In the years since the financial crisis, an important point about derivatives has often been overlooked: they serve a genuine need by helping real companies to hedge very real risks. This point came across loud and clear in a recent survey of end-users conducted by ISDA: 86% of respondents said over-the-counter (OTC) derivatives were either very important or important to their risk management strategies. This was also a recurring theme at ISDA’s annual general meeting (AGM) in Munich earlier this month, where a succession of end-users and academics stressed the economic benefits of derivatives and their value to the real economy.
These end-users generally feel the financial system is on a sounder footing today than before the financial crisis, largely as a result of regulatory changes. But enthusiasm for specific regulations varies significantly. For instance, trade execution rules got a thumbs down from investors, despite the fact these rules were meant to help those users, primarily by ensuring greater transparency. In that aim at least, regulators appear to have succeeded: 74% of respondents thought electronic trade execution would have a positive affect on transparency. But more than half felt it would have a negative impact on ease of use, while 39% and 36% thought it would have a detrimental affect on price and liquidity, respectively. That’s a higher proportion than those who thought the impact would be positive.
Another key area of end-user concern is a lack of regulatory harmonisation and the resulting fragmentation of markets. Nearly half of survey respondents thought the market was splintering along geographic lines – a finding backed up by other ISDA research. This point was also picked up by end-user speakers at the AGM, who talked of their efforts to minimise cross-border problems by reorganising their operations to ensure non-US entities avoid trading with US dealers. The result, they argued, was less liquidity and higher costs for certain products – something reflected in the end-user survey, which found 83% of those who had witnessed some level of fragmentation believe it had led to higher costs.
For the most part, though, many end-users – and corporates in particular – have been sheltered from the direct costs resulting from new regulation. Corporates are largely exempt from mandatory clearing requirements and from forthcoming uncleared margin rules, excusing them from having to stump up initial and variation margin on their hedges – money they believe would be better spent on investment and research and development.
But there are other indirect costs: dealers are subject to higher capital charges for uncollateralised trades via new credit valuation adjustment (CVA) rules. While European banks are exempt from having to apply this CVA charge for trades with corporate customers, other banks aren’t – and those capital charges are likely to be passed on. Dealers will also look to hedge any client transaction, and these offsetting trades will almost certainly require margin to be posted against them. The dealer would need to fund that margin, creating a cost that may well be handed down to the client.
End-user speakers at the AGM claimed not to have seen any marked increase in price so far, suggesting dealers are largely absorbing these costs at the moment. They did, however, say they had seen some banks pulling back from certain markets and products. In other panels, dealer representatives acknowledged banks now have to pick and choose, with higher capital and leverage costs forcing them to concentrate on those areas where they have an advantage or where they can meet return-on-equity hurdles.
That’s already having an impact, with liquidity diminishing significantly in certain markets, affecting the ability of end-users to manage their risks efficiently. One buy-side speaker said some customised products were either no longer available or were trading “by appointment” only. That’s a big problem, as tailor-made, bespoke contracts fulfil a real need by allowing firms to closely offset their risk. Any reduction in the availability or increase in costs for these products could encourage some companies to hedge less, some speakers warned – a result that would lead to increased earnings volatility, less certainty in cashflows and – ultimately – less investment, less job creation and lower economic growth. That fear was voiced forcefully by a number of AGM end-user speakers.
That scenario thankfully doesn’t appear to have played out yet. The end-user survey found that 79% of respondents plan to increase their use of OTC derivatives or keep their hedges at the same level during the second quarter of 2014. But higher costs, fragmented markets and less liquidity could eventually take its toll, depriving end-users of an important risk management tool.
That’s an unintended consequence no-one wants to see. Could we end up with less safe, less efficient markets? That’s the concern that was voiced over and over again in Munich.