An interpretation of the “hedge
or mitigate risk” criteria and the
impact to compliance with the
Dodd-Frank Act
Contents
I. Introduction 3
II. Meeting the “hedge or mitigate commercial risk” (“HMCR”) criteria4
Qualifies as a bona fide hedge (BFH) under the Commodity Exchange Act (CEA) Rules
6
Qualifies for hedge accounting treatment under ASC 815/GASB 53 8
Economically appropriate to the reduction of risks in the conduct and management of a
commercial enterprise
10
III. Application framework14
IV. Conclusion
15
Appendix A: Referenced rules and statutory language16
Note 1
16
Note 2
16
Note 3
17
Contacts
2
19
I. Introduction
The Dodd-Frank Act (“the Act”) was the primary federal policy response to the financial disruption that affected the world
economy in 2008. The Act was passed in July 2010, and included in its many provisions was Title VII, which addressed
derivative activity. The energy industry, which uses derivatives to manage commodity price risk, is impacted by the provisions
within Title VII.
The Act authorizes and directs the Commodity Futures Trading Commission (“CFTC”) to extend its regulatory oversight to
over-the-counter derivatives and swaps. For more than two years, the CFTC has worked to build a regulatory framework to
oversee derivative/swap trading and regulate the entities subject to the Act once this law is implemented.
The purpose of this whitepaper is:
• To provide an organized discussion of the relevant potential implications of having swaps activities meet the various
definitions of hedging activity
• To explore the types of activities that entities may assert are hedging activities within the rules published by the CFTC1
This paper proposes a framework for consideration in implementing the hedging-related rules established by the CFTC (“our
framework”), and discusses relevant potential implications and practical applications of specific rules approved or proposed
by the CFTC addressing hedging. The paper primarily focuses on the concept of hedging or mitigation of commercial
risk (“HMCR”) activity, which is a term used to determine certain entity-level definitions and qualification of individual
transactions for the end-user exception to clearing.
Within the discussion of the application of HMCR, we address three separate methods by which an entity can determine
that an activity is hedging or mitigating commercial risk according to CFTC guidance. These methods are:
• Bona fide hedges (BFH) for determining the classification of an entity and taking an end-user exception
• Hedges that qualify for hedge accounting under United States Generally Accepted Accounting Principles (“GAAP”)
• Transactions/hedges that are “economically appropriate” to the mitigation of commercial risk
1 The final CFTC rule concerning position limit reporting has been ruled invalid by the judicial courts and must be revisited by the CFTC. Because of
that decision, the impact from the position limit reporting rules will not be discussed herein.
An interpretation of the “hedge or mitigate risk” criteria and the impact to compliance with the Dodd-Frank Act
3
II. Meeting the “hedge or mitigate commercial risk”
(“HMCR”) criteria
The CFTC Dodd-Frank rules include two specific rule making areas in which HMCR is an important component for
compliance:
(1) Entity classification2 – the final entity classification rule allows transactions for hedging or mitigating commercial risk to
be excluded from the notional value calculation used to determine if an entity is classified as either an swap dealer (SD)
or major swap participant (MSP)
(2) End-user exception3 – a swap that qualifies for this exception is not required to be centrally cleared. This exception is
not available to financial entities, which includes both SDs and MSPs4. Additionally, the CFTC rules state that there is
a difference in what hedging activity may be excluded in the SD and MSP entity classification calculations versus what
hedging activity may qualify for the end-user exception
A transaction may qualify for HMCR treatment by meeting any one of the following criteria5 6:
• Qualifies as a BFH under Commodity Exchange Act (“CEA”) rules
• Qualifies for hedge accounting treatment under ASC 815/GASB 537
• “Is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise”8
The graphic on the opposite page presents a framework to analyze individual transactions under the HMCR criteria, and
the corresponding impact to the entity classification calculations and end-user exemption analysis. Due to swap dealers
and major swap participants not being able to claim the end-user exception to clearing, an entity must know its entity
classification before it can appropriately claim the exception. Prior to performing the calculations required to conclude on its
entity classification, an entity must understand the impact of individual transactions. As such, this framework begins with a
transaction level analysis.
• Process 1 addresses consideration as to whether individual swap transactions will qualify as HMCR as either a BFH, an
ASC 815 hedge, or an economically appropriate hedge. A transaction may meet more than one HMCR criterion, but at
least one must be met for the transaction to be considered HMCR.
• Process 2 demonstrates the impact of a transaction considered HMCR vs. not considered HMCR on the entity
classification analyses.
• Process 3 demonstrates how the election to apply the end-user exemption to clearing is dependent upon the results of
the HMCR analysis performed in Process 1 and the entity classification results of Process 2. Finally, proper documentation
is required for the election to be effective. Unlike the HMCR analysis in which only one criterion must be met, the enduser analysis requires that all three criterions within Process 3 be met before the end-user exception may be claimed.
2 Refer to Appendix A, Note 3
3 Refer to Appendix A, Note 1
4 Note that the CFTC rules state that there is a difference in what hedging activity may be excluded in the SD and MSP entity classification
calculations vs. what hedging activity may qualify for the end-user exception.
