At first glance, few people would make a connection between over-the-counter (OTC) derivatives – famously derided by billionaire businessman Warren Buffett as “weapons of mass destruction” – and the airline industry.
But as reform of the OTC derivatives markets gathers pace in the wake of the financial crisis, that link has suddenly become apparent.
The US administration and European Commission have been pushing for the greater use of clearing in the OTC markets as a way of safeguarding the financial system against future financial shocks.
OTC derivatives are contracts that are negotiated privately between two parties, and range from foreign exchange and interest-rate swaps to fuel forward contracts to credit default swaps. They are not traded on-exchange.
Nor are they processed through a clearing house, unlike most exchange-traded derivatives. That means that if either side in a trade defaults, the ripple effects can be felt throughout the financial system. The collapse of Lehman Brothers a year ago highlighted this so-called “counterparty risk”, when hundreds of Lehman counterparties were left hanging on the other sides of Lehman’s trades.
Policymakers now want as many OTC derivatives processed through a clearing house, which stands between parties to a trade and guarantees that the deal goes ahead even of one side defaults. There is also a push to force as many “standardised” OTC derivatives on to exchanges.
However a groundswell of concern emerged over the summer in the US and Europe from ordinary companies, which have grown alarmed at the extra cost this would impose on them as they go about routine business hedging.
Companies use interest-rate swaps to manage future pension liabilities, or they may use OTC commodity swaps to help manage fluctuations in the prices of raw materials.
Airlines are among the biggest users of OTC derivatives to manage volatility in the price of jet fuel. Lufthansa, for example, consumes more than 4 per cent of global jet fuel annually. It says that a $1 fluctuation in the per-barrel price of crude oil has a $60m impact on its costs.
It and other industrial companies have been increasingly vocal in arguing in Washington and Brussels that the measures could limit the ability of airlines to use OTC contracts that are typically negotiated to cover specific risks that require bespoke specifications. They are also worried that mandating a shift of swathes of hitherto uncleared OTC derivatives on to clearing houses would cause a huge drain on corporate cash – businesses would then have to find the margin collateral that is usually required to be posted to a clearing house as part of the process of guaranteeing trades.
The International Air Transport Association, commenting on the European Commission’s proposed OTC reforms in August, said: “We and our member airlines are concerned that some of the current proposals may materially increase the cost of using derivatives to manage risk and reduce their flexibility.
“We are particularly concerned that proposals to raise collateral requirements on OTC derivatives will materially increase costs for airlines’ risk management activities.
“Recent requirements to mark derivative positions to market, together with the volatility of energy prices, have led to very large swings in jet fuel hedges relative to the earnings and cash balances of many airlines. Any new requirement increasing the need to post additional collateral as a result of valuation changes could impose very material costs for the airline industry, with adverse consequences on their ability to manage risk.”
Since August, both the European Commission and the US Congress have proposed, in the form of formal proposals and bills, how the new regulatory regime for OTC derivatives would work. They go some way to addressing the airlines’ concerns.
This month the Senate banking committee, chaired by Chris Dodd, produced a bill on financial regulation that included how OTC derivatives should be treated. Like a companion bill in the House of Representatives, it contains an exemption from the clearing provision for non-financial users of OTC derivatives, although that has yet to be fully defined.
The European Commission has produced a set of reform proposals that have been submitted to the European Parliament, although they will not be finalised until after a new commission has been elected and is in place.
In a provisional version of a “communication” to the parliament and other bodies, including the European Central Bank, seen by the FT, the commission acknowledges the usefulness of bespoke OTC derivatives for non-financial companies. It says it does not want to make derivatives “excessively costly for non-financial institutions”.
It also makes clear that some of the cost of strengthening financial market structures in the wake of the crisis “can be expected to fall on non-financial institutions”. But it argues this cost – such as extra margining costs – will fall over time the more widely “central market infrastructures” are used.
Nothing will be clear until the US signs off on final legislation, nor until the new European Commission is in place, but airlines look like they have managed to make part of their case successfully so far.
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