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Wednesday, June 23, 2010

Why Don't Corporations Want to Save Money On Their Swap Transactions

As someone that worked for years marketing derivatives transactions to corporations for use in hedging one element of the debate over financial services reforms mystifies me (well actually one of many). It is how corporations have lined up with the banking community in opposition to a clearing house and transparent pricing in derivatives products.

nyt gives an overview

Currently, the only way to trade many derivatives is to call up various dealers and ask for the price at which they are willing to buy or sell. The securities dealer profits from the difference between the prices at which it buys from one party and sells to another. Investors rarely, if ever, see details on the other side of the trade. Wall Street has signaled that it can live with a clearinghouse approach, but it is strongly opposed to exchange trading of derivatives, which would introduce price competition and lower the profits

The ostensible argument is that in a clearing house arrangement companies would be obliged to tie up capital in posting margin. But the margin can be posted with treasury bills and earn interest and should the swap value move in favor of the corporation there would be extremely small margin requirements. So the cost of posting margin would be minimal. Furthermore as descibed below the lack of collateral requirement means there is a cost for credit extension built into the pricing.

It's not hard to understand why the swaps dealers would oppose the clearing house. The increased transparency would allow end users to easily compare prices and thus cut the margins on their transactions massively. As someone who was involved in the early days of some interest rate and currency derivatives I can assure you that once there was a bloomberg page giving transparency to pricing the gravy train of profits on the transactions ended, The products became commoditized the profits slashed and the "rocket scientists" were off to invent a new product that would be harder for clients to value.

There seems to be little doubt that the clearing house and transparent markets on swaps would slash margins and reduce the cost of swaps for corporations by hundreds of millions of dollars far in excess of any costs related to margin. Yet these corporations are on the side of those very dealers that are trying to preserve a market structure that puts the corporations at a gross disadvantage.

an ex Goldman VP Walter Turbevikke who blogs writes an informational advantage in a non transparent market  is crucial to large profits for the dealers:

 A trader views these advantages(better access to the markets and information than corporate counterparties) as central to his or her livelihood. Fairness, a level playing field and social utility are not important considerations to a trader. In fact, for a trader to perform the functions that are desirable, such as accurate pricing of commodities, this is appropriate.

An additional factor is counterparty risk. With swaps as currently structured should the counterparty go bankrupt the institution on the other side of the contract would be holding a worthless piece of paper as was the case for Lehman and would have been the case for AIG had the Fed not stepped into the lurch.

In contrast there was not a single failed transaction on the billions of derivative contracts traded on the Chicago Mercantile Exchange. Why was that ? because there is a central clearing house, contracts are marked to market every evening and adequate margins must be posted before trading opens the next day. The prices on the instruments traded there: fully transparent with extremely narrow bid/ask spreads. No surprise that those very banks arguing for non transparent markets for swaps trade tens of millions of dollars on the world's futures markets every day.

Experience with corporate treasury departments leads me to suspect there is another factor at work in the corporate campaign for a non transparent market that will cost them $100s of millions. The savings from moving to a transparent maket is an opportunity gain. It never shows up on an income statement or a balance sheet.

On the other hand the new proposal will include mark to market rules for all transactions. In other words even though under current accounting rules changes in value on hedges don't hit the income sheet, financial reports andevery and balance sheets will show the values of these swap transactions and they will be more transparent to financial analysts and shareholders.. While ostensibly the swap transactions will offset exposure to other price movements (exchange rates or interest rates) the increased scrutiny may make things a bit uncomfortable for corporate treasurers on the wrong side of the market. Without market to market it might have been possible to obscure this. With mark to market....impossible.

Could it be that management of these corporations in joining hands with the banks that peddle them derivatives are more interested in income and balance sheet management than in creating shareholder value ?
It wouldnt be the first time.

Wallace Turbeville  has an interesting piece that gives another accounting angle on derivatives. Currently when a bank offers a derivative to a corporation without margin requirements it is effectively making a credit extension, it must tie up capital in the event of client default.  The credit doesn't show up as a loan but is priced into the derivative transaction. The economic impact of the credit extension being part of the swap price or a loan or a loan made to the corporation to post derivative would be the same. Furthermore the lack of a clearing house and the credit extension embedded in the derivative is more likely to tie the corporation to a particular financial institution putting it at a pricing disadvantage. But this credit extension unlike a straight loan shows up nowhere on financial statements. He argues:
• the financial statements of a company that borrows money from a bank to post collateral on a derivative should look the same as
• the financial statements of a company that has an agreement with a counter party to forgo posting collateral.
While I have not reviewed the accounting treatment of every end user and every arrangement, it is certain that in a number of situations, foregone collateral credit arrangements are not treated as balance sheet debt. It may be that these transactions are misunderstood. It would be unfortunate if the end user exemption became a mechanism for continuing this practice.
Is it the bottom line of possible real dollar savings in a more transparent swaps market or the accounting optics that drives these corporations to line up their lobbyists with those of the options dealers ?

As for the Washington view at this point the House bill incorporates exemptions from the clearinghouse requirement for some non financial firms (as the corporate lobbyists favor). A key person behind the house bill is Cong Jim Himes of CT an ex Goldman Sachs banker. His argument for the exemptionas reported by the Connecticut Mirror:

Moreover, Himes said, there are really two kinds of derivatives, one good and one bad.
The good ones include those in which a farmer wants to lock in a price on his wheat at the beginning of the year so he can plan properly, or IBM tries to protect itself from fluctuations in the yen when selling billions of dollars worth of goods to Japan.

To which I would reply:

Most farmers use the commodity exchanges with clearinghouses to hedge their exposure to price fluctuations.

The foreign exchange market is transparent already due to the existence of the futures market and the easy access to price data. The spreads on simple hedging transactions in foreign exchange are minimal. The new reforms would drastically reduce those on more complex transactions.

In fact those two examples are a bit of a red herring, the focus of the legislation is the swaps market.

When more exotic swaps transactions are moved to a clearing house the transparency will increase, the spreads (markups) to end users will collapse, and the counterparty risk will be eliminated. So if some derivatives are "good" when they are used by  exporters or farmers because they reduce risk, then they will become better (no counterparty credit risk) and cheaper under the proposed reforms. The only persons really hurt would be the Congressman's former colleagues on Wall Street.