SIBOS SUPERSECTION 2014 | COLLATERAL MANAGEMENT
Treasurers are warily eyeing the impact of new regulations on the amount of collateral they must hold against hedged positions—and these new regs will affect their ability to manage and forecast cash.
Do corporate risk managers get overtime? They should, considering the increasing and ever-shifting pressures of their jobs. They must not only manage the usual threats to liquidity, such as counterparty risk, but must now conform to hundreds of evolving regulations about credit products that differ according to location. Changing regulations, besides continuing to add to treasurers’ headaches, will also increase the amount of collateral that companies must hold against the derivatives they use to hedge exposures.
“Nearly four in five (79%) of respondents report they are moderately or very concerned about the differences between the derivatives reporting regimes for over-the-counter (OTC) derivatives in the US and European Union,” according to a study by the Coalition for Derivative End-Users (CDEU).
This changing landscape has made cash forecasting difficult. If you are not sure how much cash you will have on hand, then you can’t put it to work or use it when you need it. Low interest rates don’t help. Blackrock recently tweeted that “eighty-one
percent of the global fixed-income universe (including high-yield and hard-currency emerging market debt) currently yields below 4%.” It is mind-bending that high-yield and emerging debt now return little more than an old-fashioned savings account did back when the US had interest rate ceilings on such accounts (before they were phased out in the 1980s). Some institutions have stopped paying interest altogether, and others are charging clients for cash accounts. It is a new world.
This isn’t an esoteric problem. “Any corporation with large cash needs uses credit securities to make sure they have the money they need when they need it,” says Chris Whalen, senior managing director and head of research at the Kroll Bond Rating Agency.
Financial derivatives are used by corporates across a range of sectors. A survey last year sponsored by PwC found that nearly half of all end-user companies (the buy side) that responded use derivatives to hedge foreign exchange risk and just about the same proportion use derivatives to manage interest rate risks. They use them to enter into agreements with banks that are tailored to their particular hedging needs. But new clearing and collateral rules could make that more challenging—and expensive.
Take Honeywell International. Jim Colby, the company’s assistant treasurer, explained what’s at stake to the US Committee on Agriculture. With 50% of its sales overseas, the manufacturer is exposed to currency and interest rate risk, as well as to swings in commodity prices. It uses derivatives to control those risks so that it can concentrate on its core business of supplying the aerospace industry. “We sell satellite and launch vehicle inertial measurement units manufactured in Florida to customers in Germany,” Colby testified. This may require the company to sell in euros, even though all of the costs are in US dollars. These are multiyear contracts, and Honeywell uses a variety of derivatives to lock in a rate, so it doesn’t have to worry about market swings.
“Honeywell carefully manages its ratio of fixed- to floating-rate debt in order to lower its overall cost of debt, while providing sufficient interest-rate certainty to accurately forecast and manage interest expense,” he said.
Nonfinancial end users make up less than 10% of the market, according to the Bank for International Settlements’ semiannual survey on derivatives. And nonfinancial corporations, or those using swaps to hedge a commercial risk, can get exemptions, as can credit unions with total assets of $10 billion or less in assets.
But if a nonfinancial end user enters into an agreement with a bank, it may still have to put up margin, says Thomas Deas Jr., vice president and treasurer of FMC Corporation, a Philadelphia-based chemicals producer. An overwhelming percentage of the respondents in a recent survey by the CDEU are concerned that margin requirements will hurt acquisitions, job creation, business investment and research and development.
Corporate treasurers must figure out whether their hedging instruments they use to mitigate these risks have to be cleared on an exchange, and where. Then they must calculate the necessary collateral needed to guarantee the trades. Confusion does not encourage growth.
Then there is the expense. Honeywell’s Colby said the company had about $2 billion of hedging contracts outstanding that could be defined as a swap under Dodd-Frank. “Applying a 3% initial margin and 10% variation margin implies a potential margin requirement of $260 million,” he said.
IMPACT OF NEW REGS
All the new laws test the limits of regulation because so many different instruments are used to accomplish the same task: to hedge a bet on both on- and off-balance sheet securities. It is really is a matter of definition, which can be very technical. For instance, does removing a parent guarantee from a transaction allow a bank to trade outside the Dodd-Franks rules? The Commodity Futures Trading Commission is looking into it, according to Bloomberg.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, Basel III and the European Market Infrastructure Regulation, all of which are being phased in over the next few years, are aimed at reining in risk so that financial crises never happen again. But their different approaches create headaches.
Basel III raises the amount of capital banks must put aside for derivative securities from 2.5% to 7%, an obligation that drains liquidity from the market. It also requires banks to shrink their balance sheets and keep enough money on hand to cover cash flow needs for 30 days.
The 3,000-page Dodd-Frank bill, meanwhile, creates lots of new record-keeping and real-time-reporting requirements for all users—including corporates—while dictating that most swaps be cleared by a central clearing counterparty or traded on an exchange. That means there will be differing margin requirements and settlement prices.
Meeting these rules will require treasury departments to invest heavily in new information technology systems, an investment that would come at the expense of information technology needs for departments that produce something to sell, says Deas.
The costs of using derivatives are up across the board, according to the PwC-sponsored survey, particularly for companies that use interest rate and foreign exchange rate hedges. The cost of funding will go up further because corporations will have to either invest in new technology to handle the analysis or outsource the job.
The CDEU estimates that Standard & Poor’s 500 companies would have to reduce capital spending by $5.1 billion to $6.7 billion per year in order to meet margin requirements on OTC derivatives. Most end users say margin requirements would cause them to alter their hedging strategy. Forty-four percent report they would hedge less, and 5% say they wouldn’t hedge at all.
It should come as no surprise that end users in the PwC survey say they are looking into alternatives to OTC trading, reducing the volume of their transactions or changing the types of derivatives they use.
Banks have trimmed lending so they don’t have to come up with as much capital. They have also curtailed trading in bonds and commodities. The consequences of these new regulations may not all be what regulators were looking for when drafting the rules.