Much has been written about the possible implications of recent regulations on companies that use derivatives to hedge foreign exchange, interest rate, and other risks. Shortly after the Dodd-Frank Act passed in 2010, corporate treasurers began voicing concerns about how the law would affect their derivatives programs. Non-financial institutions are exempt from many of the key provisions, but that doesn’t mean they won’t feel an impact. Treasurers feared that Dodd-Frank, in conjunction with Basel III and other recent regulatory changes around the world, would increase both derivatives prices and the complexity of hedging financial risks.
For the past three years, hands have been wrung and keyboards have clicked to the beat of the war drum, sounding alarm about the problems that the regulations might create the market. Nevertheless, little time has been spent investigating how regulations are actually affecting derivatives end users. That’s what Treasury & Risk set out to do this fall in a research project sponsored by PwC. We polled 196 Treasury & Risk readers to determine whether their fears about Dodd-Frank and other derivatives regulations have come to fruition.
We found that hedging is costing companies more and is consuming more staff time than in years past. As a result, some derivatives end users are looking into alternatives to over-the-counter (OTC) trading, while others are reducing the volume of transactions they engage in or changing the types of derivatives they use. However, very few organizations are moving away from using derivatives as a hedge for their financial risks.
Costs and Complexity on the Rise
Respondents to the Treasury & Risk survey hail from a wide range of industries. Because we’re most interested in the impact of regulations on derivatives end users, we focused our data analysis on respondents who work in sectors other than financial services. Thirty-eight percent of respondents are treasurers or assistant treasurers, or have anther role within the treasury function. Seventeen percent are CFOs, and 21 percent are vice presidents, senior vice presidents, or directors of finance.
The vast majority of these treasury and finance professionals are using derivatives to manage their company’s financial risks. Nearly half of all end-user companies represented in the survey—and 89 percent of organizations with more than $5 billion in annual revenue—use derivatives to hedge foreign exchange (FX) risks. A slightly lower proportion use derivatives to manage interest rate risks. About a quarter of all respondents hedge commodity risks, although 78 percent of those in the agriculture/mining, energy, and utilities sectors use derivatives for commodity hedging. Around 10 percent use derivatives to manage credit risk and price risk. (See Figure 1.)
Across all these types of risks, using derivatives for hedging is becoming more complex. Three-quarters of end-user companies in our survey have seen an increase in the amount of staff time they need to dedicate to recordkeeping and reporting for their derivatives transactions. Seven percent of organizations that use derivatives have seen their derivatives-trading workload grow by between six and 10 hours per week, and for 6 percent of companies it’s increased by more than 10 hours a week. Two survey respondents—both of whom use derivatives to hedge multiple types of risks—said their companies have even added two full-time equivalent staff members to handle the added work associated with derivatives regulations (see Figure 2, below).
At the same time, prices for derivatives transactions are also rising. New clearing and capital requirements have increased banks’ costs to offer derivatives. Analysts have long expected these costs to be passed on to derivatives end users, and our survey bears this out. For 8 percent of respondents, transaction prices are up across the board. Another 5 percent have seen prices rise on long-duration swaps, and 12 percent reported that a variety of transactions are costing them more. Thirty-five percent said they expect to see price increases, although they aren’t yet paying more. Only 14 percent said they are not seeing—and do not expect to see—increased prices (see Figure 3, on page 2).
The median size of the price increase, among companies that are seeing an upward trend, is 5 percent. However, the wider the variety of risks a company uses derivatives to hedge, the larger the increase tends to be. For companies that hedge commodity or credit risks, prices have increased a median of 10 percent. The majority of these organizations use derivatives to hedge exposures in at least four of the five types of risk that our survey identified.
Among derivatives end users that have seen a higher-than-median price increase, 69 percent use interest rate hedges, 56 percent use foreign exchange hedges, and 44 percent use commodity hedges. For companies that have seen derivatives prices rise across the board, the average size of that increase is 7.8 percent.
