Futures & Derivatives Law

Transcription

1 REPORT The Journal on the Law of Investment & Risk Management Products Futures & Derivatives Law CONTINUED ON PAGE 3 January 2012 n Volume 32 n Issue 1 How Hedge Funds will be Affected by Title VII of Dodd-Frank B y S h e r r i V e n o k u r, S V E N O K U R L L C 1 As the provisions of Title VII of Dodd- Frank ( Title VII ) become effective, hedge funds will find it more expensive and, perhaps, even riskier to implement their strategies in the over-the-counter (i.e., bilateral rather than exchange-traded, OTC ) derivatives market. This is because Title VII imposes on their swap dealer/security-based swap dealer (together, swap dealer ) trading counterparties new clearing, capital, margin, reporting and recordkeeping and disclosure requirements along with new business conduct standards, all of which will make it more expensive for swap dealers to do business. It is expected that swap dealers will pass along these costs to their clients, to the extent competitively feasible, in the form of increased fees and pricing. In this environment it will be even more important for hedge funds to choose their trading partners carefully and to negotiate their trading agreements effectively. Costs Associated with Margin. Title VII requires swap dealers, major swap participants, and major security-based swap participants (together, swap entities ) to collect margin from their OTC derivatives counterparties and to segregate from their own funds any collateral they receive. The aggregate costs associated with meeting these collateralization and segregation requirements represent one of the most significant new costs to be imposed on swap entities. In the absence of Title VII, there was no law or regulation requiring that swap entities collect margin to support their counterparties obligations under OTC derivatives trades. As a matter of market practice, however, swap dealers have required their hedge fund clients to collateralize their derivatives trades with initial and variation margin consistent with the dealers internal counterparty credit risk management standards. The initial margin amount as well as the amount, if any, of permitted unsecured exposure depend upon, among other factors, the hedge fund s creditworthiness and the risk tolerance of the swap dealer. Swap dealers also have insisted upon having the rights to re-hypothecate posted margin as well as to commingle posted margin with the dealers own assets. With few exceptions, this became a market practice. Margin and Segregation. In a post-title VII world, swap dealers will be required to Article REPRINT Reprinted from the Futures & Derivatives Law Report. Copyright 2011 Thomson Reuters. For more information about this publication please visit thomson.com ARTICLE REPRINT

2 January 2012 n Volume 32 n Issue 1 Newsletter ad x 4.5.qxp 2/1/2010 1:38 PM Page Thomson Reuters. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) ; fax (978) or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651) Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. For subscription information, please contact the publisher at: west.legalworkspublications@thomson.com West LegalEdcenter LOG ON. LOOK UP. LEARN. Quality legal training and CLE - online, anytime westlegaledcenter.com Part of Thomson Reuters Editorial Board Stephen W. Seemer Publisher, West Legal Ed Center JANNA M. PULVER Publication Editor, Thomson Reuters/West Richard A. Miller Editor-in-Chief, Prudential Financial Two Gateway Center, 5th Floor, Newark, NJ Phone: Fax: richard.a.miller@prudential.com Michael S. Sackheim Managing Editor, Sidley Austin LLP 787 Seventh Ave., Phone: (212) Fax: (212) msackheim@sidley.com PAUL ARCHITZEL Alston & Bird Geoffrey Aronow Bingham McCutchen LLP Conrad G. Bahlke OTC Derivatives Editor Weil, Gotshal & Manges Rhett Campbell Thompson & Knight LLP Houston, TX ANDREA M. CORCORAN Align International, LLC W. Iain Cullen Simmons & Simmons London, England Warren N. Davis Sutherland Asbill & Brennan Susan C. Ervin Dechert LLP Ronald H. Filler New York Law School Edward H. Fleischman Linklaters Denis M. Forster Thomas Lee Hazen University of North Carolina at Chapel Hill Donald L. Horwitz One Chicago Philip McBride Johnson Skadden Arps Slate Meagher & Flom Dennis Klejna MF Global Robert M. McLaughlin Katten Muchin Rosenman Charles R. Mills K&L Gates, LLP David S. Mitchell Fried, Frank, Harris, Shriver & Jacobson LLP Richard E. Nathan Los Angeles Paul J. Pantano McDermott Will and Emery Frank Partnoy University of San Diego School of Law Glen A. Rae Banc of America Securities LLC Kenneth M. Raisler Sullivan & Cromwell Richard A. Rosen Paul, Weiss, Rifkind, Wharton & Garrison LLP Kenneth M. Rosenzweig Katten Muchin Rosenman Thomas A. Russo Howard Schneider MF Global Stephen F. Selig Brown Raysman Millstein Felder & Steiner LLP Paul Uhlenhop Lawrence, Kamin, Saunders & Uhlenhop Emily M. Zeigler Willkie Farr & Gallagher West LegalEdcenter 610 Opperman Drive Eagan, MN Thomson Reuters One Year Subscription n 11 Issues n $ (ISSN#: ) For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) ; fax (978) or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651) Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered. However, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdication. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. Copyright is not claimed as to any part of the original work prepared by a United States Government officer or employee as part of the person s official duties Thomson Reuters

