Although activity in swaps will be more expensive in the short-term, increased transparency should reduce costs to below what they were pre-Dodd Frank-Act regulations, and big concerns remain around sourcing collateral, according to study published in July by Finadium, a New York consultancy.
Finadium spoke to 16 mutual funds, insurance companies and banks and brokers, many of which had to begin clearing by the June 10 deadline, providing early insight into the challenges of adapting to the swap market under Dodd-Frank. Although most corporates are exempt from clearing requirements, very large corporate swap users will have to start clearing in September. And even those that stick with uncleared swaps will face some of the same collateral issues addressed in the survey.
On the cost front, Josh Galper, managing principal at Finadium, said collateral costs in the new swap paradigm are expected to increase initially. However, respondents saw costs decreasing; even to below what they are for today’s bilateral transactions, as more trading occurs through derivative clearing members (DCMs) and over swap execution facilities (SEFs)
“Spreads should go down as liquidity grows, as more trading occurs on these central platforms,” Mr. Galper said, adding, “There should be more transparency between providers, and it will be possible for a [swap user] to select on an exchange-type of platform instead of making phone calls and hoping for the best.”
Respondents also suggested central clearing of OTC derivatives makes life operationally easier for end users, since they may have had multiple preferred counterparties but now every eligible transaction will settle on a central counterparty (CCP). “Internally, operational change encourages streamlining of business functions and this can lead to reduced costs,” the study says.
Pam Brown, a senior advisor at Chatham Financial, acknowledged the study doesn’t represent corporate end users, which are mostly still focused on providing their corporate board members with information to evaluate the costs and benefits of clearing and the end user exemption.
“That said, it is interesting to consider the views and experience of large end users as they provide some insight into the changes that are occurring in the OTC derivative market,” Ms. Brown said.
She pointed to consensus among the survey’s respondents that costs, even with clearing, will be a “’better financial deal’ than the pre-Dodd-Frank markets. It indicates, she said, “That the costs of transacting in the OTC derivatives market are changing as a result of new regulations and market practices, and the decision to elect the end-user exemption may not be so cut-and-dry going forward.”
Mr. Galper said a second significant issue noted by respondents that impacts all users of swaps, cleared and uncleared, is how they will manage their collateral: Will they have enough? Are they going to have to search for it? How will they make it work in the context their portfolios?
At least initially, market observers anticipate a shortage of the specific collateral required by different central counterparties (CCPs). That issue could be particularly vexing for corporates, many of which are not cash rich and tend not to manage large portfolios of Treasury bonds and other collateral-eligible, high-trade securities.
“It’s not sufficient to say we have extra cash and we’re going to post that as collateral. It’s really a question of what is the opportunity cost of that cash, and what else could be posted as collateral,” Mr. Galper said.
In some cases, corporates may have to rely on bank credit lines to post collateral. The study found those who have been proactive in setting up dedicated lines of credit wonder if they will really be safe should true collateral scarcity emerge, given credit lines tend to disappear when needed most.
Other survey findings include 27 percent of respondents pointing to operations as the biggest sticking point in terms of collateral management, and a concern that clearing brokers are not guaranteeing that end-users will get the same collateral back that they put in for initial margin.”