Category Archives: OTC reform

Moody’s Slips on ICE

As reported by Platts, Moody’s recently issued an analysis of the decision by ICE, the Intercontinental Exchange, that starting January 2013 its cleared OTC energy swap products would switchover and be traded as futures products. Moody’s called that “credit negative for power producers.”[1]

There are many things wrong with the Moody’s analysis. Continue reading

Exelon’s On- and Off-Balance Sheet Collateral Costs

In covering the Intercontinental Exchange’s decision to move its energy swap trades onto its futures exchange, the Wall Street Journal’s Jacob Bunge and Katy Burne cited data on the power company Exelon in order to highlight how this move might impact end-user costs:

One company worried about costs, Exelon Corp., said in a regulatory filing on May 10 that “even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral.”

But the $1 billion figure is only half the story. The other half of the story is the contingent capital that Exelon saves. But since that contingent capital is off-balance sheet, it is commonly overlooked, leading both corporate executives and reporters to significantly exaggerate the cost of using cleared futures exchanges.[1]  In comparing the financing costs of non-margined OTC trades against the financing costs of exchange-traded derivatives, it’s important to look at both the on- and off-balance sheet capital demands.

Continue reading

Turn a Blind Eye to Credit Risk?

When a bank makes a loan to a business it assumes some risk that the loan will go bad. Regulators, when they do their job, demand that the bank estimate that risk and hold capital against it. That’s safe and sound banking.

What if a bank embeds the same loan inside a derivative it sells to the business? Should the regulators treat that credit risk the same and demand that the bank estimate that risk and hold capital against it? Six U.S. Senators say “no.” They want bank regulators to turn a blind eye to credit risk so long as that risk is packaged inside an OTC swap. So much for safe and sound banking.

Yesterday Senator Mike Johanns (R-Neb.), Mike Crapo (R-Idaho), Herb Kohl (D-Wis.), Jon Tester (D-Mont.), Pat Toomey (R-Pa.) and Kay Hagan (D-N.C.) filed a bill (S. 3480) designed to block bank regulators from recognizing the credit risk embedded in OTC derivatives sold to end-users. Naturally the Senators’ press releases wax lyrical about how their bill protects these end-users by lowering their costs of managing risk. This is a dangerous illusion.

All American businesses suffer when the U.S. financial system is made unsafe and unsound. Following on the Dodd-Frank Act, banking regulators last year proposed a sensible rule finally requiring banks to properly recognize the credit risk embedded in the derivatives they sell. That’s safe and sound banking, and if this country can find its way back to a safe and sound banking system all of America’s businesses will benefit.

The proposed bill seeks to reverse course, directing bank regulators to turn a blind eye once again to obvious risks. It’s a seductive proposition. With a stroke of a pen, the Senators believe they can save a few businesses the costs associated with this credit risk. But no act of law can actually erase the credit risk and the associated cost. The proposed bill only encourages more unsound trading and the accumulation of unaccounted for risk. For a short while, certain businesses will benefit by not having to pay full fare for the risks they add to the banking system. It’s always good while the party lasts. But, in the end, we all lose.

OTC RIP

On Monday, the Intercontinental Exchange, ICE, announced that as of January 2013 all of its cleared OTC energy swap products would switchover and be traded as futures products.

This is one of the outcomes of the Dodd-Frank Act’s reform of the OTC derivatives markets. A very large fraction of swap transactions are economically identical to futures transactions, and the only rationale for that portion of the OTC market had always been evasion of regulation. Now, with the OTC swaps market subject to a parallel set of regulations substantially comparable to the regulation of futures contracts, the rationale for trading many products as OTC swaps is gone.

The OTC swaps market will continue to provide customized products not suitable for trading and clearing on futures exchanges, and in its press release, ICE confirmed that that portion of its OTC swaps business would remain: “All uncleared swaps will continue to be listed on ICE’s OTC platform, which will register as a swap execution facility.”

