To see this article in digital magazine format, click here.
The Dodd-Frank legislation was designed to lessen certain risks in our financial system. However, the regulations that will be enacted in the wake of Dodd-Frank will make the use of derivatives much more complex for pension plans, which are increasingly focused on risk mitigation in their portfolios. The ultimate structure of those regulations is not yet final, but the drafts currently in circulation will create significant burdens and make it harder for pensions to hedge their risks.
Imagine you have 10% of your portfolio indexed to the S&P. You are worried that it is overvalued or that you have too much exposure to that source of beta, or you think interest rates are going to change (higher or lower) in the next couple of months and you want to be protected against ways that movement might harm your portfolio. You are acting intelligently to mitigate risks.
Today, you can call a few trading partners—likely partners with whom you have an ISDA and have transacted before. They already have determined that these instruments are suitable for you, so your trader and theirs agree to terms for an index-based swap on the S&P or an interest-rate swap to protect you against an unfavorable change in rates. In the course of a few hours or less, you will have priced your trade competitively, concluded your transaction, and protected your portfolio from the risks that you saw as important.
If current regulatory proposals are finalized, those two simple transactions will likely face significant new regulatory requirements. This list is not meant to be exhaustive.
First, before the trade takes place, you will need to determine whether you are a “commercial end user.” The idea of an end user is that you are not a speculator or an investor, but rather are in this market and need to protect yourself against certain risks. If you are not an end user, your trade most likely will have to be cleared at a clearinghouse and transacted on a regulator-approved trading platform. If you are an end user, then, pursuant to a narrowly crafted exemption, you may not be required to transact your swap in a clearinghouse.
You may think that hedging S&P beta for a pension fund is similar to hedging jet fuel for an airline. However, the proposed regulations in this area indicate that pension plans will be regulated as “financial end users.” If that is their status in final regulations, all their standardized derivatives will have to be cleared. If, however, the transacting entity is a “commercial end user” (or if pension plans are able to persuade regulators that they should not be regulated as financial end users and instead be exempt from the clearing requirements), that still does not exempt the transaction or parties from all regulatory concerns. Even if you are a “commercial end user,” information about your swap will have to be reported to a swap data repository “as soon as technologically practicable.”
If you are a “commercial end user,” the determination whether a particular trade is exempt from the clearing requirements still will vary from swap to swap. The proposed rules do not simply ask about the nature of your entity as a hedging/protecting “end user.” They also look at the transaction and require that it not be “in the nature of,” among other things, “investing.” So, if you hoped not only to protect against risk, but also to generate a positive return on the transaction, then you may be subject to clearing requirements anyway.
So, now, if you are subject to clearing requirements, your swap will have to be executed on a Swap Execution Facility (SEF), if one is available. In those situations, you may not simply call a counterparty directly to transact. Traditional bilateral negotiation, whereby one party uses telephone, e-mail, or other communications to contact a potential counterparty to negotiate a security-based swap, will not be an acceptable method of transacting for cleared swaps. You also may not call various parties seriatim to transact.
Even though, in the past, your swaps may not have been subject to initial margin, under the proposed rules, all cleared swaps will be subject to initial and variation margin. This will make these transactions more costly. The requirement of initial margin may decrease the risk that financial end users place in the system. However, because pensions likely will be considered financial end users, the Dodd-Frank legislation will have the effect of making it more expensive for pension plans to hedge their risks.
The regulatory burden that now looks like it will be imposed by Dodd-Frank is complex. However, beyond those detailed complexities lies one other potential result: The Department of Labor has introduced a definition of “fiduciary” under ERISA that potentially would make a swap dealer who followed the CFTC’s due diligence and disclosure requirements into an ERISA fiduciary. In general, this means that, if you propose something to an ERISA plan, you cannot act as an ERISA fiduciary and then carry out the transaction you have proposed—even if you have met the normal definition of fiduciary in recommending and transacting.
Fortunately, most of the regulatory changes described above have not been finalized. However, it would be a shame if, in the name of taking risk out of the system, we made it harder for pension plans to mitigate risks in the first place.
Charles E.F. Millard was Director of the U.S. Pension Benefit guaranty Corporation from 2007 to 2009 and is now a Managing Director leading Citigroup’s Pension relations team.