Monthly Archives: October 2010

OTC #6 The Collateral Boogeyman – the real determinant of the “cost” to end-users

In an earlier post, we took a first step in answering the question ‘Which system is more expensive to the end-user, one in which both parties can agree to an uncollateralized trade, or one in which collateral is required by virtue of the fact that all trades must be cleared?’ The first step took the macro context as given across the two systems and analyzed the cost differential at a micro or single firm level. The result was that the two systems were identical in cost. In this post we take the second step and address how each system affects the macro context.

One key purpose of the OTC reform is to reduce the aggregate credit risk in the system. Proponents and opponents disagree on whether the Dodd-Frank bill or other proposals succeed in reducing aggregate risk. There are lots of valid areas for debate here. It is easy to imagine ways in which the requirement for centralized clearing may reduce aggregate credit risk, and it is also possible to imagine ways in which systemic risk may end up increasing. For more detail on both of these, see this report by the New York Federal Reserve Bank. This is where the real bottom line cost to end-users will be decided. If the reform ends up reducing aggregate credit risk, then the cost of trading derivatives will go down, regardless of whether collateral is mandated or not. If mandating clearing—together with other provisions and implementing rules—ends up reducing aggregate risk, then end-users will see a lower cost of financing their derivative positions. The cost will be paid explicitly in the form of fees for explicit credit lines, instead of implicitly in the form of bid-ask spreads on uncollateralized trades, but the aggregate cost will be lower.

So attention needs to shift. End-users need to stop talking about the free lunch they will no longer be getting. Focus needs to be put onto aggregate credit risk. Is it lower or not? If it is not lower, are there steps that can be taken that will make it lower? Lowering the aggregate risk is the key to lowering the cost of the lunch. You know you’re paying for lunch, the question is just what does it cost to make the lunch?

OTC #5 The Collateral Boogeyman – packaging credit implicitly and explicitly

In earlier posts — here and here — we addressed the fallacy that dealers offer end-users uncollateralized derivative deals for which the dealers do not charge any fee for the credit risk they are accepting. This fallacy is at the heart of the horror stories circulating about the dangerous costs that OTC reform will impose on end-users.

That post left open the question, ‘Which system is more expensive to the end-user, one in which both parties can agree to an uncollateralized trade, or one in which collateral is required by virtue of the fact that all trades must be cleared?’ In this post we take the first step in providing an answer to that question.

We need to start by making a distinction between the macro and the micro aspects of the problem. The macro aspects are the ways in which a change in the regulatory and institutional structure of the derivatives market reshapes the aggregate set of credit risks in the OTC market and the wider economy. The micro aspect takes as given the macro, and evaluates how the regulatory and institutional structure of the derivatives market reshapes the risks for a single firm. In this post, we want to put to the side those macro considerations. We’ll return to them in another post. Here we want to focus exclusively on the micro aspect. So we assume that the macro setting is the same under the two systems, and ask the question whether for the individual end-user a system that mandates collateral is more costly than a system which doesn’t.

The answer is that the two systems impose the same cost on the end-user. Mandating collateral does not make hedging more costly for the end-user.

The reason for this equivalence is that the requirement of clearing only makes explicit what is already implicit in every derivative transaction, and that is credit risk. As explained in our earlier post, an uncollateralized derivative deal creates credit exposure. End-users have to pay for that. There is no getting around it. The end-user has two choices. One is for the end-user do an uncollateralized deal, in which case the price is paid directly to the dealer through a wider bid-ask spread. The second option is to do a collateralized deal, in which case the price is paid to whichever bank agrees to fund the credit line supplying the collateral. That bank could be the derivative dealer or some other bank. The cost of the two alternatives is exactly the same.

In a PowerPoint presentation produced for a seminar one of us gave at the CFTC and the FERC we have a more extensive demonstration of this equivalence using the example of an airline hedging its jet fuel purchases. The example employs a common tool of modern financial analysis: the replication of identical risk exposures using two different packages of instruments. Essentially, an uncollateralized swap is equivalent to a collateralized swap plus a credit line that finances the margin.

