You are here: Home Articles An alternative for OTC derivatives


  • An alternative for OTC derivatives

    The financial crisis hasn’t been all bad. It has taught us a few things.

    For instance, we learned that banks can make any bet, no matter how risky, because in the end if they lose they will get their money back.

    Since a few years banks have started to charge liquidity spreads, credit spreads, funding charges and other costs to organisations that conclude Over-The-Counter (OTC) hedging contracts. Banks increasingly also enforce customers to exchange collateral for outstanding hedges which increases funding costs and it increases the net required debt as the collateral needs to be financed. Regulations for OTC derivatives are sharpened (i.e. interbank central clearing for OTC derivatives), and the extra costs on the banking side are also forwarded to the customers of banks. Also Basel III involves extra (funding-) costs charged to customers by banks.

    Before the financial crisis few corporations actively measured and managed their own credit rating. Managing the balance sheet was often considered less important than managing the profit and loss account. For many organisations it is not so easy anymore to obtain funding, and their own credit rating has become an even more important element in creating alternative funding resources. Securitisation programs, private placements, issuance of commercial paper, bonds and medium term notes, to mention a few, have become an even more important alternative for bank funding. Banks more often require “ancillary business” in exchange for funding. Once you supply them with OTC hedging transactions as ancillary business, extra charges will apply.

    Since the financial crisis really started in October 2008, the bid-offer spread on risk management transactions offered by banks have increased significantly because of these charges. Next to that, the methodology of how Over-The-Counter (OTC) derivatives are priced has changed as well, which makes it more difficult for many organisations to measure the competitiveness of their bank’s pricing. Till 2008 the OTC market was an efficient financial market. However, since the financial crisis started, liquidity has dropped significantly. The interbank market dropped to historical lows because there is lack of trust among banks on their interbank counterpart risk. The central bank in Europe has never received so much funds from European banks because European banks are less willing to lend to each other. Also USD funding from US banks to European banks has become very difficult to obtain. The measurement and management of the credit risk on financial counterparts has / should become a core task for all corporate treasurers! Why should you as a corporate trust your banks if their colleague banks do not trust them? This makes the entire discussion on credit spread charges and liquidity spread charges even more interesting.

    We believe that from a credit risk management perspective corporates should proactively be measuring and managing the credit risk on financial counterparts. The cost of risk should be paid for, simply because it makes part of your cost price. This implies that also corporates could be charging credit costs to their banks. However, we realise that at this moment for many organisations it is unthinkable to bring this forward. This is why bank independent alternatives are important.

    Since 2008 banks have lost tremendous amounts because of bad investment decisions, and it is still not over. Also the current credit crisis is hurting our banks. It should not be taken for granted that customers of banks by default will pay for bad management decisions within banks. Bank independent alternatives will give you the possibility of choice. Although some arguments given by banks “why they should charge their customers” sound logic, it smells like it is also used to bring banking reserves back on track at the cost of customers.

    Exchange traded futures have become an interesting alternative for OTC hedges. The main reasons are:

    1. Futures are much cheaper (bid – offer spread) than OTC derivatives. Savings have now become very significant.
    2. A lot of futures can nowadays also be delivered physically at expiration. This was not the case in the past. The argument to use OTC derivatives because there is no physical delivery with futures does not apply anymore.
    3. Another argument for OTC derivatives above futures was always that OTC derivatives can be tailored to the customer needs (like Notional Amount and Expiration Date). Implementing portfolio management warehousing techniques makes this argument irrelevant.
    4. Banks are charging corporates their spreads, where actually corporates should be charging spreads to their banks. The creditworthiness of your bank is probably worse than yours, which is confirmed by the fact that banks currently do not trust each other. In the current environment it is unthinkable to bring this argument forward; replacing OTC transactions by futures simply solves this issue.
    5. In the case of OTC derivatives you will have a credit risk on a counterpart with a solvency ratio of maximum 10 %. In case of futures your counterpart is the Exchange Clearing with a solvency ratio of 100 %. From a Credit Risk perspective you would be smart to use exchange traded futures instead of OTC derivatives.

  • Posted on May 20, 2015