3 January 2012 n Volume 32 n Issue 1 notify customers of their right to have their initial margin segregated with an independent custodian. Hedge funds will have to weigh the risk reduction benefit of having a collateral custodian against both the custodial fees that undoubtedly will be passed along to the customer and the pricing differential on the trade depending on whether the dealer will have use of the initial margin amount. Except for hedge funds that invest assets owned by special classes of entities, e.g., pension assets, it is expected that many, if not most, hedge funds will waive their initial margin segregation right. Interdealer Trades. Swap dealers interdealer trades entered into in order to hedge their customer positions generally do not require initial margin from either party and include high unsecured threshold amounts to be met before variation margin is required to be transferred. Post-Title VII, when a swap dealer trades with a swap entity, both swap entities will be required to collateralize any exposure, i.e., a zero unsecured threshold will apply. These swap entities may be required for the first time to post initial margin to each other and to segregate with a custodian the margin they receive. To the extent that the initial margin amounts are not netted, then, interdealer trading will be more expensive for both parties. Because the margin amounts posted to each swap dealer cannot be commingled with that dealer s general assets, the swap dealer effectively is denied a revenue source. The costs of both posting margin on interdealer trades and of losing the right to use for its own purposes the margin collected on such trades will be passed along to the hedge fund client. Initial Margin Requirements for Hedge Funds. It is anticipated that the amounts of initial margin required to be posted by hedge funds will increase once the margin provisions of Title VII become effective. Also, there is no doubt that the amount of initial margin required of a hedge fund to secure an uncleared trade will be substantially greater than the amount the hedge fund will be required to post to the clearinghouse to secure a cleared trade. For example, CFTC-approved internal models, which are to be used by swap dealers to calculate initial margin, will need to cover exposure over a 10-day liquidation horizon, versus a one-day period in the case of a cleared futures contract. The proposals made by bank regulators and the CFTC set margin requirements based on the risk profile of the swap entity s counterparty. Hedge funds are likely to be categorized as highrisk financial end-users. Hedge funds also may lose much of the benefit of their portfolio margin arrangements because of the division between cleared and uncleared trades. Under Title VII, initial margin posted by a hedge fund to secure its exposure to a swap dealer under a derivatives trade not subject to mandatory clearing will be held either by an independent custodian or by the swap dealer itself (if the fund waives its segregation right). Margin posted to support cleared OTC derivatives trades is held by the clearinghouse. Cleared versus uncleared trades will be subject to different margining regimes, thereby creating different buckets of exposure: derivatives versus cash trades; cleared versus uncleared derivatives. For this reason, hedge funds that have negotiated portfolio margining arrangements with their prime brokers in order to reduce the amount of required initial margin likely will find that these arrangements are of decreased benefit, or even no benefit. To the extent that a fund s risk-producing trades are not subject to clearing while its risk-reducing trades are cleared, the fund s initial margin amounts with respect to both its cleared and uncleared portfolios may not reflect the actual reduced risk of the aggregate portfolio. The inability to net exposures between cleared and uncleared trades may also result in an increase in variation margin. It can be anticipated that the higher margin costs associated with uncleared trades will push hedge funds toward alternative exchange-traded strategies and this is exactly where the drafters of Title VII want trading to be. Even so, the recent news that as much as $1.2 billion dollars in customer funds may be missing from MF Global calls into question the extent to which clearing reduces counterparty credit risk, especially compared to the independent custodian option available under Title VII with regard to uncleared trades thomson reuters 3

