End users face rising swap costs

3 min read
Helen Bartholomew

Derivatives end-users may have won the battle in securing exemptions from many new rules forcing central clearing and exchange-like execution of swaps transactions, but they face reduced liquidity and rising costs as a result of a sweeping overhaul of the US$691trn over-the-counter derivatives markets and new rules requiring banks to hold more capital against those trades.

“End users don’t bring systemic risk and regulators need to be pragmatic about that,” said Derek West, senior director for derivatives at Canada’s key securities regulator, Autorite des marches financiers, speaking at ISDA’s AGM in Montreal today.

Large global corporations – many of which are caught in the regulatory net – are facing an array of new challenges as they attempt to align their businesses with the regional nature of rule implementation.

“Our subsidiaries in Europe are doing business with European banks and our Asian subsidiaries are doing business with Asian banks and we’re duplicating that approach all around the globe,” said Bryan Dierlam, director for federal government relations at Cargill.

“Given the lack of global rules, what we’ve ended up with is companies working with banks from their own regime simply because the rules are simpler to understand.”

According to an ISDA survey of 376 end-user firms, more than half of respondents believe that market fragmentation has occurred, with the majority of those saying that it had a detrimental impact on their risk management capabilities.

It isn’t just the lack of regulatory harmony that is driving that fragmentation. Andrew McMaugh, senior legal counsel for QIC, an Australian asset manager, warned that a reduction in the number of futures commission merchants is exacerbating the problem.

“The lack of FCMs is definitely leading to fragmentation of markets and that’s leading to decreased liquidity,” he said at the event.

The number of FCMs has fallen from almost 200 a decade ago to just 74 today as many exit the business in the face of crippling capital and leverage ratio requirements under Basel III.

“The biggest issue for us is access or lack of access to cleared markets,” said McMaugh. “Anecdotally we hear of smaller firms unable to access markets as FCMs are increasingly unwilling to bear the cost of onboarding and serving end users.”

He also noted the growing consideration that end-user firms need to give to business continuity and commitment to OTC clearing when selecting FCM.

“We ask how they see their operation evolving and how it contributes to the longer-term business strategy.”

The rising cost of risk management activities proved to be the top concern among respondents to ISDA’s end user survey, followed by uncertainty about home jurisdiction, cross-border regulation and shrinking dealer availability

“The costs can’t be ignored and it’s not a cost that we can currently pass on to our clients,” said McMaugh.

Cargill’s Dierlam notes that trading costs are skyrocketing for many derivatives products, with studies showing an increase anywhere between two and five times current levels

“That’s significant and impacts the prices of commodities or whether end-users choose to hedge their risks at all.”

Despite those concerns, ISDA’s survey shows little reduction in appetite for hedging risks, with almost 90% of respondents viewing derivatives as an important element of risk management strategies and 83% expecting derivatives use to remain at current levels or increase over the second quarter of 2015.

Derivatives end users face rising costs, reduced liquidity