End User Exception
The end user exception is a provision in the Dodd-Frank Act that exempts non-financial commercial end users (corporations hedging genuine business risks such as commodity price exposure, foreign exchange risk, or interest rate risk related to their commercial activities) from the mandatory central clearing requirements for OTC derivatives, recognizing that requiring these entities to post margin at CCPs could drain working capital from productive commercial operations.
Key takeaways
- The exception is available to non-financial entities using OTC derivatives to hedge 'commercial risk' directly related to their business operations (manufacturing, agriculture, energy, etc.).
- Eligible entities must elect the exception by notifying their counterparty (via SDR reporting or affirmation) and must not be 'financial entities' under Dodd-Frank definitions.
- Financial entities (banks, investment advisers, commodity pools, security-based swap dealers) are ineligible for the exception regardless of the nature of the swap.
- Exempt entities must still report trades to swap data repositories and are subject to business conduct standards of the swap dealer counterparty.
- The exception is central to the lobbying effort of industrial companies (airlines, energy producers, agricultural processors) that argued mandatory clearing would impose excessive operational costs unrelated to their core businesses.
Explanation
The end user exception reflects a Congressional policy judgment that extending mandatory central clearing requirements to non-financial commercial companies hedging genuine business risks would impose disproportionate costs without commensurate systemic risk reduction benefits. These companies—airlines hedging jet fuel costs, farmers locking in crop prices, manufacturers managing foreign exchange exposure—were not the originators of systemic risk in the 2008 financial crisis, and their commercial hedging activities serve genuine economic risk management purposes.
Section 2(h)(7) of the Commodity Exchange Act (as amended by Dodd-Frank) establishes the end user exception. To be eligible, a counterparty must satisfy three requirements: (1) it must not be a 'financial entity' (financial entities include swap dealers, major swap participants, commodity pools, private funds, banking institutions, and others specified in the Act); (2) it must be using the swap to 'hedge or mitigate commercial risk' arising from its business activities; and (3) it must either report, or cause to be reported, relevant information about the swap to a registered SDR or use an alternative reporting mechanism.
The 'commercial risk' requirement is broadly interpreted but has limits. A manufacturing company that enters into an interest rate swap to hedge the floating rate exposure on its revolving credit facility (which it uses to fund operations) can elect the exception. If that same company enters into speculative interest rate swaps unrelated to any existing debt exposure, the commercial risk requirement is not met, and the exception is unavailable. The election is made on a trade-by-trade basis and requires the eligible end user to provide written notice of electing the exception to its counterparty before or at the time of execution.
In practice, the end user exception is widely used by U.S. industrial companies, energy producers and consumers, agricultural companies, and other non-financial commercial entities. The Commodity Futures Trading Commission has estimated that hundreds of thousands of swap transactions annually use the end user exception, covering trillions of dollars in notional exposure. The exception's availability is monitored by corporate treasury departments and their legal counsel, as inadvertent failure to meet the eligibility criteria could expose the company to the mandatory clearing requirements and associated margin obligations.
Critiques of the end user exception center on the systemic risk argument: even commercial end users' uncleared swaps create bilateral counterparty exposures for the dealer banks they transact with, and those bilateral exposures contribute to systemic interconnectedness. Proponents respond that the collateral impact on corporate working capital (forced margin posting to CCPs) would divert cash from productive investment, and that commercial end users' bilateral exposures are individually small relative to their dealer counterparties' much larger inter-dealer exposures.
Example
A regional airline enters into 30 jet fuel swap contracts with a major bank for $500 million notional over the next 24 months to hedge its fuel cost exposure. Without the end user exception, this swap would be subject to mandatory central clearing, potentially requiring the airline to post $15–25 million in initial margin at a CCP—capital that would otherwise fund aircraft maintenance, route development, or crew training. By electing the end user exception, the airline avoids mandatory clearing and instead maintains the existing bilateral ISDA Master Agreement with the bank, posting variation margin only as agreed bilaterally (often with a minimum transfer amount and threshold). The airline's treasury team documents the commercial risk purpose of each swap, ensuring the correlation between the derivative hedges and the actual fuel purchases meets regulatory requirements. Upon execution, the bank (as a registered swap dealer) reports the trade to the DTCC SDR, satisfying the reporting obligation on behalf of both parties.
Related terms
Basis Best Interest Standard Clearing Correlation Dodd Frank Act Exchange Exempt Reporting Adviser Financial Crisis Hedge Exemption Hedging Initial Margin Interest Rate