Is pursuing the Dodd-Frank end-user clearing exception worth the trouble?

Contributor: Alun Green

The Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission, (SEC) in a much anticipated ruling, have approved the final definitions of “swap” and “security-based swap.” In addition, the so-called “end-user” exceptions have been finalized.

Swap participants seeking an end-user exception will generally applaud the decision that exempts them from submitting swaps for central clearing. However, these participants may be surprised to learn that the additional burdens of noticing, documenting, and reporting, may make that decision more burdensome than beneficial.

For instance, if a swap participant seeks an exception, it must first file a notice with the CFTC, and additionally provide proof that it is using the noted type of swap to hedge or mitigate qualified commercial risk. The exception-seeking swap participant must then notify the Commission of how it generally meets its financial obligations associated with the swap. And finally, there are ongoing reporting burdens that require an excepted entity to report to the Commission or to a data repository, on a swap-by-swap basis, or annually for reduced activity. If the exception is invoked, each exempted entity is held responsible to hold itself open to the CFTC for any additional information that is required. This information may include trade capture details, position valuation, risk modeling, settlement, or other relevant trade-related data that must be adequately maintained.

Notwithstanding the inherent credit and operational risks that exist in all bilateral non-cleared swaps, resource considerations are necessary prior to seeking approval for a clearing exemption.

The practical implication makes the invocation of an exemption even more uncertain. That is, although the margin rules are not yet finalized, and the proposed rules do not impose margin requirements onto non-financial swap participants, there is a conflicting requirement that certain swap participants must have credit support arrangements in place to govern the rights and obligations of the parties, including margin. And these swap participants have a heightened responsibility to manage their swaps activities.

Logically, these entities are likely the counterparties of those seeking an end-user exception. However, these entities have an independent duty, separate and apart from any exception consideration, to model and manage all swaps. The heightened compliance requirements will likely pass to those swaps entities that seek to qualify for an end-user clearing exception.

One must consider that once these costs, including trade life cycle technologies, are passed on to the exception-seeking swap participant, together with the additional burdens of noticing, documenting, and reporting, is the end-user exception really worth the trouble?

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