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Special Report: In derivatives trade, RIP OTC?

By Huw Jones

LONDON (Reuters) - To get a measure of what financial markets think about plans to make trading in derivatives more uniform and transparent, ask no further than the regulators themselves. Thomas Huertas, a senior UK Financial Services Authority official, said recently that unless the plans to centralize trillions of dollars' worth of contracts were thought through carefully, it could be a bit like "putting a Chernobyl in the back yard."

With its echo of Warren Buffett's description of derivatives themselves as "financial weapons of mass destruction," Huertas' choice of language reflects how potent the industry has become, not to mention hard to understand and difficult to tame.

Yet that is just what regulators are trying to do, and they've got a fight on their hands.

Big companies regularly use derivatives as a form of insurance to guard against jumps in the price of everything from cocoa to interest rates. An airline will buy jet fuel derivatives so that if prices spike, the contract helps to make up the difference in price, enabling the carrier to budget and plan ahead. If jet fuel prices fall, the loss made on the derivatives contract is canceled out by savings from cheaper refueling bills. It's the same with barley for beer or aluminum for cans, or any other commodity you can think of.

For investment banks, this business is a high-margin, low-volume trade they are loath to lose.

The new regulations, which should make derivatives trades easier to follow, are likely to shift some trade onto exchanges -- which companies and banks alike say would boost their costs.

More than 90 percent of derivatives contracts between banks and other banks, or between banks and companies, are currently drawn up directly between the buyer and seller on what is known as over-the-counter (OTC) market. OTC is an enormous sector which on paper is worth nearly $600 trillion, roughly 10 times world economic output.

But OTC is opaque: regulators have found it hard to see who is selling and who is buying. That's especially true when things go wrong, as they did so spectacularly in 2008. When U.S. bank Lehman Brothers collapsed, authorities struggled to pin down who was exposed to derivatives contracts negotiated by the bank, raising worries about contagion. When U.S. insurer AIG's hoard of derivatives turned toxic it required a $182 billion bailout from American taxpayers.

A few months after AIG, leaders of the world's 20 leading economies (G20) agreed that derivatives contracts should be standardized, centrally cleared, reported and, where appropriate, traded on an exchange or similar type of electronic platform.

The changes are due to come into force next year, which is why airlines, beer makers and plenty of other companies are so worked up. The OTC market has largely been left to its own devices since it took off in the 1970s, when the collapse of the Bretton Woods system exposed businesses to risks like currency swings, for which derivatives offered a hedge. Now big business worries that the extra layers of complication will make life far more costly.

"The proposals would lead to a large increase in cash collateral required from airlines, which they do not have," said Brian Pearce, chief economist at the International Air Transport Association (IATA). "Hedging would become much more expensive because of the cash requirements."

Regulators privately say industry estimates on the extra costs of the new rules are, in the words of one, exaggerated "hogwash."

"The costs from the absence of transparency and standardization in derivatives were huge during the crisis and implicated taxpayers which must not happen again," says Michel Barnier, the EU's financial services chief who has written a radical reform of the sector.

TREND CLEAR, DETAILS MURKY

While final details of the new rules are yet to be put in place, the fundamental direction is clear: regulators want to impose a framework on derivatives that borrows heavily from stock markets.

Lawmakers in Europe and the United States have been busy on the new rules. In 2010, Washington approved the Dodd-Frank law, a sweeping reform of Wall Street that incorporates the G20 push toward standardization, central clearing, mandatory exchange trading for some contracts and reporting.

The European Union is set to approve a similar law. The key -- and most costly -- change will be the push to centrally clear derivatives contracts, a common and easy process for share trades because stocks are uniform. Regulators are keen on using clearing houses because they are backed by a default fund so that even if one side of a trade goes bust the contract is completed and settled without disruption to markets. Not only are risks known and contained, according to regulators, but there is also a full electronic audit trail of the parties on both sides of a trade.

PRICIER SIX-PACK?

