From the July-August 2009 issue of Treasury & Risk magazine

Regs May Trim Hedges

Given the havoc caused by credit default swaps, the Obama administration is proposing regulations that could shift most derivatives transactions onto exchanges, where requirements to post collateral keep a lid on counterparty risk. Companies say the changes could limit their use of derivatives by adding to costs and making it harder to account for such transactions. The cost concerns relate to collateral requirements. In a letter to Sen. Mike Crapo (R-Idaho), Randall Durling, director of international finance at Boeing, estimated that as of February, the aircraft manufacturer would have had to put up $150 million in collateral on derivatives positions. That "could significantly impact our business operations since [the money] is not available for our day-to-day business needs," Durling noted.

Oil giant BP Energy worries collateral requirements could prove onerous for smaller companies it does business with, says Mark Stultz, vice president of policy and U.S. regulatory affairs at BP. If companies choose not to hedge as a result, that could lead to more volatility, he says. If they need to borrow to come up with collateral and their credit rating is not good, "there's a cost-of-money factor," he adds.

Ira Kawaller, president of Kawaller & Co., a derivatives consulting company, says that if companies end up borrowing to meet collateral requirements, the regulatory changes won't have eliminated credit risk, but instead transferred it from the derivative counterparty to the lender.

Kawaller says that the problem isn't just the collateral, but the processing--the daily mark-to-market adjustments of collateral. Companies are not set up to deal with that, he says. More importantly, he questions whether companies would be willing to come up with the amount of additional collateral that would be required if a long-term derivative were losing value. The money involved could discourage companies from using derivatives whose duration exceeds five years, Kawaller says. "So we might operate with a much more short-term focus than is good for us."

Moving derivatives to exchanges could result in more standardization, which could make it harder for companies to use hedge accounting. "If you don't have good alignment of the cash flows between the risk and the hedge, you may not qualify for hedge accounting," says Columbia Business School Professor Paul Glasserman, who adds that companies that don't qualify will see more volatility on their books.

"The administration is trying to make sure there's enough credit and liquidity," says Jiro Okochi, CEO of Reval, which provides a derivatives accounting solution. "This measure will take credit and liquidity out."