Now, we are about to find out. Non-financial companies think they have won some kind of exemption – but they don’t know how much. And as Siân Williams reports, hardly anyone seems to know how much mandatory clearing would cost anyway.

Ever since the financial crisis began, banks have been calling on politicians and regulators not to overreact. Considering the banks’ recent achievements, many may feel disinclined to listen.

But in the past year a different group has begun to issue similar warnings – industrial companies. Unlike the banks, they do not fear that new laws will deliberately curtail their activities. What worries them is the drive to push derivatives on to exchanges and in to central counterparty (CCP) clearing houses.

These measures are intended to promote the safety and transparency of the financial system, above all of the banks. But safety – and perhaps even transparency – may come at a cost.

Companies that engage in over the counter derivatives, directly with banks, are scared that if these contracts have to be centrally cleared, they may have to post more collateral against the trades than they are used to doing.

This collateral is what keeps the clearing houses strong, and protects the wider financial system from defaults. But for companies themselves, it would be a cost – perhaps higher than they are paying at the moment – for using derivatives.

Some firms and their trade bodies have claimed that mandatory central clearing could even deter companies from hedging, leaving them more exposed to price risks. Even trades that remain over the counter (OTC) may have to be collateralised.

Of course, collateral is widely used in the OTC derivative markets. The International Swaps and Derivatives Association’s 2010 Margin Survey of derivatives dealers and participants suggests 70% of all OTC transactions are subject to collateral agreements.

The proportion is lower for non-financial corporate customers, however. According to the Isda survey, total collateral held against trades with non-financial companies amounted to 47% of such trades, a lower rate than for institutional investors (58%), banks and broker-dealers (78%) or hedge funds (141%).

But this use of collateral remains voluntary – something agreed between bank and customer. Financial market reforms might now make collateralisation mandatory.

In the same report, Isda set out its view on the topic: “Collateralisation works best in the cases where the volume of activity is sufficient to warrant bearing the operational and procedural burdens associated with the complex collateral process. Not all derivatives users trade these instruments frequently enough to justify the operational burden and expense of collateralisation. This latter group includes non-financial corporations, whose business models cannot easily sustain the cashflows required for collateralisation.”

In Europe, the threat of enforced collateralisation or CCP clearing, if it materialises, will come in the shape of EU legislation to reform the derivatives market. Consultation on preparing this law has been extensive. Industry representatives recognise that the European Commission has been painstaking about listening to their concerns.

But the crunch time is coming. In September the EC is expected to publish draft legislation. The best guide to what this will contain is a consultation document issued in June. In it, the EC sought comment on specific areas and sketched the shape that new regulation may take.

A loophole opens
The Public Consultation on Derivatives and Market Infrastructures holds some comfort for corporate derivative users. They are recognised as a separate category, acknowledging that they may not face the same clearing and exchange trading obligations as banks or hedge funds.

But the document still gives only a rough idea of what the new rules might be.

Though it appears that many companies may be able to avoid mandatory clearing or collateral posting, corporate exemptions will only apply up to a threshold.

Non-financial companies, the paper says, would have to clear all their eligible derivatives and inform the market regulator if they took positions beyond an “information threshold”.

There is little indication of how strict the threshold will be and what criteria will be used to determine it. Equally unclear is how much time companies will have in which to post collateral or move their contracts to a clearing house if they do surpass the threshold.

The paper says these thresholds will “be defined at a further stage, taking into account the systemic relevance of the sum of net positions by counterparty per class of derivatives”.

In other words, regulators will work out how large non-financial companies’ positions are in each kind of derivatives, and decide whether they are big enough to constitute a systemic risk that would require tighter safeguards.

The consultation paper advocates “an appropriate and balanced legislative approach for the (corporate) end users of OTC derivatives”. The aim is to achieve “a reduction of risk in the financial system that does not tolerate regulatory arbitrage” but also “a sensible system that reflects the economic and financial hedging needs of corporate end users”.

Calls for exemption
Many non-financial companies have spoken out against mandatory clearing and the requirement to collateralise OTC derivatives, and have responded to the consultation by pleading to be exempt from any mandatory requirement.

