MANAGEMENT | DERIVATIVES REGULATION
Nonfinancial corporations that hedge risk by using derivatives not traded on exchanges won an important victory in early September, when US bank regulators agreed to exempt such companies from rules that would have required them to post collateral against their positions.
The rules are designed to put into effect provisions of the Dodd-Frank Act that require cash collateral known as “margin” to be set aside when derivatives purchased from banks aren’t traded on exchanges. Such financial instruments are considered more risky than those traded on exchanges because the dealers that belong to such exchanges back the swaps with capital. Not so derivatives traded over the counter. So Congress voted to require margin against such swaps in hopes of stemming the risk derivatives that weren’t backed by collateral had posed to banks during the financial crisis.
Nonfinancial companies won an exemption from rules for such collateral when Dodd-Frank was enacted in 2010, but it was provided in the form of a side letter to the legislation that bank regulators refused to recognize as having the force of law. After a concerted lobbying effort by groups representing such companies, the regulators finally changed their minds in September, four years after Dodd-Frank became law.
“Not having to put up collateral is a big win for corporates,” Jeff Wallace, a principal in consultancy Greenwich Treasury Advisors, says. “If you do a hedge and the hedge is losing money, putting up collateral is, in a way, adding insult to injury.”
Some observers point out that because derivatives are a form of financing, any cash put up to back them would make no difference to companies’ financial results. That’s because the value of their swaps are already recognized as a reduction in cash flow, and any cash put up to back them would have no impact on that recognition.
But Wallace points out that any collateral a company put up would reduce the amount of financing available to it and would therefore increase its cost of hedging. He adds: “Putting up collateral means you have less debt to cover your working capital needs, dividends, strategic initiatives, etc.”