Now, we are about to find out. Non-financial
companies think they have won some kind of exemption –
but they don’t know how much. And as
Siân Williams reports, hardly anyone seems to
know how much mandatory clearing would cost
Ever since the financial crisis began, banks have been
calling on politicians and regulators not to overreact.
Considering the banks’ recent achievements, many
may feel disinclined to listen.
But in the past year a different group has begun to issue
similar warnings – industrial companies. Unlike the
banks, they do not fear that new laws will deliberately curtail
their activities. What worries them is the drive to push
derivatives on to exchanges and in to central counterparty
(CCP) clearing houses.
These measures are intended to promote the safety and
transparency of the financial system, above all of the banks.
But safety – and perhaps even transparency –
may come at a cost.
Companies that engage in over the counter derivatives,
directly with banks, are scared that if these contracts have to
be centrally cleared, they may have to post more collateral
against the trades than they are used to doing.
This collateral is what keeps the clearing houses strong,
and protects the wider financial system from defaults. But for
companies themselves, it would be a cost – perhaps
higher than they are paying at the moment – for using
Some firms and their trade bodies have claimed that
mandatory central clearing could even deter companies from
hedging, leaving them more exposed to price risks. Even trades
that remain over the counter (OTC) may have to be
Of course, collateral is widely used in the OTC
derivative markets. The International Swaps and Derivatives
Association’s 2010 Margin Survey of
derivatives dealers and participants suggests 70% of all OTC
transactions are subject to collateral agreements.
The proportion is lower for non-financial corporate
customers, however. According to the Isda survey, total
collateral held against trades with non-financial companies
amounted to 47% of such trades, a lower rate than for
institutional investors (58%), banks and broker-dealers (78%)
or hedge funds (141%).
But this use of collateral remains voluntary –
something agreed between bank and customer. Financial market
reforms might now make collateralisation mandatory.
In the same report, Isda set out its view on the
topic: "Collateralisation works best in the cases where the
volume of activity is sufficient to warrant bearing the
operational and procedural burdens associated with the complex
collateral process. Not all derivatives users trade these
instruments frequently enough to justify the operational burden
and expense of collateralisation. This latter group includes non-financial
corporations, whose business models cannot easily sustain the
cashflows required for collateralisation."
In Europe, the threat of enforced collateralisation or
CCP clearing, if it materialises, will come in the shape of EU
legislation to reform the derivatives market. Consultation on
preparing this law has been extensive. Industry representatives
recognise that the European Commission has been painstaking
about listening to their concerns.
But the crunch time is coming. In September the EC is
expected to publish draft legislation. The best guide to what
this will contain is a consultation document issued in June. In
it, the EC sought comment on specific areas and sketched the
shape that new regulation may take.
A loophole opens
The Public Consultation on Derivatives and
Market Infrastructures holds some comfort for corporate
derivative users. They are recognised as a separate category,
acknowledging that they may not face the same clearing and
exchange trading obligations as banks or hedge
But the document still gives only a rough idea of what the
new rules might be.
Though it appears that many companies may be able to avoid
mandatory clearing or collateral posting, corporate exemptions
will only apply up to a threshold.
Non-financial companies, the paper says, would have to
clear all their eligible derivatives and inform the
market regulator if they took positions beyond an "information
There is little indication of how strict the threshold will
be and what criteria will be used to determine it. Equally
unclear is how much time companies will have in which to post
collateral or move their contracts to a clearing house if they
do surpass the threshold.
The paper says these thresholds will "be defined at a
further stage, taking into account the systemic relevance of
the sum of net positions by counterparty per class of
In other words, regulators will work out how large
non-financial companies’ positions are in each
kind of derivatives, and decide whether they are big enough to
constitute a systemic risk that would require tighter
Rolls-Royce: serious about hedging
Rolls-Royce is one of the UK’s
leading engineering companies. A world leader in
aero-engines, it also makes marine and gas turbines,
with total sales of £10.1bn last year and profits
At the end of 2009 it had £3bn of cash and
debts of £1.7bn.
With sales worldwide, currency risk is a big factor,
especially the values of the dollar and euro against
the pound. Rolls-Royce aims to hedge these risks,
"using a variety of financial instruments with the
objective of minimising the impact of fluctuations in
exchange rates on future transactions and
It also uses interest rate swaps and caps and forward
rate agreements to control risk in the floating rate
part of its debt.
Finally, Rolls-Royce aims to minimise its exposure to
fluctuations in metals and jet fuel prices using
instruments including swaps.
