Increases in banks’ costs of capital and new derivatives regulations are starting to have an impact on corporate treasury departments—and into the critical strategies companies use to hedge exposures.
A new Greenwich Report, New Capital Rules Complicate IRD Use, from Greenwich Associates finds that new bank rules and central clearing requirements for derivatives trades are gradually starting to affect the mechanics of interest-rate derivatives transactions used by many companies to hedge interest-rate risk.
The report concludes that it is too early to determine if these changes will alter the economics of hedging to such a degree that corporate treasurers either look to new products to limit risk, or just reduce their hedging activity overall.
“Nevertheless, given the heavy use of interest-rate derivatives by this segment, ensuring safe but economical access to hedging products remains paramount,” says Greenwich Associates consultant Thomas Jacques, author of the report.
Despite “end-user” exemptions included in new regulations, growing numbers of companies are opting to pay credit charges on IRD transactions, as opposed to posting collateral or margins. Currently, about 70% of companies are paying credit charges to dealers, up from about 55% in 2014. Meanwhile, the share of companies posting collateral or margin is shrinking.
Why does this matter? Stricter capital requirements and other new rules have increased capital costs for banks and made it more expensive for banks themselves to hedge underlying exposures. As a result, dealers are more accurately pricing the costs associated with IRD transactions, down to the collateral agreements.
“Corporations are increasingly paying flat fees to compensate banks for the strain put on their balance sheets,” says Thomas Jacques. “With markets for instruments eligible as collateral generally less liquid, there appears to be an increasing willingness among dealers to assume counterparty credit risk over the implicit liquidity risk related to accepting collateral.”
Collateral Costs Could Actually Climb with Central Clearing
While intended to reduce counterparty risk and streamline the swaps market, mandated central clearing is also likely to impose additional costs and requirements (e.g., initial margin, reduced variation thresholds, daily valuations).
How this move to central clearing will impact corporate end users rests on several unknowns. Clearing many products with a single clearinghouse could produce huge netting benefits, ultimately reducing the margin required. Global exchange consolidation encourages this trend. However, in cases where little or no collateral was posted, even netted positions could result in more collateral needed as compared to the pre-clearing years.
“These regulations are likely to make cleared OTC transactions more expensive than uncleared, uncollateralized derivatives contracts,” says Thomas Jacques.