Government regulation in all intents and purposes is designed to keep people from hurting themselves; however, that’s hardly ever the end result. While there are some instances where it’s needed, I’m a firm believer that too much regulation is a bad thing. It limits our ability to grow and often times common sense is over looked.
The financial crisis of 2008 resulted in dozens of bank collapses, bailouts and financial loses. In an attempt to prevent something like that from happening again, the government introduce thousands of pages of new legislation, including Dodd-Frank.
Derivatives Didn’t Cause the Crisis
Introduced in 2010, some parts are just starting to be implemented and business are reacting to the new restrictions. Something that I often hear when talking with financial executives, is the impact that Dodd-Frank is having on their derivatives trading. Most people don’t know a whole lot about derivatives besides what they hear on the news. To them, derivatives where responsible for the entire financial crisis and are considered “financial weapons of mass destruction” – Warren Buffet. Truthfully, they did have a part to play in the collapse, but only a small one.
Derivatives are primarily used as hedging instruments. For example, an airline will purchase oil futures to hedge the price of jet fuel. The price of fuel can determine whether or not an airline posts positive earnings for the quarter. Because the price is so important and almost impossible to predict, the airline will purchase futures that will increase in value if the price of oil also increases. While paying more for fuel, the futures are generating a profit to offset the rising commodity prices.
Too Much Regulation
Dodd-Frank has unfortunately, made it very difficult to many companies to hedge their bets. What was intended to protect institutions and not allow them to get into the type of derivatives situations that hurt them so badly, has spilt over, affecting all companies that participate in the derivatives markets.
There Are Always Exceptions
As with all rules, there are exceptions fortunately. In some cases, companies may be able to avoid the abundance of derivatives regulation imposed on the markets.
Is your company a financial entity? Financial organizations are faced with the stiffer regulation under Dodd-Frank, including swap dealers, security-based swap dealers, major swap participants and major security-based swap participants.
If your company is not (i) engaging in swap transactions with a gross notional amount in excess of $8 billion annually, (ii) engaging in uncollateralized rate swaps having an outward exposure (that is, negative mark-to-market value) exceeding $3 billion (or $1 billion in the case of credit, equity, or commodity swaps), or (iii) creating more than $5 billion of average daily uncollateralized outward exposure aggregated across all of your swap positions, chances are you don’t need to worry about falling into one of these categories (although you can certainly check with your legal advisors to be sure).
If the company is not a financial entity, one hurdle has been cleared and it’s only two requirements away from avoiding the regulations (somewhat). The derivative position must be taken as a pure hedge, not a speculative trade. In the case of the airline above, this would count as a hedge and not a trading position.
Finally, to use the end-user exception to clearing and exchange trading, one party involved must report the following swap details to a regulated swap data repository or directly to the CFTC.
- Certain information about the swap terms, parties, etc.
- Notice of the election to utilize the exception
- The counter party that wishes to use the end-party exception
In addition to regulatory filing, if the company issues securities or is required to file reports under the Exchange Act, approval from the board of directors must also be secured.
Unfortunately, this information can and does change often. Since 2010, Dodd-Frank has been implemented in sections. Companies are fearful that they will adhere to the exceptions listed above, then they’ll unknowing violate some altered portion of the bill that has been modified or was newly activated. Many firms I communicate with feel that it’s simply easier to stay away from derivatives trading all together and that’s exactly what they’re doing