In a tight squeeze
Regulation is making derivatives more expensive for corporate and public-sector borrowers, to the extent that banks must offer cost-effective hedging to win bond mandates. Meanwhile, corporate use of collateral agreements is increasing as a means of reducing the cost and risk of derivatives.
Over-the-counter derivatives have been under pressure on multiple fronts for some time, as new clearing, capital and funding requirements ramp up the costs and complexities of trading. The consequences of those increased costs ripple far and wide, but debt capital markets have seen a significant impact as issuers look to hedge their exposures as cost-efficiently as possible.
“The changing landscape of legislation has affected derivatives markets more widely than expected and the costs and consequences of those changes will absolutely have an impact on the type of issuance, maturity of issuance and sometimes the geographical region and currency of issuance. There is now a lot more dialogue between banks and issuers on where the charges are coming from and how they can be reduced,” said Sean Taor, managing director and head of European DCM and syndicate at RBC Capital Markets.
The most obvious cause of the increased costs is central clearing, a key component of the G-20’s 2009 commitment to reform OTC derivatives markets. Mandatory clearing of interest rate swaps and credit default swaps began under the US Dodd-Frank Act last year, while European regulators are in the process of implementing similar rules through the European Market Infrastructure Regulation. It is the banks that face the central counterparty as members and thereby incur the operational and collateral costs of clearing, but those costs have to be passed on to the client.
Other regulations such as the Basel III capital and liquidity rules are also driving up the costs of using derivatives. As banks come under ever-increasing funding and balance sheet pressures during the phase-in of Basel III, they have had to add significant charges for uncollateralised swaps.
Inversion in decision-making
The higher costs have caused an inversion in the decision-making process for many issuers. Where hedging decisions would historically have been taken after a bond mandate had been placed, the new regulations mean many issuers will often now think about the derivatives first, given that hedging is rarely optional. Although derivatives and DCM teams might already work closely together on deals, banks’ success in financing is increasingly becoming dependent on their expertise in derivatives.
“Historically, swaps were generally considered an ancillary business opportunity driven by a financing event. But since the financial crisis and given the various regulatory changes, banks are having to make adjustments to pricing, factoring in not only credit charges, but various funding and capital charges as well.
“Consequently, the provision of the derivative component for a new issue has become a lot more important for issuers, sometimes to such an extent that bond mandates are driven by banks’ provision of swaps capacity,” said Chris Rees, co-head of DCM in the risk solutions group for Europe, the Middle East and Africa at Barclays.
Not all derivatives are affected by the regulations in equal measure, of course. Longer-dated swaps and cross-currency swaps stand to be hit harder as a result of their greater risk profile, which has led some issuers to opt for greater simplicity when hedging.
Swedish power company Vattenfall is one example of a corporate issuer that has deliberately looked to cut down its derivatives exposures in recent years.
“The regulations have certainly changed the way we look at things and we want to simplify and streamline our operations with as few outstanding transactions as possible. We are now more likely to go directly to the currencies we want to borrow in, rather than borrowing US dollars and swapping into euros, for example. If we can effectively hedge 80% of our exposure in this simplified way, that’s probably good enough,” said Johan Gyllenhoff, group treasurer at Vattenfall.
“We used to regularly put new interest rate swaps in place to hedge our debt portfolio but over the past couple of years we have tried to close out deals where possible, so if we want to change the interest rate exposure or the duration in our debt portfolio, we would prefer to cancel some outstanding swaps rather than taking on new ones, as it reduces the cost,” Gyllenhoff added.
Vattenfall is not alone, and a key cause of the change in appetite for swaps has been the capital charge for the credit valuation adjustment embedded within Basel III. As the central component of the Basel Committee’s efforts to capitalise counterparty credit risk, the CVA charge is designed to capture potential mark-to-market losses associated with the deterioration in the creditworthiness of a counterparty.