5 Refer to Appendix A, Note 2
6 Federal Register/Volume 77, pg. 30750
7 Accounting Standards Codification (www.fasb.org) and Government Accounting Standards Board (http://www.gasb.org/st/summary/gstsm53.html)
8 Federal Register/Volume 77, pg. 30750
4
Transaction level process flow for entity-level classification and end-user analysis
Process 1:
HMCR
{Transaction-specific analysis}
Process 2:
Financial entity definition
{Entity-specific analysis}
2(a): MSP analysis
Qualifies as a “bona fide”
hedge under Commodity
Exchange Act (CEA)?
Yes
Is Swap contract HMCR?
Yes
Exclude from
MSP analysis
Yes
Exclude from
SD analysis
Yes
Exclude from
SD analysis
No
No
Qualifies for hedge
accounting under
ASC 815/GASB 53?
Yes
Include in
MSP analysis
HMCR**
2(b): SD analysis
Is Swap contract
a bona fide hedge?
No
Economically appropriate
to hedge or mitigate
commercial risk?
No
Yes
Does Swap contract fail
to meet bona fide hedging
due to a tenor exceeding
12 months? (note 1)
No
Not HMCR
No
Include in
SD analysis
**Impacts entity-level analysis (refer to process 2) and
end user exemption to clearing (refer to process 3)
Process 3: End-user exemption to clearing
Consider
entity eligibility*
Eligible
Consider
transaction
eligibility**
Eligible
For qualifying swaps,
prepare HMCR
documentation
Notify SD/MSP/SDR of
election to apply end use
exemption to clearing
*Note that SD & MSP are not eligible for end-user exemption (refer to process 2)
**Note that only transactions that meet one of the HMCR criteria above (refer to process 1) are eligible for the end-user exemption
Note 1: Swaps which can be excluded from the SD definition are different than those that can be excluded from the MSP definition (as shown
above). One interpretation would be that swaps which can be excluded from the SD definition would encompass all swaps meeting the BFH
definition, and all swaps that would otherwise meet the bona fide hedge definition had they not exceeded the 12 month time horizon9.
9 See CFTC discussion of swaps that should be excluded from the SD calculation in Federal Register Volume 77, pg. 30612.
An interpretation of the “hedge or mitigate risk” criteria and the impact to compliance with the Dodd-Frank Act
5
Qualifies as a bona fide hedge (BFH) under the Commodity Exchange Act (CEA) rules
Bona fide hedging has several differing definitions within the CFTC rulemaking areas. This section of the paper focuses on
the bona fide hedge definition per the Commodity Exchange Act (“CEA”) as applied in the entity classification and end-user
exception rules. Section § 1.3 [Revised] of the CEA requires that “transactions and positions for excluded commodities” be
included within the definition of a bona fide hedge.
A three prong test can determine if a transaction meets the definition of a BFH (all three prongs must be answered in the
affirmative for the transaction to qualify as a BFH):
1. The transaction represents a substitute for a physical position typically made or forecasted to be made
2. The transaction is economically appropriate to the reduction of risks
3. The transaction qualifies as an “enumerated” hedge, as defined below (entities wishing to use “non-enumerated”
hedges must request approval from the CFTC)
Given the strict guidelines concerning the definition of a BFH, it is important to understand the explicit limitations expressed
within the CEA. The final rule defines BFHs as “… any agreement, contract or transaction…, where such transaction or
position normally represents:
• A substitute for transactions to be made or positions to be taken at a later time in a physical marketing channel
• And where they are economically appropriate to the reduction of risks in the conduct and management of a
commercial enterprise
• And where they arise from:
– (i) The potential change in the value of assets which a person owns, produces, manufactures, processes, or
merchandises or anticipates owning, producing, manufacturing, processing, or merchandising,
– (ii) The potential change in the value of liabilities which a person owns or anticipates incurring, or
– (iii) The potential change in value of services which a person provides, purchases, or anticipates providing or
purchasing.
– (iv) Notwithstanding the foregoing, no transaction or position shall be classified as bona fide hedging unless their
purpose is to offset price risks incidental to commercial cash or spot operations and such positions are established
and liquidated in an orderly manner in accordance with sound commercial practices and, for transactions or
positions on contract markets subject to trading and position limits in effect pursuant to section 4a of the Act…”10
The CFTC addresses the overlap of BFHs versus economic mitigation of risks by making BFHs more difficult to achieve
(because in addition to being economically appropriate, a BFH must meet the other two criterions above).
The CFTC rules and commentary illustrate what could qualify as a BFH based on the definition above. The table on the
opposite page lists the five specific types of transacting activities specifically allowed for under the rules (referred to as
enumerated hedges within the rules) and an example that could be interpreted from the language of each activity:
10 Federal Register Volume 76, pg. 71683
6
CFTC Enumerated Hedges11Example
1) Sales in quantities not to exceed owned or fixed
price purchased assets, and up to 12 months unsold
anticipated production of a commodity as long as it
is not entered within the last five trading days of the
month.
Financial hedges of forecasted sales of production or
forecasted sales of assets expected to be purchased at a
fixed price within 12 months. For example, forecasted sales
from a power generation facility within the next 12 months.
2) Purchases in quantities not to exceed fixed price
sales of cash products or by-products of the same
commodity, up to 12 months unfilled requirements
of the commodity for processing or manufacturing
as long as it is not entered within the last five days of
the month.