Companies cite several reasons for this. They fear the new system may be more expensive; they are worried about margin calls disrupting the predictability of their cashflow; they believe that capital which could be used to invest in growth or acquisitions might be tied up – in their view needlessly – in collateral.

Iain Foster, assistant treasurer at Rolls-Royce, the UK aero-engine maker in Derby, shares these worries. Asked how the company would cope with a strict requirement to clear trades or post collateral, Foster said its reaction would be to “reduce the amounts we hedge or restructure the group – natural hedging” (see box on Rolls-Royce below).

Some are also concerned about the costs of installing new systems to meet daily margin calls. Though banks and other financial companies may have such systems in place, not all non-financial companies use them.

“The convenience of just being able to call up a bank and do a deal makes life much more straightforward,” says Martin O’Donovan, assistant director, policy and technical at the UK’s Association of Corporate Treasurers in London.

Creating risk – or reducing it?
Non-financial companies’ main gripe is that, even if they are granted a limited exemption, they feel they do not pose systemic risk and that they are therefore being unfairly penalised for what they believe is an issue that relates to financial companies.
As O’Donovan points out, when derivatives are used for hedging, the user’s underlying position must be positive when the derivative is in a loss-making position.

“Any gain or loss on the derivative will be matched by the underlying cashflow. The last thing treasurers want to do is make cash payments as mark to market changes happen – they do derivatives to remove volatility not to create it,” he says.

Of course, the debate depends heavily on the strictness of the threshold. If it captures few firms, it is likely that the systemic risk argument will be better accepted.

Alex McDonald, chief executive of the Wholesale Market Brokers’ Association, argues: “The limit probably has to be set at something fairly enormous; including just one or two oil companies and other large participants, perhaps.”

He points out that the threshold cannot be defined solely in terms of notional value – other criteria will have to be considered.

How much is ‘a lot’?
One of the main arguments non-financial companies make against mandatory clearing is that costs will increase steeply. But their case is weakened by being very light on figures.

Very few of the participants in the debate have publicly put any numbers on the perceived threat. As a result, it is very hard to gain any reliable idea of what sort of amounts are at stake.

It appears that hardly any thorough surveys have been made to compare the entire cost of using cleared and OTC derivatives.

The WMBA cites a small table of figures produced by a power company to show the costs of a hedge.

For an exchange-traded transaction, it lists trade brokerage €0.01, clearing brokerage €0.01, delivery fee €0.01 and margin cost of funds €0.04, giving a total cost of €0.07 for the trade.

In the OTC market, the costs listed are: trade brokerage (optional) €0.005 and clearing brokerage €0.01, for a total cost of €0.015.

But these figures do not show how costs would change for that company as a whole, adding together all its hedging activity. Hence the scale of the impact on the company’s cashflow and possible borrowing requirement is not clear.

And the table also does not show the economics of the trade itself – the price the company is able to obtain from its counterparty.

Hidden costs
If an OTC derivative is not supported by any margin payment or collateral, the bank is taking credit risk on its customer. It may use credit default swaps to hedge this, or post capital against the exposure.

But one way or another, the bank is shouldering credit risk. It would be fair to assume that it expects some recompense for this, and if there is no explicit charge, that return must come through the trade itself.

If profits for banks were not fatter in the OTC market, why would they be willing to trade in it, when it obliges them to take credit risk?

In fact there is strong anecdotal evidence that, in various asset classes and at various times, banks have sought to keep business OTC because it is more profitable for them that way, rather than let it migrate to exchanges and clearing houses.

This suggests that at least some of the costs of the present way of operating are not being captured in some comparisons of OTC and exchange trading.

One source acknowledges that the execution price a company can get for a hedge in the exchange-traded market may be keener, but he says it is still preferable to trade OTC, even with a higher “upfront cost”, because that way there is no risk of nasty surprises from margin calls later.

Your risk, my risk
Credit risk also cuts both ways. Banks inevitably think about their credit exposures when engaging in any transaction, and therefore presumably seek a return on that risk.

