Back to the Future

Swapping credit

Title VII of the Dodd-Frank Act, or “the Wall Street Transparency and Accountability Act of 2010,” threatens major capital reserve burdens on OTC derivatives traders by requiring that OTC swaps are cleared through clearinghouses that will demand a margin in addition to the capital reserve required by the Regulations.

The Act also determines that Federal support will not be provided to businesses involved in swaps (there are exceptions).

This will have major implications for the financial markets.

Firstly, one of the key benefits of OTC swaps, namely avoiding the margin (capital) requirement and thereby increasing ROE, is lost when a clearinghouse is required to be used.

So what will be the response?

Here at Vox Sapiens we think that in the short term the futures market will benefit with increased volume (Back to the Future I) as the simplicity over swaps is no longer outweighed by the capital reserve benefits of OTC swaps.

Longer term, we expect the legal and financial engineering wizards to find ways around the rules as they always do (Back to the Future II). The Act is so convoluted, with so many provisions, that there are sure to be plenty of opportunities to bypass the aims of the Act.

Options are included in the swap definition – so swaps are not just swaps.

Sales for future delivery that are intended to be physically settled (certain forward contracts) are not swaps, even if they behave like swaps, can be modelled like swaps and are considered swaps by market participants. Furthermore, commodity futures contracts and options on such futures are not swaps.

The rules for swaps do not apply to “commercial end users” that have entered into a contract to hedge “commercial risk.”

Commercial end users are non-Financial Entities. But strangely, a captive finance company is NOT a Financial Entity if it complies with the “90/90” rule. This means that at least 90% of the financing business must relate to products and/or services produced by the captive’s parent or another subsidiary of the parent, and that at least 90% of the exposure relates to the purchase and lease of products and/or services.

So no longer a level playing field between captives and independents.

We look forward to the next few years as the loopholes are identified, exploited and challenged.

THIS POST IS FOR INFORMATION AND EDUCATION PURPOSES ONLY AND IS NOT TO BE INTERPRETED AS LEGAL ADVICE
This post was updated Jan 6th, 2013

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