Dodd-Frank, Swaps Clearing and Compliance for Pension Plan Asset Managers

According to the Bank for International Settlements, the notional amount outstanding, as of June 2013, of global over-the-counter derivatives exceeded $692 trillion. Interest rate swaps reflect the largest category at about $425.6 trillion. Given the jumbo size of this market, it is no surprise that regulators have demanded more transparency about the mechanics of the global swaps market, including reporting to regulators and the public dissemination of reported information. It is also no surprise that regulators have demanded what they deem to be risk-reducing measures such as the clearing of these instruments and collateral collection. With the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), numerous market participants are now required to clear their swaps. Click here to learn about the three categories of organizations that are required to adhere to swap clearing and trade execution requirements under Section 2(h) of the Commodity Exchange Act (“CEA”). Given the complexity of the prevailing swaps-related rules and regulations as well as the evolving nature of these mandates, any educational insights are welcome.

As an economic consultant, trainer and expert witness who regularly does work in the pension risk management arena and author of Risk Management for Pensions, Endowments and Foundations, I was delighted to have a chance to get comments about this important topic of swaps clearing and trade compliance from Davis Polk attorneys Lanny A. Schwartz and Gabriel D. Rosenberg. Mr. Schwartz is a partner, and Mr. Rosenberg is an associate in Davis Polk’s Trading and Markets practice. Besides the questions and answers provided below, and acknowledging that there is a lot to learn about swaps-related compliance, readers may want to download "Are You Ready? New Swap Trading Requirements For Pension Plan Asset Managers" (August 2013) by Attorneys Schwartz and Rosenberg, in conjunction with BNY Mellon.

Question: What is your motivation for writing about this topic as well as offering educational webinars?

Answer: We continue to receive numerous inquiries from swap market participants, many related to clearing. Swaps dealers were the first to have to demonstrate compliance with Dodd-Frank's swaps clearing mandate in March of last year. Most asset managers were required to clear specified types of interest rate swaps and credit default swaps as of June 2013. Other entities, including ERISA plans, had a deadline of September 2013.

Question: What areas have you identified as requiring more time and attention?

Answer: We are still mid-stream in terms of implementing a wide array of rules. Compliance is not a simple “check the box” exercise. Some swaps are now subject to mandatory clearing, but this is a relatively small part of the universe in terms of instruments traded in the market. Trading on a regulated futures exchange or swap execution facility is currently voluntary. Margin requirements are not yet final. Documentation requirements are similarly critical and require significant attention.

Question: What is a qualified independent representative and why is that important to an asset manager that has pension plan clients?

Answer: Before a swap dealer can act as an advisor to a pension plan regarding swaps, which in this context means making customized recommendations, the plan manager must verify that the pension plan has a qualified independent representative ("QIR") in place. A QIR is an agent of a Special Entity (such as a corporate or public pension plan) that is knowledgeable and independent of any swap dealer counterparty.

Question: It sounds like there is a large amount of due diligence that must be carried out by swaps dealers, asset managers and end-users such as pension plans, respectively. Would you elaborate?

Answer: You are correct that each category of swap market participant has a large amount of due diligence to carry out in order to ensure that they are compliant with Dodd-Frank's trading, clearing and other provisions. Swap dealers will generally require counterparties to adhere to one or more of the International Swaps and Derivatives Association (“ISDA”) protocols and other documentation as relevant to their activity. For example, suppose Big Bank X is a leading dealer of swaps and has been approached by Global Asset Management Firm Y to handle its trades on behalf of various end-users such as pension plans of Fortune 500 companies. Before Big Bank X will speak in detail about swaps with Global Asset Management Firm Y, it generally will need to make sure it has proper documentation in place. Unless Global Asset Management Firm Y can demonstrate adherence (or enters into alternative documentation developed by the swap dealer, Big Bank X will generally not transact with them.

Question: What are some of the action steps that a pension plan must take?

Answer: A pension plan, whether a corporate ERISA plan or government employee benefits plan, must have an account with a Futures Commission Merchant (“FCM”) in order to enter into swaps trades that are subject to clearing. This requires diligence and negotiation of important documentation about the clearing relationship. Pension plans should also consider the trade-offs between using swaps and nearly equivalent futures contracts.

Question: Are there areas of vulnerability that need to be better addressed?

Answer: A firm needs to have people in place who are experienced and knowledgeable about Dodd-Frank, operational processing, legal documentation and the use of technology for data inputting and report generation. None of these areas are trivial and require care and diligence. Additionally, since things are in flux as new rules are being adopted, it is critically important for any swap market participant to stay abreast of compliance mandates.

Question: Headlines are replete these days with news about regulatory investigations and lawsuits about how London Interbank Offer Rates (“LIBOR”) are determined by quoting banks. Inasmuch as the majority of swaps are tied to some type of LIBOR fix, how is swaps trading likely to be impacted?

Answer: The increased scrutiny about LIBOR could result in increased regulatory interest in other indexes that are referenced by swaps.

Question: What is the role of external counsel versus the internal General Counsel?

Answer: It is critical for asset managers to develop an educational program that allows front, middle and back office professionals to understand what rules, policies and procedures need to be established and followed. External counsel can add value by explaining the ISDA Protocols and other documentation and compliance requirements to clients. An end-user’s General Counsel should make sure that everything is in place in order to comply with Dodd-Frank. Plenty of clients say they don’t even know where to start and feel overwhelmed.

Question: There is so much more to discuss. Readers should stay tuned for further updates. At the client level, it sounds like you will both remain quite busy.

Answer: Susan, we appreciate the opportunity to share our insights with readers of your blog. We urge everyone with a stake in good governance to pay attention and do whatever is needed to comply with Dodd-Frank's swaps rules.

