Monthly Archives: April 2011

Margins & End-Users #4: The Hidden Cost of Credit in Non-margined Derivatives

When an end-user posts margin on a derivative, the cost of posting the margin is easy to identify. For example, if the margin is funded by drawing down on a line of credit, interest is paid on the credit line. The end-user also earns money on its margin account, so the net cost is the difference between the two cash flow streams. The size of the difference will vary through time and depending upon circumstances. For example, if, as time progresses, the market moves against the end-user, the margin account will be drawn down so that the difference between the two cash flow streams grows.

What about when a dealer bank sells a derivative and forgoes any requirement that the end-user post margin? Some people think the end-user is getting a better deal. If, as time progresses, the market moves against the end-user, it will accrue a liability with the dealer bank. But the end-user doesn’t pay any interest on this liability. So, these people evidently believe, the end-user is getting credit for free.

Actually, the dealer bank is not foolish enough to open a derivative trade with an end-user forgetting about the possibility that the end-user might accrue a liability. The dealer bank does charge for this credit. But the charge is not separately itemized anywhere. Where is it? It’s in the bid-ask spread. When the dealer bank sells the derivative, the terms of the sale bake in a profit. If the derivative is not margined, so that the dealer bank may end up extending credit it will set a wider bid-ask spread and bake in a larger profit.

Just because the price of credit is never separately itemized is no reason to believe the end-user isn’t paying the price.

Margins & End-Users #3: Chicken Little

In our last post on margins and end-users, we explained the fallacy at the heart of the complaint that a margin requirement would deplete an end-user’s scarce capital. A number of people have put the question to us, “If you are correct, then why are so many business interests lobbying so hard against the mandate?” It’s a fair question. We have been asking it in one version or another since the discussion on OTC derivatives reform began and the lobbying began. There are many approaches and aspects to the question, and, probably, many divergent answers. In this post, we’d like to raise just one point on the matter: just because many end-users oppose the mandate doesn’t automatically mean their arguments are valid.

We’ve been through this before. Those readers who are old enough to remember the 1990s will remember another political battle over how to deal with stock options granted as a form of compensation to employees.

Under the then applicable method for accounting for stock option grants, Accounting Principles Board (APB) Opinion No. 25, at-the-money options could be awarded as if they had a zero cost. Companies were able to give valuable compensation without charging an expense.

Of course the option grants had value. Of course, granting stock options as compensation was an expense to the firm. But the accounting did not correspond to the reality. When stock option grants had been few and small, this was not a big deal. But when option grants grew to become a major element of compensation, especially in certain industries and among senior management, the discrepancy between the accounting and the reality became too large to ignore.

In 1993, FASB, the professional accounting standards organization, proposed mandatory expensing of option grants.

Large portions of the business community were alarmed and initiated a massive public relations and lobbying effort to stop this. The claim was made that expensing options would discourage the use of stock options to reward performance and obstruct the effort to align the interests of the management and shareholders. The mandate would destroy the growth of the high tech sectors, costing Americans precious high end jobs. Cisco System’s CEO announced that “I think it will impact whether we grow headcount again to the same extent in the US or not”. A study by the Employment Policy Foundation was circulated among policy makers claiming that the loss to the economy would be more than $2.3 trillion over a decade. The world as we then knew it would end.

When the lobbying failed to persuade the accounting standard setters, the companies turned to Congress, threatening to legally undercut FASB’s authority.

In 1995, FASB backed down. What we then got was FAS 123, a watered down requirement for companies to either expense or at least disclose in the footnotes the impact of options awards on earnings per share.

Then came the dotcom bust and the WorldCom and Enron accounting scandals, among other events. The authority and aura surrounding the opponents of expensing flagged. The public came to see the flexibility in accounting standards in a new, unflattering light. More people understood the value of requiring that companies call a spade a spade.

In 2004, FASB issued a new rule, 123(R), finally requiring companies to expense option awards in their financial statements.

