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.
|Rolls-Royce: serious about hedging
Rolls-Royce is one of the UK’s leading engineering companies. A world leader in aero-engines, it also makes marine and gas turbines, with total sales of £10.1bn last year and profits of £915m.
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.
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.
|EEX study suggests CCP is cheaper|
Those who claim it is cheaper to engage in derivatives OTC than through a central clearing counterparty are not taking the cost of credit risk into account, according to a study by the European Energy Exchange in February.
The report found it was cheaper on average to use a CCP, which theoretically eliminates counterparty risk, than to buy an OTC derivative and hedge the counterparty risk exposure using a credit default swap.
Using a one year contract as an example, the study took account of transaction costs, the cost of protection against default and the cost of liquidity needed for posting additional and variation margin in a CCP.
Over a year, the total daily margin paid to a CCP is on average less than the premium paid to the seller of a CDS to hedge the counterparty risk. This obviously varies, depending on the counterparty’s credit rating. However, EEX concluded that there were some situations when the OTC route could be cheaper. Central clearing works out more expensive if a position goes out of the money, as daily margin costs are high.
But the opposite is true if the trade looks like making money. As an OTC position moves into the money, the credit risk exposure to the counterparty grows. This means that if the risk is to be fully covered, more credit protection needs to be bought. As a result, the cost of hedging rises as the position becomes more profitable.
An exchange-traded derivative, on the other hand, requires low margin payments if it is making a profit.
“We have been told by many market participants that exchange clearing is too expensive,” said Iris Weidinger, chief financial officer of EEX in Leipzig. “There is a lot of misunderstanding. It’s not true in general that clearing is too expensive. It’s important to look at all cost components, especially costs for managing credit risks in bilateral trading.”
About 1,000 Terawatt hours (TWh) of power is cleared weekly through European Commodity Clearing, which clears for EEX. The other 3,500 TWh traded in the German power market each week go over the counter and are not centrally cleared.
Not all market participants buy credit protection when they trade OTC, and some use it only rarely.
But the aim of the study is to compare like with like – studies that conclude OTC trading is cheaper often neglect to take credit protection into account.
The study factored in account processes, transaction fees, liquidity provision and credit protection. The cost of the first three is the same or lower for OTC traders, it found, but the cost of credit protection is much higher.
“In this model we considered 100 scenarios — in most cases ECC clearing yields cost advantages for clients compared to bilateral risk management,” Weidinger said.
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).
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.
Isda finds nearly half of corporate derivatives are collateralised
The International Swaps and Derivatives Association’s 2010 Margin Survey estimated that the total amount of collateral in circulation in the OTC derivatives market fell by 20% in 2009, from $4tr at the end of 2008 to $3.2tr at the end of 2009.
Isda attributed this to “a marked decline in market volatility and a return to more normal interest rate levels and credit spreads”. It said this was consistent with the 23% decline in gross counterparty credit exposure in the first half of 2009, reported by the Bank for International Settlements.
But between 1999 and 2009 the estimated total amount of collateral grew at a compound annual rate of 35%, while the BIS measure of credit exposure grew by 13% a year.
This suggests that not only is the use of collateral growing, but it occupies a growing share of the market.
However, corporate customers are less likely to have to post collateral. Survey respondents said their collateral against exposure to non-financial companies amounted to 47% of that exposure. This was the lowest proportion except for sovereign and supranational counterparties, with 25%.
The 15 biggest dealer firms are usually more avid users of collateral than smaller firms in Isda’s survey. But for corporate customers, it is the other way round. Lesser dealers’ collateral covered 57% of their corporate exposure, while for the biggest dealers it was 32%.
This may reflect the fact that bigger banks tend to do business with bigger companies, which are often regarded as safer from a credit point of view.
There is great variation in the use of collateral by asset class. Of currency derivatives, only 57% are subject to collateral agreements. This rises to 60% for metals, 64% for energy and other commodities, 71% for equity, 79% for fixed income and 93% for credit derivatives.
The survey found that on average, 86% of firms and all the large dealers sometimes took credit rating into account when setting collateral thresholds. Twelve percent of respondents but 27% of large firms took CDS spreads into account.
Of total collateral, around 82% is cash and 10% government bonds, with the rest in other securities.