Financial hedges of forecasted purchases used in production
or forecasted purchases of assets for a fixed priced sale
within 12 months. For example, forecasted gas purchases
for a gas fired power generation facility within the next 12
months or forecasted power purchases to serve fixed price
retail load blocks won at auction.
3) Offsetting sales and purchases of the same
commodity that do not exceed the volumetric
quantity bought and sold at unfixed prices basis
different delivery months as long as it is not in the
last five days of the month.
Financial hedging of price risks associated with contracted
physical index purchases and sales for different months. For
example, assume an entity executes a crude purchase and
sale agreement whereby an entity will purchase crude at the
prevailing market rate in June and sell crude at the prevailing
market rate in November. Swaps executed to economically
hedge the purchase price in June and the sale price in
November would meet this exception.
4) Purchases and sales entered by an agent in which
the agent has an agreement in place with the person
who owns the asset being hedged.
Agents who both manage the physical scheduling of a
commodity and the execution of hedges for another entity.
For example, a power co-op managing physical price risk
that schedules and executes transactions with the market on
behalf of its member end-users.
5) Hedging of the items in (1)-(4) above as long as
Cross commodity hedges that are economically appropriate
they are not in the same quantity and commodity
to the price risk an entity is exposed to. For example,
provided that the change in fair value of the hedge
executing a natural gas swap to hedge a power exposure
substantially relates to the change in fair value of the or executing a crude oil swap to hedge a natural gas liquids
item being hedged.
exposure.
Non-Enumerated hedges not included within the enumerated section of the standard above must be submitted to the CFTC
for review and approval12.
Within the energy industry, the most common types of transactions likely to qualify as BFHs as defined by the CEA would
be up to 12 months of anticipated purchases or sales as explained in 1 and 2 above. However, it is common within the
industry to have contracts that surpass 12 months of anticipated purchases or sales. Based on a strict reading of the rules,
these would not qualify as a BFH under the CEA’s definition. As such, when determining an entity’s classification and the
applicability of the end-user exception, contracts settling greater than 12 months from inception would not meet the
definition of a BFH and would not qualify for the end-user exception (unless the contracts met the
11 Federal Register Volume 76, pg. 71684
12 Federal Register Volume 76, No.223 pg. 71684
An interpretation of the “hedge or mitigate risk” criteria and the impact to compliance with the Dodd-Frank Act
7
definition of one of the other two exceptions defined below). If the only characteristic preventing the trade from meeting
the BFH definition per the CEA is that the tenor of the trade exceeds the 12 month time horizon, it appears the transaction
could be excluded from the SD analysis.
Qualifies for hedge accounting treatment under ASC 815/GASB 53
ASC 815 (previously SFAS 133) provides the requirements for hedge accounting within U.S. GAAP. GASB 53 provides hedge
accounting requirements, which are similar to ASC 815, for government entities. As such, ASC 815 will be referred to for
the remainder of this document.
Hedge accounting is an election within U.S. GAAP that allows for the recognition of income/expense associated with a
derivative instrument to more closely match the economics of the relationship between the hedge instrument and the
hedged item. This election is allowed to be made only if certain criteria are met.
Criteria to elect to apply hedge accounting
Each type of hedge accounting that can be elected under ASC 815 Derivatives and Hedging requires that all of the
following criteria be met:
• Hedge Accounting/Risk Policy: The entity must have an overall hedge accounting and risk policy that details the
circumstances under which hedge accounting will be applied and how it will be applied. While hedge accounting
guidance requires specific calculations, the manner in which the calculation is performed is often flexible to the needs of
the hedge relationship.
• Hedge Documentation: As hedge accounting is an election, contemporaneous documentation of the election is
required prior to applying hedge accounting. In addition to documentation, cash flow hedges need to be supported
by the representation that a forecasted transaction is probable of occurring. Commonly, a test is used to determine the
probability of the hedged item occurrence by comparing actual hedged item results to forecasted hedge item results.
This analysis supports an entity’s ability to adequately forecast that the hedged item is probable of occurring.
• Hedge Assessment: A hedge assessment is a calculation that must be measured against certain standards. This
calculation tests if the hedge relationship has been effective in offsetting changes in fair value/cash flow of the hedged
item and is expected to be effective in the future. The calculation results in determining whether hedge accounting can
be applied or hedge accounting cannot be applied. This assessment is required to be performed at the inception of the
hedge relationship and at least quarterly during the life of the hedge relationship.
• Hedge Measurement: The hedge measurement calculation determines the actual dollar amount of ineffectiveness in
the hedge relationship and is recorded as an adjustment to current earnings.
Given these eligibility, documentation, and ongoing assessment requirements, the term “qualifies for hedge accounting”
raises several questions.
“Qualifies”
The term used within the CFTC rules is “qualifies”13. This term raises a question as to if the transaction only needs to
meet the requirements for hedge accounting, not necessarily to be actually receiving hedge accounting in the financial
statements. A reasonable interpretation of the “qualifies” language could be that a transaction only needs to meet the
requirements for hedge accounting, not actually be in an active hedge relationship for financial statement purposes.
