Dodd Frank's impact on producers
New rules could increase the regulatory risk a bank faces in providing hedging services to producers
Paul B. Turner, Reed Smith, Houston
An old adage of traders says that "the only place you will find a perfect hedge is in a Japanese garden." Nonetheless, hedging has become an important part of the oil and gas industry, especially for producers.
Producers – particularly midsize and smaller ones – have fairly recently become more accustomed to hedging their production, at least in part, for price risk and, potentially, basis risk. Indeed it seems that, during the past 10 years, banks have increasingly required such hedging practices as part of the financing of a company's product. As a consequence, many producers have implemented more formal hedging programs and corresponding risk policies. As part of this trend, large banks and energy companies have become an increasingly important part of this segment to provide producers choices among hedge providers in implementing their hedging programs and in seeking greater liquidity in the marketplace.
In June of 2010, however, significant changes were introduced into the derivatives market with the passage of Title VII of the Dodd Frank Act (Dodd Frank), designed to bring substantially increased regulation to the swaps markets. Under Dodd Frank, the federal regulators are charged with increased supervision of, among other things, the financial energy markets. At its core, the aim of Dodd Frank is:
- to drive as much swaps activity to be executed, and cleared, on exchanges;
- to increase the amount and standardization of collateral to secure most transactions; and
- to impose greater and tighter regulation on the largest participants in the swaps market, including those that are key players in the energy markets by providing hedging products to producers.
Separate and apart from Title VII dealing specifically with swaps, Title VI imposes new restrictions on most large banks' trading activity, including with respect to derivatives. One of Title VI's key components is the so-called Volcker Rule. The Volcker Rule, when fully implemented, will limit the proprietary trading – i.e., for their own account – that many banks in the US are able to do. Even for banks' continued swap dealing activity, the Volcker Rule imposes additional regulation that could increase the regulatory risk a bank faces in providing producers such hedging services.
The combination of effects of these new regulations is one that may be disproportionately felt by the producer community. This article discusses four such effects – particularly as they relate to producer hedging programs and the associated documentation for such programs. It specifically addresses:
- documentation for new swap dealer relationships;
- amendments to existing over-the-counter hedging relationships;
- the ISDA Protocols and IECA Amendment; and
- potential changes relating to collateral and security arrangements.
New relationships
As more and more swaps business moves from a model characterized largely as bilateral over-the-counter (OTC) transactions to one where such transactions are executed on an exchange or are transacted on exchanges as futures contracts, the potential number of available counterparties may decrease, and the need for an intermediary, such as a futures contract merchant (FCM), becomes greater. Many producers (particularly those that are midsized and smaller) typically did not formerly transact on exchanges much – and thus, many do not have existing relationships with FCMs.
From a documentation perspective, relationships with an FCM tend to involve a greater number of documents for execution than an OTC relationship. In a typical OTC transaction before Dodd Frank, most hedging with a counterpart involved a master agreement (typically with a credit support agreement), while individual transactions were entered by way of a fairly short and simple confirmation. For such contracts, the parties were largely free to negotiate and tailor the documentation to their individual needs (including agreed-upon credit arrangements which often provided for a threshold of unsecured credit). For FCM relationships, the documentation governing the parties' relationship and transactions comes from multiple sources. For futures contracts, specifications (quantity, term, etc.), as well as numerous rules relating to the contract, are driven by the rules of the exchange listing the contract. Individual counterparts have no ability to negotiate such rules and specifications.
The overall agreement that governs the relationship between an FCM and its customer (e.g., the producer) is governed by a form of agreement provided by the FCM – a Futures Clearing Agreement – for which there typically is a lessened ability for the counterpart to negotiate changes to the form. The parties also execute (typically) a tri-party agreement between the customer, executing broker and clearing broker called a Give-Up Agreement.
The Give-Up Agreement essentially governs the terms and conditions when a dealer that executes particular types of transactions "gives up" the transactions to a prime broker who becomes the ultimate counterparty. Finally, if the customer expects to engage in exchange-traded swaps, the FCM and producer typically also will sign an OTC Addendum (which tailors the Futures Clearing Agreement for exchange-traded swaps).
Existing relationships
For most end-users in the producer community, even if they are not themselves Swap Dealers or MSPs, their existing documentation may nonetheless need to be amended after Dodd Frank. Various reporting obligations impact every swap transaction, even when no Swap Dealer or MSP is involved. For example, OTC swaps between two end-users must be reported (including all primary economic terms) to a Swap Data Repository (within 48 hours or less). Moreover, to the extent the terms or cashflows associated with such swaps change over the course of the swap, such changes also must be reported.
Dodd Frank, by its terms, typically does not dictate which of the two end-user counterparties would need to report such data. Therefore, the parties must agree between themselves which of the two will do so (or if they will use a third party). That agreement relating to the reporting of such data usually is memorialized in a Swap Reporting Agreement. Perhaps more surprising, if two end-user counterparts engage in physical bookouts of natural gas or crude oil, they may need to change their current process for such bookouts through additional documentation after such bookouts are agreed to. Otherwise, such bookouts themselves may qualify as swaps subject to Dodd Frank. If the existing relationship is with a counterparty that becomes designated as a Swap Dealer or MSP, there likely will be additional changes to their legal documentation, which are discussed immediately below.
