Whether or Not to Collateralise 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.