If banks provide the fuel for modern economies, then corporates are its engines. Without them, we would earn and consume nothing, trade would evaporate, savings would be wiped out, banks would fail and tax receipts would plunge.
Care then is needed when drafting rules and protocols to ensure they do not drive corporates off the road. And in these most sensitive times for corporates, particular care should be taken. This makes it all the more surprising that the latest proposals from the US administration – to clear all standardised derivatives – rides roughshod over corporate interests. The corporate sector is rightly incensed.
Nicholas Scarles, chairman of the Investment Property Forum's Property Derivatives Interest Group, admits there are benefits to be had from forcing most of the large derivatives users to pool their standardised activity on exchanges or within clearing houses, particularly the netting of counterparty risks. However, he warns there are legitimate collateral issues that could hurt a large number of commercial enterprises. An ordinary corporate, for example, will not derive the same benefit as dealers from netting because, typically, they will have only a handful of largely directional trades. And any move towards contract standardisation could be similarly detrimental; the standards might not match the needs of corporates and they would be deprived of devising tailor-made alternatives. Martin O'Donovan, assistant director at the Association of Corporate Treasurers, warns that such a move would carry substantial costs. Many corporates would need committed loan facilities to meet central counterparty margin calls. These are in much shorter supply today and obliging entities to use the few resources they do have in such a way would be far from ideal.
Balancing floats
What of the large derivatives users themselves? With a market cap of €10bn, Veolia Environment has €20bn of outstanding debt and €8bn worth of notional derivatives exposure. The French environmental services company uses vanilla swaps to switch a portion of its fixed-rate exposure to floating; cross-currency swaps to manage its emerging market payables; and index swaps to manage its inflation exposures. All those instruments would probably fall under the “standardised” derivatives rule. Baptiste Janiaud, head of market operations and corporate finance at Veolia, is far from amused by the proposals. Although he concedes there are benefits that accrue from clearing – notably the credit risk reduction and the accounting asymmetries that corporates have to deal with in the difference between fair and market values – he believes these would be outweighed by the disadvantages.
He said it would be very difficult for most corporates to use central clearing on at least three counts. First, because it would be harmful to their banking relationships.
Second, because of the additional funding costs that would arise from the need to post initial and variation margin, the associated forecasting work and the credit lines they would need to put in place. Third, there is administration – corporates such as Veolia do not generally have the administrative infrastructure to support margin movements. In the UK, National Grid has made more than 30 bond issues in the past 18 months. As well as hedging the interest rate risk on issuance, the firm actively manages its rate exposure over the course of a bond transaction and regularly uses the cross-currency swap market to hedge the foreign exchange exposure arising from its borrowing activity. Alison Stevens, senior capital markets manager at National Grid, said that having to meet CCP margin calls would be unwelcome for many of the same reasons that apply to Veolia. If companies such as National Grid were to be prevented from tailoring their transactions, Stevens said it would be problematic from both a risk perspective and an accounting angle. She cannot see any benefits in terms of narrowing the bid-offer spreads – which, she said, are already narrow for interest rate swaps. She worries that if corporates are able to continue as before, but banks are penalised for trading with them bilaterally, the bid-offer spreads for corporates will worsen. In all, she is concerned that any move to greater standardisation of clearing could lead to significant increased costs.
Hedging bets
In Germany, Siemens uses a range of over-the-counter derivatives for hedging purposes. Thanks to the firm's strong rating and creditworthiness, it can easily enter into OTC contracts today, without having to pledge any collateral. The idea of being forced to use a CCP is therefore bad news for the company. Hans-Peter Rupprecht, head of treasury and investment management and corporate treasurer, said Siemens might at times benefit from the introduction of CCPs in terms of risk management, but insisted such gains would be outweighed by the attendant costs and operational issues.
As a corporation, Siemens has cash rather than securities – and that cash is used to support its ordinary business. To meet CCP margin calls, Siemens would therefore need additional cash or committed credit lines. These would not only come at a cost, but might also raise issues with the pari passu clauses it already has in place with its lenders. Ideally Rupprecht would like to have as much freedom as possible – to clear what he wants and to use whichever instruments best meet his economic needs.
So what should the rulemakers take away from this? If all standardised derivatives have to be cleared, Janiaud said corporates will either hedge less or they will use more non-standardised derivatives – driving business in the opposite direction to that intended. Corporates are not the only entities that would struggle with using CCPs for all their standardised OTC business; rulemakers won't want to hear this, but there are also any number of instances in which banks, hedge funds, sovereigns, structured product originators and others would legitimately not want to clear even the most standardised of instruments.
Blanket rules simply will not work, even for them. Rupprecht said the proposals would make the position substantially worse for corporates. This, he believes, is surprising on two counts. First because the corporate sector was not responsible for the sub-prime crisis and the current economic malaise. And second, because derivatives are not one of the main problems that need to be fixed. O'Donovan warns that this particular part of the regulatory backlash – if implemented as suggested – addresses markets that are not in need of reform and imposes potentially punitive or restrictive measures on sectors, such as the corporate one, for crimes they have not committed.
© Efinancial News 2009, www.efinancialnews.com