Iain Foster, the company’s assistant
treasurer, is against mandatory clearing for
non-financial companies as he believes it could cause a
lot of difficulties for some firms. At the moment,
Rolls-Royce only uses OTC contracts and does not
"The biggest issue is liquidity risk, not cost," says
Foster. "The reason we use derivatives to hedge is to
fix profit volatility and cashflow volatility."
He pointed out that the company had a mark to market
loss on its derivatives of £2bn at the end of
2008. "Without pre-arranged funding, it would have been
difficult to fund [the margin calls for] that, given
the state of the markets at that time," he says. By the
end of 2009, the company had a mark to market gain of
£44m on its derivative positions.
But Foster says it is difficult to determine whether
OTC or exchange-traded derivatives are more expensive.
"Trying to work out any cost difference is very
difficult," he says.
"Measuring bid/offer spreads is easy but you also need
to factor in the cost of liquidity facilities
potentially needed to provide margin calls over the
life of the deal. At least with an uncollateralised OTC
hedge the total cost is known at inception."
The consultation paper advocates "an appropriate and
balanced legislative approach for the (corporate) end users of
OTC derivatives". The aim is to achieve "a reduction of risk in
the financial system that does not tolerate regulatory
arbitrage" but also "a sensible system that reflects the
economic and financial hedging needs of corporate end
Calls for exemption
Many non-financial companies have spoken out against
mandatory clearing and the requirement to collateralise OTC
derivatives, and have responded to the consultation by pleading
to be exempt from any mandatory requirement.
Companies cite several reasons for this. They fear the new
system may be more expensive; they are worried about margin
calls disrupting the predictability of their cashflow; they
believe that capital which could be used to invest in growth or
acquisitions might be tied up – in their view
needlessly – in collateral.
Iain Foster, assistant treasurer at Rolls-Royce, the
UK aero-engine maker in Derby, shares these worries. Asked how
the company would cope with a strict requirement to clear
trades or post collateral, Foster said its reaction would be to
"reduce the amounts we hedge or restructure the group
– natural hedging" (see box on Rolls-Royce
Some are also concerned about the costs of installing new
systems to meet daily margin calls. Though banks and other
financial companies may have such systems in place, not all
non-financial companies use them.
"The convenience of just being able to call up a bank and do
a deal makes life much more straightforward," says Martin
O’Donovan, assistant director, policy and
technical at the UK’s Association of Corporate
Treasurers in London.
Creating risk – or reducing it?
Non-financial companies’ main
gripe is that, even if they are granted a limited exemption,
they feel they do not pose systemic risk and that they are
therefore being unfairly penalised for what they believe is an
issue that relates to financial companies.
As O’Donovan points out, when derivatives are used
for hedging, the user’s underlying position must
be positive when the derivative is in a loss-making
"Any gain or loss on the derivative will be matched by the
underlying cashflow. The last thing treasurers want to do is
make cash payments as mark to market changes happen –
they do derivatives to remove volatility not to create it," he
Of course, the debate depends heavily on the strictness of
the threshold. If it captures few firms, it is likely that the
systemic risk argument will be better accepted.
Alex McDonald, chief executive of the Wholesale Market
Brokers’ Association, argues: "The limit probably
has to be set at something fairly enormous; including just one
or two oil companies and other large participants,
He points out that the threshold cannot be defined solely in
terms of notional value – other criteria will have to
How much is 'a lot’?
One of the main arguments non-financial companies make
against mandatory clearing is that costs will increase steeply.
But their case is weakened by being very light on figures.
Very few of the participants in the debate have publicly put
any numbers on the perceived threat. As a result, it is very
hard to gain any reliable idea of what sort of amounts are at
It appears that hardly any thorough surveys have been made
to compare the entire cost of using cleared and OTC
The WMBA cites a small table of figures produced by a power
company to show the costs of a hedge.
For an exchange-traded transaction, it lists trade brokerage
€0.01, clearing brokerage €0.01, delivery fee
€0.01 and margin cost of funds €0.04, giving a total
cost of €0.07 for the trade.
In the OTC market, the costs listed are: trade brokerage
(optional) €0.005 and clearing brokerage €0.01, for a
total cost of €0.015.
But these figures do not show how costs would change for
that company as a whole, adding together all its hedging
activity. Hence the scale of the impact on the
company’s cashflow and possible borrowing
requirement is not clear.
And the table also does not show the economics of the trade
itself – the price the company is able to obtain from
If an OTC derivative is not supported by any margin
payment or collateral, the bank is taking credit risk on its
customer. It may use credit default swaps to hedge this, or
post capital against the exposure.
