To get a measure of what financial markets think about plans to make trading in derivatives more uniform and transparent, ask no further than the regulators themselves.
|||To get a measure of what financial markets think about plans to make trading in derivatives more uniform and transparent, ask no further than the regulators themselves.
Thomas Huertas, a senior official at the UK’s Financial Services Authority, said recently that unless the plans to centralise trillions of dollars’ worth of contracts were thought through carefully, it could be a bit like “putting a Chernobyl in the back yard”.
With its echo of Warren Buffett’s description of derivatives themselves as “financial weapons of mass destruction”, Huertas’ choice of language reflects how potent the industry has become, not to mention hard to understand and difficult to tame.
Yet, that is just what regulators are trying to do, and they have got a fight on their hands.
Big companies regularly use derivatives as a form of insurance to guard against jumps in the price of everything from cocoa to interest rates. An airline will buy jet fuel derivatives so that if prices spike, the contract helps to make up the difference in price, enabling the carrier to budget and plan ahead. If jet fuel prices fall, the loss made on the derivatives contract is cancelled out by savings from cheaper refuelling bills. It is the same with barley for beer or aluminium for cans, or any other commodity you can think of.
Shifting exchanges
For investment banks, this business is a high-margin, low-volume trade they are loath to lose. The new regulations, which should make derivatives trades easier to follow, are likely to shift some trade onto exchanges – which companies and banks alike say would boost their costs.
More than 90 percent of derivatives contracts between banks and other banks, or between banks and companies, are currently drawn up directly between the buyer and seller on what is known as the over-the-counter (OTC) market. OTC is an enormous sector, which is worth nearly $600 trillion (R4.2 quadrillion) on paper, roughly 10 times world economic output.
But the OTC market is opaque: regulators find it hard to see who is selling and who is buying. That is especially true when things go wrong, as they did so spectacularly in 2008. When US bank Lehman Brothers collapsed, authorities struggled to pin down who was exposed to derivatives contracts negotiated by the bank, raising worries about contagion.
When American International Group’s (AIG’s) hoard of derivatives turned toxic, the insurer required a $182bn bailout from US taxpayers.
A few months after AIG, leaders of the Group of 20 (G20) leading economies agreed that derivatives contracts should be standardised, centrally cleared, reported and, where appropriate, traded on an exchange or similar electronic platform.
The changes are due to come into force next year, which is why airlines, beer makers and plenty of other companies are so worked up. The OTC market has largely been left to its own devices since it took off in the 1970s, when the collapse of the Bretton Woods system exposed businesses to risks like currency swings, for which derivatives offered a hedge. Now big business worries that the extra layers of complication will make life far more costly.
“The proposals would lead to a large increase in cash collateral required from airlines, which they do not have,” said Brian Pearce, the chief economist at the International Air Transport Association (Iata). “Hedging would become much more expensive because of the cash requirements.”
Regulators privately say industry estimates on the extra costs of the new rules are, in the words of one, exaggerated “hogwash”.
“The costs from the absence of transparency and standardisation in derivatives were huge during the crisis and implicated taxpayers, which must not happen again,” says Michel Barnier, the EU’s financial services chief, who has written a radical reform of the sector.
While final details of the new rules are yet to be put in place, the fundamental direction is clear: regulators want to impose a framework on derivatives that borrows heavily from stock markets.
Legislators in Europe and the US have been busy on the new rules. In 2010, Washington approved the Dodd-Frank law, a sweeping reform of Wall Street that incorporates the G20 push towards standardisation, central clearing, mandatory exchange trading for some contracts and reporting.
Clearing houses
The EU is set to approve a similar law. The key – and most costly – change will be the push to centrally clear derivatives contracts, a common and easy process for share trades because stocks are uniform. Regulators are keen on using clearing houses because they are backed by a default fund so that even if one side of a trade goes bust, the contract is completed and settled without disruption to markets. Not only are risks known and contained, according to regulators, but there is also a full electronic audit trail of the parties on both sides.
But companies fear more bureaucracy. Take the example of an airline. “For the airlines, fuel can be 20 to 30 percent of their cost base, so they’ve always had to be very systematic about managing price volatility and are therefore the most mature sector in terms of using OTC contracts,” says Steven Jones, a managing director for the commodities business at Morgan Stanley.
Though airlines buy jet fuel on an ongoing basis, there is no standardised derivatives contract. This means the airline has to call Jones and ask him to write a bespoke deal. Morgan Stanley, one of 14 or so trading houses with deep enough pockets and experience to offer such contracts, then draws up an agreement derived – hence the term derivatives – from the underlying commodity, in this case the price of jet fuel on the physical market as tracked daily by Platts, an energy publication. As airlines buy fuel through the month, Jones factors in changing spot prices, which is one reason why such a deal is hard to standardise.
