Boxed In

The government's push to standardize over-the-counter derivatives could severely disrupt corporate hedging programs.

Eager to prevent a repeat of last year’s financial-market meltdown, in which the federal government was forced to bail out a number of big firms or risk a dominoes-like implosion of the credit-default-swaps market, the Treasury Department has drafted legislation that would impose tight new regulatory controls on the entire over-the-counter derivatives market. That market encompasses not just credit default swaps but all sorts of other derivatives contracts companies use to hedge commodity, interest-rate, and currency risks.

Corporations have largely applauded the Administration’s efforts to bring more oversight and transparency to this market. But they have railed against Treasury’s recommendation to “standardize” as many OTC transactions as possible and have them cleared on an exchange or through a central counterparty (CCP). Although that would both increase transparency and mitigate counterparty risk, it would also force companies to post collateral — cash or Treasuries — against their hedges based on a daily or twice-daily marking to market of their positions, thus tying up precious cash.

It’s not just an issue for large companies. While OTC derivatives can be complex, many kinds of companies take advantage of them, even if only sporadically. According to the International Swaps and Derivatives Association, not only do more than 90% of the Fortune 500 use customized derivatives but so do half of midsize companies and thousands of small companies. “I would be shocked if I was talking to a treasurer for even a small $50 million company that didn’t know about their availability,” says Tim Murphy, foreign-currency risk manager for $25.3 billion manufacturer 3M. Before joining the company 8 years ago, Murphy spent nearly 12 years on the sell side of the derivatives market, at a bank.

Nash-Finch, a $4.7 billion wholesale grocery distributor, uses swaps to convert some of its floating-rate debt to a fixed rate, or to hedge its price exposure on the 3 million to 6 million gallons of diesel fuel its truck fleet burns through each year. It doesn’t use derivatives for trading or other speculative purposes. Despite this small footprint — at the start of this year the company had two interest-rate swaps outstanding with a notional value of $52.5 million, and no diesel-fuel swaps — Nash-Finch may soon find be among the many companies whose modest hedging programs are less risky but more complicated and expensive.

That’s because the push for centralized clearing would, among other things, jeopardize companies’ ability to apply favorable hedge-accounting rules to their derivatives transactions. That accounting treatment is available under FAS 133 only when a derivative is “highly effective” in hedging the underlying risk, meaning that its value moves in a nearly perfect inverse relationship to the value of the underlying exposure.

Finance chiefs fear that standardized contracts might not offer that precision, and without hedge accounting, any fluctuations in the value of a company’s derivatives positions would flow through to its income statement rather than its balance sheet, introducing an unwanted new source of volatility to the bottom line.

“If companies can’t arrange the perfect hedge, they may be caught in a precarious position,” says one treasurer. “It can cause pretty severe income-statement volatility, and that goes contrary to the purpose of hedging.”


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