Dodd-Frank Act to have broad impact, add to hedging costs, sources say

By Emma Trincal

New York, July 20 - The Dodd-Frank Wall Street Reform and Consumer Protection Act expected to be signed into law by the president this week will modify some of the rules under which structured products sellsiders and brokers do business in the United States and associated costs, sources said.

However, many of the changes will take place over time, indirectly and, in some cases, in little steps, they noted.

Broad, indirect impact

The act's consequences are indirect but sure to be felt since its far-reaching changes will impact primarily financial institutions, which are the main players in the structured products market, several lawyers at Morrison & Foerster said during a conference call the law firm sponsored prior to the Senate vote on Thursday as well as through recent interviews with Prospect News.

"The new legislation will have a broad impact on structured products and the derivatives market," Keith Styrcula, chairman of the Structured Products Association, said in an e-mail.

The new rules governing derivatives and swaps that create mandatory clearing requirements are seen as being the measures that will impact the industry the most.

More costly hedges

"The act does not regulate structured products. Yet it will have a strong impact on the structured products industry as it will significantly increase the cost of hedging exposures," David Trapani, counsel at Morrison & Foerster, told Prospect News.

The new regulation of the over-the-counter derivatives market will require many derivatives trades to take place on exchanges or similar electronic systems and be routed through clearinghouses.

"To the extent that issuers hedge through derivatives, the act will indirectly affect issuers' ability to hedge because it will increase their cost," Trapani added.

Clearing exemptions

Some swaps will be exempt from the clearing requirement if one of the parties to the swap is not a "financial entity" but a "commercial end-user" that uses swaps to hedge or mitigate commercial risk, Trapani said.

Financial entities include dealers, swap dealers, major swap participants, commodity pools and certain private funds, he explained.

"To the extent that the issuers deal with a commercial hedger, they won't have to clear unless the end-user opts out," Trapani said.

But even the commercial end-users exemption is unlikely to make a "meaningful difference" for issuers in terms of costs, he noted.

That's because even if a swap is exempt from the new clearing rule, hedging costs will remain higher in the new regulatory landscape, Trapani said.

"The act would impose new capital requirements, which will increase hedging costs no matter what," said Trapani. "Just because it doesn't clear doesn't mean it's not costly. Whether you're dealing with cleared or non-cleared swaps, the act will lead to higher hedging costs for issuers of structured products."

Some market participants predicted that banks may have to transfer some of their riskiest swaps to affiliates. Such transfers may prevail more for commodities-linked deals than for interest rates swaps, some said.

Overall, most agreed that hedging will be considerably modified once the first derivatives rules get implemented.

"The act is likely to have a profound impact on certain aspects of the structured products business," Styrcula said in the e-mail.

"We're looking closely at the concept of hedges on structured products being deemed proprietary trading, which we'd raised as a concern a year ago with Congressional staffers."

Fiduciary duty

The Dodd-Frank Act will not just affect issuing banks but also broker-dealers and the way deals are sold to retail investors.

"The financial reform is expected to have broad implications for the offering of structured products," Styrcula said.

The act contains a number of provisions aimed at increasing investor protection. One of the top ones is to give the Securities and Exchange Commission the mandate to conduct a study and issue a report to Congress within six months of enactment in order to decide whether it makes sense to submit brokers to the same standard that currently applies to financial advisers.

The act "empowers the commission to make a final decision whether to impose a fiduciary duty on broker-dealers," Anna Pinedo, partner at Morrison & Foerster, said in an e-mail.

Lawyers would not comment on the implications for the industry of an eventual new fiduciary standard for brokers.

But in an e-mail to Prospect News, Styrcula said, "The fiduciary standard is well-intentioned but is likely to have a chilling effect on wealth managers. It may cause professionals to be overly conservative and not take strategic steps to reduce risk in portfolios using all available investment strategies."

A KID maybe

The act also grants the SEC rulemaking authority to require broker-dealers to provide retail investors with specific documents or information prior to the purchase of an investment product or service, lawyers at Morrison & Foerster said.

For instance, the SEC may require that certain documents or information be delivered by broker-dealers when conducting sales.

"The recent initiative in Europe called 'Key Information Document,' or 'KID' - a simplified prospectus with a new disclosure document - may be a model for regulators considering point of sale disclosure requirements," said Pinedo.

She noted that the European initiative is designed to help investors get familiar with products over time and to facilitate product-by-product comparisons.

Exclusion of residence

The act also requires the SEC to modify the definition of accredited investor.

Excluding the value of a person's residence from the net worth test represents one of the main changes, sources noted.

"Going forward, in calculating net worth, an individual may no longer count the value of his primary residence," Pinedo said.

Although the SEC has the authority to periodically adjust the dollar threshold, the $1 million in net worth threshold will remain unchanged for the next four years, according to the act.

'Hundreds of rulemakings'

Most observers noted that it may be difficult to predict the immediate impact and possible additional costs of the Dodd-Frank Act.

"The ultimate scope of the act's provisions will be unclear for quite some time, as it either directs or permits the SEC, the Commodity Futures Trading Commission and the Federal banking regulators to undertake hundreds of rulemakings," Pinedo said.

In some areas, such as the regulation of swaps and derivatives, both the SEC and the CFTC are required to work closely together to implement rules, she noted.

"The law gives regulators a lot of leeway to implement new measures," Pinedo said.

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