13 Federal Register Volume 77 No. 139, pg. 42590
8
While ASC 815 requires each of the items mentioned above to apply hedge accounting, a reasonable interpretation
could be that all items are required to meet the “qualifies” criterion. We note that the CFTC comments in the final rules
concerning the MSP definition14 (and by corollary, the end-user exception) do not explicitly require hedge assessments
or documentation15. However, that commentary was in reference to the overall HMCR exception, and not specifically
addressing to the ASC 815 criteria. To meet the “qualifies for ASC 815” criterion within the HMCR exception, a reasonable
interpretation could be that the following items would be needed:
• Hedge Accounting/Risk Policy: As hedge accounting is an election, so too is the HMCR exception. As such,
contemporaneous hedge accounting/risk policy documentation is required.
• Hedge Documentation: As hedge accounting is an election, so too is the HMCR exception. As such,
contemporaneous hedge documentation is required. This hedge documentation should provide support concerning the
probability of the forecasted transaction actually occurring, which the individual financial instrument is hedging.
As noted above, a reasonable interpretation could be that a transaction may “qualify” for hedge accounting for the
Act, but not actually receive hedge accounting within the financial statements. As such, it will be critically important to
distinguish in the hedge documentation the specific purpose of the documentation: qualification for hedge accounting
under the Act, application of hedge accounting in the financial statements, or both.
• Hedge Assessment: An assessment calculation is required prior to the application of hedge accounting. By default, a
transaction cannot qualify for hedge accounting unless a hedge assessment is performed prior to the election.
Note that the one item that a reasonable interpretation could determine to not be required is a hedge measurement
calculation. The hedge measurement calculation is not performed at the inception of a hedge relationship, but is
instead performed periodically after inception to measure the actual dollar amount of hedge accounting ineffectiveness
in the relationship. Because it is not required to support the inception of hedge accounting relationship, a reasonable
interpretation could be that it is required for purposes of HMCR qualification under the Act.
Inception vs. ongoing maintenance
A key question associated with meeting HMCR criterion via “qualifies” for hedge accounting method would be determining
what would happen if hedge accounting would no longer be appropriate? This can happen within the energy industry for a
variety of reasons, which may include the following:
• Commodity prices can diverge such that previously assessed commodity relationships meeting the requirements for
hedge accounting no longer qualify
• Business operations may change such that forecasted transactions previously believed to be probable, no longer are
• The pricing mechanism of the hedged item changes such that the hedge instrument is no longer highly effective
In these situations, traditional hedge accounting for these transactions must be discontinued.
We noted the following guidance within the CFTC rules and ASC 815 literature concerning ongoing monitoring
and assessment:
• Transactions elected for the end-user exception must be documented at inception, however the CFTC has commented
that documentation is not required for the HMCR exception for entity classification16.
14 As indicated previously, the SD definition does not specifically reference ASC 815 hedges.
15 Federal Register Volume 77 No. 100, pg. 30676
16 Federal Register Volume 77 No. 100, pg. 30676, and No. 139, pg. 42572
An interpretation of the “hedge or mitigate risk” criteria and the impact to compliance with the Dodd-Frank Act
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• The CFTC indicated that ongoing effectiveness testing is not required for the HMCR exception17 within the entity
classification rule or for qualifying for the end-user exception to clearing18. However, the CFTC did indicate that the
economically appropriate designation should be continuously monitored to ensure reasonableness of the exception19.
• SD and MSP classifications must be monitored on an ongoing basis (quarterly).
• ASC 815 requires both contemporaneous hedge documentation at inception of the hedge relationship and ongoing
hedge assessments to support the continued application of hedge accounting.
Based on the above observations of the CFTC rules, a reasonable interpretation could be the following:
• For MSP classification, because there is an ongoing monitoring requirement related to determining if entities have
tripped the requirements of the rule, each transaction should continue to be monitored to ensure that it qualifies for
economic appropriateness.
• For MSP classification, instruments meeting the HMCR exception under the hedge accounting criterion should continue
to meet hedge accounting requirements. Hedge assessments would continue to be performed to support both the
designation of new transactions and the continued designation of existing transactions.
• These requirements do not exist within the end-user exception.
Recent trends
The Financial Accounting Standards Board (“FASB”) has recently released an exposure draft (a proposed change to
accounting standards) to simplify hedge accounting20. This exposure draft has focused on many areas, but one of the most
significant changes was the loosening of hedge accounting assessment requirements from “highly effective” as required in
current U.S. GAAP to “reasonably effective” in the proposed exposure draft. “Reasonably effective” was intentionally not
defined within the exposure draft to allow for entities to qualitatively support hedging relationships. It is expected that only
in rare circumstances would a quantitative analysis be required to support the assertion of “reasonably effective” hedge
relationships.
This change could potentially allow for more relationships to qualify for hedge accounting under proposed amendments
to U.S. GAAP. Consequently, more transactions would qualify for the end-user exception for clearing and be excluded from
the MSP notional value calculation. This change would appear to align with the thinking of the CFTC, as the definition of
HMCR has also been left intentionally undefined. As such, a reasonable interpretation would be that the proposed change
in hedge accounting requirements would change the requirements of entities in applying the HMCR criteria although it has
the potential to allow additional transactions to be excluded from the clearing requirement.
Economically appropriate to the reduction of risks in the conduct and management of a
commercial enterprise
This section will discuss swaps deemed to be economically appropriate to the hedging or mitigation of risk. This subcategory of HMCR encompasses a broader scope of transactions than those envisioned under bona fide hedging (which,
for example has limits on the tenor for anticipatory hedges) or under ASC 815 (which has strict criteria in the assessment of
the degree of offset as being “highly effective”21 and limits what types of risks may be identified and designated as being
hedged). As noted in the CEA22, a swap is deemed to be HMCR when “such a position is economically appropriate to the
reduction of risks that are associated with the conduct and management of a commercial enterprise.”
