A Glimpse at the Implications of Dodd-Frank
Dodd-Frank Act – Beyond Financial Institutions
10 Important Considerations for Any Company that Trades Financial Derivatives
The Dodd–Frank Wall Street Reform and Consumer Protection Act, known as Dodd-Frank or DFA, was signed into law in 2010 in response to the financial crisis of 2008. Enacted to reduce risk and increase financial system transparency, Dodd-Frank has brought about the most significant changes to financial regulation since the Great Depression. According to a high level summary posted by the U.S. Senate Banking Committee, Dodd-Frank proposed eight areas of regulation as follows:
- Regulate Credit Cards, Loans and Mortgages
- Oversee Wall Street
- Stop Banks from Gambling with Depositors’ Money
- Regulate Risky Derivatives
- Bring Hedge Funds Trades Into the Light
- Oversee Credit Rating Agencies
- Increase Supervision of Insurance Companies
- Reform the Federal Reserve
Companies that are a party to a financial derivative transaction (this might be an interest rate hedge or a swap transaction of a commodity) are subject to the requirements imposed by DFA. The type of transactions and the type of company will dictate the compliance requirements.
It’s complex. While many critics disagree with the financial reforms of Dodd-Frank, its complexity can’t be argued. Markets and regulators are still wrestling with the complicated implementations. In addition to every aspect of the financial industry, it has heavily affected several specific industries. The remainder of this piece will provide some additional implications of Dodd-Frank to companies in the energy industry, specifically companies dealing with derivative contracts.
What does Dodd-Frank mean for energy companies? The short answer: centralized clearing and exchange trading of swaps and much stricter oversight and reporting requirements – especially for oil, gas, power and utility companies that are registered as swap dealers or major swap participants. Dodd-Frank brings all energy swaps under the jurisdiction of the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC). This regulatory framework contemplates transforming the over-the-counter (OTC) market for swaps into a market with strong similarities to the futures market. In addition, organizations will be required to replace bilateral swap arrangements with a centralized swap system that standardizes reporting and reconciliations. If you are subject to the requirements of DFA, you may have to revise your trading practices, internal processes, company agreements, and capabilities to record and report derivative transactions. The following will help your organization assess trading activities and whether or not it’s impacted by DFA.
Important considerations and questions for energy companies that trade derivative transactions
- Ensure swap transactions are periodically tested against definitions and thresholds of a swap dealer and major swap participant, and results are documented and retained.
- Upon trade execution, are transactions for hedging purposes labeled and documented as such, that may fall under the definition of a swap (including the often overlooked embedded option in a physical contract)?
- Are individual swap transactions tagged and identified as such, and are mechanisms in place to quickly aggregate swap transactions across the entire organization?
- Can the organization aggregate and monitor position limits daily?
- Calculate potential collateral requirements for swap transactions that will qualify for a clearing exemption.
- Has the organization amended the International Swaps and Derivatives Association, Inc. (ISDA) and other master agreements to reflect new DFA rules, including the identification a reporting party to comply with reporting requirements?
- Modify approach of transaction execution with capital review of counterparties and dealers. Also evaluate viability of alternative transactions such as futures and physical contracts.
- Identify which swaps will migrate from OTC-brokered negotiations to an electronic SEF (Swap Execution Facility) or through a DCM (Designated Contract Market).
- Develop real-time communications and data interfaces with SEFs, DCMs, and SDRs (Swap Data Repositories) are in place for transaction and compliance reporting.
- Is data necessary for periodic CFTC reports easily accessible, stored and retrievable for up to five years after the transactions’ settlement or expiration?
For more information, or if you need help navigating Dodd-Frank or addressing the aforementioned list of considerations, please contact us. John Sorrells, 713-594-6307, JSorrells@BridgepointConsulting.com or Ross Warriner, 832-465-5590, RWarriner@BridgepointConsulting.com.