The End (User) Game

Wednesday, 05/5/2010 - 11:42 am by Wallace C. Turbeville | One Comment

The ‘end user’ exception that would exempt certain businesses from mandatory clearing of transactions is not the right path for financial reform.

Regulation of the derivatives markets has focused in great measure on requiring transactions to be submitted to clearinghouses. The benefits of clearing transactions include the disclosure of trade data, transparency of prices and timely collateralization of default risk. For certain other transactions, bi-lateral collateral — collateral posted by both parties — would be required.

A group of market participants has resisted these regulations with significant success. These are companies (referred to as “end users”) that hedge price risk embedded in their businesses — notably energy prices, foreign currency and interest rates. They range from power generators and distributors to airlines. They are resistant to posting collateral associated with their hedging activities. The rationale behind the end user exception has received remarkably little attention and analysis.

End users have dramatically increased their use of derivatives to hedge risks in recent years. Trading desks sprang up at many financial institutions to address this need and sometimes to engage in proprietary trading for profit. The results from these new enterprises have been mixed, to say the least. Trading complex and illiquid derivatives in a marketplace dominated by well-capitalized financial institutions and hedge funds has been a challenge.

End users that hedge risks have been challenged by the need for liquid capital. A derivative can involve volatile price swings and cash funding requirements before it matures. Here is an example:

• Company A, which purchases power as part of its business, seeks to hedge against the risk that power prices exceed $40 on August 1, 2010. To achieve this result, it enters into a swap with Bank X.

• The two sides agree that Company A will pay $40 to Bank X on August 1. Bank X, in exchange, will simultaneously pay the market power price as of August 1 to Company A.

• Company A uses the money it receives to actually buy power. The $40 payment to Bank X has synthetically replaced the exposure to power prices on August 1.

• If, on June 1, the market for power delivered on August 1 is $35, the value of the swap to Bank X is $5. Theoretically, Bank X could sell the position for this amount. $5 is booked by Bank X as a profit as of that date. However, if Company A goes into bankruptcy, Bank X will not receive the payment on August 1. So Bank X is exposed to the credit of Company A in the amount of $5 as of June 1.

This floating credit risk is common to all derivatives. (The risk is actually greater since Bank X could lose even more by the time it replaces the Company A position should it go into default.) The risk is very real and is the same risk that is collateralized by clearinghouses.

Sometimes parties agree that collateral must be posted to offset this credit exposure. Alternatively, the parties could agree to forgo collateral and simply carry the exposure as a risk. Carrying this risk is the same as making a loan. In fact, a trade in which collateral is foregone is best viewed as two transactions combined into one: the derivative itself and a credit line in the amount of the foregone collateral.

Banks that trade with end users often agree to forgo collateral within set limits. Banks have finite amounts of potential credit exposure to companies and can deploy this capacity by making conventional loans. Alternatively, it can deploy this capacity by carrying risk in derivatives trades with that company. It is well known that using the capacity in connection with trades is far more profitable for banks than lending.

On the surface, it appears illogical for an end user to agree to transact a derivative that is not collateralized. A company could always use its credit capacity with its bank to borrow money to fund the collateral requirements. The effect on available credit capacity should be the same. If banks make more money by packaging the credit extension with the derivative, the all-in cost to the company must, by definition, be higher than separating the credit from the derivative by borrowing to fund collateral.

Similar logic applies to end users’ non-bank counterparts. These parties also extend credit if collateral is foregone, but an end user can only borrow so much and still maintain its credit standing. Unless the counterpart is mispricing the transaction, it will charge for the extension of credit. In theory, the end user should be indifferent about whether it borrows money to post collateral or transacts with the agreement that collateral will be foregone.

These are simple examples. In reality, there are very complex and costly arrangements which enable companies to transact without posted collateral.

Based on all of this, why do end users resist requirements to collateralize so strenuously? Remember that the cost is not the amount of collateral; the collateral is returned if there is no default. The cost is the difference between the cost of borrowing the funds used as collateral and the investment return on the collateral while it is posted.

One reason for resistance is convenience and avoiding operating expense. However, many end users trade on cleared exchanges as well as in bi-lateral markets, so the processes for collateralization are familiar. This suggests that additional factors enter into their motives.

It may be more productive to focus on factors other than costs. Companies that use derivatives to hedge their business risks receive advantageous treatment under accounting rules. Current hedge accounting rules provide that price movements that change values as described above are not recorded as profit or loss. The theory is that the value of the derivative and the value of the hedged item are inversely related.

While this rule makes sense, it does not make sense to ignore the embedded debt (in the form of foregone collateral) in a derivative. Simply stated

• the financial statements of a company that borrows money from a bank to post collateral on a derivative should look the same as

• the financial statements of a company that has an agreement with a counter party to forgo posting collateral.

While I have not reviewed the accounting treatment of every end user and every arrangement, it is certain that in a number of situations, foregone collateral credit arrangements are not treated as balance sheet debt. It may be that these transactions are misunderstood. It would be unfortunate if the end user exemption became a mechanism for continuing this practice.

This is far from trivial. Most agreements to forgo collateral require immediate funding of collateral if adverse credit events occur. It becomes a demand loan-a loan that can be called for repayment at any time. This can cause a liquidity crisis at the very time that the company is most vulnerable, resulting in a death spiral. Such events have occurred several times in the past. After the Enron meltdown, the ratings agencies responded by trying to measure the risk of a liquidity crisis resulting from this phenomenon, but it is difficult to craft general rules to measure the risk. The problem continues and periodically threatens the marketplace.

These arrangements are pervasive in the market. A line graph representing bi-lateral credit exposures in certain markets would look like a plate of spaghetti with a multitude of credit arrangements. What a challenge for the credit officers and legal teams for each of these companies to make sense of it all!

Finally, financial institutions almost never post collateral to end users. The end users simply do not have the market power to demand it. But that’s alright. After all, is there any risk that a financial institution like Lehman would ever go into default?

Avoiding an accounting exemption is very appealing. But perhaps the better way to address this is to encourage efficient, third party systems, short of full on clearing, to track these exposures and to facilitate efficient collateral funding in bi-lateral transactions. The simple exemption for end users in financial regulation does not encourage the development of such a system. It ignores a troubling practice which need not burden the marketplace.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.