During the debates over reform of the OTC swaps market, much was made of the OTC market’s ability to offer customized products. While this ability was advantageous, its relevance to the size of the OTC market was always exaggerated. ICE’s announcement for its energy products is likely to be just the first in a major switch back to futures trades for a sizable fraction of the OTC market. The exact extent and the timeline for this switch will depend on many factors, including the ongoing battles over how specific rules are implemented and the ongoing shakeout in the future business model for banking.

Morgan Stanley says potahto

You like potato and I like potahto,

You like tomato and I like tomahto,

Potato, potahto, tomato, tomahto!

Let’s call the whole thing off!

            from Let’s Call the Whole Thing Off by George & Ira Gershwin

This past Tuesday was the closing date for Comment Letters to the CFTC on its proposed Volcker Rule, and this gives us a second batch of responses to consider. The letter submitted by Morgan Stanley (back in February) is interesting because in Attachment 2, the company focuses specifically on commodities and provides three Example Customer Transactions that Morgan Stanley alleges would be impaired by the proposed Rule. These examples help to make concrete the actual activities that the banks allege are uniquely provided by banks and that are endangered by the Volcker Rule.

For today, let’s focus on just one of Morgan Stanley’s three examples:

Example B, Helping a Major U.S. Airline Reduce Jet Fuel Related Costs.

As part of a Chapter 11 restructuring, a leading U.S. airline sought Morgan Stanley’s help to reduce its operating costs, working capital requirements, and balance sheet usage associated with its jet fuel supply. Prior to bankruptcy, the airline managed a large jet fuel supply operation in which it maintained up to a month’s inventory, creating significant operational overhead and a need for costly financing. To reduce these expenses, Morgan Stanley provided the airline a long-term contract for delivery of jet fuel, typically one day prior to the airline’s daily need to service its fleet. Morgan Stanley provided all logistical support and sold the airline jet fuel at a lower price than it was paying previously. This enabled the airline to reduce its operating expenses, reduce the size of its balance sheet and lower its overall interest expense.

I’m missing the part where Morgan Stanley explains how this is market making. Continue reading

CVA Lessons: Is it better to charge or to subsidize credit risk?

One often hears that competition promotes the efficient and weeds out the inefficient. Yes, but only insofar as there is a level playing field. Give special privileges to certain players, and the best might end up dominated by the inefficient.

Analysts who overlook the power of privileges may mistake dominance for efficiency, getting backwards the true state of affairs.  They also miss that the distortion reduces the welfare of society and redistributes wealth and power in favor of the inefficient.

That’s true in any industry and especially relevant in the case of the dominance of OTC derivatives markets over exchange trading during the last three decades.

Continue reading

Reply to “jump”

In a previous post, I criticized a report by the consulting firm IHS on the potential impact of the Volcker Rule on the US energy industry.  Kurt Barrow, Vice President of IHS Purvin & Gertz and co-author of that report, has sent me the following reply:

Thank you for your interest in our report.  We wanted to take an opportunity to clarify a few points about our work.

The first point in your Blog refers to “bans banks from proprietary trading” but should instead speak to “restrictions on market makers.”  We have no issue with bans on bank proprietary trading, and the banks have already exited, or are Continue reading

The quickest way to a conclusion, … jump.

Earlier today, the consulting firm IHS released a report decrying the horrible consequences that the Volcker Rule would have for the US energy industry and the economy.

It’s a hatchet job.

Why?

Continue reading

NERA Doubles Down

In a previous blog post, I criticized a study by the economics consulting firm NERA purporting to measure the costs companies would face as the Dodd-Frank reform of the OTC derivative markets is implemented. NERA is working on behalf of a group of energy companies lobbying to avoid some of the law’s mandates. Last week, NERA filed a “Briefing Note” with the CFTC specifically addressing my criticism and explaining the reasoning that leads them to stand by their original numbers.

What is at issue? Dodd-Frank forces companies to margin swap trades that previously could be executed without margins. Does this impose extra costs on those companies? If so, how large are these costs?

Continue reading

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.