17
18
19
20
21
22
10
Federal Register Volume 77 No. 100, pg. 30680
Federal Register Volume 77 No. 100, pg. 45275
Federal Register Volume 77 No. 100, pg. 30680
http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1175801889654
ASC 815-20-25-75
See Appendix A, Note 2
This section will first consider the term “economically appropriate” and will then consider the following additional phrase
used in the definition of HMCR23: “Such position is:
(1) Not held for a purpose that is in the nature of speculation or trading
(2) Not held to mitigate the risk of another… swap position, unless that other position is itself held for the purpose of
hedging or mitigating commercial risk as defined by this section…”
Speculation vs. economically appropriate…
Speculation or trading is often an arbitrary term within the energy transacting industry. Activities that are interpreted as
economic optimization by some entities could be viewed as speculating by others. The CFTC has described speculation,
investment or trading as activities involving swap positions “held primarily to take an outright view on market direction,
including positions held for short term resale, or to obtain arbitrage profits”24. While the CFTC agrees that there is a fine line
between speculating and economic hedging25, such a distinction must be made.
A reasonable interpretation would be that “economically appropriate” in this context is addressing the ability of the swap to
offset the cash flow or fair value risk of some identified risk related to an entity’s business. Several examples of swaps were
used by the CFTC within the position limit reporting final rule to incorporate considerations of “economically appropriate”26.
In these examples, two factors are repeatedly considered: 1) from a volumetric perspective the quantity of swaps does not
exceed the quantity of risk held by the entity; and 2) from a value perspective, the value change to the swap resulting from
an underlying price movement is offsetting the value change in the risk driven by the same pricing change.
In the context of transacting a swap to offset a risk related to an entity’s operations, such as the output of a plant or
facility operated by the entity, the consideration of quantities appears relatively straightforward when contrasted against
the diverse number of discretely priced energy products or commodity grades are used in many entities’ risk mitigation
programs.27 How an entity is to determine whether the swap achieves an acceptable degree of offset to the risk it is meant
to hedge or mitigate is not specified in detail. A reasonable interpretation of such consideration would rely on qualitative
understanding relevant to the markets, products and risks being used or hedged. If the CFTC had considered that an
absolute threshold was necessary, appropriate, and relevant to all instances, a reasonable interpretation would be that one
would have been incorporated into the rulemakings. Instead, the CFTC left the term undefined. A reasonable interpretation
would be that a qualitative assessment would allow for consideration of facts and circumstances that are relative to each
unique HMCR situation.
Challenges in applying “economically appropriate”
There are gray areas that may warrant consideration in the application of the “economically appropriate” test. For example,
one may view that the requirement that a swap mitigates commercial risk is a determination that is made in the context of
whether a swap is more likely to mitigate the overall risks to a commercial enterprise or more likely to create overall risk to
a commercial enterprise. A proponent of this view would likely deem a swap to qualify as “economically appropriate” if it
were “more likely than not” to mitigate risks to the enterprise (i.e., a greater than 50% degree of offset).
Alternatively, one may consider the individual swap in the context of the identified risk that it is meant to hedge or mitigate
and determine that the swap does address the risk in question (without regard for other risks brought about by the swap
instrument). An example of this would be the use of a crude oil swap to mitigate the risk associated with a forecasted
23
24
25
26
27
Federal Register Volume 77 No. 139, pg. 42591
Federal Register Volume 77 No. 100, pg. 30676
Federal Register Volume 77 No. 139, pg. 42573
Federal Register Volume 76 No. 223, pg. 71696
Federal Register Volume 77 No. 100, pg. 30673
An interpretation of the “hedge or mitigate risk” criteria and the impact to compliance with the Dodd-Frank Act
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y-grade (economically representing a basket of natural gas liquids) purchase. Such a swap would have cash flows impacted
by changes in the benchmark crude oil index. In the context of the identified risk being hedged (i.e., the basket of natural
gas liquids), consideration would be given to the correlation between crude oil and natural gas liquids prices, such that
crude oil may not be deemed an effective hedge for all natural gas liquids products at all times. Accordingly, in the context
of overall risks to a commercial enterprise, one may view that the crude oil index risk created by the swap introduced
risk (as no inherent crude oil risk was identified related to the entity’s business), but may have also mitigated a portion
of an identified risk. With such a view, the example would require judgment from the entity applying the “economically
appropriate” test.
Challenges in applying the hedge and mitigate commercial risk exception
As indicated by the lengthy comment process on the entity definitions and commentary by the CFTC, the application of the
HMCR exception will likely be challenging. Even the hedge accounting prong of HMCR taken from ASC 815, which provides
objective standards for the application of hedge accounting, contains items that could be considered subjective. We note
the following areas as some of the challenges:
Application of ASC 815
The application of ASC 815 would appear to be the most defendable prong in regards to the HMCR exception. It provides
the most objective standards that have been established and recognized by existing regulatory and rule making entities
(Securities and Exchange Commission, Financial Accounting Standards Board, Governmental Accounting Standards Board,
etc.).