But in an OTC derivative, the company is also taking risk on the bank – or on other counterparties in its own industry. 

The European Energy Exchange published a study into OTC and cleared costs in February, more detailed than the power company example offered by the WMBA. The EEX argued that if credit risk is taken into account, central clearing is often cheaper than OTC trading (see box below).

Duration factor
McDonald says the cost difference between OTC and cleared trades depends on the duration of the contract. He says that OTC transactions with a duration of less than one year “have a minimal cost of credit” but that the cost of margining them would be “notable”.

When capital buffers are held by banks, the amount is a function of the contract’s duration, he says, which means less is needed for shorter contracts.

“For contracts with a maturity of under one year, centrally clearing or posting collateral would be more of a cost burden relative to how trades would otherwise be settled,” McDonald says.

Equally, he argues, at extra long maturities such as 10 years, the costs of margin with a CCP become particularly acute, depending on the shape of the yield curve.

Another possible argument in favour of the OTC method of dealing with credit risk is that banks are likely to set the credit terms for clients according to their particular creditworthiness.

Clearing houses, on the other hand, do not distinguish between users according to their relative strength, but charge everyone the same amount, based on the riskiness of the particular derivative position.

From one perspective, it could be argued that this means the stronger counterparties of a CCP are subsidising the weaker. Equally, this should make weaker companies more willing to use CCPs.

When comparing the costs of OTC and exchange trading, netting also needs to be taken into account. If a company is very directional in its derivatives trading, its total costs are likely to be higher than those of a company taking a number of buying and selling positions, some of which might cancel each other out.

Cashflow and financing
One aspect that many commentators agree on is that, whatever the relative costs of OTC and cleared trading, participating in a CCP means the customer can be called on to change its margin payments daily.

Although companies are used to managing constant inflows and outflows of cash, they have argued that meeting daily margin calls would strain their cashflows.

The obvious way to deal with this need would be to borrow from banks.

Though he could not give any figures as to how much more expensive clearing might be, O’Donovan believes the cost of funding a company’s liquidity needs for margin calls could have an adverse impact on a business by using up its borrowing capacity.

“There’s a limit to what a firm can borrow,” he says. “Money used for margin could otherwise be used to gear up.” He believes that margin is an “unproductive use of a company’s capital structure”.

To this, regulators might counter that while margin may seem unproductive for the company that pays it, the cash protects the financial system as a whole, and hence taxpayers.

Richard Raeburn, chairman of the European Association of Corporate Treasurers, says trying to determine what the costs of clearing might be at this stage is “an impossible question”, and that they are an indirect cost.

But he says: “Companies would need to be prudent and make sure they had borrowing lines. They obviously would draw on cash to meet margin calls. Any cash call for margin translates into incremental borrowing.”

Companies might find that banks are quite happy to provide finance for their margin needs. After all, if banks are prepared to take their customers’ credit risk by providing them with OTC derivatives, would they not be willing to take the same risk in loan form, allowing the customer to clear its trades with a CCP?

This would arguably make the whole system more transparent, as banks’ credit exposure would be clearly acknowledged and priced, while the derivative risk was taken care of by the clearing house.

But Alex McDonald, for one, resists this idea, describing it as “Turning the risk on a derivative into a risk on a loan.” In his view no risk would be removed by such a change – it would merely be converted into a different form.

Debating in the dark
With no clear estimates for the costs of clearing and collateralisation, it is difficult to know whether companies’ fears are justified.

Having to post margin against trades did not stop the evolution of the US agricultural futures markets, for example, even though those have always been heavily populated by industrial hedgers.

Oil and gas markets also swung heavily towards CCP clearing, even for OTC transactions, once the Enron collapse in 2001 showed firms that credit risk was real.

It is probable, however, that non-financial companies’ two years of lobbying will not be in vain, and that they will win substantial exemptions from clearing and collateral rules.

O’Donovan says: “The Commission recognise that non-financial firms are not a big part of this problem. I think our point of view has been generally accepted.”

How much light has genuinely been shed by the whole process, and whether the end result will be optimal for corporate derivative users, and for the market as a whole, is much harder to say.