Among the power players in Washington, corporate treasurers are conspicuously absent. But when the tools they need to manage risk--over-the-counter (OTC) derivatives--were threatened by the wave of regulatory reform, treasurers reacted quickly and effectively. And they have moved the playing field, even though the outcome is still uncertain.
Legislators' proposals to eliminate over-the-counter trading of derivatives and force all derivatives trading onto exchanges are part of the fallout from the credit crisis.
A House bill and Senate drafts "started out to be more aggressive, but members of Congress were absolutely bombarded with objections from end users," reports Pat Ryder, director of financial risk management at $5 billion Eastman Chemical Co. in Kingsport, Tenn. "End users have never been more united. They pushed back effectively."
Now, while there's still debate about how to regulate the use of derivatives by banks and dealers, there's a growing consensus that companies that hedge with derivatives, the so-called end users, should be left out of it, Ryder says. The legislative focus has shifted to "the Big 20 banks and dealers, the ones that could create significant systemic risk." But there's still ambiguity about who would call the shots on derivatives trading, and "the more ambiguity there is, the harder it is for us to price," he notes.
There's no question that keeping OTC derivatives is a high priority among finance executives. "Like all treasurers, I'm trying to pay attention to the various bills floating around," says Brent Callinicos, treasurer at $23.6 billion Google in Mountain View, Calif. "Some are more corporate-friendly than others. Whatever Congress does should take into account end users like us, and what we need is not one-size-fits-all products."
While exchange-traded derivatives are standardized, OTC derivatives can be tailored to match the position a company is hedging. The more closely a derivative matches the position being hedged, the easier it is to qualify for hedge accounting.
Easier to regulate exchange-traded derivatives might work for some companies, but not for Google, which has large foreign exchange exposures it hedges with OTC derivatives, Callinicos explains. And while hedge accounting is important, that's not the main reason Google customizes its hedges, he insists.
"Friendly accounting treatment is fine, but we hedge for economic reasons, not accounting reasons," he says. And exchange trading could spoil those economic reasons. "We have maturity dates that matter. If an exposure matures on Wednesday, but the exchange doesn't settle until Friday, we could be stuck without protection for two days, and in volatile markets, two days can mean a lot."
Google also wants to pick the strike price. "The more a company is forced to accept standard strike prices and maturity dates, the less effective the hedge will be. For some companies, that may be okay, but it just won't work here," Callinicos says. "We do our statistical risk analyses and then want to design a hedge that fits what we're trying to do."
Callinicos has reasons to be optimistic because treasurers turned the tide by sending experienced, articulate practitioners to Washington to explain patiently to legislators and their staffs the consequences of removing OTC derivatives from the corporate risk management tool kit. Ann Svoboda, both a treasurer (Cadbury) and author (Real Cash Flow), went to Washington armed with well-honed talking points.
Forcing derivatives trading onto exchanges shows a lack of understanding of the nature and value of hedging, Svoboda told members of Congress. "If I have an FX exposure, I would put on a hedge for a very specific amount and date," she explains. "The end user needs a hedge that can be tailored to fit the exposure." Some legislative proposals have exempted FX hedging, but interest-rate hedges also need to be tailored, she says.
Many of the proposals require posting of collateral, which would damage the market, Svoboda claims. "If you add an interest cost to an interest-driven hedge, that skews the math and changes the coverage." Putting up collateral also drives up companies' working capital and "shrinks our ability to grow the business and create jobs," she insists. Creating jobs is a topic that commands attention in Washington these days.
Special protection misses the point, Svoboda argues. "When you hedge, you know your counterparty. You're in a credit relationship. They are essentially just another vendor, and we don't need to be protected by regulation and collateral from a derivatives vendor any more than we do from a raw materials vendor."
What the government ultimately will do is still in flux. Last December the House passed a broad financial reform bill that included regulation of OTC derivatives. "We're comfortable with the House version," reports Brian Kalish, finance practice lead at the Association for Financial Professionals (AFP). It differentiates between players that cause systemic risk and end users that are basically just trying to hedge exposures, Kalish explains.
Corporate hedgers fared pretty well in the House, reports Michael Bopp, a partner in the Washington office of the law firm Gibson Dunn & Crutcher and chair of its financial markets crisis group. Over and over, amendments to tighten the regulation were defeated by broad margins and amendments to make the bill more hedger-friendly were adopted, Bopp says. But the Coalition for Derivatives End-Users, an umbrella lobbying organization that includes AFP, the National Association of Corporate Treasurers, Financial Executives International and dozens of corporations, is hoping to do even better in the Senate, he says.
The problem with the House bill is that it doesn't clearly define key terms like "substantial net counterparty exposure," he says, and it delegates a great deal of authority to the Securities and Exchange Commission and the Commodity Futures Trading Commission.
"The CFTC chairman prefers no exemption for end users," Bopp points out. "It's not hard to imagine that he might use broad authority to narrow the exemption."