The economic calamity that had been forecasted to follow this requirement did not happen. Now, a few years later, the option expensing mandate is largely uncontroversial—at least as uncontroversial as any other accounting rule.

We believe the situation with regard to end-user complaints about margining their derivative trades is analogous. It is another case of individuals being enchanted with a form of financing that seems costless only because it is off-balance sheet. Just because costs are not disclosed doesn’t make them disappear: they are there and they are real. Recognizing the costs does not create the costs. On the contrary: what often creates unnecessary costs is the refusal to be up front and transparent about them, whether in the design of nonsensical accounting rules or in the crafting of exemptions in regulatory regimes. Mandating margining does not raise the costs of hedging. The forecasts of dire economic consequences are unfounded.

Margins & End-Users #2: Does a Margin Requirement Deplete An End-User’s Scarce Capital?

In a previous post, we described the recent rulemaking proposals for implementing the Dodd-Frank OTC derivatives reform with respect to end-users and the margin requirement. We ended by noting that a variety of business interests continue vigorous lobbying campaigns targeted to expanding the end-user exemption from the margin requirement. The main argument goes something like this…

  1. in the old, unregulated OTC derivatives market, end-users could negotiate a swap with their dealer banks without any requirement to post margin;
  2. a requirement to post margin depletes an end-user’s scarce capital;
  3. this raises the cost of hedging and doing business, companies become less competitive and jobs are lost.

Does a margin requirement deplete an end-user’s scarce capital?


The margin requirement only forces the end-user to recognize on its balance sheet a contingent capital requirement that, absent the margin requirement, lies off-balance sheet.

A private, uncollateralized derivative contract—as opposed to a centrally cleared one—has a profit and loss account with the dealer bank. If, as time progresses, it happens that the end-user is losing money on the trade, the dealer bank is de facto lending it money. Before agreeing to the derivative, the dealer bank will have calculated the potential size of the liability that might accrue. Within the dealer bank, a credit committee will have to approve the derivative, just as if the derivative included a loan. Remember, we’re just at the starting point, when the derivative is first negotiated. Formally, there is no loan and no liability yet shows up on the end-user’s balance sheet. Nevertheless, the bank is approving the deal with an eye to a contingent liability. Before approving the deal, the credit committee will review the end-user’s file, examining its current credit rating, the set of other liabilities it has outstanding, its current cash flow situation and so on.  If the end-user has already used up all of its debt capacity, the bank is not going to approve the derivative. It will only approve the derivative if the end-user has some unused debt capacity, and the bank will count on that unused debt capacity to assure that the bank gets paid in the event that the price of the derivative moves against the end-user. Each uncollateralized derivative contract approved consumes some of that debt capacity, so there is a limit to the volume of uncollateralized transactions the dealer bank will approve. Although the contingent liability does not immediately appear on the balance sheet, the dealer bank knows it is real enough.

If a margin requirement is imposed, then the end-user can fund the margin account with a comparable loan from a bank. Of course, this loan must be recorded on the balance sheet.

For the end-user, this is the only difference between the two systems: on- or off-balance sheet financing of its trading in derivatives. The end-user’s creditors take careful note of the off-balance sheet financing it uses. It faces the same capital constraint under both systems. If posting the margin exhausts its available capital, then opening the unmargined derivatives contract will also exhaust its available capital. Allowing the trades to be financed off-balance sheet does not give the end-user any extra debt capacity. Imposing the margin requirement does not bump up against any capital constraint any sooner. Removing the margin requirement does not release any capital for use elsewhere. The only difference to the end-user is in the accounting—does the contingent liability lie on- or off-balance sheet.

Margins & End-Users #1: What’s Up?

