Commodity Swaps: Corporations Face Rising Transaction Costs

Increased transaction costs associated with new regulations on banks and swaps markets could cause companies to reduce hedging activity and assume more risk from direct exposures to energy and other commodities, according to a new report from Greenwich Associates.


Although corporate users of derivatives have been isolated from the direct impact of new regulations in the United States and Europe by so-called “end-user exemptions,” new rules included in the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Bank for International Settlements’ Basel  III standards will change the economics of the commodities derivatives business for banks.


Commodities, by their very nature of inherent volatility, are risk-weighted-asset intensive. As such, increased capital costs associated with new reserve requirements will have a significant impact on these businesses. At the same time, changes in derivatives rules will make it more expensive for banks themselves to hedge risks and will also force banks to incur the substantial costs of developing and operating the infrastructure needed to trade in newly created Swap Execution Facilities (SEFs) and Designated Contract Markets (DCMs). There will also be an increase in cost related to additional margin.


For banks that specialise in these products, these rising costs will eat into overall returns on equity, already substantially down from pre-2008 levels. Some institutions that are already adapting a more conservative stance as a follow-up to the credit crisis are likely to pull out from offering capital to some commodity-linked transactions.


These changes could prompt some large banks to exit the commodities derivatives market or scale back, which would limit competition and narrow companies’ choice of dealers.


They will almost definitely raise transaction costs for companies looking to hedge energy and other commodities exposures.


On a global basis, companies now hedge 53% of their commodities exposure financially, declining from 56% in 2009. By sector, oil and gas producers increased the proportion of their exposure hedged to over 61% — from 51% last year. “The likely result of regulatory changes is that corporates, facing higher costs to hedge, will hedge less and risk their own income statements,” says Greenwich Associates consultant Andrew Awad.


More Energy Firms See Central Clearing
Although most corporations that hedge their energy exposure expect to continue using bilateral OTC derivatives, a full one-quarter say they expect to increase the proportion of their business done on a centrally-cleared basis.


On average, companies execute just over 85% of their energy derivatives volume in OTC trades, those surveyed indicated, and less than 15% in exchange-traded futures and options. Of those that trade using OTC contracts, 88% of that volume is executed on a bilateral basis with the remaining 12% centrally-cleared.


Greenwich Associates does not expect to see a change in how companies execute their hedges.


“What’s really interesting is that contrary to expectations, a full 25% of corporates want to increase their trades on a centrally-cleared basis even though they don’t need to do so and they would also incur margin costs. What’s possibly driving this is credit capacity. Unsurprisingly, the highest proportion of these companies is in the oil and gas sector where derivative volumes are highest,” Andrew Awad said.


Heads in the Sand?
Delays in enacting the final rules may have many participants in Greenwich Associates research thinking that they will not be affected. At least half of those interviewed by Greenwich Associates expressed that view, while others said they had no idea how much they would be impacted.


“That reflects the uncertainty in the marketplace as to the implementation of the rules, but it also reflects a bit of a lack of reality,” said Andrew Awad. “There will be an impact, but it may be a delayed impact. Those who think the regulations won’t have much effect on their operations have their heads in the sand. Just because the regulations officially focus just on financial institutions it does not mean corporates won’t feel some pain.”