Whether or Not to Collaterlise the Hedging Process: That is the Question

Published: April 01, 2012

Whether or Not to Collaterlise the Hedging Process: That is the Question

by François Masquelier, Chairman, Luxembourg Corporate Treasury Association (ATEL)

Whether we like it or not, in future the hedging of financial risks may never be the same again. As we have often pointed out, since the first decisions after the London and Pittsburgh G20 summits, the great and the good of this world have decided on better regulation of finance in the broad sense, by adopting a series of restrictive and preventative measures designed to protect businesses, banks, governments and of course private individuals. One thing seems certain: nothing will ever be the same again.

For OTC (Over-The-Counter) type derivatives, for example, the idea was to require the use of central counterparty clearing houses (CCPs). This would involve the need to put up cash collateral, which is a sort of safety reserve to cover the risk of counterparty default – CVA, and for the bank the potential pre-financing of the value receivable on a downward revaluation – FVA. This collateral is also called a margin call. The European Commission’s objective is to use organisations to record and report on outstanding trades (organisations called trade repositories). A powerful lobby of treasurers’ associations will no doubt put a stop to this obligation to give collateral. The exemption will apply below a certain threshold, to be defined. However, we should not be too quick to rejoice over this short-term respite.

Even if we happen to be under the exemption limit, we should still fear the perverse and insidious effects of Basel III and MiFID II, which indirectly oblige banks to use margin calls for their clients. The thing that we are trying to avoid springs back into our faces like a boomerang. However, for some people this need for a margin call in the form of cash to be provided throughout the life of a financial product is perhaps an opportunity to gain a competitive advantage or benefit from more favourable prices. It is by no means certain that a company with a cash surplus, that is prudent in managing its cash and that has an average rating, would find it beneficial, whatever the outcome of political and technical debates, to use margin calls to fine-tune its hedging cost or its return on short-term investments. This is what we shall try to demonstrate.

The requirement to post collateral

It seems hard to be really critical of the regulators’ ideas and objectives, particularly in Europe. When we look at the iBOXX index and the 7-year spread, for example, and its movements – or bank 5-year CDS – we will be alarmed to find that volatility has become extreme. Even if spreads are narrowing, they are still at incredibly high levels. Counterparty risk is truly not a myth or a mirage far away in the middle of the desert. We believe that the market itself must impose its own standards and conditions. The regulator should still lay down rules, provided:

(1) that they are harmonised throughout the world;

(2) that they provide effective and complete exemptions which are not cancelled out by other rules; and

(3) that they leave end-users the option of deciding how they want to cover themselves.

This is a major challenge. Bank ratings have been downgraded sharply. Neither the worries over the euro nor over sovereign debt provide any grounds for holding back. Regulators must now act and the trick will be how best to adapt to these new obligations. Of course, companies with borrowings will be worse off and will probably have to adapt their strategies for hedging financial risks. The challenge will be to know whether you should hedge at a higher cost with no collateral, or at a lower cost with collateral. The calculation will be purely financial. Conversely, others could perhaps derive much benefit from certain market opportunities.[[[PAGE]]]

Questions to ask yourself

Non-financial companies should ask themselves whether collateral might not sharply reduce the cost of hedging. Since the Basel III principles are not likely to change, we may assume that the cost of hedging will rise as the hedging period gets longer. We may assume that the longer the hedging period, the dearer the derivative instrument will be. This being the case, we need to ask ourselves how much dearer?

We have carried out this exercise on theoretical examples (purely indicative examples quoted by major institutions). The answer varies from one institution to another because the bank’s CDS matters, as does that of the counterparty. The assessment and the exercise are therefore complicated. However, one thing is clear: derivatives will become more expensive over time. If the company, with a cash surplus, having opted for a conservative investment policy (S.T./under 3 months), puts part of this surplus up as collateral, it will be remunerated at a rate comparable to that given by a bank for an ordinary deposit. It will not suffer any real loss of income. The calculation then becomes interesting. A company with a cash surplus, and therefore with no liquidity risk, can in this way remove the credit risk. By putting up collateral it in fact frees itself from the risk of counterparty failure where the revaluation of the portfolio is positive. In cases where on top of that the hedging gain is important; it is all profit for the company. This is not the case for a company with borrowings. It would be swapping credit risk for liquidity risk – at the end of the day it would gain nothing in terms of risk. Furthermore, the cost of borrowing (depending on spreads) can be even higher than hedging cost savings.

Possible solutions

There are several possible solutions:

(1) Do nothing and do not agree to margin calls (at the risk of paying more for your hedging)

(2) Sign a CSA (Credit Support Annex) type bilateral agreement (with margin calls with or without ‘threshold’ or ‘daily’ terms)

(3) Sign an agreement with a central counterparty clearing house (CCP) (with daily margin calls, with no materiality threshold, with an initial margin on top, hiking the total cost)

(4) Use an ISDA deposit (to avoid margin calls and also to boost the return on investment)

The dilemma is in choosing between (1) significantly better hedging or trading terms, but with potential cash volatility and higher administrative cost in exchange, and (2) poorer hedging terms, with no cash volatility or additional administrative cost. An opportunistic strategy could also be chosen to vary with market conditions. Initially, we might think that short-term hedging could be done without collateral, while longer-term hedging would have collateral, to reduce cost. We may question whether it is realistic to use a clearing house since the price of the entry ticket is so high (initial margin and initial fee in addition to variation margins), and whether the implicit administrative cost is acceptable and manageable for the treasurer of a medium-sized company.

We might think that CCPs would be restricted to (very) big companies with large volumes. The final option referred to above (i.e., the ISDA deposit) is very attractive because it keeps down the cost of the hedge or improves return on the deposit. The other advantage of an ISDA deposit is being able to decide the term of the deposit, without necessarily aligning it with the duration of the collateral (as in the example referred to). Obviously, this deposit is at risk for the company in the event of failure of the counterparty bank.[[[PAGE]]]

So what would be advisable?

It would seem obvious that cash rich companies with an average rating (of between BBB+ and BBB-), that have adopted a conservative and short-term investment strategy for their surplus cash, would find it beneficial – selectively at first – to use bilateral agreements of the CSA or ISDA deposit type to improve the cost of the hedge or to boost the return on the deposit (for the longest foreign exchange hedging terms, where the difference is most material). The principles referred to for foreign exchange apply equally to interest rate hedges. Bilateral agreements seem to us to be more flexible and easier to use. This would enable the company to avoid the impact of the bank’s credit charge and pre-financing cost (i.e., the Credit Valuation Adjustment and Funding Valuation Adjustment). By using the Value at Risk (VaR) on fluctuations in the derivative, it is easy to estimate the gain to be obtained on the cover or the investment.

The situation is still pretty hazy. Not all banks know how they are going to pass the costs on to their clients. Furthermore, the bank’s credit standing and that of its counterparty (as evidenced by the cost of their CDS) will affect the cost of cover, amongst other things. It is therefore advisable to use an opportunist approach, and to gradually favour a few quality banks for longer and potentially more costly hedges, without collateral. It is obvious that a well-designed strategy could give the company a non-negligible competitive advantage over the competition, particularly if the competition has borrowings. Hedging strategy will change, the writing is on the wall; but it will not necessarily have only adverse effects for the ‘richest’ and most prudent companies.

Francois Masquelier

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Article Last Updated: May 07, 2024

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