The key assumption behind this micro argument is that the reform of the OTC market leaves the macro setting unchanged. We revisit this assumption in a later post.

Shocks to Cash Flow Are Absorbed By External Financing

The April 2010 issue of the Journal of Finance carries an article providing a statistical analysis of how firms respond to cash flow shocks. The authors are Vladimir Gatchev, Todd Pulvino and Vefa Tarhan. It stands in a long line of empirical research attempting to nail down an answer to that question. The line is long because firms have broad array of ways to respond, and because these responses can involve complicated dynamic strategies through time. Therefore, getting the statistical analysis right so that one can make a reliable inference is a very difficult task. One of the main points of this article is that most of the previous literature oversimplified the representation of a firm’s available responses and consequently obtained an exaggeratedly large estimate of how capital investment responds to cash flow shocks.

These authors find that capital investment is largely insensitive to cash flow shocks. Instead, the shocks are largely absorbed by changes in debt and other external financing. Given the complexity of the issue, this study is unlikely to be the last word on the matter.

OTC #4 The Collateral Boogeyman – lobbyists trot out the free lunch

During the debate leading up to passage of the Dodd-Frank bill a large number of end-users lobbied to shape the bill’s provisions concerning the OTC derivatives markets. One of the main objectives of their lobbying was inclusion of an exemption for end-users from the mandate that swaps be cleared. Clearing would require that end-users post margin on their positions, while under the old system dealers could sell an OTC swap without any margin requirement. As a part of the lobbying effort a number of end-user trade associations attempted to quantify the capital drain that an undifferentiated clearing mandate would impose on them.

What is striking about these calculations is that they each assume that dealers charge NOTHING for the privilege of posting no margin. A wonderful free lunch if you can get it.

For example, the Edison Electric Institute, a trade association for electric power companies, joined with a number of other energy-related trade associations to produce a report titled “OTC Derivatives Reform: Energy Sector Impacts”. The report is a compendium of little numerical examples, one for each of the lines of business represented among the sponsoring organizations: an independent oil and gas producer, a rural electric cooperative, a publicly-owned electric utility, a public gas utility, a large electric power company, a regulated transmission & distribution utility, a regulated natural gas utility, a wholesale power developer, a competitive electric power supplier, a large natural gas producer and a regional transmission organization. Each example is constructed on the premise that the hedges negotiated under the old OTC system involve costless margin.

The Natural Gas Supply Association, together with the National Corn Growers Association, produced a press release (April 2010) with one of the most quoted figures for the total cost of imposing the clearing and margin requirement on end-users: “Looking beyond our industries to the entire derivatives market, we estimate this provision would drain a staggering $900 billion of productive capital from the U.S. economy – effectively cancelling out the entire economic stimulus package of 2009.” To see the calculation behind the $900 billion figure, one has to contact the NGSA, which we did. Once again, existing swaps are assumed to be open with zero margin and the end-user pays NOTHING for this privilege.

The Business Roundtable, too, attempted to quantify the economy-wide impact in a report based on a survey of some of its members. The report concludes that “a 3% margin requirement on OTC derivatives could be expected to reduce capital spending by $5 to $6 billion per year, leading to a loss of 100,000 to 120,000 jobs, including both direct and indirect effects.” This calculation, too, assumes that under the old system companies are granted swaps with zero margin and at NO COST. The calculation has other weaknesses, too. For example, the $5 to $6 billion annual reduction is really just a one-time reduction. But these other weaknesses, while relevant to the overall public debate, do not reflect the fundamental illusion driving so much of the agitation among end-users. That illusion is the belief in a free lunch.

In the debate leading up to passage of Dodd-Frank, these calculations went largely unchallenged. But the debate is going to be revisited as the rulemaking process grinds forward and the details of the end-user exemption and the terms for clearing and margins are specified. All signs are that many end-users continue to be under the illusion that they can get a free lunch from their dealers. Some know this is untrue, but the calculations are simple and helpful. We can expect these issues to be revisited. But this time calculations like these should not go unchallenged. If we want to understand the potential costs of imposing a clearing requirement we need a reasonable basis for evaluating the cost of credit under both the old and any proposed version of the new system. In estimating the cost under the old system it is clearly wrong to assume a zero cost. Dealers don’t offer unmargined swaps without charging a fee. The hard part is estimating what that fee might be. But we all know it’s not zero.