Few Companies Are Leaving Derivatives Behind
In some cases, companies are responding to the higher prices and increased complexity by moving away from bilateral, OTC derivatives trades, but few are substantially modifying their reliance on derivatives to hedge financial risks. Nearly two-thirds of respondents (63.5 percent) said they have not changed the fundamentals of their derivatives program as a result of new regulations, and almost as many (61.6 percent) said they’re not considering any changes at this time.
Seven percent of survey respondents reported that they have reduced their hedging volume as a result of regulatory changes, by a median of 25 percent of notional value. The largest businesses are the least likely to decrease their trading volume; 95 percent of companies with annual revenue over $5 billion said they have not reduced the scope of their derivatives programs.
Although fewer than one in 10 companies has already reduced its hedging volume, that isn’t the whole story. Around 3 percent of survey respondents have modified their non-derivative arrangements to reduce their use of derivatives. Twelve percent said they’re analyzing their exposures in more detail to determine whether they can reduce their reliance on the instrument. Eight percent said they’re moving to shorter-duration derivatives, and another 8 percent have modified the types of derivatives they use.
Nevertheless, only 1.4 percent of end-user respondents said that they’re moving away from using derivatives altogether for financial risk management. (see Figure 4, below).
It's clear that rising prices and the increasing demands derivatives trades are placing on treasury staff are both acting as drivers of companies’ re-evaluation of their approach to hedging. Survey respondents whose companies are experiencing derivatives transaction price increases above the median 5 percent are the most likely to be changing their programs. These organizations are almost three times more likely than other businesses to be reducing either their transaction volume or the proportion of exposure they hedge. They’re twice as likely to be moving to shorter-duration derivatives, and more than twice as likely to be modifying the types of derivatives they use.
Likewise, companies in which recent regulations have increased the staff time spent on derivatives by at least two hours per week are almost twice as likely as the typical company to be reducing their transaction volume and more than twice as likely to be modifying the types of derivatives they use. Still, not one organization in our survey that has above-median price increases or more than two hours per week in increased workload is entirely moving away from derivatives for hedging financial risk.
Bilateral vs. Exchange-based Trading
Many of the survey respondents whose companies are continuing to use derivatives for hedging are moving some (or all) of their activity away from OTC trading. Eighteen percent are already using swap execution facilities (SEFs), the new CFTC designation for trading platforms that enable market participants to trade swaps with more than one other market participant. Another 10 percent said they’re considering starting to trade derivatives on SEFs. Some are also replacing OTC derivatives with exchange-traded futures—10 percent for hedging commodity price risk, 8 percent for FX hedging, 7 percent to hedge interest rate risk, and 6 percent to hedge other financial risks.
Although SEFs and futures exchanges offer derivatives end users substantial advantages in terms of pricing, transparency, and management of counterparty risk when compared with bilateral OTC transactions, they also offer a limited range of options for financial instruments’ notional value and tenor. Thus, they severely limit a company’s flexibility in finding hedges that precisely match their various exposures. Seventeen percent of respondents said that one result of recent derivatives regulations will be a reduction in the effectiveness of their hedge accounting as they move to more standardized products.
A good alternative to using choosing between OTC derivatives and those traded on a SEF or exchange might be to combine the two approaches. A company might save money if it used SEF- or exchange-traded derivatives to hedge those risks that standard financial instruments can address. Then it could turn to the OTC market to hedge more unique exposures.
However, fewer than 5 percent of survey respondents said they are currently combining OTC derivatives with SEF- or exchange-based trading. This approach is popular with companies that use derivatives to hedge credit risk, though. A full 43 percent of those organizations are using both OTC and SEF- or exchange-traded derivatives. And it's a tactic that might be growing in popularity; 14 percent of all respondents are currently considering the combined approach.