However, we expect that the ASC 815 prong will be the most onerous to meet due to the documentation requirements and
effectiveness testing requirements. In addition, a reasonable interpretation would be that transactions should continue to
be subject to ongoing effectiveness testing, which could threaten the ongoing use of HMCR.
Additionally, ASC 815 does not provide for a singular standard in regards to the application of hedge accounting. This
flexibility appears intentionally written into ASC 815. Thus, transactions hedging the exact same risk may result in different
ASC 815 accounting conclusions depending upon an individual entity’s derivative accounting policy documentation and
hedge assessment methodology. In addition, speculative activities may qualify for hedge accounting in certain situations28.
As speculative activities are specifically exempted from the HMCR exception, while likely to be a rare situation, this potential
allowance of hedge accounting under ASC 815 would appear to contradict the intent of the CFTC.
“Economically appropriate”
The application of the “economically appropriate” criterion appears to be a subjective prong to meeting the HMCR
criterion, and thus could be challenged by regulators and auditors. As noted above and by the CFTC, there is a fine line
between speculation and “economically appropriate” hedging activities. As noted in the final published rule on entity
classification, the CFTC intentionally left judgment29 within the “economically appropriate” definition. While these risks are
limited to the six risks defined by the CFTC within the hedge or mitigate risk definition, these risks are broadly defined such
that most commercial risks will be covered.
We note the certain transacting strategies common to the industry may cause concern. While many entities may execute a
single transaction to hedge forecasted purchases or sales, many other entities employ a dynamic strategy that results in an
28 Per EITF 02-03 “A derivative held for trading purposes may be designated as a hedging instrument, prospectively, if all of the applicable criteria
in Statement 133 have been met.”
29 Federal Register Volume 77, No 139, pg. 42572
12
entity transacting multiple times based on their “view of the market.” Different individual strategies may exist, but each is
associated with replacing a single executed hedge with a subsequent offsetting hedge and a new hedge, often referred to
as optimization.
The following examples illustrate different scenarios within the energy industry that may be considered “economically
appropriate” mitigation of risk by certain entities or speculation by others:
• A refining operation anticipates future purchases of 10,000 barrels of oil in December. In January, the refiner transacts a
swap to purchase 10,000 barrels of crude for December delivery at a fixed price. In February, the refiner decides to reexpose its operations to crude oil price risk and executes an offsetting swap for 10,000 barrels of crude for December
delivery. Further assume that in March the refiner chooses to re-hedge its December exposure and enters into a third
swap; again to fix the price of 10,000 barrels of crude for December delivery.
• A refining operation produces jet fuel. The refiner anticipates the production and sale of jet fuel in three years’ time;
however no such contract readily exists that allows the refiner to fix the future price of jet fuel. Instead the refiner
enters into a crude oil swap and determines that such a swap is “economically appropriate” to the mitigation of its
future sale of jet fuel because jet fuel is a product made from the refining of oil. Consider further that subsequent to the
transaction, a jet fuel product becomes available in the financial markets. With the intention of identifying a swap better
suited for its risks, the refiner enters into an offsetting crude swap and also executes a swap to fix its future sales price
of jet fuel.
• An electricity generator seeks to mitigate power price risks related to the anticipated production and sale of 100
megawatt hours (“MWH”) of power in 2015. The only readily available electricity products in the market would be
“calendar strip” transactions (those that call for an equal amount of power to be delivered throughout the calendar
year, at the same fixed price); therefore the generator transacts a swap for 100MWH at a fixed price, for delivery in
2015. In the year 2014, the market now has products readily available for each month or quarter of the year 2015.
The generator enters into a second “calendar strip” swap for 100MWH to offset its initial swap. The generator then
executes several additional swaps for varying quantities in each month or quarter in 2015. The purpose of each swap is
to more closely match the executed hedge instrument to the load profile against which the entity must deliver power.
• An electricity generator seeks to mitigate power price risks related to the anticipated production and sale of 100
megawatt hours of power in 2013. Due to the relatively near term of the forecast, the market has products available
for each month of 2013, and thus the generator executes individual monthly financial contracts to hedge forecasted
production for each month. Due to a forecasted decline in generation due to demand reduction, the generator
executes offsetting contracts to lower the amount of net financially hedged forecasted generation. This net position is
then adjusted subsequently based on forecasted generation shifts.
Each potential scenario had an original instrument to mitigate a risk, a second offsetting instrument to re-open the risk,
and a third instrument to re-mitigate the risk. However, each scenario was different as to the reasons each instrument was
executed. Questions that these scenarios raise include: Do all of these transactions meet the “economically appropriate”
threshold? Does only the original transaction meet the threshold? Do only the first two meet the threshold? Do subsequent
transactions undo prior designations?
While the rule states that the volume of the hedge instrument must always remain “economically appropriate,”
understanding where to draw the line between speculation and “economically appropriate” hedging activity may be a
challenge for entities wishing to apply the HMCR exception. Although not required, documentation concerning how an
entity is meeting the “economically appropriate” threshold should be considered as a means to archive decision making.
Additionally, entities should consider the involvement of external counsel in documenting and supporting assertions made
concerning the “economically appropriate” criterion.
