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Manufacturer’s Corner: New Law Exempts Non-Financial End Users From Margin Requirements For Uncleared Swaps

Here is good news for a certain subset of Manufacturer’s Corner readers.  But first, some highly-condensed and incomplete history.  A little while ago, Congress decided that derivatives are Bad, and imposed a bunch of new rules about them in the Dodd-Frank Act so that big banks couldn’t blow up the world or some such.  The problem is that a lot of non-financial entities also use derivatives to hedge certain risks necessarily incurred in their businesses.  Manufacturers fall within that class – for instance, they may wish to hedge exposure to price fluctuations in commodities or foreign exchange rates (I mean, a manufacturer who exports a lot of goods to the EU will necessarily be long Euros whether it wants to be or not, and since currency speculation isn’t really in the manufacturer’s wheelhouse, it would want to hedge that position).  Subjecting manufacturers to some of the new rules struck many as unfair, because while lots of different people were blamed for the financial crisis, manufacturers certainly weren’t.

The new rules didn’t really do a super job of limiting the burdens imposed on non-financial “end users” of derivatives, who pretty much by definition aren’t systemically important to the global financial structure.  For example, non-financial end users were not originally exempted from requirements about posting initial or variation margin[1] for uncleared swaps.[2] 

Which brings us to the good news: on January 12, the President signed a bill exempting non-financial end users from the initial and variation margin requirements for uncleared swaps.  This is probably a good thing, if for no other reason than because people weren’t prepared to comply with the new requirements: a recent ISDA survey revealed that about 33% of end users were uncertain whether the margin requirements applied to them, and about 64% were at least somewhat concerned about their ability to comply with them.  Of course, it is also a good thing because the rules imposed needless burdens on manufacturers.

A lot of work remains to be done in this area.  For instance, it is not entirely clear that large manufacturers that do their hedging through a centralized treasury unit fall within the current end user definition.  And the rules on when a forward contract with embedded volumetric optionality[3] is treated as a swap remain unclear (though the CFTC is working on that). But it’s good to see some headway being made.

[1] Basically, this is security to protect the counterparty in the event of default.  Initial margin is posted up front.  Variation margin fluctuates over the life of the swap contract.

[2] Lots of swaps are cleared through central clearinghouses.  People who are smarter than I am generally think those are safer than those that aren’t cleared through clearinghouses.  Those that aren’t cleared are called “uncleared swaps” and are subject to heightened rules.  Non-financial end users make up a large portion of the uncleared swap market.

[3] I’m so sorry I just had to write that phrase in this column.  Look, sometimes a forward contract isn’t just “I will pay you $X to deliver Y tons of stuff to me in three months,” but rather the parties retain some flexibility to change quantities and prices and delivery based on market conditions and operational considerations.  That flexibility can start to make a forward contract look suspiciously like an option, and an option is treated as a swap, whereas a forward contract is not.