But one way or another, the bank is shouldering credit risk.
It would be fair to assume that it expects some recompense for
this, and if there is no explicit charge, that return must come
through the trade itself.
If profits for banks were not fatter in the OTC market, why
would they be willing to trade in it, when it obliges them to
take credit risk?
In fact there is strong anecdotal evidence that, in various
asset classes and at various times, banks have sought to keep
business OTC because it is more profitable for them that way,
rather than let it migrate to exchanges and clearing
|EEX study suggests CCP is cheaper
Those who claim it is cheaper to engage in derivatives
OTC than through a central clearing counterparty are not
taking the cost of credit risk into account, according to
a study by the European Energy Exchange in
The report found it was cheaper on average to use a CCP,
which theoretically eliminates counterparty risk, than to
buy an OTC derivative and hedge the counterparty risk
exposure using a credit default swap.
Using a one year contract as an example, the study took
account of transaction costs, the cost of protection
against default and the cost of liquidity needed for
posting additional and variation margin in a CCP.
Over a year, the total daily margin paid to a CCP is on
average less than the premium paid to the seller of a CDS
to hedge the counterparty risk. This obviously varies,
depending on the counterparty’s credit
rating. However, EEX concluded that there were some
situations when the OTC route could be cheaper. Central
clearing works out more expensive if a position goes out
of the money, as daily margin costs are high.
But the opposite is true if the trade looks like making
money. As an OTC position moves into the money, the
credit risk exposure to the counterparty grows. This
means that if the risk is to be fully covered, more
credit protection needs to be bought. As a result, the
cost of hedging rises as the position becomes more
An exchange-traded derivative, on the other hand,
requires low margin payments if it is making a
"We have been told by many market participants that
exchange clearing is too expensive," said Iris Weidinger,
chief financial officer of EEX in Leipzig. "There is a
lot of misunderstanding. It’s not true in
general that clearing is too expensive. It’s
important to look at all cost components, especially
costs for managing credit risks in bilateral
About 1,000 Terawatt hours (TWh) of power is cleared
weekly through European Commodity Clearing, which clears
for EEX. The other 3,500 TWh traded in the German power
market each week go over the counter and are not
Not all market participants buy credit protection when
they trade OTC, and some use it only rarely.
But the aim of the study is to compare like with like
– studies that conclude OTC trading is cheaper
often neglect to take credit protection into
The study factored in account processes, transaction
fees, liquidity provision and credit protection. The cost
of the first three is the same or lower for OTC traders,
it found, but the cost of credit protection is much
"In this model we considered 100 scenarios — in
most cases ECC clearing yields cost advantages for
clients compared to bilateral risk management," Weidinger
This suggests that at least some of the costs of the present
way of operating are not being captured in some comparisons of
OTC and exchange trading.
One source acknowledges that the execution price a company
can get for a hedge in the exchange-traded market may be
keener, but he says it is still preferable to trade OTC, even
with a higher "upfront cost", because that way there is no risk
of nasty surprises from margin calls later.
Your risk, my risk
Credit risk also cuts both ways. Banks inevitably
think about their credit exposures when engaging in any
transaction, and therefore presumably seek a return on that
But in an OTC derivative, the company is also taking risk on
the bank – or on other counterparties in its own
The European Energy Exchange published a study into
OTC and cleared costs in February, more detailed than the power
company example offered by the WMBA. The EEX argued that if
credit risk is taken into account, central clearing is often
cheaper than OTC trading (see box below).
McDonald says the cost difference between OTC and
cleared trades depends on the duration of the contract. He says
that OTC transactions with a duration of less than one year
"have a minimal cost of credit" but that the cost of margining
them would be "notable".
When capital buffers are held by banks, the amount is a
function of the contract’s duration, he says,
which means less is needed for shorter contracts.
"For contracts with a maturity of under one year, centrally
clearing or posting collateral would be more of a cost burden
relative to how trades would otherwise be settled," McDonald
Equally, he argues, at extra long maturities such as 10
years, the costs of margin with a CCP become particularly
acute, depending on the shape of the yield curve.
Another possible argument in favour of the OTC method of
dealing with credit risk is that banks are likely to set the
credit terms for clients according to their particular
Clearing houses, on the other hand, do not distinguish
between users according to their relative strength, but charge
everyone the same amount, based on the riskiness of the
particular derivative position.
From one perspective, it could be argued that this means the
stronger counterparties of a CCP are subsidising the weaker.
Equally, this should make weaker companies more willing to use
When comparing the costs of OTC and exchange trading,
netting also needs to be taken into account. If a company is
very directional in its derivatives trading, its total costs
are likely to be higher than those of a company taking a number
of buying and selling positions, some of which might cancel
each other out.