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III. Application framework
Earlier in this paper we discussed the implications of hedge activity to various CFTC rules which drive reporting
requirements. Any framework adopted by an entity to comply with the rules under the Act should help ensure compliance
with the rules while also properly applying exemptions within the Act. For example, an entity may consider that based on
the quantitative nature of its activity, it is a major swap participant when the true nature of that activity conforms to certain
end-user exemptions which may impact that entity’s conclusion about its entity classification.
The CFTC has not required documentation as it relates to the use of the HMCR exception for entity classification purposes.
However, the end-user exception does require documentation and the criteria for determining hedges for the MSP
definition and the end-user exception are nearly identical. As such, it may be expected that in application, documentation
of the HMCR exception for entity classification will in effect be required for those entities wishing to exclude transactions
from clearing.
The documentation required by the end-user rule is on a transaction by transaction basis and must support the assertion
that a swap was executed for purposes of hedging or mitigating commercial risk. To put that in practice, an entity should
think strategically when designing a process that accurately reflects the nature of risks present in its business and best
leverages current processes around deal capture and authorization.
At a minimum, an entity will be expected to have a document that links entity-wide strategies and risks (including
considering those publicly disclosed) to specific business units or assets that give rise to risks, coupled with designation at
the individual swap level on conformance of the swap with that stated strategy.
Based on Deloitte’s experience, common industry practice is to maintain hedge documentation at a level that is higher
than the individual transaction (portfolio level designation). This higher, portfolio level documentation is often done on
a transacting book basis, or some other form of grouping within an entity’s listing of open transactions, such that any
transaction within that book receives hedge accounting based upon the hedge documentation at the portfolio level.
Provided transactions within the book meet the attribute requirements of the hedge documentation, the instrument is
designated to have been elected to receive hedge accounting.
A reasonable interpretation could be that a similar level of documentation concerning HMCR could meet the intentions of
the rules. The CFTC states it will require notification of the end-user exception on a transaction by transaction basis30. To
support the assertion that the transaction “qualifies” for hedge accounting, the notification provided to the CFTC could
reference HMCR documentation maintained at the book level to support the election.
30 Federal Register Volume 77, No. 139, pg. 42565
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IV.Conclusion
Understanding the term “hedge or mitigate commercial risk” will be of central importance as entities attempt to understand
and comply with the CFTC rule-making areas addressing entity classification and the end-user exception to clearing. CFTC
rules addressing these activities are written to be applied transaction by transaction. Depending upon an individual entity’s
strategy for complying with aspects of the Act (e.g., clearing via the end-user exception), entities should determine and
document the hedging purpose of each financial transaction executed.
To meet the requirements of the hedge or mitigate commercial risk criteria, entities have three separate methods:
• BFHs for determining the classification of an entity and taking an end-user exception
• Hedges that qualify for hedge accounting under U.S. GAAP
• Transactions / hedges that are “economically appropriate” to the mitigation of commercial risk
The bona fide hedge criterion specified in the CFTC entity classification rules appears the most restrictive and difficult to
meet. However, the CFTC has also provided the most commentary and objective standards to determine that this criterion is
met. Additionally, transactions meeting the definition of a BFH per the CEA appear to have the widest application as these
transactions may:
• Be excluded from entity classification calculations
• Apply to meeting the end-user exception to clearing
While transactions meeting the “qualifies for ASC 815” or “economically appropriate” criteria may not have as wide
an application, meeting either one of these criteria will allow an entity to exclude the transaction from the MSP entity
classification and qualify for the end use exception. A reasonable interpretation could be that to the meet the “qualifies for
ASC 815” criterion, an entity will be required to prepare the following:
• Hedge accounting/risk policy
• Hedge documentation
• Hedge assessment
The “economically appropriate” criterion appears to be the most subjective of the three hedge or mitigate commercial risk
prongs. A reasonable interpretation would be that “economically appropriate” in the context of the CFTC rules appears to
address the ability of the swap to offset the cash flow or fair value risk of some identified risk related to an entity’s business,
while also considering the volume level of the transaction.
As entities begin to apply and comply with the CFTC rules and implementing the Dodd-Frank Act, careful considerations
should be made to how the hedge or mitigate commercial risk criteria will be applied. While the CFTC has indicated that
documentation is not required for all aspects of the hedge or mitigate commercial risk criteria, documentation in some form
could allow entities to objectively judge their transacting against these criteria and more appropriately comply with the
individual rules.
An interpretation of the “hedge or mitigate risk” criteria and the impact to compliance with the Dodd-Frank Act
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Appendix A: Referenced rules and statutory language
Note 1:
End-user exception
The end-user exception is provided for in Section 723(a)(3) of the Act. First, section 2h contains the requirement for
clearing:
(h) CLEARING REQUIREMENT.—(1) IN GENERAL.—(A) STANDARD FOR CLEARING.—It shall be unlawful for any person
to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization that is
registered under this Act or a derivatives clearing organization that is exempt from registration under this Act if the
swap is required to be cleared.
Within the same section, the exception to the clearing requirement is provided:
(7) The requirements of paragraph (1)(A) shall not apply to a swap if 1 of the counterparties to the swap—
(i) Is not a financial entity;
(ii) Is using swaps to hedge or mitigate commercial risk; and
(iii) Notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations
associated with entering into non-cleared swaps.
