Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Corporate OTC derivatives

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

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
(Brazil and Mexico). These reports indicate that “An
estimated 50,000 firms in the emerging market world have been

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

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.


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