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…
- in the old, unregulated OTC derivatives market, end-users could negotiate a swap with their dealer banks without any requirement to post margin;
- a requirement to post margin depletes an end-user’s scarce capital;
- 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.