Although portions of proposed legislation from both the US House Financial Services Committee and House Agriculture Committee to reform the over-the-counter (OTC) derivative market have been positively received by corporate end-users, the ultimate outcome may mean the death or vast reduction in the number of customised hedges, according to Reval, a derivative risk management and hedge accounting solutions provider.
“The two bills nearing votes in the House do not go far enough in introducing outright exemptions for corporate end-users of OTC derivatives and instead allow regulators to decide if corporations can be excluded from any margining or capital provisions,” said Jiro Okochi, chief executive officer and co-founder of Reval. “It is important that the end-user community continue to work with members of Congress and regulators to improve the proposed legislation as we move forward.”
In their testimonies before US Congress in recent months, representatives from several large companies, which use OTC derivatives to hedge against fluctuations in interest rates, foreign exchange (FX) rates and commodity prices, have asked to be exempt from having to trade on an exchange. The common view has been that end-users would decrease their use of hedging with OTC derivatives if required to post cash for margin and if standardised contracts did not allow enough flexibility to offset the specific business risk each company may have.
“I think there needs to be a bit of a wake-up call, as right now legislators feel like they are incorporating what corporate end-users need, but they are setting up market dynamics that may end up hurting the very swaps these corporate end-users want,” warned Okochi. “So yes, corporate end-users may not have to post margin for customised swaps, but no one will be making markets in those products.”
According to Okochi, unless swap dealers have the same margin and capital posting exemption for hedges sold to corporate end-users, they will either increase prices to make it worthwhile to enter into customised swaps with corporations or may simply refrain from dealing with the hassle and costs of supporting this market.
“Some of the regulators have already indicated that they believe all OTC derivatives should be cleared or be on an exchange, so not specifically exempting corporate end-users in the legislation is risky,” Okochi said. “Even if the current commissions would give corporate end-users a pass today, what happens when a new commissioner with a different view is named?”
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