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.