Last month the Association of Corporate Treasurers put out a document explaining why companies must be exempted from all the reforms being proposed for OTC derivatives. This “international body for finance professionals working in treasury, risk and corporate finance” does not want the corporate use of OTC derivatives to be subject to central counterparties, collateralization, and exchange trading.
The main argument that they give is that while the OTC derivatives reform proposals are motivated by systemic risk concerns, the corporate use of OTC derivatives is not a systemic risk:
The risk to the system as a whole from failure of a commercial customer of a bank is unlikely to be material. ...
Importantly, non-financial companies generally deal in large but not systemically significant amounts. ...
It is unlikely that a non-financial services sector company using derivatives for hedging will itself represent a systemic risk to the financial services sector.
I am amazed that the Association of Corporate Treasurers could make such claims when the fact is that the last couple of years have seen a corporate derivatives disaster on a scale that has been systemically important enough to require government bail outs.
Korea is a good example of a country where derivative losses on KIKO (Knock In Knock Out) foreign exchange options in the small and medium enterprises were so large that the government had to step in to provide liquidity support and credit guarantees on a large scale to the sector. In Brazil and Mexico, the central bank conducted foreign exchange interventions that were designed to bail out the companies that had suffered huge losses in foreign exchange derivatives.
The June issue of Finance and Development published by the IMF provides quick summaries of what happened in Asia (China, India, Indonesia, Japan, Korea, Malaysia, and Sri Lanka) and Latin America (Brazil and Mexico). These reports indicate that “An estimated 50,000 firms in the emerging market world have been affected.”
Though the losses were large ($28 billion in Brazil alone) and systemically important, they came at a time when the financial sector was losing money in trillions, and inevitably less attention was paid to those who were content to lose money by the billion.
The Association of Corporate Treasurers is particularly horrified that a company doing a derivative deal should put up collateral:
In attempting to remove the credit risk between company and bank which is not systemically significant, a serious liquidity risk for the firm would introduced instead. ...
... if a company has to put up cash collateral it turns its hedge transaction into an immediate cashflow which will not match the timing of the counterbalancing commercial cashflow being hedged – perhaps by many years. This introduces a serious cashflow problem, potentially nullifying much of the benefit of the hedge.
What I have observed is that the discipline induced by mark to market is extremely valuable in risk management. Among the rules of thumb that I like to apply to corporate risk management are the requirements that: (a) the derivative position must be acceptable if held to maturity even if the intention is to unwind the position within a short period, and (b) the mark to market losses must be acceptable even if the position is intended to be held to maturity. These two symmetric rules rule out a whole lot of speculative positions.
Finally, when the Association of Corporate Treasurers talks of liquidity risk, it must be remembered that the relevant liquidity risk is a tail risk. The day to day volatility of mark to market cash flows does not produce a significant risk to the company – this is a liquidity nuisance and not a liquidity risk. The real risk is when the mark to market losses are large enough to threaten financial distress.
Under such conditions, the uncollateralized OTC derivatives impose equally severe liquidity risk because (a) the OTC derivatives may provide for margins to be deposited in these extreme cases, and (b) other lenders (including trade creditors) start refusing to roll over their debt. Cases like Ashanti Goldfields highlight the liquidity risk of OTC derivatives to the company.