Phantom Costs to the Swap Dealer Designation and OTC Reform

The CFTC is working to finalize the rule defining swap dealers and major swap participants. Under the Dodd-Frank financial reform, the rules governing operation of the OTC derivative market operate in large part through codes of conduct imposed on these entities. As reported most recently by Silla Brush at Bloomberg, a number of companies are hoping that the rules will be redrafted so that they escape designation and the responsibilities that go along with it. To bolster their lobbying effort, these companies commissioned a report by the economics consulting company NERA to estimate the costs of applying the law to them. The Bloomberg story quotes me as saying that “the study exaggerates the costs of the rule.” Here’s a little more meat behind what I meant.

NERA calculates the cost of posting margin as follows. According to the 26 companies that sponsored its report, the average company would have had to post $235 million in margin. NERA estimates the margin account would have earned interest at a rate of 3.49%, pre-tax. According to NERA, the Weighted Average Cost of Capital (WACC) for the energy companies who sponsored its report at 13.08%, pre-tax. That is, in order to raise the capital needed to fund an extra $1 in the margin account costs the average company 13.08%, but that account only earns 3.49%. The difference is 9.59%. The idea is that a company is losing the difference, or 9.59%, on every $1 is has to post in margin. Multiplying 9.59% by $235 million per firm yields an annual cash flow shortfall of $23 million per firm, NERA’s estimated Annual Carrying Cost of Margin.

One big error in the calculation is the use of the 13.08% WACC figure as an estimate of what it would cost to fund the margin account. This is comparable to the error of discounting a specific project’s cash flow using the company’s WACC, ignoring the fact that the risk of the project may be very different from the average risk of the firm. Every introductory corporate finance textbook warns the reader against this mistake. The average WACC reflects the average riskiness of all of the different assets of the firm. It makes no sense to compare the average WACC against the expected return of a specific asset or project and claim that that is a rate of return shortfall. A manager who did that, would consistently see a shortfall in relatively safe projects and a premium in relatively risky projects, regardless of the actual NPV of each project. The NPV is determined by comparing the project’s expected return against the project’s own cost of capital, not against the firm’s average cost of capital. Only in the specific case that the project’s risk equals the firm’s average project risk, is the WACC coincidentally the right cost of capital. That is clearly not the case for the margin account. It is invested in relatively safe assets. In contrast, the NERA companies’ average WACC reflects investments in power plants, oil wells, and derivative trading operations, all of which can be expected to be much riskier. That is why NERA’s calculation is an exaggeration. It isn’t just off by a rounding error. The key number it uses has absolutely nothing to do with what NERA purports to measure.


  1. Posted January 25, 2012 at 2:34 am | Permalink

    Stan, that’s a fair point, but let’s distinguish 2 different issues. First, the point of my post is to say one shouldn’t use the WACC as the measure of the required return on the collateral account. Instead, you have to ask about the riskiness of the collateral account itself. Whatever that is, it’s the right number. Second, what is the right number? I said the funds would be invested in relatively safe assets, while you counter with the dangers evidenced by MF Global. Reasonable people may differ here, while still operating in accordance with the first point, that is, looking to the risk of the asset itself to determine the required rate of return. But the range of difference isn’t likely to include anything anywhere in the vicinity of NERA’s 13% figure, at least not the range justified by any evidence.

  2. Posted January 24, 2012 at 7:54 pm | Permalink

    I’m not sure I quite follow what you mean when you say that” the margin account…is invested in relatively safe assets”..
    Isn’t that what John Corzine might of have said and did ?
    As your aware all his trades were “centrally cleared” …Repo too..

    I’m not sure about the proposed future rules… but its my impression that the Variation margin ends up being a bet on the capitalization and customers of the clearinghouse your dealing with..

    Am I wrong…

    Stan Jonas

3 Trackbacks

  1. By NERA Doubles Down « Betting the Business on March 19, 2012 at 5:03 am

    […] a previous blog post, I criticized a study by the economics consulting firm NERA purporting to measure the costs […]

  2. By Thursday Breakfast Links | Points and Figures on February 2, 2012 at 6:28 am

    […] article on OTC swaps reform. What you get is a nice lesson on WACC. Weighted Actual Cost of Capital. […]

  3. […] with errors and unfounded assumptions, even worse than the Volcker Rule piece. (For a critique see the observations of Professors John Parsons and Antonio […]

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