As regulators tasked with implementing the Dodd-Frank reform of the OTC derivatives market continue the task of drafting regulations, debate continues surrounding the issue of whether end-users will be forced to post margin on their swap transactions. We addressed the central economic points in a series of posts last fall–(1) (2) (3) (4). Since then we returned to the issue as it occasionally popped back onto the radar screen. In the wake of new draft rules released in mid-April, we thought it useful to take stock once again.

There are two separate components of the Dodd-Frank reform that are the primary focus of this debate.

First, there is the mandate for a large portion of swaps to be cleared in a central counterparty clearing (CCP). Clearing entails margining.  So a clearing mandate applied to end-users would require end-users to post margin. However, the law specifically exempts end-users from the clearing mandate. Debate continues over how the implementing rules will define an end-user. Everybody wants their own trades to qualify under this exemption.

Second, there is the mandate for swaps not cleared in a central counterparty clearing (CCP) to nevertheless be margined. The draft rules released earlier this month pertain to this mandate. The CFTC’s proposed rules exempt end-users from the mandate to post margin on uncleared swaps. Banking regulators—the Federal Reserve, FDIC and others—proposed rules that exempt end-users up to a certain threshold exposure, after which margin must be collected. These draft rules are now up for comment.

A variety of business interests continue vigorous lobbying campaigns targeted to expanding the end-user exemption from the margin requirement. Why?

The main argument goes something like this…

  1. in the old, unregulated OTC derivatives market, end-users could negotiate a swap with their dealer banks without any requirement to post margin;
  2. a requirement to post margin depletes an end-user’s scarce capital;
  3. this raises the cost of hedging and doing business; companies will be forced either to hedge less and become riskier, in turn increasing the overall risk in the system; alternatively, costs will go up , companies will be less competitive and jobs will be lost.

In the next post we’ll examine this argument.

GNP linked securities? Link to inflation as well.

In an article in the Financial Times this week, Patrick Honohan, Governor of the Central Bank of Ireland, proposes that Irish debt repayments be linked to the country’s growth:

“One dimension which, in my personal view, has not yet received the attention it deserves is the potential for mutually beneficial risk-sharing mechanisms. A variety of financial engineering options could be considered going beyond the plain vanilla bonds currently employed.

A simple version, which could indeed be useful beyond the specific case of Ireland, would, over time, shape the arrangements with European partners in such a way that Ireland pays more if its GNP growth is strong; less and slower if growth remains weak. The aim of such GNP-linked bonds or similar risk-sharing innovations must be to restore, through growth, a favourable dynamic to the sovereign debt ratio, putting its sustainability too, like that of the banks, beyond doubt.”

After a sharp decline in GNP per capita that put Ireland back a decade, Patrick Honohan is worried that the downward cycle of debt overhang and austerity measures will further erode growth and make debt even more burdensome. Continue reading

Can Goldman Sachs’ Financial Engineering Make It A Synthetic End-User?

Oil Daily, a publication of the Energy Intelligence group, had a story yesterday authored by Gregory Gethard about a deal between the refining company Alon USA and Goldman Sachs’ commodities trading arm, J. Aron. The headline reads: “New Goldman Sachs US Refinery Deal Sets Alarm Bells Ringing”.

What is the structure of the deal, and what are the alarm bells about?

First, to the structure… According to the story, the refiner, Alon, agrees to purchase from Goldman 70,000 barrels of crude oil per day for use in its Big Spring Refinery in Texas. Goldman, in turn, purchases from Alon the refined products it produces. Goldman also pays to lease the storage facilities at the refinery. The sales are all made at market prices. The deal runs at least through May 2013, and potentially into 2016. These general terms of the deal were outlined by the refiner in an 8K filing with the SEC. A similar deal had been executed between Alon and Goldman in mid-2010 for product at Alon’s Krotz Spring refinery in Louisiana, as reported in a company 8K filing with the SEC. An article on by Pauline McCallion describes that earlier deal and the motivations for it.

What are the results of the deal? How does it restructure risk?

Continue reading

%d bloggers like this: