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Risk Management

Eris Standards Could Help Mitigate Swap Cost Hike

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November 08, 2016

With margin rules coming online, even exempted corporates will feel the effects of pricing.

Accounting-MoneyAs margin rules kick in the cost of entering over-the-counter (OTC) swap transactions is likely to skyrocket, even for nonfinancial corporates that are exempted from margin requirements. This will make listed swap futures an increasingly attractive alternative way to hedge risk. Swap futures are already eligible for hedge accounting treatment, and accounting changes now in the works could simplify that process even further. Eris Standards could help mitigate the cost increase.

Eris Exchange’s swap futures are based on OTC swaps but they provide liquidity and transparency of exchange-traded products. They also require posting margin and being cleared, two elements that have traditionally been anathema to most nonfinancial corporates. The evolution of the futures and swap markets in recent years may change that.

Founded in 2010 by a handful of large futures trading firms, Eris first sought business from corporates several years ago when it launched its Flex Futures, exchange-traded contracts that provide the customization available with OTC swaps. But they didn’t quite meet expectations so the company launched Eris Standard contracts. Eris Standards are available in 2, 3, 4, 5, 7, 10, 12, 15, 20 and 30-year benchmark tenors and seek to match the economics of plain-vanilla swaps. However, rather than having to renew them at monthly or quarterly intervals, like traditional futures, Standards can be held for the entire duration of the hedged asset or liability.

“An Eris 5-year Standard is actually a swap futures contract for 5 years, and can therefore effectively hedge a 5-year asset or liability,” said Geoff Sharp, managing director at Eris Exchange.

That’s potentially big news for corporates, which are likely to face significantly higher costs related to OTC swaps. Initial margin requirements for OTC swaps went into effect for the largest dealers in October and will be phased in for everyone else over four years. Variation margin, which seeks to eliminate exposures between counterparties on a daily basis, also went into effect for dealers last month and will phase in through March 1, 2017.

Corporate end users are exempted from posting margin, but it is virtually certain that their bank counterparties will pass on their additional costs to clients, hiking up corporates’ hedging costs.

“It’s going from zero to 10-day Value at Risk (VaR) … Where financial institutions never had to collateralize inter-dealer swap transactions previously, now they do,” said John Coleman, a managing director of the fixed-income group at R.J. O’Brien & Associates(RJO), the oldest and largest independent futures brokerage and clearing firm in the US.

Ten-day VAR is the methodology to calculate margin requirements on uncleared swaps. The margin on cleared swaps is determined by 5-day VaR, while futures apply 2-day VaR. Although collateral-requirements are not direct ratios to the length of VaR applied, Mr. Coleman said, the initial margin requirements for OTC swaps imposed on financial counterparties will often be multiples of those imposed on swap futures.

“Being exempt from margin isn’t all that wonderful. It means bank counterparties will have to hit corporates for a lot more money in terms of the bid/ask spread,” Mr. Coleman said.

Eris initially sought to drum up interest from corporates in its Flex product, which was explicitly designed to achieve hedge accounting treatment, a necessity for most corporates to avoid earnings volatility. The regulators, however, determined that the product’s collateral requirement had to be calculated using 5-day VaR, rather than 2-day, putting it in the same category as cleared swaps and essentially negating a major advantage.

The Standard product requires less collateral, but its more standardized structure, echoing traditional futures contracts, has fostered the perception that eligibility for hedge accounting is difficult if not impossible. Mr. Sharp said that’s no longer the case, adding that the dates of the hedge and the underlying asset or liability do not necessarily have to match in order for the hedge to be effective.

“Hedge accounting doesn’t explicitly require the dates of hedge instruments to perfectly match the hedged asset or liability anymore,” Mr. Sharp said, adding that date-matching was previously a key factor in determining whether a hedge could qualify for hedge accounting treatment. But as derivatives must now be marked to market, the question of hedge eligibility is more about the performance of the hedge.

“Hedge accounting treatment has evolved to become a regression test, showing that the price behavior of a hedge and the position being hedged match within certain tolerance levels for the life of the position being hedged,” he said, adding that Eris Swap Futures display this characteristic and price behavior.

To that end, RJO’s fixed-income group commissioned GFM Solutions Group to develop an “accounting case study” to illustrate how the exchange’s interest-rate swap futures can achieve hedge accounting treatment, and when Eris saw the completed study it offered to participate in its distribution and promotion. The study examines a company that on January 15, 2016, expects to issue $100 million in 5-year fixed debt between May 2 and July 1, 2016. It hedges the risk of rising rates by purchasing Standard swap futures, which become effective June 15 while the debt is expected to be issued June 1, a mismatch that is one of several reasons it is not a perfect hedge.

Today, such mismatches do not preclude receiving hedge accounting treatment, but the end user must perform quantitative analysis regularly to substantiate the hedge will be effective, said Charles Brobst, managing partner at GFM. Excessive ineffectiveness must be reported in earnings, potentially creating volatility that corporates typically seek to avoid. However, GFM found only trivial amounts of earnings volatility in virtually all the cases it analyzed, Mr. Brobst said.

“As a proportion of the exposure amount, it’s well less than 0.025% in any given period of the analysis in the study, and in more volatile applications of hedge accounting it was still less than 0.2% in any given period,” he said.

The Financial Accounting Standards Board is working on an amendment to its hedge accounting guidance that as currently written would do away with the ongoing quantitative analysis.

“End users will need to provide an initial assessment of effectiveness that says, ‘Yes, although the features of this hedge contract and the underlying exposure are not identical, the contract will be effective in offsetting changes in the underlying exposure,” Mr. Brobst said, “And therefore all changes in the hedges value will be recorded as effective.”

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