Published: October 01, 2010
When executing a derivative trade, there are two major considerations a company needs to think about: who they choose as their bank counterparty and how they are satisfying their internal policies regarding derivative trading. The current market environment for corporates entering into derivative hedging transactions is one of uncertainty — not only about the fluctuation in interest rates, currencies and commodity prices, but also about the creditworthiness of banks and even sovereign states. Add to that uncertainty about the regulatory environment, and the external factors for determining which banks to trade derivatives with becomes even more important. Internally, companies must comply with board policies and regulatory requirements, such as Sarbanes-Oxley and the forthcoming rules from OTC derivative reform. When executing a derivative trade, then, only the right system functionality and related processes will enable a company to effectively recognise and respond to changes in the external environment, while ensuring compliance with internal requirements.When a company enters into a relationship with a bank, it is usually for multiple services, such as short- and long-term financing, brokerage, capital markets, payments, cash management, etc. However, when deciding which bank to deal with for derivative trades, the factors that are most important to consider are:
When executing a derivitive trade, only the right system functionality and related processes will enable a company to effectively recognise and respond to changes in the external environment, while ensuring compliance with internal requirements.
Before the credit crisis, corporates could concentrate on a few of these (e.g., price, relationship) and ignore the rest without concern. These days, however, timely information on all these factors is critical. By automating the life cycle of the derivative transaction, corporate treasurers, their back offices and treasury accountants can obtain this important information quickly and in a way that provides a valuable audit trail, a structured process for approval and overrides, and a straight-through processing environment for eliminating manual errors.
Internal factors relate mainly to the specific controls and limits usually written into risk management policies to ensure compliance with board and regulatory requirements. Such requirements result in policies and procedures that traders need to follow to ensure that only approved instruments are traded and only for approved business purposes. These include:
Let’s take a closer look at what a company needs when considering these external and internal factors and how technology can make it easier to execute a derivative trade once pre-hedge analysis has been completed and before post-trade processing begins:
Credit rating
What to consider
Board directives usually require corporates to deal only with banks with a minimum credit rating (e.g., A+, AA or better) as they know that no price is good enough to outweigh a bad credit rating. Corporates need immediate access to the credit rating (short- and long-term) of any bank they are considering dealing with. Additionally, they ought to know if the bank is on a credit watch. These days, knowing the domicile of a bank is also useful, as sovereign risk is an extra factor in some parts of the world and needs to be considered. Trading with a bank domiciled in a country where sovereign risk is greater than individual bank risk really means that the bank risk is at least equal to the sovereign risk.
System needs
A system should be able to store a company’s minimum credit rating requirement and the current credit rating of a prospective bank. It should only permit trading with banks that meet or exceed the minimum requirement. A useful complement to ratings is the directional indication of short- and long-term credit spreads. This helps to avoid the frequent complaint that rating agency information is backward-looking and not anticipatory. If a corporate has access to CDS spreads for bank counterparties, simple statistical measures can be calculated. Also required is a means of attaching a quantifiable limit, either as part of an overall credit tier or individually at the bank level. The limit may be further classified by trade type or derivative type and tenor (short- or long-term). A company should then have the ability to check the amount of an intended trade against the available limit. [[[PAGE]]]
Price
What to consider
Quotes can be obtained via email, phone, through an electronic trading network (ETN) or via a combination of these. It is a simple matter to compare prices if all bidders are provided with the same trade information and, in return, provide quotes expressed in the same terms. ETNs allow a user to enter details of the intended trades. Phone or email quotes can be supported by draft term sheets. For vanilla instruments like FX spots and forwards or IR swaps, this is very straightforward. A system that allows the generation of draft term sheets, supports email, and the storing and comparison of quotes is needed. Maintaining a history of historical quotes (including unsuccessful quotes) is very useful. It allows a corporate to negotiate with counterparties and explain why business is not being sent a bank’s way. It often results in revised pricing from a bank eager to do business.
System needs
With a system directly connected to an ETN, quotes can be pulled in and refreshed automatically. These can be augmented by manual quotes via email or phone. A user needs to then see all the quotes in one place, preferably with the best quote clearly marked. Then a user needs to see how much business has been given to bidders year-to-date and the average deviation from the successful bids. [[[PAGE]]]
Credit lines
What to consider
Companies drawing down on credit lines or revolving facilities must check against the available lines.
System needs
Companies should be able to check credit limits or facility limits for available usage. A key characteristic of a good check is that it covers the whole tenor of the trade to make sure there are no forward-dated drawdowns against the facility and that the maturity of the trade is prior to the end of the facility.