ISDA Protocol and IECA Amendment
The August and March Protocols are ISDA-published standardized amendments that assist parties in updating their existing swap-relationship documentation to comply with Dodd-Frank – particularly for transactions with Swap Dealers and MSPs. The Protocols supplement the terms of existing ISDAs by adding notices, representations and warranties and covenants required to be provided by SDs and MSPs, but which also directly relate to non-SDs/MSPs.
The August Protocol focuses on SD and MSP compliance with Dodd-Frank's external business conduct (ECB) requirements. Its purpose is to supplement the terms of existing master agreements by adding notices, representations, and covenants that will comply with Dodd-Frank's requirements. The August Protocol Questionnaire lists a party's legal status and contact information, and requires that party to make representations as to whether or not it is a commodity pool operator, ECP (including detailed questions regarding the satisfaction of the prongs of that definition), SD, MSP, or other type of entity, and to make statements or disclosures to satisfy the "know-your-customer" information requirements.
While similar to the August Protocol, ISDA's March Protocol focuses on SD and MSP compliance with Dodd-Frank's internal business conduct (IBC) requirements and mandatory clearing of certain classes of interest rate swaps and credit default swaps. Like the August Protocol it contains notice information, representations, and covenants required for Dodd-Frank compliance, however the March Protocol also contains provisions designed to address the end-user exception to mandatory clearing.
The International Energy Credit Association published an amendment to each of the foregoing ISDA Protocols to streamline and standardize negotiations between end users and SDs/MSPs in preparing the documentation required to comply with Dodd-Frank. Under the Amendment Adopting, Incorporating and Amending the ISDA August 2012 Dodd-Frank Supplement, parties can elect to either adhere to the procedures in the Protocol Agreement (including the Adherence Letter and Questionnaire) or forego such procedures and simply use the IECA Amendment and attachments. If the IECA Amendment is used, it amends and is deemed to be incorporated into the covered agreements. The Amendment clarifies certain terms and it was drafted with the intent to protect and benefit end users.
Changes to collateral and security requirements
To the extent producers already are making use of futures agreements and exchange-traded derivatives, little is likely to change regarding their collateral requirements for such contracts in the near term. However, many producers that traditionally have hedged almost exclusively through the OTC markets may find that a trend toward having more and more of their hedging activity on exchanges could be a drain on their liquidity.
For futures contracts and swaps listed on an exchange, an FCM will require both initial and variation margin from its customer, based on the contracts the customer has executed through the FCM. The initial margin is an amount that must be posted with the FCM regardless of the market movement of the contracts (similar to the posting of an Independent Amount under the ISDA). Variation margin fluctuates as the exchange prices for the customers' positions fluctuate (similar to the fluctuation of mark-to-market exposure). Such margin is intended to protect the exchange and FCM from credit risk to the customer as market prices move. Such margin generally is required to be very liquid.
For uncleared swaps, although initial and variation margin may not be required with respect to all transactions, Dodd Frank nonetheless imposes requirements for securing such positions. Whether a producer will be required to post collateral to secure its uncleared swap obligations most likely will depend on the relevant counterparty to the transaction. Under rules proposed by regulators such as the FDIC and the Federal Reserve, if a financial institution qualifies as an SD or MSP and is otherwise regulated by any of the agencies proposing such rules (Covered Swap Entities or CSEs), the CSE will be required to collect both initial and variation margin from non-financial end users that have entered into uncleared swaps with the CSE unless the end user's aggregate notional swap exposure falls below certain thresholds.
Initial and variation margin thresholds vary depending on the type of swap and risk profile of the counterparty, but in general, non-financial end users are not subject to a regulated threshold. However, non-financial end users still may be required to post collateral to CSEs based on unregulated thresholds bilaterally negotiated by the parties to the uncleared swap.
If a non-financial end user enters into an uncleared swap with an SD or MSP that does not qualify as a CSE (a Non-CSE) or another end user, the CFTC has proposed rules addressing uncleared swap margin requirements. Fortunately for non-financial end users, they generally are exempt under proposed CFTC regulations from posting margin collateral under their uncleared swaps with either Non-CSEs or other end users. Despite such exemption, end users may nonetheless be required to post collateral according to bilaterally negotiated credit arrangements securing their uncleared swaps, such as an ISDA Credit Support Annex.
About the author
Paul Turner is a partner in Reed Smith's Energy & Natural Resources Group in the firm's Houston office, where he focuses his practice on the energy and commodity markets—principally the physical and financial trading of energy commodities. He has been involved in the regulatory and commercial restructuring of the energy industry, and the ongoing changes to the physical, futures and derivatives markets. Over the past several years, Turner has played a key role in significant litigation and commercial matters related to commodity contracts, forward contracts, and derivatives for major energy companies and retail electric providers, and has also represented numerous clients in some of the largest energy and commodity company bankruptcies.