By John Hintze
Corporates face big decisions as a new swap collateral regime looms.
The third and final deadline to clear interest-rate and credit-default swaps, on September 9, will introduce a new and substantially more complex collateral paradigm. The vast majority of US corporates are exempt from clearing, but they, too, are likely to face significant new collateral challenges to continue using swaps.
“The idea here is to have increased oversight in the system, and frankly the introduction of all this isn’t all that different than what the exchanges provide today for futures contracts,” said George Zinn, treasurer of Microsoft, which in late June was putting the final pieces in place to begin clearing.
Mr. Zinn added that requiring clearing and what appears likely to be stringent new margin requirements for uncleared swaps—still to be finalized—will increase “friction” in the system and ultimately costs.
Alternative ways
Some corporates may find alternative ways to hedge risk or forgo hedging altogether. Most, however, will likely seek to manage their collateral as efficiently as possible, requiring significant changes from current practice beginning with establishing new relationships with counterparties. Those relationships will require vigilant monitoring for risk and heightened abilities to value exposures and transfer collateral.
The first choice for nonfinancial end users, however, will be whether to clear swaps or not. Clearing will require companies to choose at least one futures commission merchant—a first unless they’ve used the futures market—as well as register for central clearing parties (CCPs) and establish relationships with swap execution facilities (SEFs) and swap data repositories (SDRs). In addition, cleared swaps will require corporates to post variation and—for the first time—initial margin.
Nonfinancial companies must choose whether to clear or seek the end user exemption, requiring board approval, by September 9.
Microsoft is completing a platform to clear interest-rate swaps, which it mainly uses to adjust the duration of its fixed-income portfolio. Mr. Zinn said the firm was close to announcing its choice of FCM, which will manage the firm’s initial and variation margin requirements.
Toyota, on the other hand, will continue pursuing uncleared swaps, handling those trades and the related collateral movements entirely in-house. It has been exchanging collateral with bank counterparties since 2004, negotiating exposure thresholds over which it posts collateral, usually on a monthly basis. Jonathan Cowan, director of rate desk and derivatives, said Toyota started moving toward daily collateral exchanges and zero thresholds around the time of Lehman Brothers’ collapse.
“The biggest challenge was on the processing side,” Mr. Cowan said. “Most corporates don’t have a full-time collateral department, and neither do we, so we needed to find a way to arrive in the morning, value the collateral and exchange it if necessary, and continue with our day jobs.”
That required automating the company’s derivatives platform, which Toyota did in-house, and Mr. Cowan said the firm achieved 100 percent straight-through-processing a year and a half ago. “It required a lot of work on the valuation side to make sure internal systems could handle the real-time valuation requirements,” Mr. Cowan said.
UnCleared vs. cleared
The uncleared swap market, at least under proposed rules, provides more flexibility than the cleared market, where daily margin calls are required and clearinghouses set initial margin requirements. In the uncleared world, initial margin would be negotiated between counterparties, as would initial- and variation-margin thresholds and the frequency of variation-margin calls. Swap dealers and major swap participants must update margin status and if necessary collect it with nonfinancial end users at least weekly.
“We needed to find a way to arrive in the morning, value the collateral . . . and continue with our day jobs.”
— Jonathan Cowan, Toyota
For some corporates, that resembles current practice, although initial margin would be new for most. Many companies, however, typically use their bank counterparties for commercial loans, commercial paper, securities underwriting and other financial services. Both banks and their clients tend to view swaps transactions in the context of their broader relationships and risk exposures, resulting in many end users currently having infrequent margin calls if any at all.
Going the safe route
Although some flexibility remains under the banking regulators’ margin proposal, which is anticipated to be finalized at some point this summer, many corporates are likely going to have to upgrade their systems or pay a third party to handle some of the load. Luke Zubrod, director at Chatham Financial, said companies with oodles of cash and/or access to significant liquidity at low cost—Microsoft and Toyota fit that description—are the most likely to consider clearing or fully collateralizing swaps.
Most companies, however, will opt for thresholds, in order to maintain collateral—typically cash, US Treasuries, or other high-quality securities—that can be used for more productive business pursuits. One challenge they will face is tracking their exposures to several bank counterparties against the thresholds they’ve negotiated with each.
“It complicates matters, but maybe in a different way than one might think,” Mr. Zubrod said. He added that beyond the operational challenges, including measuring the amount of collateral that must be posted or called, the “most relevant question will be which of my counterparties is actually offering the best deal?”
