As we begin to move toward the final stages of legislation on the OTC derivatives market, let’s re-examine some of the factors that will ultimately impact costs to End-Users, post reform.
There are areas where costs could increase under the reform and factors that could drive costs down:
Potential Cost Increases:
1. End-Users being required to post cash to cover margin costs to execute derivatives on an exchange or to the clearing firms to clear non-standard trades.
· Under all US proposals End-Users are exempt from this requirement.
2. Swap Dealers requiring cash collateral from End-Users to cover the margin costs they have clear their trades (whether exchange-traded standardized contracts or non-standardized contracts).
· Senator Lincoln’s bill has the strongest language to eliminate this risk to the End-User.
· HFSC’s and Dodd’s bills have it but more discretion by regulators to allow it.
3. Swap Dealers widening bid/offer spreads or charging fees to cover their increased cost of capital, which will go up and should be higher for un-cleared trades.
· No doubt capital charges are going up (see below for more).
4. Swap Dealers widening bid/offer spreads or charging fees to cover their increased cost for new, real-time regulatory reporting requirements.
· Probably minor in the grand scheme of things.
Offsetting End-User Benefits Under the Reform:
1. Derivative transparency increases and more people enter into swaps and costs go down.
2. Derivative execution efficiency increases and processing fees go down.
3. The safety of the now regulated derivative markets brings in new users and more liquidity, driving costs down.
So the big question is, will the key benefits outlined above outweigh the potential increased cost of capital that banks will be charged. This all of course depends on what that capital charge calculation is, and if Swap Dealers will actually pass it on. The Catch-22 is that because End-Users will not be required to trade on exchanges or be forced to clear, all End-Users transactions should be un-cleared. The reason for this is that a clearing firm needs to have a margin agreement with both parties in order to be able to function and cannot just have margin from Swap Dealers, as the mark-to-market position can go against the End-User. By default, then, capital charges will increase for Swap Dealers to enter into swaps with End-Users.
At the end of the day, the markets will determine how costs will increase or not. Some Swap Dealers may be willing to keep bid-offers the same to win or keep key clients or, if costs increase for un-cleared trades, End-Users may in the end decide it is more advantageous to exchange-trade their derivatives, if they can, or to opt at the end of the day to clear their trades or enter into collateral agreements with Swap Dealers to get a better price. The answer will be known a few years out through analysis of the derivative volumes and activity patterns, which, because of the reform’s repository requirements, should be real-time, accurate and transparent.
As I have mentioned in past blogs, the last bill to be proposed on OTC derivative reform was to be issued by Senator Blanche Lincoln (D-Ark), Chairman of the Senate Agriculture Committee, who also has jurisdiction over the CFTC. Today, Senator Lincoln finally issued her bill in a bold move with some surprising changes.
Up until a week ago, word on Capitol Hill was that she was going to come out with a fairly moderate bill with no major differences to what we have seen from the House or from Dodd’s bill with the Senate Banking Committee. However, with the advantage of going last, she has been able to address some of the concerns of both hard line democrats and regulators, while keeping the spirit of end-user exemptions, but with one major impact. In a surprise move, this bill eliminated the Fx Forward and Fx Swap exemption, which was in all of the other bills. With the inclusion of these instruments, Swap Dealers, Major Swap Participants and Banks would be required to trade them on exchanges if available or clear them, which in both cases would require the associated additional capital charges and margining costs. Real time data repositories would also have to report on them, which given their high volume of transactions, could prove to be challenging and costly.
Although end-users can still enjoy the benefits of not being forced to exchange trade, clear or post margin against those trades, it was better to have these instruments exempted outright, as I fear the dealer costs mentioned above will be passed on to end-users.
But it is important to take note that, for end-users, she has done what no other bill has done, which is to actually define what an end-user is and to more clearly articulate what end-users will be exempted from, whether that means being required to exchange trade or clear contracts even if Swap Dealers, Major Swap Participants and Banks are required to do so. Clearly defining the end-user is a suggestion I made to the Committee last year in my testimony. With a clear end-user definition in the legislative language, potential loopholes that could put the financial system at risk can be appropriately addressed without the unintended consequences of crippling the legitimate hedging activities of businesses.
On this positive note, Senator Lincoln is providing better clarity and demonstrating that she understands some of the root causes of the financial crisis. For example, the definition of Major Swap Participant (MSP) has caused angst with some who have felt that they could be erroneously included in this category. In her legislative language, she clarifies the definition of an MSP as one that could cause risk to the financial system of the US—for example, banks that are highly leveraged. Other bills had no mention of leverage, the true root cause of the crisis, and focused too much on single counterparty risk as opposed to systemic risk. In addition, the CFTC is named specifically as the one to define what a substantial net position is, which makes sense since it is best equipped to determine this for MSPs who won’t be regulated by the Fed or other Prudential Regulator.
So no doubt Swap Dealers and banks are not too thrilled as there is stronger language on exchange trading, clearing, capital and margining requirements. It could also become illegal to bail out banks that end up in trouble because of their derivative activity.
It will be interesting to see in the week ahead how Senator Lincoln’s own Committee will vote on the bill and whether she will have enough Republican support to prevent a filibuster in the Senate. My guess is that she will have it, given the renewed attention on fraud from the SEC’s recent charges against Goldman Sachs.
Strange things are happening in the longer end of the USD LIBOR swap curve where USD Swap rates were trading below US Government bond yields at the end of March. In other words, swap spreads were negative for the first time in the 25+ years of the interest rate swap market. LIBOR, or the London Interbank Offered Rate, is an index based on the interest rate at which banks lend to each other in London in a particular currency and calculated from a panel of major banks http://www.bbalibor.com/bba/jsp/polopoly.jsp?d=1645. As most of the banks polled are of Single A or higher in credit rating, the LIBOR flat swap curve implies approximately a Single A bank credit curve, so a AA corporate should trade at LIBOR less a spread and maybe a weaker single A corporate should benchmark itself at slightly above LIBOR when looking to swap its own debt using the LIBOR swap market.
As the US Government credit rating is AAA, it has typically been trading at a lower yield than the equivalent USD Swap rate and as a spread over US Treasuries, so the USD Swap rate was always positive. The chart below depicts the historical data of 10-year Treasuries vs 10-year Swap rates, which over the last five years averaged 46 basis points and peaked almost at 90 basis points during the height of the financial crisis. The spread flirted with being 0 at the start of 2009 when the world was unsure whether the US was headed for a double dip or worst Depression 2.0. Since then, however, the economic picture has gradually improved, yet last month the spread broke the 0 floor and dropped as low as -9 basis points.
What is the swap market trying to tell us?
It could be a supply and demand factor due to a lack of new issuance—banks not lending or borrowers not borrowing—or due to the lack of corporates paying fixed in a steep yield curve that has forced down swap spreads. It’s probably a stronger reflection of the large debt load the US government needs to issue to pay for the bailouts and programs and a disconnect with the LIBOR markets where banks have access to liquidity and do need to lend to each other. Whatever the reason, something needs to give on the credit side, where either the swap curve should be reflective of BBB banks and the swap yields should be higher than the expected rise in US government yields or probably the reality that the US government should be downgraded to AA to reflect the huge and ever-increasing budget deficit and debt issuance, at least that is what the USD swap spreads are saying. The other time swap spreads were negative in a G7 currency was when Japanese swap spreads were negative to JGBs around the end of 2001—which was around the time S&P cut Japanese credit a notch to AA (http://www.nytimes.com/2001/11/29/business/s-p-cuts-credit-rating-of-japan.html?pagewanted=1).