OTC #3 The Collateral Boogeyman – the delusion of “free” credit from your friendly neighborhood derivatives dealer

During the debate about financial reform, end-users were scared silly about the possibility that they might have to post collateral on their derivative positions. The horror stories that have been making the rounds are largely baseless. The common plot line in these tales runs something like this… (1) In the OTC market as it was before reform, dealers used to sell end-users derivatives without requiring any collateral, (2) after reform, when all trades are forced to be cleared, end-users will have to post collateral, and, finally, (3) collateral is expensive, so that end-users will see their costs of trading go up.

Hidden in the argument is the unstated premise that in the OTC market before reform it was somehow possible to get something for nothing. An uncollateralized derivative transaction between dealer and end-user exposes the dealer to credit risk from the end-user. Dealers know this. Every deal they do with an end-user must be approved internally by a credit committee, just as does any loan. The end-user’s credit is examined and the deal is scored so that the dealer can decide if it wants to accept the credit risk. The deal is also priced with the credit risk in mind. There is no line item charge such as “credit fee in lieu of collateral”, but that doesn’t mean no price is paid. Profit on derivative deals are generally captured through the terms of the deal – i.e. through the bid-ask spread. So an end-user who seeks an uncollateralized derivative is getting credit and paying for that credit.

Complaints that mandatory clearing will raise end-users’ costs of hedging are all premised on the fallacy that the dealer is giving the end-user a free lunch. But that is just not so. It illustrates how poorly informed many end-users are about the real costs of their trades with derivatives dealers. Bottom line, under both systems the end-user has to pay to finance the credit associated with trading derivatives. Under the old system the end-user’s payment is implicit. Under the Dodd-Frank reform, the payment will have to be explicit.

Which system is more expensive to the end-user? That’s a deep question we won’t answer here, but that we do address in other posts. The point here is that the opponents of reform don’t even begin to address the real issues that bear on which system is more expensive. Instead, they have built their opposition on a straw man that assumes end-users are somehow getting their credit for free.

We’ve made this argument in a presentation to the CCRO which is a private, best-practices organization of risk managers at energy end-users.

Packaging Exposure to China

Risks usually come in a bundle. If you want exposure to a particular factor risk – or you want to hedge that particular risk and concentrate your exposure onto other factor risks – you may have to find a way to create that exposure synthetically. Investment managers are constantly looking for ways to do this. The Financial Times had a nice piece on getting exposure to China risk. Hedge fund manager Hugh Hendry seems to think that a portfolio of Japanese corporate bonds has a big China exposure.

OTC Reform #2: End-Users Stand to Benefit from Transparency – Lessons from TRACE

Transparency is one of the objectives of the Dodd-Frank bill and the reform of OTC derivatives markets. End-users and the public at-large stand to gain the most from transparency. Dealers stand to lose as competition is intensified and profit margins are cut.

There is an important precedent for this: the recent reform of trading in the U.S. corporate bond market through the imposition of the TRACE system. A good analysis of what happened appears in a paper by Henrik Bessembinder and William Maxwell, and we rely on the information in that paper for the summary presented here.

The U.S. corporate bond market is very large. In 2006 there was $5.37 trillion outstanding, and $470 billion in new issues. But this market had traditionally been very opaque. Issuances are by different companies in different financial situations, and issuances by the same company differ by seniority, time to maturity and covenants, among other things. Many of the big buyers—insurance companies, pension funds, and so on—hold to maturity, so that there is little turnover in the market. Corporate bonds represent 20% of outstanding bonds, but less than 3% of trading activity. The market had been organized through dealers with little in the way of public price quotation and transaction price reporting. In 2002 the round-trip trading cost is estimated to have been 25 basis points.

