Over at New Deal 2.0, former Goldman Sachs VP Wallace Turbeville explains derivative trading to end users in an interesting way that I haven’t seen before. You should read the whole thing, but in a nutshell here’s how he describes the process:
- A bank sells a derivative to an end user. For example, for an airline company it might be a hedge against fuel prices rising in the future.
- If the hedge goes the customer’s way (i.e., fuel prices go up), the bank pays up. But if the hedge goes the bank’s way (i.e., fuel prices decline), the end user has to pay up.
- As always, though, there’s a risk of default. Maybe the end user won’t make good on his payment.
- In essence, then, the bank is selling both a hedge and a loan at the same time, and assuming credit risk on the loan.
Why do this? Why not, instead, extend an ordinary loan, have the customer post that as collateral, and sell the hedge at a lower price since there’s no credit risk built in? Turbeville:
It is widely known that deployment of credit capacity to trading with a company is far more profitable than conventional lending. This means that
- the profit from a trade coupled with the extension of credit through forgone posting of collateral is far more profitable than
- the profit from a conventional loan plus the profit from a trade in which no credit is extended.
Viewed from the perspective of the company making the trade, it is either willing to pay more for the packaged deal or it does not properly evaluate the all-in cost.
Turbeville goes on to explain in more detail why traders benefit from this arrangement (it locks in customers and helps banks build dominant positions in particular markets) but then circles back to his starting point:
There is a lingering, unanswered question raised by the foregoing discussion: Why do the end users prefer packaged credit and trading deals, even though the banks make more than the unpackaged alternative?
The obvious possibilities are inertia and convenience — though given the efficiency of modern finance it’s hard to believe that separate credit facilities would really end up being much less convenient, especially for large, sophisticated companies. But in a followup piece, Turbeville suggests a different answer: a conventional loan is carried on a corporation’s balance sheet as debt, while the embedded loan in a packaged derivative isn’t. So the packaged deal provides an attractive accounting loophole:
Avoiding an accounting exemption is very appealing. But perhaps the better way to address this is to encourage efficient, third party systems, short of full on clearing, to track these exposures and to facilitate efficient collateral funding in bi-lateral transactions. The simple exemption for end users in financial regulation does not encourage the development of such a system. It ignores a troubling practice which need not burden the marketplace.
In other words, maybe the end user exemption that just about everyone supports isn’t such a great idea after all. Via Mike Konczal.