That may all change over the next two or three years. In OTC trades, banks typically charge long-standing customers a credit fee with no security needed. But in the new system, derivatives customers such as airlines may have to clear each trade they make, which means posting daily margins – a proportion of the sum risked. They will also need to have a pool of cash to cover any calls for those margins should the market move against them. Some bankers estimate that for an airline this cash pool might amount to several million dollars.
“The main concern for corporates is cash flow management, and how to deal with the… margin calls that come with doing a trade on exchange or through a clearing house,” said Jones.
“Dealing with a bank direct on an OTC basis enables a corporate to utilise the bank’s credit line, and thus removes the administrative burden of managing daily margin calls.”
Indeed, an International Swaps and Derivatives Association survey of corporate derivatives last year found just 47 percent of corporate contracts were collateralised at a cost of just over $3 trillion.
Collateralisation at the moment is voluntary.
Airlines – or any company that hedges using derivatives – will not be able to avoid margin calls by sticking to uncleared contracts because regulators plan to slap punitive capital charges on them. This rule is designed to force companies to use standardised contracts that can be centrally cleared and even traded on an exchange.
Unless a standardised contract emerges for bespoke contract users, companies face trying to use exchange-traded proxies – oil derivatives, say – but may end up with an imperfect hedge. That is likely to drive up operating costs.
“We have already seen airlines reduce hedging as it got more expensive, leaving airlines more vulnerable to fuel price volatility,” Pearce said.
And it is not just airlines. A study by a coalition of US business groups estimated a 3 percent margin requirement on swaps used by Standard & Poor’s (S&P) 500 companies could cut capital spending by $5.1bn to $6.7bn and cost up to 130 000 jobs.
Craig Reiners, a commodity risk manager at US brewer MillerCoors, told US Congress last month that he spent $2.8bn a year on commodities such as aluminium for cans and barley for beer. Asked if regulatory costs were likely to be passed on, forcing up the price of a six-pack, Reiners said: “It would certainly have an impact.”
Iata was unable to say if higher hedging costs would be reflected in ticket prices. Jon Eilbeck, a managing director of Deutsche Bank, says that without the ability to hedge jet fuel costs through OTC derivatives, “European airlines would face significant problems”.
Policymakers have little time for those complaints. They say higher costs in derivatives trading will simply correct a situation where risks have been underpriced, or priced in an opaque way.
“We’re aware and focused on the cost of a six-pack because we also oversee agricultural markets,” Commodity Futures Trading Commission chairman Gary Gensler told Congress last month after Reiners’ remark.
“I would say our intention is not to have margin requirements applied to an end user such as MillerCoors.”
Svein Andresen, secretary-general of the Financial Stability Board, the body tasked by the G20 leaders to turn its pledge into action, says the financial crisis exposed a host of weaknesses – limited transparency, counterparties with big exposures, poor risk management – that must now be addressed.
Transparency
The derivatives industry, though, fears the new regulations will go beyond simply making derivatives safer and more transparent.
Some believe they aim to shrink the sector as another way to cut banks and their profits down to size.
“What I am keen to see is that legislation does not have as one of its purposes to make a market bigger or smaller,” said Damian Carolan of law firm Allen & Overy.
“Players in the market understand (that if) the regulatory burden will increase, profits in the industry will shrink.”
The investment banks that offer bespoke trading in derivatives face the loss of tens of billions of dollars in revenue from the shift to central clearing. JPMorgan said last year it alone could lose roughly 10 percent, or between $2bn and $3bn annually, in revenues.
“The general guesstimate is probably 15 to 20 percent of investment banking revenue in total is derivatives-related. It’s an order of magnitude that’s a material issue for some of them,” said Piers Brown of Evolution Securities.
Some bankers even see the new regulations as one weapon in an ideological war against them. Should the entitlement to enter into private trading now be seen as exceptional rather than the norm, they ask.
“On OTC clearing, it may end up costing too much for a pension scheme to buy a bespoke contract to hedge a risk,” said Guy Sears of Investment Management Association. “The requirement to put trades through a clearing house and exchange paradoxically may mean that some risks will be managed in a less efficient way. You will have unhedged risks that society will carry.”
The reality, said Denzil Jenkins of Chi-X Europe, “is that OTC is absolutely going to shrink and OTC will probably be a minuscule proportion of what it was before”.
Could London and New York lose their place as the chief derivatives markets in the world? Anthony Belchambers of the Futures and Options Association believes the way the new rules are enforced will be critical.
“If the US and EU miss a step in getting the balance right between safety and risk, the Asian markets and financial centres will be the beneficiaries,” he says. – Reuters
Source: http://www.iol.co.za/derivatives-reform-may-cost-billions-1.1034155
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