Clearing and Collateral
Many companies that are continuing to trade over the counter have responded to recent regulatory changes by either starting to clear their transactions or entering into new credit support annexes (CSAs), documents that stipulate collateral requirements, with their dealers. Nearly one in five survey respondents said they’re entering or amending CSAs with their swap counterparties. CSAs are most popular among companies that use derivatives to hedge commodity price risk; our survey indicates that more than 40 percent of these businesses have begun posting collateral.
Overall, 17 percent of survey respondents are clearing their OTC derivatives trades through a clearing organization. That number is much larger for certain types of hedgers: Almost half of companies hedging price risk, and 57 percent of those hedging credit risk, are clearing their trades. (See Figure 5.)
Forty-one percent of respondents said their organization has applied for an end-user exception to the Dodd-Frank Act’s clearing requirements and has taken all the steps necessary to achieve the exception. Twenty-eight percent said they’re still considering applying, while 22 percent said that although they’re eligible for the exception, they decided not to apply.
The companies that are feeling the greatest impact from regulations are also the most likely to be considering substantial changes to how, and where, they handle derivatives trades. Respondents whose organizations are seeing higher-than-median price increases, or are dedicating two or more extra hours to derivatives trading each week, were about half as likely as the typical respondent to say that their company is not considering new execution or clearing options, nor considering increasing its use of non-OTC derivatives. Along the same lines, companies facing high prices are more than twice as likely as other companies to be looking into SEFs, and they're three times as likely to replace OTC derivatives with exchange-traded futures for hedging interest rate risk. (See Figure 6, below.)
Ultimately, more than a third of respondents (36 percent) said that they think the OTC market—without clearing or posting collateral under CSAs—is the only way their organization can effectively meet its hedging needs. These organizations are absorbing higher prices and are managing counterparty risk in their OTC trades by tracking their banks’ credit ratings (56 percent), monitoring their banks’ credit default swap levels (31 percent), spreading their exposure among a group of counterparties (45 percent), and keeping exposure to any particular counterparty below predetermined limits (38 percent).
What are derivatives end users’ biggest concerns going forward? One-quarter are frustrated by the lack of clarity on how different governments will coordinate the regulation of cross-border trades. Almost 10 percent have a similar complaint about the lack of clarity around margining and collateral requirements, while 14 percent are concerned about the changes to operations and working capital management that they would need to undertake to post collateral. Twenty percent cited higher prices as their top concern. But the largest proportion of end users (27 percent) said they simply don’t have the time or internal expertise to deal with all the regulatory changes in the derivatives market.
That frustration dovetails with respondents’ viewpoint on the benefits of derivatives regulations overall. Most agree at a high level that Dodd-Frank, Basel III, and the other regulations affecting derivatives markets have some value. One treasurer even stated that governments “should have gone farther with regulating this marketplace.” But the vast majority of the survey’s corporate respondents wish they weren’t affected by the tightening oversight. Twenty percent called the regulations “unnecessary and intrusive.” Another 41 percent said that the rules are necessary for financial companies, but that requiring changes for end users of derivatives was an overreach (see Figure 7).
Only 5 percent of respondents from non-financial institutions said the regulations are “essential to market stability.” Interestingly, twice as large a proportion of respondents from financial institutions (10 percent) believe recent derivatives regulations are essential. And 22 percent of banking respondents think the regulatory changes have been helpful because they’ve increased transparency in the derivatives market, while just 14 percent of respondents from non-financial companies feel the same way.
As prices and complexity rise in the over-the-counter derivatives market, companies are considering their alternatives. In this analysis, most are finding that no other financial instrument can replace the precise hedging capabilities of OTC derivatives.
For that reason, corporate end users are largely staying the course with their derivatives programs. They’re bearing higher prices and larger workloads for treasury staff, and they're hunkering down in anticipation of the changes that will undoubtedly continue to flow.
Meg Waters is the editor in chief of Treasury & Risk. She is the former editor in chief of BPM Magazine and the former managing editor of Business Finance.