then some regulations might not apply. Consider what impact the increasing collateral requirements will have on liquidity and borrowing. Armed with that analysis, a company can decide whether to trade on exchanges, trade over-thecounter—or forgo derivatives altogether. Evaluate your classification Timing it right: Corporates must act now Q4 2012 Finalization of increased margin requirements for undeclared trades Q1–Q2 2013 Margin requirements for uncleared trades Jan 2013 End-user exemption April 2013 Swap data reporting July 2013 Mandatory clearing A company must establish if it qualifies as an end user, or whether it’s considered a swap dealer (SD) or major swap participant (MSP), which are newly minted categories created by the Act. SDs are market-makers that play a dealer role and regularly enter swaps contracts. An MSP is a non-dealer that maintains a substantial position in swaps and has a high counterparty exposure with high risk in US markets. While most corporates won’t be considered SDs or MSPs, heavy users of derivatives, like companies involved in energy or commodities, may. Because stricter requirements apply to these specific categories, this determination is crucial. Weigh the costs and benefits of changing strategies End users have numerous choices for executing and clearing their swap transactions, each of which could impact price and cost. A company should start talking to its banking counterparties now to get a better idea of how reform will affect the cost of existing and future derivative transactions and may want to reconsider its banking relationships. Analyze the administrative and operational requirements Most derivatives will be subject to new recordkeeping and reporting requirements, so new systems for mass data storage and other compliance matters will need to be in place. Companies should look into outsourcing some of the necessary tools and infrastructure as well as exploring processes and liquidity requirements for posting collateral. Assess impact on financial reporting Modifying your derivatives trading strategy will require a reassessment of your application of hedge accounting. Standardized derivatives may not exactly match the terms of the hedged exposure, leading to income statement volatility and additional compliance rules. And changing risk management strategies to aggregate risks and hedge only net exposures might result in line item volatility and could require an amendment to hedge accounting documentation. So while some rules aren’t final yet, it’s clear that the Act will have a significant effect on most corporates. Companies must start planning now so they’re not caught off-guard by growing costs, demands on cash, and changes in risk management.
  • 7. Home At a glance 01 02 Upcoming 10Minutes topics 03 04 Upcoming 10Minutes     How PwC can help Toward a more flexible supply chain Cybersecurity realities Volatility has become a fact of life in today’s business landscape. Yet, after years of global expansion, many companies’ supply chains are brittle, unable to respond to frequent fluctuations in demand and supply. This 10Minutes explores strategies companies can deploy to make their supply chains more agile and adaptable. Nearly 80% of large US businesses suffered a known security breach in the past year, risking company growth, competitive positioning, shareholder value, even national security. With so much on the line, company leaders must begin thinking and acting differently when it comes to security. A company that thinks like its adversaries—looking at its unique business ecosystem and identifying its most crucial assets—will have a distinct advantage over those that do not. Beyond outsourcing and shared services— to real business value Operations, traditionally seen as spenders rather than contributors, have cut costs heroically in the last several years to protect margins. But in the face of slow-growth prospects and volatile economies, companies are asking operations leaders for even more. Along with greater savings, can operations deliver flexibility, scalability, and innovation? 10Minutes discusses transformations in business services and why a move to a global business services model may be the answer.
  • 8. Home At a glance How PwC can help 01 02 03 04     Upcoming 10Minutes To have a deeper discussion about derivatives reform impact on the corporate world, please contact: Raymond Beier, Partner PwC (646) 471-2634 Edward Heitin, Partner PwC (646) 471-3366 Tell us how you like 10Minutes and what topics you would like to hear more about. Just send an email to: Download and experience the 10Minutes series with enhanced multimedia on your iPad. Look for “PwC 10Minutes” in the iTunes App store. Christopher Rhodes, Partner PwC (646) 471-5860 Tim Schutt, Partner PwC (678) 419-1472 Special thanks to Amie N. Thuener for her contributions to this 10Minutes. © 2012 PwC. All rights reserved. “PwC” and “PwC US” refer to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 10Minutes® is a trademark of PwC US. NY 13-0020