Although language in the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act exempts corporate derivatives users from centralised clearing mandates, US companies that use commodities derivatives believe the new rules will increase their costs of hedging – and companies in Europe expect a similar result from forthcoming EU regulations.
The results of a new Greenwich Market Pulse Study from Greenwich Associates reveals that US companies that employ commodities derivatives expect to see an increase in commodities hedging costs regardless of the final outcome on the still open question about whether the new law will require corporate ‘end users’ to post margins on swap transactions that are not centrally cleared.
In crafting the new law, both the US Senate and House bills included a provision explicitly exempting commercial end users from margin requirements in non-cleared swap transactions. That provision was dropped in the final law approved by both houses and signed by President Obama. In a June 2010 letter, Senators Christopher Dodd and Blanche Lincoln stated that the intent of legislators was in fact to exempt commercial end users from the margin requirements. It remains to be seen how US regulators will interpret and enforce the law and what approach EU rule-makers will take toward commercial end users.
There is no doubt that corporate hedging costs may increase if companies are forced to post margins on over-the-counter (OTC) swap trades – particularly if, as some observers fear, US regulators interpret Dodd-Frank requirements as being retroactive to existing trades, as opposed to limited to new transactions. However, the 65 companies participating in the Greenwich Market Pulse predict higher hedging costs even if margins are taken off the table.
“Two-thirds of study participants say rules requiring banks and non-bank financial institutions to centrally clear all derivatives transactions will increase their own costs,” said Greenwich Associates consultant Andrew Awad. “To some extent it’s inevitable: if banks are forced to lay off their own risks through centrally cleared transactions and are subject to a range of new capital, margin and recordkeeping requirements, the additional costs will be passed through to their commercial clients.”
Companies fear even more damaging consequences if regulators were to adopt a narrow definition of the ‘end-user’ exemption that limited the type of user that could qualify. Seventy percent of corporates say they expect mandated central clearing to have a negative impact on their ability to effectively hedge commodities exposure.
Centralised Clearing Benefits
Despite the negative impact on costs, companies around the world do expect the shift of derivatives trades to exchanges or other central clearing counterparties (CCPs) to generate important benefits. Almost all the participants in the Greenwich Market Pulse say central clearing is effective in mitigating counterparty risk, and 60% cite reductions in ISDA and CSA documentation as an important advantage.
Commodities Users Weigh Consequences of Central Clearing, Position Limits
A majority of commodity derivatives users participating in the Greenwich Market Pulse agree that mandatory centralised clearing will increase their hedging costs – and a smaller but meaningful share think the new rules will diminish the effectiveness of their hedging practices.
In addition to margin requirements, commodity derivatives users point to several drawbacks with centralised clearing, including higher transactions costs and reduced flexibility related to standardisation of contracts.
In light of these responses, it’s hardly a surprise to see that these companies are not rushing to shift their derivatives trades to centralised clearing. Less than a quarter say any of their derivatives trades were centrally cleared on an exchange or other central counterparty over the past 12 months. Only 25% expect to be doing any derivatives trades on a centrally cleared basis within the next 12 months. Globally, about a third predicts they will be doing centrally cleared derivatives trades within the next year.
“Beyond concerns about centralised clearing, many commodity derivatives users are even more worried about the impact of the position limit rules included in Dodd-Frank, which a majority says will reduce their ability to effectively hedge commodities exposures and half think will increase hedging costs,” said Greenwich Associates consultant Frank Feenstra.
Who Should Be the CCP?
Preferences about which organisation should serve as the CCP for derivatives clearing vary by region. Generally, commodities market participants in the US favour CME Group, with Intercontinental Exchange (ICE) also receiving a meaningful number of votes. In continental Europe, ICE receives the most votes, but market participants are more fragmented, giving strong support to Eurex, CME Group and Euroclear.
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