Note 2:
Definition of hedge or “mitigate commercial risk”
For purposes of section 2(a)(7)(A)(ii) of the CEA and § 39.6(b)(4), a swap shall be deemed to be used to hedge or mitigate
commercial risk when the swap is:
1) Economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where
the risks arise from:
(A) The potential change in the value of assets that a person owns, produces, manufactures, processes, or
merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the
ordinary course of business of the enterprise;
(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the
ordinary course of business of the enterprise; or
(C) The potential change in the value of services that a person provides, purchases, or reasonably anticipates
providing or purchasing in the ordinary course of business of the enterprise;
(D) The potential change in the value of assets, services, inputs, products, or commodities that a person owns,
produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning producing,
manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business of the enterprise;
(E) Any potential change in value related to any of the foregoing arising from foreign exchange rate movements
associated with such assets, liabilities, services, inputs, products, or commodities; or
(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or
anticipated assets or liabilities;
OR
2) Qualifies as bona fide hedging for purposes of an exemption from position limits under the Act;
OR
3) Qualifies for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic
815, Derivatives and Hedging (formerly known as Statement No. 133)
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In addition to meeting one of the requirements from above, the swap must not be:
1) Used for a purpose that is in the nature of speculation, investing, or trading
2) Used to hedge or mitigate the risk of another swap or securities-based swap, unless that other swap itself is used to
hedge or mitigate commercial risk as defined by this rule, or the equivalent definitional rule governing security-based
swaps promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934
Note 3:
Entity definitions
Section 721 of the Act amended the CEA by adding the defined terms “swap dealer” and “major swap participants.” The
Commodity Futures Trade Commission (“CFTC”) issued finalized definitions of swap dealer and major swap participant in
April 201231, along with interpretive guidance concerning these definitions.
Swap dealer
Section 721 of the Act provides the base definition of a swap dealer as any entity who:
•
•
•
•
Holds itself out as a dealer in swaps
Makes a market in swaps
Regularly enters into swaps with counterparties as an ordinary course of business for its own account
Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps32
This definition was further defined by the CFTC to contain a de minimis exception for a certain amount of swap dealing.
Swap dealing below this threshold would not result in an entity meeting the swap dealer definition. The CFTC determined
de minimis threshold is a gross notional amount of swaps executed over the prior twelve months not exceeding $3 billion.
A phase in period would exist such that the threshold would begin at $8 billion and would be studied over a two and half
year period to determine an appropriate threshold.
The CFTC further stated that entering into swaps in certain situations should not be considered swap dealing. Specifically,
swaps executed for the following reasons may be excluded from the notional calculation of swap dealing:
• The price risks arise from the potential change in the value of assets that the person owns, produces, manufactures,
processes, or merchandises, liabilities that the person owns or anticipates incurring, or services that the person
provides or purchases
• The swap represents a substitute for transactions or positions in a physical marketing channel
• The swap is economically appropriate to the reduction of the person’s risks in the conduct and management of a
commercial enterprise
• The swap is entered into in accordance with sound commercial practices and is not structured to evade designation as
a swap dealer33
31http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/defs_factsheet.pdf
32 Section 721 (49) of the Act
33http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/defs_factsheet.pdf
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Major swap participant
Section 721 of the Act provides the base definition of a major swap participant. Any entity who:
• “Maintains a substantial position in any of the major swap categories, excluding positions held for hedging or
mitigating commercial risk
• A person whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects
on the financial markets
• Any financial entity that is highly leveraged relative to the amount of capital such entity holds and that is not subject to
capital requirements established by the appropriate Federal banking agency and that maintains a substantial position
in any of the major swap categories”34
The four major swap categories are defined as:
•
•
•
•
Rate swaps (any swap based on reference rates such as interest rates or currency exchange rates)
Credit swaps (any swap based on instruments of indebtedness or related indices)
Equity swaps (any swap based on equities or equity indices)
Other commodity swaps (any swap not included in the first three categories)35
A substantial position is determined to exist if either of two thresholds is met:
1) Uncollateralized exposure, after the impact of netting agreements: An entity with an uncollateralized exposure
exceeding $1 billion in each of the credit, equity and other swap categories, and $3 billion in the rate category, would
be determined to be a major swap participant.
2) Uncollateralized exposure plus potential future exposure: An entity with an uncollateralized exposure plus future
potential exposure exceeding $2 billion in each of the credit, equity and other swap categories, and $6 billion in the
rate category, would be determined to be a major swap participant. Future exposure would be determined by:
• Multiplying the total notional principal amount of the person’s swap positions by specified risk factor percentages
(ranging from ½% to 15%)
• Discounting the amount of positions subject to master netting agreements by a factor ranging between zero and
60%
• If the swaps are cleared or subject to daily mark-to-market margining, further discounting the amount of the
positions by 80%36
34 Section 721 (33) of the Act
35http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/defs_factsheet.pdf
36http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/defs_factsheet.pdf
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Contacts
Clint Carlin
Partner
Deloitte & Touche LLP
+1 713 982 2840
[email protected]
William Hederman
Director
Deloitte & Touche LLP
+1 703 885 6450
[email protected]
John Bayne
Senior Manager
Deloitte & Touche LLP
+1 713 982 4017
[email protected]
An interpretation of the “hedge or mitigate risk” criteria and the impact to compliance with the Dodd-Frank Act
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