“One thing you can say about Dodd-Frank and Basel III is that they are both very impressive tree killers,” wryly notes one derivatives lawyer.
Indeed, the new rules are mind-numbingly dense – the former weighs in at 848 pages.
And it’s not just forests that look set to suffer. The array of financial changes contained in those pages is poised to have numerous unintended consequences for the world’s financial industry, especially in Asia.
Nothing is yet set in stone, but one definite outcome is that the cost of using foreign exchange (FX) derivatives will rise – and with it the cost of raising debt in Asia.
One big concern for banks in this region is that these new rules will penalise swap dealers for providing longer-dated cross-currency swaps to companies if the trades can’t be centrally cleared. Already some banks are cooling off in providing longer-dated products.
These derivatives allow companies to raise money in one currency and swap into another at set rates. This offers corporates a vital tool to hedge future revenue flows or foreign-currency debt.
The concerns are not just armchair speculation. Bankers are already calculating the costs of providing non-cleared, long-dated hedging products based on these new regulatory demands.
The rough figures so far do not look good.
“Based on preliminary calculations, the cost of providing a cross-currency swap for anything above five years is going to increase potentially five-fold. The bank simply won’t absorb that and it’s difficult to see why the corporate would want to either,” says Adam Gilmour, head of corporate sales and structuring for Asia at Citi in Singapore.
Such an increase in swap costs could well force credit-risky companies (read: the many highly leveraged Asia corporates) to either issue shorter-term debt or raise funds in local-currency markets.
Put simply, the new financial rules by the US and Basel Committee could well have major consequences for Asia’s credit markets.
Know your counterparty
The regulations targeting derivatives have one key aim: to centrally clear as many trades as possible.
Under Basel III proposals, the capital cost of conducting a centrally cleared derivative trade is considerably cheaper than a similar, bi-lateral over-the-counter (OTC) transaction.
The reasons are security and transparency. Centrally cleared derivatives should provide more efficient pricing. And the consequences of default on a cleared derivative are effectively shared between the clearing members.
Under the new rules, dealers (known in this context as the counterparty) would have to set aside more capital for companies seeking to conduct OTC swaps than if they conducted an equivalent exchange-based or cleared transaction. This is especially the case if the swaps have longer durations, and if the corporate looks likely to struggle during market downturns.
“[Under Basel III] banks will determine capital requirements by applying data for a stressed environment,” says Paget Dare Bryan, partner at Clifford Chance in Hong Kong. “This means banks will have to look at a corporate’s bond valuation [to gain a sense of how risky the market deems that company to be]. So if the bond is trading under par you have to put more capital aside [for swap transactions]. This compares to simply assessing its credit rating.”
Raising capital for trades with relatively risky companies is not necessarily a bad thing, but the extra cost of allocating more capital to these derivatives will be profound for riskier companies, limiting business.
A McKinsey & Company report estimates that the new guidelines could raise the cost of OTC trades by up to 85 basis points on the market value of un-netted (i.e. the cost of capital is calculated on the gross notional value of a trade), uncollateralised OTC positions.
It could well be higher for companies deemed particularly risky – comprising much of Asia’s emerging markets-based corporate world.
CCP uncertainties
McKinsey argues that the best way for banks to negate these extra costs would be for dealers to combine collateral and netting arrangements – the process by which two firms net out all derivative positions in the event of default for one single payment stream – and to move some businesses and products to independent central counterparty clearing platforms (CCPs).
That all sounds sensible – provided it’s feasible. The trouble is that in Asia many of these concepts are a long way off compared to Europe and the US.
As Asiamoney discussed in our March edition, the region lacks CCPs. While several are being set up, they are likely to lack liquidity in many types of centrally cleared derivatives for some time to come, and illiquid products are more expensive.
These CCPs may reach out to other clearing centres to tap more liquidity, but this would require agreements over margin levels, regulatory and technological compatibility – a complicated (and probably costly) process.
Failing that, national clearing members would have to set up shop in every major jurisdiction, stump up the CCP margins and pay the fees. Again, this would be expensive, and likely lead CCPs to ignore non-critical markets. That in itself would force users to conduct fewer standardised trades bilaterally.
Even assuming these issues were surmounted, corporates with high debt and low ratings would find it expensive to become CCP clearing members. Those who only conduct a few OTC trades a year would be unlikely to join anyway. Major corporates in the US are already having some success in seeking exemptions.
Collateral constraints
Instead of becoming CCP members, companies could opt to cheapen the cost of their OTC FX swaps through different means: collateral arrangements. But that’s fraught with uncertainty.
The act of setting aside collateral allows a swaps dealer some protection in case either counterparty goes bust – and would reduce the level of capital a dealer would need in place for a non-cleared OTC trade. This assurance lets the broker dealer offer the company cheaper derivative prices.
But it’s not been popular in the FX derivative space. According to a 2011 International Swaps and Derivatives Association (Isda) survey published in April, among the top 14 OTC global derivatives dealers, 65% of FX trades conducted carry collateral commitments, compared to an average of 80.2% on all OTC derivatives.