4 January 2012 n Volume 32 n Issue 1 Eligible Collateral. Post-Title VII, swap entities will be restricted with respect to the types of collateral they can accept from hedge funds. Hedge funds are financial end users for purposes of Title VII. Under the proposed CFTC rules, swap entities will be permitted to accept from a financial end-user only immediately available cash and, subject to haircutting, certain U.S. government and agency obligations; for initial margin only, swap entities also may accept senior debt obligations of U.S. government-sponsored entities. To the extent that a hedge fund s dealers have permitted the fund to pledge other types of collateral, the fund will incur the added expense of acquiring regulatory compliant collateral. Even funds that have sufficient cash and other qualifying assets to meet their collateral needs may wish to use their cash for investment opportunities. In light of increased margin amounts and decreased categories of acceptable margin, hedge funds should look for future commission merchants that can manage their collateral in the most effective ways possible. It is anticipated that at least some major banks will be offering collateral optimization services that will include the transformation of non-cash holdings into eligible collateral. Reduction of Close-out Netting Benefits. Because the dealer push-out rule restricts the derivatives products that can be traded by an insured depositary institution, hedge funds that trade with U.S. banks may be facing multiple entities that have been spun off from the same U.S. bank. With respect to uncleared trades, a hedge fund could find itself with a separate portfolio for each such bank affiliate. Because exposures in one portfolio cannot be netted against exposures in any other portfolio, the hedge fund will have an increased exposure to the bank as a whole should it become insolvent. Depending upon their particular strategies, hedge funds will want to explore whether they can get better pricing and collateral terms from U.S. versus non-u.s. swap dealers. Costs Associated with Trading with Special Entities. If a hedge fund s assets constitute plan assets of an employee benefit plan subject to Title I of the United States Employee Retirements Income Security Act of 1974, as amended, the fund will be categorized as a Special Entity. Swap dealers that trade with Special Entities will need to comply with detailed rules that will be costly to implement. Some swap dealers may choose not to trade with Special Entities because of the added costs, which could make it more difficult for these hedge funds to find suitable trading counterparties. Costs Associated with Documentation. Hedge funds will be required to execute amendments to their existing ISDA Master Agreements and Credit Support Annexes so that their swap dealer counterparties can meet their documentation and other obligations under Title VII with respect to uncleared trades. Specifically, the CFTC s proposed rules would require that the parties trading documentation provide for a complete and independently verifiable methodology for valuing each swap so that both parties can value their positions in a predictable and objective manner and that any valuation disputes be resolved expeditiously. The standard form of ISDA 2002 Master Agreement includes an elaborate provision for determining the value of a portfolio upon its early termination, but the provision frequently results in disputes. Whether the Title VII-compliant trade valuation provisions are included in the parties ISDA Master Agreement, master confirmation for a particular product type or individual trade confirmation, hedge funds will want to negotiate the way in which their non-standard, uncleared trades will be valued, because portfolio value determines the amount of the fund s initial and variation margin requirements. Hedge funds also must be careful when negotiating their clearing agreements to ensure, among other things, that they have sufficient time to move their trades should their clearing members decide to reduce their exposures or even exit a particular business line. Hedge funds facing these changes need to develop an overall response plan that starts with an understanding of their current usage of swaps and exposures to swap dealers and that considers sev Thomson Reuters

5 January 2012 n Volume 32 n Issue 1 eral factors including liquidity, credit exposure, and underlying business needs. This kind of plan, to be successful, will require coordination of the trading, marketing, compliance, operations, technology and legal functions and the training of personnel in each of these areas. NOTES 1 In addition to operating her own legal practice specializing in derivatives, Sherri Venokur is a senior consultant at the Regulatory Fundamentals Group. RFG provides alternative asset managers with tools and templates that can simplify their SEC registration process, build a business-friendly compliance program and help them to keep current as regulations change thomson reuters 5