Many companies rely heavily on hedging – which may be defined as the process of using financial instruments to reduce or eliminate the risks resulting from fluctuations in the market price of credit, foreign exchange, or commodities impacting on their cash flow, profits or corporate value.  Interest rate swaps, for example, are commonly used to hedge pension liabilities.  More specifically, an airline may use derivative products such as futures and options to manage fluctuations in fuel costs.  Another common corporate use of derivatives involves issuing a fixed rate bond, and then swapping the coupon flows into floating rate so that the liability is serviced at current market values.  In all of these examples, the corporate treasury is using derivatives to avoid risks and uncertainties, and undesirable P&L volatility. 

For a number of months discussions around potential reforms to the OTC derivatives markets have been taking place.  In recent weeks the debate has gained momentum with calls from the European Commission for greater transparency and for the centralized clearing of OTC contracts by moving them onto an exchange. 

These discussions introduce financial uncertainty for non-financial institutions. A greater use of clearing would require them to keep large amounts of extra financing with the clearing house for margin calls in response to daily mark to market valuations; the current negotiation by corporates of OTC contracts with their banks does not require this.  Potentially this would impose a huge drain on corporate cash, and increase the complexity of dealing.  Furthermore, in an attempt to remove credit risk through centralized clearing the additional capital needing to be raised with the clearing house introduces liquidity risk to the equation.  OTC transactions are used by corporate treasuries to eliminate risks not to amplify them. 

Non-financial companies, which account for a small proportion of all derivative transactions, are especially aggrieved as they believe they are being put in the same basket as financial institutions by policy makers who are attempting to reform financial services despite, when in practice, the corporate impact on systemic risk is negligible. 

Non-financial institutions have already been exposed to huge regulatory reform – through Sarbanes Oxley (SOX) and other accounting related legislation – and have suffered the consequences of corporate failures, and the over exposure of non-financial institutions to derivative markets.  In the mid-nineties, for example, California’s Orange County lost $1.5 billion of taxpayers’ money in leveraged interest rate deals.  The implementation of SOX has initiated stricter requirements around financial reporting and made the board of corporate organisations increasingly accountable for financial practices that carry a disproportionate level of risk.  It was poorly packaged, non-transparent products being sold by banks that caused the current crisis, not legitimate corporate use of OTC products and non-financial institutions should not have their investment activity stifled because of that. 

If some of the rumored reforms relating to OTC derivatives were to materialize they would completely miss the intended objective of discouraging inappropriate risk taking and speculation.  Additionally, they would exert a further squeeze on precious corporate cash resources, diverting them from financing economic recovery.  The way forward is surely to legislate for greater transparency in the analysis and reporting of corporate hedging operations, so that the use of derivatives would be seen as both commercially responsible and effective.  Let’s hope IAS and FASB can achieve this at long last!