Early drafts of the House bill were meant to constrain the use of derivatives altogether, says Chip Register, managing director of Sapient Global Markets in Boston. But that has shifted to attempts to push as much activity as possible to exchanges, clearing mechanisms and trade warehouses, where it can be better measured and managed.
"It seems now to have less to do with the corporate world and more with the professional market, made up of banks, investment managers, etc.," Register says.
Trading derivatives through exchanges or clearing houses is one issue, and it appears likely that end users will win an exemption. But posting collateral is another issue, and here an exemption for end users is not at all assured.
"Even if they are exempted from clearing requirements, they still could be subject to margin requirements and have to post collateral," reports Dave Hall, chief operating officer of Chatham Financial in Kennett Square, Pa. What kind of collateral--cash or noncash--is not clear, but either would create a strain on end users, he says. Much of the lobbying effort now is focused on trying to get end users exempted from margin requirements for OTC derivatives.
A bill introduced last month by Sen. Chris Dodd (D-Conn.) would not exempt end users from OTC derivatives trading restrictions. But Sens. Jack Reed (D-R.I.) and Judd Gregg (R-N.H.) are said to be working on a compromise derivatives measure that could be substituted for the derivatives portion of Dodd's bill, and their proposal apparently does provide some exemption for end users.
The devil is in the details. "There is too much 'may' and 'could' language" in the House bill and Senate drafts, Ryder says. "They need to define a 'financial institution.'"
Some in Congress seem inclined to distinguish between "material" players and those who are not. "The definition of a 'material user' needs to be precise and not based on size alone," Callinicos says, arguing that a corporation could have large exposures and use many OTC derivatives and still not be a "material" user. The definition needs to reflect the type of corporation and the nature of usage, not just size, he insists.
The strategy so far has been to draw a line between us and them, corporate hedgers and the banks and dealers. Corporate hedgers generally don't advocate tighter regulation, but if there is to be regulation, they feel strongly that end users should be exempt.
"Currently 80% to 90% of the swaps transactions do not involve end users," Bopp points out. They are transacted dealer-to-dealer or dealer-to-bank and are not for hedging. "The vast majority of the swaps market could be regulated even with an exemption for end users," he says. And because a regulated counterparty would be on the other side of most end-user hedging transactions, even they would be indirectly regulated, he adds.
If a non-financial uses swaps to speculate, that company would not qualify for the exemption under the House bill or language in some of the Senate drafts, Bopp notes. Most end users don't object to having such companies included in the regulatory regime, he says.
Exempting end-users from requirements to trade through exchanges or clearing houses would exempt the transaction and both counterparties, but the House bill and some Senate drafts would require the dealer to report these transactions to a central trade data base, where they could be reviewed by regulators for signs of market manipulation or growing risk, Hall explains.
If banks and dealers see their costs rise, they will pass them through to end users in bid-ask spreads and might require bilateral margin agreements with end users. If the government doesn't require end-users to post collateral, their bank counterparties still could, and "there would be cash flow consequences if we have to enter bilateral margin agreements," Ryder says.
One problem with an us-vs.-them strategy is that companies that hedge need counterparties, which are likely to be banks or dealers. If regulation effectively restrains speculators, will they show up to take the other side of a corporate hedge? "That could be a problem," Callinicos concedes. "We do need counterparties, and regulation that discourages them could handicap us, even if we are exempt from the regulations."
Still, he's not too worried. "The cost is likely to go up if banks can't do OTC derivatives the way they find most cost-effective, but it's a competitive market," Callinicos says. "I'm sure they'll find a way."
Could There Be a Silver Vein?
Maybe having only exchange-traded contracts in a regulated marketplace would be good for corporate hedgers. That contrarian view comes from Jeff Wallace, managing partner of Greenwich Treasury Advisors in Boulder, Colo.
"Banks hate the idea, so it must be good for their corporate counterparties," Wallace suggests. Here's why. Pricing on an exchange would be more transparent, and banks have been overcharging for the credit risk involved, he says. "Banks choose the valuations. You can argue but it won't get you far. Derivatives chew up credit lines," and now that credit lines overall are being reduced and priced at their true market value, you don't want to waste credit capacity.
Exchange-traded derivatives also involve posting collateral and margin calls. Putting up cash collateral would be a minor problem for investment-grade hedgers, Wallace says, and below-investment-grade users that are already being squeezed by their banks actually might fare better on an exchange. Not wanting to put up cash collateral is a "knee-jerk reaction" to something that makes sense, he argues. After what happened in 2008, not having collateral to back up derivative gains and losses is "something neither corporates nor taxpayers can afford," Wallace insists. Many Lehman counterparties wished they had collateralized their profitable net Lehman positions, he adds.
OTC derivatives can have the big advantage of being perfect hedges that minimize hedge accounting problems, Wallace notes, but the Financial Accounting Standards Board will be coming out with new rules for hedge accounting and may well require effectiveness testing for all hedges, with no shortcut for perfect hedges done with OTC derivatives, as the International Accounting Standards Board already does. If so, the hedge accounting work for OTC and exchange-traded derivatives would be pretty much the same. --Richard Gamble