More than 5 years in the works, the prudential regulators issued a final rule October 22 imposing margin requirements on financial institutions’ over-the-counter (OTC) swaps that could soon increase their nonfinancial corporate clients’ hedging costs.
Early on in the rulemaking process, regulators appeared intent on pursuing a backdoor approach to imposing swap margin requirements on corporates, by requiring swap dealers to levy them on their clients. Concerns about the impact of tying up corporate capital in margin requirements, however, culminated in legislation passed early this year that exempted companies using swaps for hedging purposes. The final regulatory rule exempts them from margin as well.
Nevertheless, corporates can expect increased hedging costs.
“Corporate end-users are generally pleased with the rule, which exempted them from the requirements in keeping with legislation passed as part of the Terrorism Risk Insurance Act in January 2015,” said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial. “However, the rule will create new burdens for the market and some of those burdens will impact corporate treasurers.”
Swap dealers typically hedge their swap exposures to corporate counterparties, and those hedges will now require margin, and to support those requirements they will have to invest time and resources in documentation, systems and processes. The margin requirement also applies to bank inter-affiliate trades, when a bank seeks liquidity from an affiliate rather than a third party to hedge a swap exposure.
Mr. Zubrod said it is difficult to discern the cost increase stemming specifically from new margin requirements because banks must also comply with Basel III’s net stable funding supplementary leverage ratios. “Anything that causes a dealer to sideline cash or securities due to an end-user’s need to hedge risk is likely to increase cost” that banks will pass on to clients, he said.
Mr. Zubrod added that hedging cost increases could arrive at any time. “With respect to capital requirements, dealers could increase prices recognizing that some trades executed today will still be in place when those requirements take effect.”
Swap dealers with greater than $3 trillion in gross notional amounts are subject to initial margin requirements starting Sept. 1, 2016. Other financial entities must begin posting margin on March 1, 2017. They will be required to fully collateralize the mark-to-market value of their swaps on a daily basis.
Chatham notes that a range of factors, including an entity’s cost of capital, access to liquidity, and transaction volume, will determine how a swap end user responds to more costly hedges.
“Regulators expect that these indirect costs will cause some market participants to consider margining or clearing their derivative transactions, even if they are not required to do so,” Chatham says.