Cashflow and financing
One aspect that many commentators agree on is that,
whatever the relative costs of OTC and cleared trading,
participating in a CCP means the customer can be called on to
change its margin payments daily.
Although companies are used to managing constant inflows and
outflows of cash, they have argued that meeting daily margin
calls would strain their cashflows.
The obvious way to deal with this need would be to borrow
Though he could not give any figures as to how much more
expensive clearing might be, O’Donovan believes
the cost of funding a company’s liquidity needs
for margin calls could have an adverse impact on a business by
using up its borrowing capacity.
"There’s a limit to what a firm can borrow," he
says. "Money used for margin could otherwise be used to gear
up." He believes that margin is an "unproductive use of a
company’s capital structure".
To this, regulators might counter that while margin may seem
unproductive for the company that pays it, the cash protects
the financial system as a whole, and hence taxpayers.
Richard Raeburn, chairman of the European Association of
Corporate Treasurers, says trying to determine what the costs
of clearing might be at this stage is "an impossible question",
and that they are an indirect cost.
But he says: "Companies would need to be prudent and make
sure they had borrowing lines. They obviously would draw on
cash to meet margin calls. Any cash call for margin translates
into incremental borrowing."
Companies might find that banks are quite happy to provide
finance for their margin needs. After all, if banks are
prepared to take their customers’ credit risk by
providing them with OTC derivatives, would they not be willing
to take the same risk in loan form, allowing the customer to
clear its trades with a CCP?
This would arguably make the whole system more transparent,
as banks’ credit exposure would be clearly
acknowledged and priced, while the derivative risk was taken
care of by the clearing house.
But Alex McDonald, for one, resists this idea, describing it
as "Turning the risk on a derivative into a risk on a loan." In
his view no risk would be removed by such a change –
it would merely be converted into a different form.
Debating in the dark
With no clear estimates for the costs of clearing and
collateralisation, it is difficult to know whether
companies’ fears are justified.
Having to post margin against trades did not stop the
evolution of the US agricultural futures markets, for example,
even though those have always been heavily populated by
Oil and gas markets also swung heavily towards CCP clearing,
even for OTC transactions, once the Enron collapse in 2001
showed firms that credit risk was real.
It is probable, however, that non-financial
companies’ two years of lobbying will not be in
vain, and that they will win substantial exemptions from
clearing and collateral rules.
O’Donovan says: "The Commission recognise that
non-financial firms are not a big part of this problem. I think
our point of view has been generally accepted."
How much light has genuinely been shed by the whole process,
and whether the end result will be optimal for corporate
derivative users, and for the market as a whole, is much harder
Isda finds nearly half of corporate
derivatives are collateralised
The International Swaps and Derivatives
Association’s 2010 Margin Survey
estimated that the total amount of collateral in
circulation in the OTC derivatives market fell by 20%
in 2009, from $4tr at the end of 2008 to $3.2tr at the
end of 2009.
Isda attributed this to "a marked decline in market
volatility and a return to more normal interest rate
levels and credit spreads". It said this was consistent
with the 23% decline in gross counterparty credit
exposure in the first half of 2009, reported by the
Bank for International Settlements.
But between 1999 and 2009 the estimated total amount
of collateral grew at a compound annual rate of 35%,
while the BIS measure of credit exposure grew by 13% a
This suggests that not only is the use of collateral
growing, but it occupies a growing share of the
However, corporate customers are less likely to have
to post collateral. Survey respondents said their
collateral against exposure to non-financial companies
amounted to 47% of that exposure. This was the lowest
proportion except for sovereign and supranational
counterparties, with 25%.
The 15 biggest dealer firms are usually more avid
users of collateral than smaller firms in
Isda’s survey. But for corporate
customers, it is the other way round. Lesser
dealers’ collateral covered 57% of their
corporate exposure, while for the biggest dealers it
This may reflect the fact that bigger banks tend to
do business with bigger companies, which are often
regarded as safer from a credit point of view.
There is great variation in the use of collateral by
asset class. Of currency derivatives, only 57% are
subject to collateral agreements. This rises to 60% for
metals, 64% for energy and other commodities, 71% for
equity, 79% for fixed income and 93% for credit
The survey found that on average, 86% of firms and
all the large dealers sometimes took credit rating into
account when setting collateral thresholds. Twelve
percent of respondents but 27% of large firms took CDS
spreads into account.
Of total collateral, around 82% is cash and 10%
government bonds, with the rest in other