Analysis: Moving your corporate hedges to an exchange

By Daniel Flatt | Mar 4, 2013

Derivatives Regulation is pulling end-users to exchanges. CT analyses newly-available tools and the costs incurred moving onto an exchange.

On January 2, the Commodity Futures Trading Commission (CFTC) published the first list of swap dealers who can trade derivatives under the close scrutiny of the US regulator. It’s hard not to notice the absence of Asian banks with a presence in the US.

Of the 65 names listed, the expected suspects are on board: Citi, Deutsche Bank, Goldman Sachs and Morgan Stanley. Aside from a handful of Japanese and Australian names, the Asian cupboard is bare.

In the case of DBS, for example, the decision won’t have a dramatic impact, at least in the short-term. Each firm may trade up to $8 billion of swaps with US-based counterparties without triggering the CFTC registration requirement.

Regional banks are working much harder to chew the ears off local regulators to ensure regulatory conditions won’t be overly challenging in the markets where they do have critical mass.

Hong Kong and Singapore, although still at consultation stages, are unlikely to deviate too far from Europe and the US, however.

So what does this mean for the humble corporate treasurer based in Asia? Life will be troublesome and the cost of doing business more expensive. This much is certain.

The general consensus is that there will be relief around capital and margin requirements for trades that are cleared centrally. The CFTC has stated clearing requirements shall not apply to a swap if one of the counterparties is a non-financial entity using swaps to “hedge or mitigate commercial risk”.

But don’t get excited. Bilateral trades will not be cheap. Traditional over-the-counter trades will get caught by Basel III rules on margin requirements for non-centrally cleared trades.

Margin call
This is a testy subject. The rules imply that anyone entering into a bilateral trade will be subject to initial and variation margining.

Basel Committee on Banking Supervision and Internaional Organization of Securities Commissions (IOSCO) would require both sides of the trade to post an initial margin buffer to cover ten-day default risk to independently segregated accounts.

Analysis from the International Swaps and Derivatives Association (ISDA) suggests if the existing universe of non-cleared OTC derivatives outstanding were margined based on the proposals, incremental collateral demand could run to near $16 trillion.

“The cost of meeting such requirements would be prohibitive – even if the collateral could be sourced,” says Keith Noyes, Asia-Pacific director for ISDA. “Instead, transaction volume would have to shrink. This will reduce liquidity. Since dealer cost will go up, look for bid/offer spreads quoted to corporate end-users will widen as well.”

One group treasurer for an Asia-headquartered tech company is equally concerned: “This could result in significant amounts of assets being immobilised, to eliminate a risk which does not really exist. In a forward FX trade, your only risk if your counterparty fails is the value of any FX gain you might have made on the contract.”

There is plenty of debate as to whether these barriers will either divert corporate treasury departments to the futures market or to simply not hedge at all. The latter is certainly not advisable – any treasurer who thinks he can play the FX markets is out of his depth.

Moving onto an exchange is equally fraught with risks. Simple foreign exchange forward futures are less liquid than their over-the-counter (OTC) brethren and basis risk is a major concern.

This is why most treasurers aren’t interested in this product despite the lower costs. That said, regulation is forcing the debate and it is vital to prep up on the options and alternatives that are available for treasurers.

Costs of a centrally-cleared swap:
In addition to the capital and default fund costs borne by the clearing member, Kishore Ramakrishnan (pictured), director of financial services at Ernst & Young, takes us through other ways a treasurer will be squeezed:

Initial Margin: collateral required at the outset of a trade and held by the derivatives clearing organisation (DCO) for the life of the transaction. Some futures commissions merchants (FCM) have suggested that they may collect additional initial margin on top of what DCOs require.

Variation Margin: collateral that is either collected or returned by the DCO based on the mark-to-market value of the transaction, which is calculated on a daily basis at least.

Price Alignment Interest (PAI): interest associated with variation margin. An end-user must pay PAI on variation margin that is received and receive PAI on variation margin that is posted.

Clearing Fee: fee charged by a DCO at the outset of a trade. A FCM can also levy a clearing fee for each trade.

Maintenance Fee: a monthly or quarterly fee to maintain one’s portfolio of cleared positions. This could be a flat amount or a percentage of total notional amount in the portfolio of cleared trades. This fee is charged by the DCO, but some FCMs also levy their own maintenance fees.

Balance Sheet Fee: a monthly or quarterly fee to compensate a FCM for the use of its capital to back cleared trades.

Safekeeping/Usage: an ongoing fee charged for the use of eligible, non-cash collateral (e.g. treasuries).

Swap futures
And how about the new contracts emerging out of all the new regulation? Practically unknown a year ago, the swap future has become far more popular with buy-side users since the exchanges saw the potential post-Dodd-Frank. The aim of a swap future is to retain some of a swap’s traditional custom characteristics, but can be cleared as a future.
Recently, the CME Group launched interest rate futures, while the ICE exchange converted all of its energy market swaps into futures or options-style contracts. As The Corporate Treasurer went to press, the Singapore Stock Exchange was on the verge of launching iron ore, freight and oil swap futures.
According to the Eris Exchange, interest rate futures can provide margin savings of between 40% and 80% compared to cleared OTC interest rate swaps. The holding period for initial margin is slightly less than centrally cleared swaps, depending on the liquidity, and the latter are likely to be subject to numerous margin calls in a given day.
Gurpreet Banwait, product manager at risk analytics firm FINCAD, explains that the exchange consolidates all cash flows – posted collateral, interest in collateral, fixed and floating payments, and up-front and termination payments – in a single “stream”. This is then reflected in a single price, allowing the swap exposure to be traded and cleared as a futures contract.

But basis risk still exists with swap futures. “These new types of contracts still do not fully mimic the bespoke nature of swaps, and raise a concern over basis risk,” Banwait says. “This would actually increase earnings volatility compared to hedging the risk completely.”

Marginally absurd
Forgive the pun but it seems marginally absurd that regulation is steering treasurers away from tools that have for many years provided relatively cheap, custom hedging to new products that require more analysis and in many cases open up to more basis risk.

Sadly because too many companies – Korean exporters, being a classic example – were caught betting on the foreign exchange market with complex derivatives, sympathy is in short reserve. Whichever way you cut it, treasurers will have to come to terms with more expensive contracts in the OTC markets or less-than-perfect hedging but cheaper opportunities in the sanitised exchange markets.