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.