Current Topics for Corporates Trading Derivatives
On this Ropes & Gray podcast, asset management attorneys Egan Cammack and Lindsey Jones highlight a few key topics for buy-side corporate derivatives users to consider in the coming year as they monitor existing, and assess new, derivatives transactions. Egan and Lindsey discuss counterparty credit evaluation, representations and corporate actions related to derivatives regulatory requirements (including under Dodd Frank), and planning for the U.S. Dollar (USD) LIBOR transition.
Lindsey Jones: Thanks, Egan. Like you said, there are a number of items that buy-side derivatives users should dust off each year in terms of their derivatives trading. For corporate entities, including portfolio companies of private equity funds, these issues include evaluating counterparty credit risk to their sell-side bank and dealer derivatives counterparties, reviewing— and, if necessary, updating— representations and board resolutions related to derivatives regulations (like the End User Exemption from Clearing), renewing GMEI or LEI registrations, and an action item that is somewhat unique this year, which is to make sure they have a plan for the transition of any remaining LIBOR-linked derivatives (such as interest rate hedges).
Egan Cammack: Taking these items in turn, counterparty credit risk is really an ongoing task. Once an entity enters into a derivatives transaction with a counterparty, it is important to monitor the credit risk it has to that counterparty on an ongoing basis. This is particularly important for uncollateralized transactions, which are transactions where no margin is being exchanged. Notably, for corporate buy-side entities, loan-linked derivatives (like interest rate swaps, caps and floors) are commonly uncollateralized. As our listeners know, these products are designed to hedge interest rate risk to which corporate entities are exposed through the variable interest rate that is applied to their debt through credit agreements such as term loans and revolvers.
When a counterparty’s obligations are not fully secured by a perfected security interest in collateral, a party runs a greater risk of not being able to recover what it is owed if the counterparty defaults because it is essentially an unsecured creditor of the counterparty. One misconception in the derivatives market that we sometimes hear is that derivatives are supposed to be “bankruptcy remote.” The reality is that it has always depended upon how your counterparty is regulated. In the wake of the post-2008 crisis, that level of regulation in the insolvency context has increased as global governmental insolvency regimes have been adopted to expand the imposition of potential delays, and in some cases, reductions, in recovery. Even if margin is being exchanged, if a party has over-collateralized any of its derivative contracts, it may also be treated as an unsecured creditor in respect of the excess collateral in the event of a counterparty’s insolvency.
Having said all that, there are things buy-side entities can do to try to monitor and address counterparty credit risk. Lindsey, why don’t you tell us a little bit more about that.
Lindsey Jones: Happy to, Egan. Derivative market participants should keep an eye on the news and review annual reports and periodic financial statements provided by their sell-side counterparts. For banks and broker-dealers, important events are typically either reflected in annual audited financials or other periodic public filings. Reviewing and evaluating these filings, as well as any media reports, is a good way to monitor for any potential credit issues with a counterparty. Buy-side derivatives users may also consider directly engaging in regular discussions with industry participants with whom they have a relationship in order to gather market news and intelligence.
If a concern is identified, a buy-side entity will typically have a few options in terms of trying to offset counterparty risk. Of course, they can choose to do nothing, and instead, just monitor the situation. They can also seek to novate (or move) a derivatives’ position to a new counterparty or unwind transactions with a given counterparty. Both of these options require the swap counterparty to consent and, typically, will involve a negotiated fee and liquidity constraints that can be exacerbated in turbulent markets. A third option would be to purchase CDS protection on the swap counterparty, so that they may be at least partially hedged in the event of a counterparty insolvency. That being said, if a dealer counterparty has been publicly in trouble, this last option is also likely going to be subject to additional fees and liquidity concerns.
Egan Cammack: Turning back to our checklist, another item that buy-side derivatives users should do annually is to review any regulatory elections and representations they have made and ensure that they remain accurate. These representations are frequently made in questionnaires associated with ISDA protocols (sometimes referred to as “Dodd Frank questionnaires”). While in many cases representations will stay the same, changes in company organization, ownership or business areas may trigger changes.
Lindsey Jones: That’s a good point and I would add that this is particularly important for buy-side derivatives users who rely on the End-User Exemption from Clearing, which many corporates do. Regular affirmation that a company continues to be eligible for the End-User Exception is important. In particular, corporate derivatives users who are public companies (or subsidiaries of public companies) and who rely on the End-User Exemption need to annually ensure they review and renew board approvals for entering into swaps in reliance on the End-User Exemption.
Last, but not least, we wanted to remind all entities that trade derivatives are required to have an LEI (also known as a “GMEI”) and that those LEIs must be renewed annually, or they lapse.
Egan Cammack: Thanks, Lindsey. That leaves us with one last item to discuss today which is somewhat unique this year. Although the transition of the cash and derivatives markets away from LIBOR (the “London Interbank Offered Rate”) has been underway for quite some time, this year is particularly important for the transition. As many of our listeners know, USD LIBOR reference rates will cease publication on a representative basis after June 30th this year. For many corporate entities, this is relevant because USD LIBOR has historically been the most common reference rate used in the interest rate derivatives corporates use to hedge their interest rate exposure under their credit agreements. As these agreements cease to reference LIBOR and fall back to another rate (typically a tenor of Term SOFR), buy-side entities will want to ensure their swaps fall back on the same timing and to the same rate as the debt that is being hedged. As the scope of issues and considerations involved with this transition is worthy of its own podcast, listeners will have to be on the lookout for an upcoming podcast that we intend to publish in the near future.
Lindsey Jones: Thanks, Egan. I believe that covers it for today. To our listeners, we encourage you to keep an eye out for the LIBOR transition podcast as well as additional podcasts relevant to our asset management group. Please do not hesitate to reach out to us if you have any questions or need any assistance. For more information on topics of interest to the asset management industry, please also visit our website at www.ropesgray.com. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.