The swaps proposal issued by banking regulators on April 12 would raise a host of new issues for derivatives end users and their bank counterparties, including the need for companies to monitor their derivatives positions more closely and ensure they're able to post cash or collateral to handle unexpected events. The proposal could also lead to companies' having to manage more counterparty relationships, which would also be a concern for banks.
"Every treasurer must maintain sufficient credit to meet future demands," says Tom Deas, treasurer at chemical company FMC in Philadelphia and president of the National Association of Corporate Treasurers (NACT).
That means devoting resources to handle potential margin calls that could otherwise be used to grow the business. Companies currently value their derivatives exposures quarterly in preparation for their earnings reports. The proposal requires posting margin when predetermined thresholds are exceeded, and that means companies would probably have to track those values in as close to real time as possible so as not to be caught unaware when collateral is demanded.
"You're going to have to put in place systems similar to what a bank trading room already has," Deas says, noting that under Sarbanes-Oxley, companies can't simply rely on margin calculations provided by their banks. "We have to do our own calculations of what we owe, and if they match the bank's, we make the payment," he says. "So we'll have to replicate the same systems banks use."
The proposal, for which comments are due June 24, requires non-financial companies that use derivatives to post cash or collateral when the net market value of their derivative positions exceeds thresholds determined by their counterparty banks. Companies with strong credit profiles, as determined by their banks, would have much higher thresholds than those with weaker profiles.
Currently, there is no regulatory requirement for derivatives end users to post collateral. Banks already develop thresholds to determine whether to extend additional credit to customers, whether in the form of derivatives or cash products, and they may require corporate customers to post cash or collateral. If the net market value of a customer's positions exceeds the threshold, the bank's capital is at risk.
Those arrangements give companies some leeway, which could result in additional time for a derivative contract to recover from a stressful situation. Under the proposal, those arrangements would have to be codified in credit support annexes (CSAs) that require immediate collateral when thresholds are exceeded.
Luke Zubrod, a director at Chatham Financial, notes that today bank counterparties may simply refuse additional trades with a company if it exceeds thresholds. "In the new world, the banks would have to draw hard line in the sand and shift that risk back to customer by asking for more collateral," Zubrod says.
In signing CSAs with bank counterparties, corporate finance executives would have to understand thoroughly the derivative portfolio value, what collateral would be posted, why, and the amounts. Jiro Okochi, CEO of Reval, says this is arguably a lesser burden than having to post initial and variable collateral at a clearing firm, as Dodd-Frank requires financial institutions to do. But even for a highly rated company with low funding costs, a requirement to post collateral "will still be a big deal," Okochi says.
Companies with lower credit profiles would have additional burdens. Okochi says companies that must raise cash to meet a margin call may "lose the cost of carry on that collateral," since the return on their collateral is likely to be significantly lower than their borrowing costs. "Plus, loan covenants may complicate additional borrowing," he says, noting that once a company posts collateral, its ability to value its derivatives in real time becomes essential in order to retrieve the collateral as soon as possible from the bank.
Although regulators have said the proposed rules are designed to minimize the likelihood that corporate end users have to post margin, in the wake of the financial crisis, such assurances ring hollow for treasurers seeking to manage limited company resources.
Deas expresses concern that during periods of market stress, regulators could push banks to lower their thresholds, resulting in corporate counterparties suddenly having to post more collateral just when it's most difficult to raise cash.
To lessen the likelihood of exceeding the threshold set by a bank counterparty, companies may forgo some hedges, thereby increasing their risk. Or companies--especially those with a high cost of capital--may increase the number of their bank counterparties. "They may spread out transactions among a number of banks to stay under each one's threshold," Zubrod says.
That becomes problematic for their lenders, with whom companies typically transact swaps, because more banking institutions--some perhaps without lending relationships to the company--will be vying for the company's cash or collateral. "That cash or margin is leaving the company and going to other banks," says William Mansfield, head of global financial markets in the Americas region for Rabobank International. "If I'm a lender to that corporation, I would prefer that it stays in the lending group."
Increasing the number of derivative counterparties is also an additional burden on the company's treasury. "The company is going to have to negotiate CSAs with each swap dealer," Okochi says, adding that each relationship will have to be monitored and have cash or collateral lined up to post if thresholds are exceeded. "So a company could have 10 CSAs, and it's going to have to manage potential collateral postings for each one."
In that respect, clearing through a central agency is less complicated, Okochi notes, especially given that many companies currently track their derivatives exposures using spreadsheets. In addition, he says, while corporates may have to post collateral, there is no such requirement for their bank counterparties. So treasury executives may be wise to track the credit health of their banks. "I would assume a corporate would feel very uncomfortable posting collateral to a weaker credit," Okochi says.
Deas says NACT believes banking regulators do not have the authority to impose margin requirements on end users. One of the lessons from the Enron and WorldCom meltdowns was the risk posed by ratings-based triggers, which can mean that at the very time a company needs access to credit, it's less able to get it, he says. "The regulators are replicating that risk with this rule."
For more on the banking regulators' proposal, see Latest Margin Proposal Riles End Users.