Derivatives Users Fear Higher Hedging Costs

A Greenwich Associates news release about its recent research on the subject said the fear of higher expenses by many U.S. companies comes despite the fact that language in the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act exempts corporate derivatives users from centralized clearing mandates.

The U.S. firms’ fear of higher costs also comes regardless of the final outcome on the still open question about whether the new law will require corporate “end users” to post margins on swap transactions that are not centrally cleared, Greenwich said.

According to the news release, in crafting the financial reform measure, both the U.S. Senate and House bills exempted commercial end users from margin requirements in non-cleared swap transactions. That was dropped in the final law approved by both houses and signed by President Obama. However, in a June 2010 letter, U.S. Senators Christopher Dodd (D-Connecticut) and Blanche Lincoln (D-Arkansas) stated that the intent of legislators was to exempt commercial end users from the margin requirements. “It remains to be seen how U.S. regulators will interpret and enforce the law and what approach EU rulemakers will take toward commercial end users,” Greenwich commented in the news release.

“Two-thirds of study participants say rules requiring banks and non-bank financial institutions to centrally clear all derivatives transactions will increase their own costs,” said Greenwich Associates consultant Andrew Awad, in the news release. “To some extent it’s inevitable: If banks are forced to lay off their own risks through centrally cleared transactions and are subject to a range of new capital, margin and record-keeping requirements, the additional costs will be passed through to their commercial clients.”

Companies fear even more damaging consequences if regulators were to adopt a narrow definition of the “end-user” exemption that limited the type of user that could qualify. Seventy percent of corporations say they expect mandated central clearing to have a negative impact on their ability to effectively hedge commodities exposure.

Almost all the participants in the Greenwich study say central clearing is effective in mitigating counterparty risk, and 60% cite reductions in ISDA and CSA documentation as an important advantage.

According to the news release, in addition to margin requirements, commodity derivatives users point to several drawbacks with centralized clearing, including higher transactions costs and reduced flexibility related to standardization of contracts.

Companies are not rushing to shift their derivatives trades to centralized clearing:  Fewer than a quarter say any of their derivatives trades were centrally cleared on an exchange or other central counterparty over the past 12 months, and 25% expect to be doing any derivatives trades on a centrally cleared basis within the next 12 months, according to the study.