As Isda rightly points out, the reason is that non-financial companies use FX derivatives extensively, and frequently don’t have to provide collateralisation.
The trouble with getting corporates to post collateral is that many regional companies lack sophisticated collateral management operations, especially if they only conduct a few such trades a year.
Handing over collateral to a dealer may also make them uncomfortable. And while they could post collateral with third-party custodians, this would cost, defeating the purpose.
It also looks as though corporates entering into trades purely for hedging purposes may be exempt from the need to post collateral anyway.
Under new Commodity Futures Trading Commission regulations, there are plans to allow for pure hedging parties, such as corporates, to be outside new proposed collateral requirements and, therefore, exempt from requirements to post.
That may sound like good news for companies, but ironically a rule designed to protect them when using derivatives could shut them out.
By posting collateral, companies ensure that a bank has some compensation in the event they fall into trouble. But if they don’t need to do so, swap dealers have no angle to negotiate a cheaper trade, especially for longer-dated derivatives.
Convincing corporates
Despite the rule changes, dealers are confident they can persuade corporates to hand over collateral in order to keep the costs on derivative dealings down.
Lutfey Siddiqi, UBS’s head of FICC corporate coverage and FX distribution for Asia Pacific, is one. He has been hiring foreign exchange sales specialists with more than just markets experience, including skills negotiating collateral agreements.
“You’ll find a number of salespeople with credit backgrounds have this collateral negotiation experience. It’s not necessarily so common in staff with a pure FX history,” Siddiqi says.
What the banks would most like to do is persuade more companies to hand over collateral for dealers to use for their own ends (see box on previous page). This would reduce the cost of an Asian company entering into a long-dated OTC trade – but there are risks.
“When collateral is handed outright over to the dealer, or they use the collateral, the counterparty becomes an unsecured creditor; you lose proprietary claim on your own assets. All the bank has the obligation to do is return the equivalent security to you but if it cannot, you may not get anything back,” says Patrick Phua, partner at Mallesons Stephen Jaques in Beijing.
In other words, companies stand to lose the capital that they post if their dealer falls into trouble. It’s counterparty risk, just the other way around.
Looking local for debt
With the first batch of capital changes likely to be implemented by 2013, dealers and FX swap-using companies are already pondering the consequences.
Asia’s international debt market could be heavily affected. Currently most Asian companies raising debt outside their borders do so in a foreign currency, typically US dollars. But with most of their balance sheet likely to be denominated in their local currency, this leaves a currency risk. An easy solution until now has been to use FX swaps to mitigate this.
That could change if the cost of using such swaps begins to soar.
Fixed income bankers in Hong Kong believe that Asian companies will issue more local-currency debt to avoid the regulatory uncertainty and potential costs of foreign-currency fund raising.
“There’s definitely a risk that certain longer-dated currency swaps end up costing too much, in fact we’re already seeing some banks veer away from offering such swaps,” notes an Asia head of capital markets for a European bank. “It could well mean that regional companies instead look to finance themselves in their local-currency bond market, where they don’t need to use a swap.”
But raising money from local credit markets is not a perfect antidote to doing so internationally. Borrowers in US dollars enjoy a global investor base, which increases chances of issuing cheaper debt – even considering the costs of swapping proceeds back.
Local-currency bond markets are far smaller, leaving them prone to saturation. Plus global investors looking to take part in such deals would take on both credit risk and currency volatility.
Both factors could force borrowers to pay more to attract investors, impacting their reasons for tapping the markets in the first place. Asia’s local-currency bond markets are also less able to supply long-term debt funding, which could force companies to start borrowing in shorter tenors, increasing their refinancing risks.
The future
While international banks grapple with the foreign currency and credit ramifications of being unable to offer FX swaps at rates as favourable as before, the potential exists for Asia’s banks to jump in.
Currently the 14 largest OTC dealers hail from Europe and the US, but if they struggle to offer FX swaps to regional corporates at competitive rates, well-capitalised regional banks have an opportunity to do so instead.
It may take some time for them to achieve the sophistication needed to do so on a sizeable scale, but the prospect exists.
The ideal scenario would be for more dealers to provide bespoke OTC swaps for regional clients. Firstly, it would prevent too many issuers raising in local currency and, secondly, it would dilute the control of the major swap dealers who have dominated for too long.
That would promote market competition, transparency and widen risk dispersal amongst more financial institutions – a worthy goal.
Paying for risk
One outcome is certain: derivatives contracts for corporates are set to become more expensive. But that is no bad thing if it brings more security, and less financial contagion.
It makes sense for companies to be offered the true cost of hedging in a clear manner, rather than for banks to offer cut-price derivative dealing services for the privilege of making proprietary money or conducting obscure risk-dispersal techniques.
It will be up to individual companies to decide whether to cough up for the right to use derivatives, either through paying to centrally clear or through a collateral agreement. They could also opt not to do so and limit their options to raise international debt.
Ultimately, paying for a cleaner, more transparent pricing system for derivatives makes sense. It is a necessary but bitter pill to swallow. As bankers, lawyers, and diligent corporates will realise after sifting through the banking regulation, the days of cheap international financing are over.