After Treasury &Risk ran a recent article on the Fed's proposed margin rules fornon-cleared derivatives transactions, we received a reader inquiryasking for further clarification. Joseph Neu of The NeuGroup, anetwork that promotes knowledge sharing among corporate treasurers,asked about the combined effects of the current Fed proposal andregulatory capital charges on margin-exempt swaps.

If capital requirements drive up the price of derivativestrades, will companies consider posting margin to reduce costs,even though they fought long and hard to avoid being included inthe collateral rules?

To answer, we sat back down with Luke Zubrod, director of riskand regulatory advisory with Chatham Financial and a technicaladvisor to the Coalition for Derivatives End-Users. Luke regularlyconfers with U.S. Congressional staff and federal regulatoryagencies including the Commodity Futures Trading Commission (CFTC)and Federal Reserve regarding derivatives regulatory matters, andfrequently helps T&R suss out the details ofcomplex derivatives regulations.

T&R: As we discussed inour last conversation, the Fed proposal offers endusers an exemption from margin requirements. That's clearly avictory; it's something they fought for for a long time. But ifcapital requirements and funding charges make executing unclearedswaps a lot more expensive when companies don't post margin, is themargin exemption very valuable?

Luke Zubrod: That's a relevant question.One of the questions behind the question is: How does this latestproposal treat capital? The answer is that this rule doesn't makeany change to capital requirements; it defers to the existingcapital framework. But the question is still very relevant.Basel III, which is being implemented in stages over a periodof years, increases capital requirements for derivatives exposures.If a corporate end user wants to do a trade with a bank, and thattrade means the dealer has to set aside more capital to backstopagainst potential losses on the trade, the dealer needs to get areturn on that capital. Dealers will get a return on capital byincreasing the transaction prices corporates pay them.

The capital requirement is one of two primary forces that willlikely push up derivatives transaction pricing in the near future.The other force is the initial margin that dealers now have topost. Dealers have traditionally posted variation margin to eachother, so that's not a game-changer in the new Fed rule. But theytraditionally have not posted initial margin to each other. Now,just as the capital rules require a dealer to set aside capitalwhen dealing with corporate end users, they'll have to post initialmargin. They're going to have to fund that initial margin, andthat'll cost them something. They'll eventually pass that cost onto end users.

T&R: So the cost increase may benoticeable for corporate treasurers who use derivatives to hedgeday-to-day financial risks.

LZ: Yes. It appears that swaps end usersdodged the bullet on margin. But that doesn't necessarily mean theyavoided the economic impact, because the economic impact is notreflected only through margin. It's also reflected through capitaland funding charges, and those will materialize over the next fouryears, as capital and margin requirements for dealers get phasedin.

T&R: How do you expect end usersto respond to these higher costs?

LZ: That's interesting, because end userscould make the higher charges go away by doing what they worked sohard to avoid having to do—marginingthe trades. If you're a derivatives end user, will you chooseto post margin or clear your trades in order to reduce thetransaction prices you pay, even though you're technically exempt?I've been thinking about how end users might square up thatanalysis. And I think it will not be a one-size-fits-all reactionacross all end users. I think it'll depend on companies' cost ofcapital and access to liquidity.

For a company with a high cost of capital, the opportunitycost of having to sideline funds into a margin account is verysubstantial. If the company could put that money to work at, say,15 percent return on investment, but instead it's forgoing thatkind of return and earning fed funds on a margin account, theopportunity cost is large. Companies with a lot of physical assets,like real estate or equipment, often don't have easy access toliquidity, so they would generally pay the higher transaction coststo avoid posting margin.

But if a company has a lower cost of capital and higher accessto liquidity—a large line of credit, say—it might decide it'sworthwhile to tie up tens of millions, even hundreds of millions,of dollars in a margin account to save money on its hedging costs.I think companies in that situation will look at it.

T&R: Have you talked to anycorporate end users about their reaction to increases in the costof derivatives trades?

LZ: About a year ago, I asked a group oftreasurers from blue-chip companies how they were thinking aboutthe decision of whether to post margin. Of the 20 or so treasurersin the room, five said they would consider clearing or margining ifthe cost savings of doing so was substantial. So again, it's notone-size-fits-all, but it depends on the transaction price versusthe economics of margin—where a company fits within the frameworkof cost of capital and access to liquidity.

We have not seen these pricing effects hit the market yet.Theoretically, in anticipation of knowing these costs are out therein the future, especially for longer-dated trades that will stillbe in place when higher capital requirements are phased in, youcould start to see some of these costs show up in the market today.It's not clear to me why this isn't happening.

Maybe it's just a very complicated exercise to perform thecalculations and integrate those calculations across asset classesand geographies. I could imagine the burden of implementing thesekinds of calculations could take some time.

So, theoretically, we could see these pricing effects soonerrather than later, but practically speaking, we have not seen thathappen just yet.