The treasurer: creating price tension on the derivatives front
David Renz is director, advisory risk, SunGard Ambit Treasury Management
A banking book requires a number of careful deliberations on the use of derivatives. In particular, the introduction of EMIR, Dodd-Frank and their brethren across the world has a number of important consequences for this market, writes David Renz
First and foremost, a swap will absorb liquidity for the bank. This creates two specific problems. First, in case a bank need not clear its derivatives, it may attract a higher or lower rate for its pay and receive fix positions with its counterparties, mostly due to the efficiency of the counterparties’ derivatives operations. There is a grey area where a smaller bank may create price tension by revealing its independent valuation while negotiating rates.
On the other hand, if a bank enters a derivatives transaction with a non-financial client not subject to central clearing and must hedge, then it effectively creates a liquidity line to this client because the bank has to pay margin, whereas the client does not. Pricing this liquidity line correctly is key to ensuring that these trades add value. Hence, apart from correctly pricing the hedge transaction, the client’s transaction price needs to include the price for the potential liquidity outflow associated with it and probably requires an explanation of the calculation to the client. If derivatives were too expensive for some reason, then a treasury operation keen on creating price tension may also offer slightly different deals to ensure that a client stays on board. The inevitable rebate provided may, due to sophisticated transfer pricing, be reflected in the internal income distribution.
As swaps and other derivatives absorb liquidity, diversifying a swaps portfolio is critical to creating price tension, too. This works along two channels. First, a larger derivatives volume allows a smaller bank to attract better rates or at least make good the substantial costs of clearing broker services, where trades have to be cleared. Second, by hedging both ways, the diversification effects in the margin calculation will allow compression of the margin calls, since it allows to avoidance of the revenue and liquidity pitfalls of one-way bets. Furthermore, a nice spread may be earned across the entire curve.
When it comes to product innovation, being able to price structure or engage in cost-efficient hedging structures in the FX world allows treasurers to retain a competitive edge and get into niche markets as opposed to keeping their position square.
Apart from this, such a technique allows treasurers to ensure that any price tension experienced elsewhere in the bank may be balanced by taking more rates risk.
Of course, this requires a well thought-out infrastructure. Sophisticated pricing of positions according to market standards, initial margin calculations and the projection of future margin calls form the backbone of the processing infrastructure.
Additionally, an operational, tactical and strategic approach to cash and liquidity management, coupled with sophisticated collateral management and execution, helps ensure that the bank’s liquidity is deployed in the right fashion.
Lastly, the bank needs to closely coordinate its asset liability management strategy, determined by how treasury positions itself and the entire balance sheet on the curve as a result of creating price tension on the banking book.
