Analysis: Pssst, looking to trade a swap without margin?

NEW YORK/WASHINGTON Thu Apr 14, 2011 1:09am EDT

NEW YORK/WASHINGTON (Reuters) -- Hey buddy, looking for a bespoke hedge on oil prices or forex rates, without paying millions in margin to your bank? I may be able to help...

If new rules proposed this week stand as written, that may be the pitch from major hedge funds like Citadel or big commodity firms such as BP (BP.L) who have long offered similar hedging services as the Wall Street banks, but struggled to grow their business in an increasingly crowded market.

That outlook could change after the Federal Deposit Insurance Corp said on Tuesday that banks would be required to collect collateral from customers who don't meet certain credit criteria if they want to sell uncleared swaps.

A separate proposal from the Commodity Futures Trading Commission -- which applies to swap market players who aren't banks -- stipulates end-users are not required to set aside margin at all, regardless of whom they trade with.

As a result of that discrepancy, companies with a lower credit rating looking to trade customized, nonstandard swaps may have a choice: trade with their usual bank and pay the requisite margin; or find a new counterparty with a tolerance for credit risk who won't be required to collect collateral.

"The difference (in regulations) is really quite notable because it could put the banks at a disadvantage," a regulatory affairs executive at a major corporation that trades swaps told Reuters on condition of anonymity.

Just how much they are able to benefit from the so-called regulatory arbitrage remains to be seen. Banks may opt to cut fees to keep business. Regulators could clamp down if they see non-banks are taking on too much risk.

And it would require those same companies to lower credit standards that experts say are now uniform across the market, something they may be loath to do.

"It's more of a symbolic distinction than anything else," said John Parsons, executive director at the Massachusetts Institute of Technology's Center for Energy and Environmental Policy Research.

"You're not going to get a profit-making advantage in selling these things to uncreditworthy counterparties," said Parsons, a former consultant on energy risk management.

Still, the discrepancy puts a spotlight on the smaller, lesser-known risk management divisions that exist within many of the world's leading funds and commodity corporations.

Those units threaten to complicate the impact of regulations that are geared primarily to divide the world between passive end-users and risk-taking financial traders.

SMALL NICHE

Tuesday's rules apply only to swaps too complex to be standardized, a shrinking sub-set of the $600 trillion market as regulators increasingly force trading through clearing houses and onto more transparent exchange-like venues. Last year about a third of over-the-counter trades were uncleared.

They also wouldn't affect corporations with high credit ratings, which could continue to trade with banks without posting margin. Major companies such as brewer MillerCoors (SAB.L)(TAP.N) and Caterpillar (CAT.N) have campaigned fiercely to be exempt from margin requirements they fear would tie up billions in capital unnecessarily.

For companies that don't boast rock-solid credit ratings, a growing number of options beyond Wall Street have appeared over the past decade, particularly in the commodities space.

Companies from Royal Dutch Shell (RDSa.L) to agribusiness giant Cargill have pitched prospective customers on the idea that they can offer better end-to-end hedges than the likes of Goldman Sachs (GS.N) or Barclays Capital (BARC.L), often emphasizing an ability to offer physical offtake or delivery.

"It's true, this could be a huge advantage for any non-bank that trades derivatives," a former senior bank lobbyist told Reuters. "There are hedge funds like Citadel that have flirted with this idea for years."

BP's risk-manager arm, which boasts a team of 15 across the globe, and Shell's division have regularly featured in league tables of leading energy derivative dealers. But the firms offer no details on how big those divisions are, how much they trade or what share of the market they might command.

Will their corporate financiers really want more risk?

"(They) would still be using the balance sheet when entering into uncollateralized trades with other end-users, and that's costly," said Craig Pirrong, a professor and a director for the Global Energy Management Institute at the University of Houston. "So it's not clear how much of a competitive advantage they would have over banks."

Even if those blue-chip firms decide companies with weaker credit profiles aren't worth the risk, other firms may be ready to take the chance in order to grow.

Swiss oil trading behemoth Vitol, which made headlines this month by becoming the first company to export crude from rebel-held Libyan territory, offers risk management to companies as diverse as Indonesian coal producers, UK power plants and African oil producers, according to its website.

Hedge funds such as Red Kite, a major force in the copper market, are becoming increasingly involved with financing mining projects and the hedging that typically accompanies it.

If they continue to offer hedges to other firms, they risk becoming classified as "swap dealers", the highest of the CFTC's three-tiered scheme, putting them on a par with the biggest banks and increasing their capital requirements.

They may be at a crossroads: delve deeper into this space and exploit the loophole, or shut down these operations to focus on their core business, avoiding the top level.

"It will come back to these firms losing their ability to call themselves end-users based on their trading practices. The bank lobbyists will never let this fly," said Kevin McPartland from TABB Group.

REASON TO DISBELIEVE

There are other reasons to believe these corporations and banks can't -- or won't -- take advantage of an imbalanced regulatory environment.

For one, banks are likely to fight this fiercely, loath to cede an inch after losing the war for tougher regulation. They are already in uproar over the drive for more transparent trade, which they fear will erode their competitiveness.

For another, banks offer generally superior reach and breadth across financial and commodity markets; faced with lower costs from new competitors, the banks may be ready to give up margin to keep market share, one expert said.

Finally, regulators could intervene if they see that non-banks are taking on too much uncollateralized risk. Memories of pipeline-operator-cum-financial-powerhouse Enron's vast but doomed trading empire have yet to fade.

"There's plenty of examples where these situations have blown up in the past," said a former Wall Street derivatives trader who now consults with banks on policy. "Do regulators really want to create another Enron?"

(Additional reporting by Lauren Tara LaCapra and Herb Lash; Editing by Dale Hudson)

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Comments (1)
longandshort wrote:
We have met the enemy and he is us. Banks charge ‘end users’ an exorbitant premium for the privilege of only having to post illiquid collateral as margin.

Corporate treasurers who use shareholder (and perhaps taxpayer) funds to pay these exorbitant premiums are rewarded with Super Bowl tickets etc.

Apr 14, 2011 4:44am EDT  --  Report as abuse
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