But companies fear more bureaucracy. Take the example of an airline. "For the airlines, fuel can be 20-30 percent of their cost base, so they've always had to be very systematic about managing price volatility and are therefore the most mature sector in terms of using OTC contracts," says Steven Jones, a managing director for the commodities business at U.S. bank Morgan Stanley.

Though airlines buy jet fuel on an ongoing basis, there is no standardized derivatives contract. This means the airline has to call Jones and ask him to write a bespoke deal. Morgan Stanley, one of 14 or so trading houses with deep enough pockets and experience to offer such contracts, then draws up an agreement derived -- hence the term derivatives -- from the underlying commodity, in this case the price of jet fuel on the physical market as tracked daily by Platts, an energy publication.

As airlines buy fuel through the month, Jones factors in changing spot prices, which is one reason why such a deal is hard to standardize.

That may all change over the next two or three years. In OTC trades, banks typically charge long-standing customers a credit fee with no security needed. But in the new system, derivatives customers such as airlines may have to clear each trade they make, which means posting daily margins -- a proportion of the sum risked. They will also need to have a pool of cash to cover any calls for those margins should the market move against them. Some bankers estimate that for an airline this cash pool might amount to several million dollars.

"The main concern for corporates is cash flow management, and how to deal with the ... margin calls that come with doing a trade on exchange or through a clearing house," said Jones in a room just off Morgan Stanley's large, bustling trading room in London's Canary Wharf. "Dealing with a bank direct on an OTC basis enables a corporate to utilize the bank's credit line, and thus removes the administrative burden of managing daily margin calls."

Indeed, an International Swaps and Derivatives Association (ISDA) survey of corporate derivatives last year found just 47 percent of corporate contracts are collateralized at a cost of just over $3 trillion. Collateralization at the moment is voluntary.

Airlines -- or any company that hedges using derivatives -- won't be able to avoid margin calls by sticking to uncleared contracts because regulators plan to slap punitive capital charges on them. This rule is designed to force companies to use standardized contracts that can be centrally cleared and even traded on an exchange.

Unless a standardized contract emerges for bespoke contract users, companies face trying to use exchange-traded proxies -- oil derivatives, say -- but may end up with an imperfect hedge. That is likely to drive up operating costs.

"We have already seen airlines reduce hedging as it got more expensive, leaving airlines more vulnerable to fuel price volatility," IATA's Pearce said.

And it's not just airlines. A study by a coalition of U.S. business groups estimated a 3 percent margin requirement on swaps used by Standard & Poor's 500 companies could cut capital spending by $5.1 billion to $6.7 billion and cost up to 130,000 jobs.

Craig Reiners, commodity risk manager at U.S. brewer MillerCoors, told U.S. Congress this month that he spends $2.8 billion a year on commodities such as aluminum for its cans and barley for beer. Asked if regulatory costs are likely to be passed on, forcing up the price of a six-pack, Reiners didn't hesitate. "It would certainly have an impact," he said. IATA is unable to say if higher hedging costs will be reflected in ticket prices. Jon Eilbeck, a managing director of Deutsche Bank, says that without the ability to hedge jet fuel costs through OTC derivatives, "European airlines would face significant problems."

SHRINKING OTC?

Policymakers have little time for those complaints. They say higher costs in derivatives trading will simply correct a situation where risks have been underpriced, or priced in an opaque way, for customers like airlines who are not fully aware how much they are paying in administrative fees.

"We're aware and focused on the cost of a six-pack because we also oversee agricultural markets," Commodity Futures Trading Commission Chairman Gary Gensler told Congress this month after Reiners' remark. "I would say our intention is not to have margin requirements applied to an end user such as MillerCoors," said Gensler.

Svein Andresen, Secretary General of the Financial Stability Board, the body tasked by G20 leaders to turn its pledge into action, says the financial crisis had exposed a host of weaknesses -- limited transparency, counterparties with big exposures, poor risk management -- that must now be addressed.

