In covering the Intercontinental Exchange’s decision to move its energy swap trades onto its futures exchange, the Wall Street Journal’s Jacob Bunge and Katy Burne cited data on the power company Exelon in order to highlight how this move might impact end-user costs:
One company worried about costs, Exelon Corp., said in a regulatory filing on May 10 that “even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral.”
But the $1 billion figure is only half the story. The other half of the story is the contingent capital that Exelon saves. But since that contingent capital is off-balance sheet, it is commonly overlooked, leading both corporate executives and reporters to significantly exaggerate the cost of using cleared futures exchanges.[1] In comparing the financing costs of non-margined OTC trades against the financing costs of exchange-traded derivatives, it’s important to look at both the on- and off-balance sheet capital demands.
My colleague, Antonio Mello, and I have discussed this in more detail in our paper on “Margins, Liquidity and the Cost of Hedging.” An exchange traded derivative requires that the company post margin. That’s an obvious, on-balance sheet cost of hedging. If a company like Exelon enters into a non-margined OTC swap, current accounting conventions allow it to avoid recognizing any current capital cost on its balance sheet. But corporate executives should not be fooled into thinking the OTC swap has not cost it anything. The swap dealer selling the non-margined swap is granting the company a contingent line of credit that will be drawn down if prices move so that the swap is out-of-the-money to the end-user. The swap dealer is going to examine the company’s financial situation and want to be assured that the company has unused debt capacity that can fund this contingent credit line. Entering into the OTC swap uses up this debt capacity. That’s a cost comparable to funding the on-balance sheet margin requirements of an exchange-traded derivative.
When a swap dealer sells Exelon a non-margined swap, it is granting the company a contingent line of credit that will be drawn down if prices move so that the swap is out-of-the-money to the end-user. The swap dealer is going to examine the company’s financial situation and want to be assured that the company has unused debt capacity that can fund this contingent credit line. Entering into the OTC swap uses up this debt capacity. That’s a cost comparable to funding the on-balance sheet margin requirements of an exchange-traded derivative.
Taking a look at Exelon’s quarterly financial statement we can get a glimpse at the scale of the off-balance sheet contingent credit demand associated with Exelon’s non-margined OTC swaps. Although it doesn’t appear on-balance sheet, the narrative material of the 10Q discusses the company’s liquidity, available credit facilities and the scale of certain contingent liabilities. Since few OTC swaps are ever unconditionally non-margined, the company discloses the margin it must post under certain circumstances such as a credit rating downgrade. And the company then compares this against its available credit capacity:
The Registrants believe their cash flow from operating activities, access to credit markets and their credit facilities provide sufficient liquidity. If Generation lost its investment grade credit rating as of March 31, 2012, it would have been required to provide incremental collateral of $2.8 billion, which is well within its current available credit facility capacities of $4.2 billion, which includes collateral obligations for derivatives, non−derivatives, normal purchase normal sales contracts and applicable payables and receivables, net of the contractual right of offset under master netting agreements.
So, if Exelon is forced to move its hedging program onto a derivative exchange, as Exelon discloses and the Wall Street Journal reports, the company will have to post an additional $1 billion that will appear on-balance sheet. But what Exelon doesn’t explicitly recognize, and what the Wall Street Journal also overlooks, is the fact that the company will also have a $1 billion smaller off-balance sheet contingent liability due to the reduction in OTC swaps. The company’s net available capital will be unchanged.
[1] In assembling the $1 billion figure, Exelon’s focus is on non-cleared swaps that it buys, which is not what the ICE story is about. ICE is shifting its cleared OTC swaps onto a futures exchange. Like exchange traded futures which are cleared, these cleared OTC swaps already required margin, so changes in where they are traded do not contribute to the $1 billion figure. However, Exelon trades many non-cleared OTC swaps, which are not included in the ICE decision. These are the ones that contribute to the $1 billion figure.
