In the wake of the financial crisis, the Obama Administration and Democratic leaders in Congress are pursuing financial regulatory reforms intended to enhance transparency and accountability while restoring stability to capital markets. One focal point of this comprehensive effort is the creation of new regulation and oversight of over-the-counter (OTC) derivative transactions.
Over the past two weeks, the House Financial Services Committee and the House Agriculture Committee have both passed proposals to regulate major dealers of over-the-counter derivatives. To read the Financial Services bill, which the committee amended and passed along party lines on October 15, 2009, CLICK HERE. To read the Agriculture bill, which the committee amended and passed with bipartisan support on October 21, 2009, CLICK HERE. Under both proposals, major derivatives dealers would face new registration, record-keeping, and reporting rules; new capital standards; and new margin requirements. The proposals would also require many derivatives transactions to be cleared by a third-party clearinghouse or traded on a regulated exchange to provide enhanced transparency and reduce systemic risk.
After significant advocacy by individual business end-users as well as NAREIT and other trade associations that represent them, both bills provide exceptions from many of these requirements for transactions that include companies that use derivative products to hedge against specific commercial risks. For additional information on NAREIT's efforts, CLICK HERE.
Many REITs and other businesses rely upon low-cost, customized OTC derivative products - such as interest rate swaps, interest rate caps, forward starting swaps, and foreign exchange forward contracts - to mitigate risk and to manage the cost of development and operational activities. For example, many REITs have significant exposure to variable rate debt. Rather than carrying the interest rate risk inherent to this debt a REIT may choose to use derivatives products to lock in fixed interest rate payments while maintaining the flexibility and other benefits offered by variable rate debt.
NAREIT staff, with the guidance of the NAREIT Derivatives Reform Task Force, has been actively analyzing how the various OTC derivative reform proposals would impact REITs and publicly traded commercial real estate companies. NAREIT has also joined with the U.S. Chamber of Commerce, the National Association of Manufacturers, The Real Estate Roundtable and other associations to form the Coalition for Derivative End-Users. The Coalition has engaged with key members of Congress and their staff to ensure that policymakers understand the importance of low-cost customizable derivatives products for prudent risk management.
The Coalition has focused its efforts on three key issues. First, the Coalition has opposed proposals to force end-users to access derivatives products through exchange trading, which would limit customization and increase volatility on income statements and balance sheets. Second, the Coalition has expressed concern that significant amounts of working capital could be tied up if cash collateral is required by central clearing or bilateral margining requirements. Third, the Coalition has advocated that, to be most effective, capital requirements intended to contain systemic risk should be focused on major market participants, not on end-users.
In order to address concerns about systemic risk posed by OTC derivatives, the proposals passed by both the House Financial Services Committee and the House Agriculture Committee aggressively regulate the 85 to 90 percent of all derivative contracts that are transacted between major market participants. Among other things, these proposals would force exchange trading or central clearing and impose cash margin requirements for derivatives transacted between dealers or other entities which maintain derivatives positions significant enough to pose risk to the broader financial system.
In a victory for REITs and other end-users of derivatives, both proposals recognize that OTC derivatives are important risk management tools used by corporations in virtually all sectors of the economy by providing targeted exceptions for these transactions. Specifically, both proposals seek to impose the bulk of regulations on swap dealers and "major swap participants" as opposed to the business end-users that use derivatives for risk mitigation. Both proposals provide exemptions for certain foreign-exchange hedges. Additionally, both proposals would exempt derivatives transactions that include end-users from exchange trading and central clearing requirements - although the exemption is stronger in the Financial Services bill.
However, some concerns remain. For example, while the Agriculture Committee bill provides a clear exemption for end-users from bilateral margin requirements which could create a significant drain on working capital, the Financial Services Committee bill would provide regulators with the authority to impose margin requirements. And while the Financial Services Committee bill exempts end-users from the central clearing requirement, the Agriculture Committee bill would require end-users to first demonstrate to federal regulators that they can meet their financial obligations in order for a swap to be exempt from the clearing requirement.
With action completed in both the House Financial Services and Agriculture Committees, the two proposals must now be reconciled as a single bill before it will be brought before the entire House for a vote. This vote may occur as early as November. In the Senate, where attention has been focused on health care reform, the schedule for action is less clear.
NAREIT staff will continue to work with the members of the NAREIT Derivatives Reform Task Force, the Coalition for Derivatives End-Users and others to educate policymakers and advocate for the continued availability of these important risk management tools.