Companies May Reduce Hedging Due to Higher Costs

The report, “Commodity Swaps: Corporations Face Rising Transaction Costs,” also found that as a result of higher expenses, companies could assume more risk from direct exposures to energy and other commodities.

While corporate users of derivatives have thus far been isolated from the direct impact of new regulations in the United States and Europe by end-user exemptions, according to the report, new rules included in the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Bank for International Settlements’ Basel III standards will change the economics of the commodities derivatives business for banks.

Increased capital costs associated with new reserve requirements will have a significant impact on these businesses. At the same time, changes in derivatives rules will make it more expensive for banks themselves to hedge risks and will also force banks to incur the substantial costs of developing and operating the infrastructure needed to trade in newly created Swap Execution Facilities (SEFs) and Designated Contract Markets (DCMs). There will also be an increase in cost related to additional margin.

For banks that specialize in these products, these rising costs will eat into overall returns on equity, already substantially down from pre-2008 levels, Greenwich said. According to the report, some institutions that are already adapting a more conservative stance are likely to pull out from offering capital to some commodity-linked transactions. These changes could prompt some large banks to exit the commodities derivatives market or scale back, which would limit competition and narrow companies’ choice of dealers.

Companies now hedge 53% of their commodities exposure financially, declining from 56% in 2009. “The likely result of regulatory changes is that corporates, facing higher costs to hedge, will hedge less and risk their own income statements,” said Greenwich Associates consultant Andrew Awad.

Copies of the report can be requested here.