The derivatives industry, though, fears the new regulations will go beyond simply making derivatives safer and more transparent. Some believe they aim to shrink the sector as another way to cut banks and their profits down to size. "What I am keen to see is that legislation does not have as one of its purposes to make a market bigger or smaller," said Damian Carolan, a financial services partner at Allen & Overy law firm.

"Players in the market understand the regulatory burden will increase, profits in the industry will shrink."

The investment banks that offer bespoke trading in derivatives face the loss of tens of billions of dollars in revenue from the shift to central clearing. JP Morgan said last year it alone could lose roughly 10 percent or between $2 billion and $3 billion annually in revenues.

"The general guesstimate is probably 15 to 20 percent of investment banking revenue in total is derivatives-related. It's an order of magnitude that's a material issue for some of them," said Piers Brown, a banks analyst at Evolution Securities.

Some bankers even see the new regulations as one weapon in an ideological war against them. Should the entitlement to enter into private trading now be seen as exceptional rather than the norm, they ask.

"On OTC clearing, it may end up costing too much for a pension scheme to buy a bespoke contract to hedge a risk," said Guy Sears, a director of the Investment Management Association, which represents large investors who use derivatives. "The requirement to put trades through a clearing house and exchange paradoxically may mean that some risks will be managed in a less efficient way. You will have un-hedged risks that society will carry."

The reality, said Denzil Jenkins, director of regulation at Chi-X Europe, a share trading platform, "is that OTC is absolutely going to shrink and OTC will probably be a miniscule proportion of what it was before."

A CHANCE FOR ASIA?

Whatever the case, central clearing of some types of standardized contracts like interest rate swaps and credit default swaps is already well underway, along with reporting of transactions to repositories.

But the industry fears the push will go beyond central clearing to requiring trades themselves to be executed on an exchange-like platform.

Exchanges need fully uniform contracts so they can execute large volumes and make money in a thin-margin business model. Although the OTC derivatives sector turns over trillions of dollars, the number of contracts actually traded is tiny compared to the daily volumes of shares on an exchange. ISDA said, for example, fewer than 2,000 standardized interest rate swaps -- the most liquid OTC contract -- are traded on average each day, with 67 percent of them executed among the so-called G-14 or 14 largest dealers. In credit default swaps -- an insurance against default of a company or government -- only five "names" average more than 20 trades a day and all are linked to government bonds, ISDA said.

"You can clear a lot more than you can put onto an exchange, which has a very limited and limiting business model. If we get it right there will be no damage to the real economy. If we get it wrong, people will be stuck with the volatility," said Richard Metcalfe, head of global policy at ISDA.

Banks also point out that many attempts by exchanges to offer standardized derivatives contracts have ended up in the bin because nobody would provide liquidity to keep them alive. "The authorities must realize that liquidity is provided by people risking capital and exchanges are not in that business," said John Serocold, senior director of the International Capital Market Association. "You can't oblige people to make firm prices to someone they don't have a relationship with. A big risk in the process is that policy-makers are seeking to copy across from cash equities to other markets with very different characteristics."

Paul Tucker, a deputy governor of the Bank of England, points to the universe of non-financial users of derivatives who rely on them as a form of insurance. The outstanding stock of interest rate, foreign currency and equity derivatives in the corporate sector is about the equivalent of world GDP, a sign they are of some use: "Therefore whatever reforms are made in that area, it will be quite important not to throw the baby out with the bathwater."

Despite their protestations, banks have already begun to adapt to the new world. Some have even taken stakes in clearing houses. The IntercontinentalExchange (ICE), which is closely aligned with big banks, moved quickly to become the leading clearing house for credit default swaps in Europe.

As the United States and EU push ahead with reform, Asian members of the G20 are in slower gear, partly because far less derivatives trading takes place there -- at least for now. Could London and New York lose their place as the chief derivatives markets in the world? Anthony Belchambers of the London-based Futures and Options Association believes the way the new rules are enforced will be critical. "If the US and EU miss a step in getting the balance right between safety and risk, the Asian markets and financial centers will be the beneficiaries," he says.

(Edited by Simon Robinson and Sara Ledwith)

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