The saga involving the proposed regulation of over-the-counter derivatives, as covered in this post from last month, continues.

For several weeks, Senator Christopher Dodd (D., Conn.) has been expected to introduce a bill that addresses several of the stickier issues surrounding OTC derivatives. Over the past month, he has been working with Senator Bob Corker (R., Tenn.) to come up with a bipartisan plan. Other legislators who’ve been working on the bill are Jack Reed (D., Rhode Island) and Judd Gregg (R., New Hampshire).

The most contentious issue continues to revolve around “the end user exemptions,” says Luke Zubrod, director of U.S. public real estate advisory practice with Chatham Financial, a consulting firm specializing in managing interest rate and foreign exchange risk. That is, will businesses that use derivatives to hedge their risks be treated differently than financial institutions that participate in the market to a much greater extent?

Most corporate finance folks, not surprisingly, hope that this is the case. Otherwise, they may find that they have to move all their derivatives transactions to exchanges, as well as post collateral on their trades.

While these changes are designed to reduce the risks inherent in the transactions, they also would significantly boost the costs of using derivatives, Zubrod notes. Today, many companies can execute unsecured trades using their own creditworthiness. Or, they may be able to secure a transaction using collateral that’s less liquid, such as property.

Under some of the legislation that’s being considered, however, companies would have to secure all derivatives transactions with cash or highly liquid securities, such as U.S. Treasuries. Zubrod uses a $100 million, 5-year interest rate swap to show the possible costs; interest rate swaps account for more than half of all OTC derivative transactions, he adds. A $100 million swap would require cash collateral of about $2.5 million, or 2.5 percent of the notional amount of the trade. In addition, companies would have to post a variation margin to cover the potential downside to the transaction. The variation margin on a 5-year swap typically comes to about $5 million for every percent that rates decline. So, if a company locked in a 5 percent rate and rates later fell to 3 percent, it would have to come up with $10 million for the variation margin, along with the $2.5 million in collateral.

“Companies would have to weigh the risk that they could have a significant drain on their working capital,” versus the risk that they’re actually trying to hedge against, Zubrod notes. Some may decide it makes more sense not to hedge and keep their cash free.

At the moment, it appears that broad support exists for applying these proposed regulations to swap dealers and major participants in the derivatives market, rather than business end users. The question remains: Who should be defined as a business end user and exempt from these regulations? Most of the proposed regulations considered three criteria in determining this, Zubrod says: the size and trading activity of the entity; whether it is hedging or speculating; and the type of business in which it’s involved.

While these criteria are designed to cover organizations that are speculating with derivatives, it’s possible that nonfinancial firms also could get caught up in them, Zubrod notes. In particular, larger firms and those with captive finance units would be most vulnerable, says Sam Peterson, consultant in the government regulatory advisory practice with Chatham.

What can CFOs and treasurers do? Continue to “reach out to your senators with support for strong end-user exemptions,” says Zubrod. “It’s not too late.” ###