Price is an insufficient parameter, because once an end user exceeds the exposure limit and the next swap is collateralized, the bank counterparty can price it more attractively. However, counterparties with which the company remains below the thresholds will most likely have to offer less competitive prices, since the exposure is uncollateralized.
Mr. Cowan said Toyota faced a similar paradigm early on. “You really have to be proactive in managing your exposures,” he said, adding that the zero thresholds level the swap field.
“As soon as I’m on an unequal footing in terms of collateral, suddenly it’s a lot more complicated to figure out who I should trade with,” Mr. Zubrod said.
the Great unknown
The great unknown remains the banking regulators’ margin proposal, first issued in April 2011. Eastman Chemical plans to apply for the end user exemption. However, it is waiting for the proposal to be finalized, so all the costs can be taken into consideration, before making a final decision on whether to clear, according to Pat Ryder, director, financial risk management, at the company.
Mr. Ryder said the uncleared OTC market should continue to offer more flexibility in terms of matching hedges to the underlying risk and achieving hedge accounting, and most likely Eastman will opt for that market, but a severe final rule could change the equation.
In addition, it’s still uncertain what fees from FCMs, CCPs and other service providers on the clearing side will be. For many firms, Mr. Ryder said, clearing will require establishing some additional infrastructure, to calculate positions daily, input threshold limits, and ensure compliance with internal policies around margining and credit limits—whether operations are taken in-house or outsourced.
“If you choose to clear, you must have controls in place that are similar to a trading organization,” Mr. Ryder said.
Jon Anderson, global head of valuations and OTC derivatives for fund administrator SS&C GlobeOp, said regulators are requiring additional reserves in reaction to the underpricing of risk leading up to the 2008 financial meltdown, but that tends to make the market less efficient and more costly to trade in.
“It means that collateral has now become a part of the trading decision, whether you’re a bank or a corporate,” Mr. Anderson said.
“Collateral has now become a part of the trading decision.”
— Jon Anderson, SS&C GlobeOp
Key to optimizing collateral is accurately valuing positions, and then actively refuting collateral calls or making them when appropriate. General Motors has outsourced that task to SS&C since it emerged from bankruptcy in 2009 and faced much more aggressive credit support annexes (CSAs) from bank counterparties, and Anderson said SS&C is discussing playing a similar role for other corporates. For its 100-plus clients—now mostly buyside funds—the firm
averaged 450 daily calls last year and managed $1bn in collateral exchanges.
Outsourcing that function, of course, carries a cost. Another cost arises if corporates choose to safeguard excess collateral that’s not supporting uncleared swaps with third-party custodians. The big custodial banks, including BNY Mellon, State Street and Northern Trust, are seeking that business, and to provide other services to help manage collateral more efficiently.
More collateral, less to invest
Another major cost for both cleared and uncleared swaps will stem from simply having to tie up more collateral that could otherwise have been invested in fixed-income or a new plant, especially for corporates putting up cash instead of securities. “They’ll have decreased investment returns on that cash, so it will be a drag on the treasury department’s internal rate of return,” said James Malgieri, EVP and head of service delivery and regional management for BNY Mellon’s Global Collateral Services business.
Despite handling its large book of derivatives in-house, Toyota has successfully avoided additional hires by automating the process. So far, neither Microsoft nor Eastman Chemical have hired additional treasury staff. Nevertheless, they and other corporates are entering unknown territory, and unlike the financial community there are few trade groups or other resources to turn to for advice on best practices and technology solutions. (An Association of Financial Professionals spokesperson said it has yet to address the issue).
If a company determines that some swaps should be cleared while others not, the equation becomes even more complex, because the processes are so different. “Using both would bring in twice the operational challenges. They act differently in terms of how you manage the collateral, how you get and make calls, and how their cashflows are processed,” said Ted Leveroni, executive director of derivative strategy at Omgeo. Half-owned by the Depository Trust & Clearing Corp, Omgeo provides processing solutions for cleared and uncleared derivatives.
End users will have to make decisions that may include certain hedges not being cost-effective anymore.”
— George Zinn, Microsoft
Only the largest corporations are ever likely to consider using a combination of cleared and uncleared swaps, perhaps as clearing for some FX products comes into sight, and the cost may ultimately be prohibitive. Corporates will have to weigh costs against the benefits, not only to choose whether to clear or not, but whether to hedge and with what. Mr. Zinn noted that regulators are increasing reserve requirements through the banks they directly oversee, increasing their costs that will be passed on to end users in a variety of ways.
“End users will have to make decisions that may include certain hedges not being cost-effective anymore,” Mr. Zinn said, adding, “ Behavior will change, and in interesting ways.”