“In the past, the discussions around pricing and derivatives were pretty vanilla but now there is much more bespoke content to it and much more intellectual capital involved. The conversations are all about getting the issuer to mitigate any costs they have”
While corporates and sovereigns secured an exemption from CVA capital in CRD IV, the European iteration of Basel III, the same position has not been adopted in other jurisdictions, which has been a catalyst for change in hedging patterns.
“What we have already seen as a result of the introduction of CVA capital is a shortening of the tenor appetite that some banks may have as they try to limit the capital increase, and variability of that capital, to a shorter period of time. Mandatory termination clauses, or any other feature which serves as a tenor risk mitigant, are being increasingly requested by banks but also increasingly resisted by borrowers,” said Jason Goss, managing director in the derivatives solutions group at RBC Capital Markets.
Faced with the increased cost of using derivatives, corporates can choose either to simplify and reduce their exposures, for example by issuing in their domestic markets rather than the international market, or they can look to reduce the cost charged by their counterparties.
“The cost of not being hedged on a new issue in a foreign currency is much more than the cost of the new regulatory environment. This is particularly the case for cross-currency swaps, but there is a growing tendency among corporates to think more carefully about the costs of entering into new interest rate swaps,” said Bruno Laurier, global head of rates sales for corporates and head of Western Europe FX and interest rate derivatives corporate sales at Societe Generale.
One option for issuers is to enter into collateral agreements with counterparties to eliminate the new charges being imposed on uncollateralised swaps. Use of credit support annexes has increased since the financial crisis, but not just as a result of regulation.
In an age when the creditworthiness of banks can no longer be taken for granted, the posting of variation margin is a prudent way for corporates to manage their counterparty risk during the lifetime of a trade. Vattenfall, for example, began putting CSAs in place even before the financial crisis.
“At Vattenfall we issue very long-dated bonds in different currencies, so we usually need access to the derivatives market to swap them from fixed to floating and use cross-currency swaps. Having such long-dated transactions outstanding does pose concerns over mark-to-market risk and in 2007 we began to put collateral agreements in place bilaterally with our banks. That has enabled us to lower any capital charges that the banks might add on to the cost of the derivatives,” said Gyllenhoff.
CSAs on the rise
The use of CSAs appears to be rising across the industry. In its annual margin survey, published in April, the International Swaps and Derivatives Association found that 91% of OTC derivatives, both cleared and non-cleared, were subject to collateral agreements at the end of 2013, up from 74% in 2012. As for non-cleared trades, 90% were subject to collateral agreements in 2013, up from 69% in 2012.
“Corporates that are frequent issuers in cross-border capital markets are generally actively managing their counterparty risk either by migrating towards CSAs or novating transactions across counterparties to optimise their risk management portfolios and swap capacity. Some corporates are therefore also being more selective on which entities they transact swaps with,” said Rees of Barclays.
Most collateral agreements would typically only involve the posting of variation margin, but under standards drawn up by international regulatory bodies, initial margin will also be required for non-centrally cleared derivatives in the future, further increasing costs for end-users. In the meantime, however, some banks are still seeing only intermittent use of CSAs among their clients.
“We have seen a few issuers sign collateral agreements for specific transactions where they might need a long-dated cross-currency swap and that’s the only way to get an acceptable price from the bank, but we still see many issuers reluctant to sign CSAs, especially for interest rate swaps, which is still a very competitive market, so there is much less pressure on issuers to set up collateral agreements,” said Felix Orsini, global co-head of DCM corporate origination at Societe Generale.
Looking forward, the costs of using the derivatives market is unlikely to decrease in the future, but nor will the hedging needs of corporate issuers. With interest rates still at record lows in many countries, the demand for bonds remains high, which will continue to necessitate more creative thinking from both banks and their clients.
“In the past, the discussions around pricing and derivatives were pretty vanilla but now there is much more bespoke content to it and much more intellectual capital involved. The conversations are all about getting the issuer to mitigate any costs they have,” said Taor of RBC Capital Markets.