Dodd-Frank and The Illusion of Transparency
For the majority of middle market borrowers, broadly defined as entities having annual revenues of $10mm to $500mm, transparency for hedging risk with interest rate swaps under Dodd-Frank regulation is an opaque, 2+2 = 5 equation. We are making a bold statement here as one of the primary goals of Dodd-Frank was to create more transparency in the OTC (Over the Counter) derivative markets.
Dodd-Frank created rules requiring swap-providing Banks to provide hedgers with the mid-market swap rate and the swap spread over that swap rate. This spread represents the bank’s profit for underwriting the risk (note: not all banks are required to disclose this information, it typically depends on the size of the bank). This change was a breakthrough in a market that was up until then very opaque, and thus hedgers should all be celebrating, right? Not so fast.
How is transparency quantified?
What is the definition of transparency? In this context, it is an easily observable price to buy or sell a financial instrument. Stocks are a good example. Apple is trading at around $115 per share today. Specifically, the price to buy (called the ASK) is $115.40 and sell (called the BID) $115.38. That means a mid-market price of $115.39. Easy. Let’s look at another stock called WHTMM (We Hope to Make Money) with an ASK price of $10.00 and a BID price of $5.00.
The spread between the ASK and BID prices is 50%. The wide spread is likely because WHTMM doesn’t have many shares outstanding, low volume and only one market maker. However, there is transparency, and we know the mid-market is $7.50.
Mid-Market, A deeper look
Using “Mid-Market” as a benchmark is important for pricing any security. The spread between bid and ask is dependent upon numerous factors: the number of shares outstanding, how many market makers, and supply and demand among them.
Transparency benchmarked to a highly traded index – like LIBOR – is marginalized if the spread over that index (mid-market in the case of swaps) can’t be justified.
We have a fairly good idea why the stocks mentioned above have different spreads over mid-market, but what about the spread over mid-market on an interest rate swap? A Bank is clearly at risk if the hedger defaults. For underwriting this risk, a bank deserves to make a spread. That being said, how do Banks determine their spread given a specific, quantifiable level of risk?
Several inputs go into determining the spread over mid-market or what banks call CVA (“credit value adjustment”). They are 1) The credit risk of the hedging counter-party. For example, a loan priced at 1M LIBOR + 2.00% is a better credit risk to the bank than a 1M LIBOR + 4.00%. 2) Term interest rates. A 10-year swap has more risk to the bank than a 5-year swap. Simple. For a Pay Fixed Swap, the risk to the bank is if term rates fall, and there certainly is more risk if the 10-year swap rate is 6.00% versus today’s 2.60% in this scenario. 3) The Banks run interest rate curve scenarios to determine their worst-case exposure and determine at what point in time that risk is expected to peak in the event rates fall more than the market is anticipating. Calculating this “what if scenario” isn’t easy and every bank has its own methodology. However, in our experience the exposure numbers are fairly consistent among the banks.
Credit + Term Risk + Rate Risk + Profit = Spread
Coming up with a spread is fairly complicated, and unless hedgers have the know-how and exposure models, there is no way to determine what the spread should be. Many hedgers are at an additional disadvantage because they’re borrowing from a single bank, and can’t easily bid out the swap transaction due to the lender’s reluctance to allow another bank be a party to its collateral. Alternatively, syndicated loans offer much more transparency, as there can be 10 or more lending banks involved. When we are hired to organize a swap bid on a syndicated credit facility, the swap spreads among the banks can be surprisingly wide.
What do we see in the marketplace?
This will come as a shock to most (especially after we provided the basis of how spreads are calculated) that many banks quote spreads at or close to 35 basis points for a 3, 5, or 10-year swap. Obviously, the term component wasn’t used as part of the calculation. We’ve also come across no difference in spread over mid-market for a borrower priced at 1M LIBOR + 1.50% versus 1M LIBOR + 3.00%. In one instance, the hedger had secured the swap exposure with cash as collateral. One would consider this a “risk-free” transaction for the bank; however the bank quoted a spread of 30 basis points. The only spread calculation the bank needed to make was the transaction cost and the bottle of Champagne they would pop after the swap is executed.
On first glance, there seems to be transparency in the OTC derivatives market because banks have to quote mid-market and their spread, and because of this, Banks routinely ask their hedging clients why they feel they need to hire an advisor. However, if one were to ask the Bank how they arrived at their spread, one will quickly come to the realization the OTC derivatives market for middle-market companies with a single credit provider remains a mystery and transparency is an illusion.