Limit checking (current and potential exposure, daily and trader limits
What to consider
A company with an existing derivative position will be in either a net asset or liability mark-to-market position with each of the bank counterparties to the derivatives. The net position also could be calculated at the ISDA level. From a counterparty exposure perspective, the asset positions are of interest to the company, i.e., bank counterparties owe the company money and, therefore, there is a current exposure (albeit unrealised). Corporates often look to trade derivatives with the banks that lend to them (increasingly so after the credit crisis) and so they are in a net liability position with lending banks and may be less concerned with potential future exposure checks. The company may also want to make an allowance for potential future exposures should market rates move further in its favour and create a greater exposure to the bank. This is usually done by adding a percent of trade notional based on the outstanding tenor and instrument type or with a more sophisticated Value-at-Risk (VaR)-based estimate.
Board or treasury policy will dictate a maximum exposure to each bank counterparty that is allowed. Some boards restrict limits to particular credit ratings. The immediate and potential impact of entering into a new trade with a counterparty needs to be assessed against the total limit. This should be a global limit and not just a subsidiary limit, i.e., locally a subsidiary may be in a net liability position with a bank though globally the company may be in a net asset position. No matter how competitive a bid, being close to breaching or actually breaching a limit will mean that a trade cannot be done with a counterparty. Unless the limit is increased, some of the existing risk is passed on or the trade is executed in part.
System needs
After entering the terms of an intended trade with a bank, a company should immediately run a limit check against the bank. The answer should come back as a ‘Yes’ or ‘No’. A ‘No’ answer should prevent the user from saving a trade, unless there is an override by an authorised user to find the unutilised limit (exposure limit – current exposure [current mark-to-market] – potential future exposure). The limit needs to be done at both the subsidiary and global levels. A technology solution should allow checking against trader and daily limits. Soft or hard stops should be configurable to allow limits to be overridden, maintain an audit trail, and require third-party approval.
The immediate and potential impact of entering into a new trade with a counterparty needs to be assessed against the total limit.
Relationship
What to consider
Most companies formalise their trading relationship with banks via an ISDA Master Agreement or Collateralised Swap Annex (CSA), which lays out the terms of what instruments and jurisdictions the two parties can trade. This agreement may also include the need to post collateral, acceptable types of collateral, collateral thresholds, and trigger events that amend any of the terms of the agreement, e.g., a change in rating triggering a lower threshold. Thus, prior to executing a derivative trade, a company needs to check that the intended instrument is covered by an existing agreement and that the corporate entity itself is covered by the agreement. Some companies prefer to spread their business around and need to know how much prior business has been given to different banks. Being able to know quickly how much business has been given to bidders in the current year is very useful. With this price history, companies can better negotiate.
System needs
A quick check of ISDAs or CSAs is made to verify that the corporate entity is able to trade the intended derivative with the bank. Online access to these documents provides a quick reference. The ability to store and report the specific terms of a CSA is very useful, as is the ability to manage future collateral postings over the life of a trade. If spreading business around is important, then being able to run a report to show how much business has been given to each bank is very helpful. To do this, a history of all bids, successful and unsuccessful, needs to be kept.
Additional services
What to consider
Many banks provide a range of services to corporates as part of the bank relationship. They may act as loan arrangers or syndicators, provide cash management services or trade finance. Some loan agreements may stipulate that any hedging transactions must also be executed with lending banks, making this a factor in addition to price when considering who to trade derivatives with. Banks also may offer ongoing trade services such as monthly marks-to-market, roll forward or pre-delivery of FX Forwards, mutual termination or novation of IR swaps, or risk management services. These are also considerations when selecting a bank with which to trade.
Alternatively, companies may only want to deal with banks for specific instrument types, reflecting the particular expertise of the bank. Controls then need to be in place to limit the instruments that can be traded with any given bank.
System needs
The ability to do a pre-trade check of potential bank counterparties against approved deal types is required. [[[PAGE]]]
Trader limits
What to consider
To comply with internal policies that limit the notional amount of trades that traders can enter into, companies need to be able to perform a simple check of the notional against a limit.
System needs
Companies require a system that warns or prevents a trader from entering a trade with a notional greater than that approved. Controls should be at the trader level. Either soft or hard checks should be able to be performed.
Daily settlement limits
What to consider
Companies must be able to comply with internal policies that limit the maximum cash settlement on any given day.
System needs
Companies need to be able to check the impact of a trade’s future cash settlements on daily settlements limits to ensure they are not breached.
The ability to strore and report the specific terms of a CSA is very useful as is the ability to manage future collateral postings over the life of a trade.
Trade-type approval
What to consider
Companies are required to comply with any internal policies that limit the types of instruments that can be traded.
System needs
Companies require a system that prevents a trader from entering a trade that he or she or the company is not authorised to deal. This should be controlled at the trader level as junior traders are often limited in the instruments they may trade. Controls can be soft or hard based on the policy, i.e., no trading at all or subject to senior approval. Auditing of overrides is also required.
While there are a range of factors other than price that a company may consider when selecting a bank counterparty to trade with, and there are limits and controls to comply with internally, having the tools with which to gather and provide this information quickly is now a must-have. For this reason, companies that want to be efficient, responsive and compliant use treasury or derivatives systems rather than relying on Excel or paper documents.
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