Private Equity and Derivatives - Double Whammy or Blissful Combo?

According to the U.S. Government Accountability Office, nearly 4 out of 10 surveyed pension plans say they allocate monies to private equity. Allowing that some managers have turned in acceptable returns, respondents also cited numerous "challenges and risks beyond those posed by traditional investments." Valuation and limited transparency are two issues cited in "Defined Benefit Pension Plans: Guidance Needed to Better Information Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity" (GAO-08-692, August 14, 2008).


To shed light on some of the intricacies associated with private equity investments, I authored a case study for the February 2009 issue of PEI Manager, a private equity and venture capital focused publication. The bottom line is that institutions that invest in private equity funds are directly impacted by their portfolio companies' use of derivatives.


"Swapping out" by Dr. Susan Mangiero, an Accredited Valuation Analyst and CFA charterholder, is reproduced below. Email Ms. Jennifer Harris, Associate Editor - PEI Manager, for permission to reprint the case study.


                                                                       * * * * * *




Private Equity Holdings (“PEH”) is required by its charter to avoid companies that use derivative financial instruments to speculate. In reviewing numbers for FAS 157 reporting purposes, a PEH managing partner notices that one of its portfolio companies, ABC Incorporated (“ABC”), recently included a FAS 133 entry for a $20 million interest rate swap hedge. During a call to the company to query about how the swap is being used, the PEH managing partner is informed that its counterparty is Global Bank Limited (“Global”). Not only has Global just reported a $30 billion loss due to poor valuation of its structured product portfolio, it posted no collateral in favor of ABC while ABC was required to pledge $2 million in U.S. Treasury Bills in order to protect Global in the event that ABC could not make its contractual swap payments to Global. Not being too familiar with derivative instrument pricing and default risk analysis, PEH hires an expert to investigate whether the swaps reflect a hedge versus a market bet and to further assess how PEH should adjust the valuation of its equity stake in ABC. What does the expert need to look at and how should she arrive at an appropriate conclusion?




This fact situation, ripped from the headlines, raises several important valuation questions, including, but not limited to the following:


  • Notwithstanding FAS 133 numbers, is the company exposed to changes in interest rates that could adversely impact cash flow, liquidity and net income?
  • Was the swap correctly valued?
  • How might ABC be impacted by Global’s deteriorating health?
  • What adjustments, if any, should PEH make to its initial valuation of ABC equity?

There are several critical issues here, all of which could seriously hamper the fortunes of both ABC shareholders and PEH investors. An inaccurate valuation of the swap leads to a flawed accounting representation for ABC and may lull treasury staff into thinking that the hedge offers full protection against unexpected moves in interest rates. PEH may report a bad FAS 157 number which in turn could lead to flawed asset allocation decisions made by institutional limited partners or the overpayment of performance fees to PEH. A poorly constructed hedge (in economic versus accounting terms) that exposes ABC to negative market conditions could force PEH to violate its prohibition against speculative trades being executed by portfolio companies. If Global does not meet its swap obligations and/or files for bankruptcy protection, ABC may not be able to recover its collateral quickly or could lose it altogether, depending on its standing vis-à-vis other creditors.


Swap pricing models can differ depending on the complexity of the transaction. However, for standard fixed to LIBOR swaps, the secondary market is large ($111 trillion, according to the Bank for International Settlements). Active trading makes it easy to readily obtain prices for various maturity interest rate swaps with quotes reflecting the discounting of future projected fixed and floating swap payment amounts. In contrast, the assessment of credit worthiness varies, sometimes considerably, across banks. Unfortunately for ABC, even if they posted more collateral than should have been required, the fact remains that they have no immediate recourse in the event that Global’s distress prevents the bank from paying what it owes to ABC. If Global defaults, ABC will then have to decide on a course of action that could include any or all of the following:


  • Enter into a second interest rate swap to replace Global at a now higher fixed rate
  • Attempt to sell the initial swap in the open market and consider another way to hedge against rising interest rates though few will be willing to accept the Global risk
  • Take legal action to reclaim its collateral
  • Write down the value of the swap on its books

There is no ideal situation. The expert will necessarily have to ask ABC what they plan to do in the event of swap non-performance and how it is expected to impact its cash flow, cost of money (which in turn affects capital budget decisions), balance sheet, dividend payments and interest coverage. Once that scenario analysis is conducted, both the expert and PEH will be able to quantify how much of an adjustment downward they will need to make for both accounting and performance reporting purposes.

LIBOR Manipulation - Comments from the Author

Given its global prevalence as a performance benchmark, the ongoing scrutiny about the economic accuracy of the London Interbank Offered Rate ("LIBOR"), is not surprising. In the text that follows, one of the authors of a recent paper about LIBOR rate-setting adds a few comments.

"Thank you, Susan, for your October 15, 2008 coverage of our "Libor Manipulation?" research manuscript. As always, you succeeded in 'cutting to the heart' of a rather complex topic in your customarily succinct, yet engaging style. When your readers download and peruse our work, I would encourage them to focus on the manner in which we extend and elaborate on the analysis done by the Wall Street Journal. For instance, we were able to detect two specific dates in time that reflect structural 'breaks' in data patterns. One occurred shortly after (and doubtlessly occurred in response to) the publication of the Journal's announcement of its investigation. However, the other event occurred over eight months before the appearance of this announcement, and appeared to coincide with the publication of three relevant external news events that affected the industry. Your readers will find more information in our manuscript. We welcome readers' comments."

Submitted by Professor Michael Kraten, PhD, CPA, Sawyer Business School, Suffolk University