At the start of 2001, the SEC approved creation of a new system called TRACE—the Transaction Reporting and Compliance Engine. All bond dealers were required to report to the NASD (National Association of Security Dealers) all trades in publicly issued corporate bonds. The NASD makes the transaction data publicly available through the Financial Industry Regulatory Authority website and 3rd party vendors. The system was introduced gradually between 2002 and 2006, starting with the largest bonds and ultimately covering all of them, and initially allowing a large time delay in price reporting but gradually reducing it.

As a result of the reform and improved transparency, the round-trip cost of trading these bonds have been cut in half.

The flip side of that, of course, is that dealer profits have been reduced. Competition among dealers is more intense. Each bond is offered by a larger number of dealers, and their prices are more competitive with one another. Dealers have seen their revenue drop drastically, by more than $1 billion/year. Employment in the bond trading departments has been cut back sharply.

Transparency in the OTC derivatives markets has the potential to yield similar cost benefits to end-users. These would ultimately be passed along back to consumers.

OTC Reform #1

The Dodd-Frank bill that was signed into law in July 2010 includes important reforms of the OTC derivatives markets. These markets cover a large portion of the financial instruments currently used for risk management at non-financial corporations. The reforms have the potential to make these markets function more effectively, potentially lowering the costs of hedging. But, executed poorly, the reforms could also impede the functioning of the market.

As with all pieces of legislation, passing the bill is only one step in a long process of working out the full content of the reforms. One of the next steps is writing the myriad regulations that will define how the law is to be implemented in concrete detail. The bill mandated that this rulemaking process be completed within 360 days of the bill’s enactment. The CFTC and the SEC—the two agencies with primary responsibility for portions of the OTC derivatives markets—are actively engaged in this rulemaking process.

Throughout the rulemaking process there will be significant debate about how best to implement the reforms. We expect this debate to provide plenty of opportunity to explore the functioning of these markets for risk, how end-users utilize these markets, and other issues central to risk management, and we intend to focus a good portion of our posts on these issues. Consistent with the focus of this blog and our associated course, our attention will be on non-financial corporations—the so-called end-users—and how the proposed rules for the OTC derivatives markets affect the operation of these corporations. We won’t focus on the many other aspects of the rulemaking.

We start with a brief statement of the major objectives of the reforms of the OTC derivatives markets.

Regulatory authority. The Dodd-Frank bill gives regulators authority over essentially ALL trading in OTC derivatives. From the 1980s, a defining characteristic of the OTC derivatives market had been the lack of regulatory scrutiny. In some cases, the markets had evolved this way. In other cases—such as the infamous Enron loophole for energy derivatives markets—this lack of oversight was enshrined into law. The Dodd-Frank bill restored the principle that a well functioning market generally requires some sort of policing.

Transparency. To date, OTC derivatives markets have been among the most opaque of markets. Prices of transactions are generally not publicly available the way they are in so many other financial markets. Even the size of the markets is unclear. What data is made available is in a generally useless format that is incomparable to other markets serving similar ends, such as the commodity futures exchanges, which produce clear and meaningful statistics on their operations. The Dodd-Frank bill mandates “real-time public reporting” of transaction and pricing data. This is facilitated in part by the fact that all transactions must be reported to a trade repository. In addition, a large portion of trading will move onto exchanges and similar entities, where pricing is intended to be more transparent and competitive.

Clearing. A key feature of bilateral markets like the OTC derivatives market is the multiplication of credit risk. Participants often reduce exposure to a certain market risk by adding on an offsetting position. This reduces market risk, but increases total credit exposure. A key innovation of futures markets is the use of centralized clearing, which allows offsetting market exposures to cancel one another, reducing the total credit risk in the marketplace. OTC derivatives markets have generally functioned with much less clearing of offsetting transactions. The Dodd-Frank bill mandates clearing of all standardized OTC derivatives. And by establishing higher capital requirements for non-cleared transactions, it encourages the standardization of the derivatives being offered OTC. The objective is to reduce the total volume of credit risk in the system, and to reduce the systemic risk.

Will the Dodd-Frank bill accomplish these objectives? Stay tuned.

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