Changes to swap costs prompt alarm Off the peg or custom made? For some derivatives users, the choice could soon narrow sharply. There are growing fears that specially-tailored swaps will become prohibitively expensive under new rules coming into effect from next year. Regulators want most users to pick only from the racks of standardised products. The swaps market is where institutions swap $650tn of interest rate, commodity and credit exposure among themselves. As the new regulatory regime for derivatives looms, there is concern about the side effects of rules that are designed to make the financial system safer. Swaps include many that are tailored for end-users to hedge specific business risks. For example, pension funds that have promised to provide benefits linked to inflation might set up an inflation swap with a bank to make sure they are not hurt by an unexpected rise in consumer prices. International trade and infrastructure projects also sometimes benefit from currency swaps tailored to insulate their foreign financiers from fluctuations in exchange or interest rates. Regulators want to impose much higher upfront costs, through what is known as an initial margin. Standardised swaps will be passed through a central clearing house, which will take on the risks of either party defaulting. For custom-tailored swaps, which cannot be centrally cleared, there is a tougher regime. When an investor or bank elects to use a swap with unusual characteristics, they will need to provide upfront margin that varies across different asset classes of credit, commodities, equities, interest rates and currencies. It is this margin that has alarmed many in the derivatives industry. "The level of initial margin for uncleared derivatives is going to be very tall for people looking to hedge specific risk," says Philip Obazee, head of derivatives at Delaware Investments, part of Macquarie Group. Swaps are designed to serve a specific purpose and users often need a particular type of hedge. At the end of the day, it won't be economical for people to use an uncleared swap if [the] initial margin is untenable. Brad Golding, managing director at Christofferson Robb & Company, a private money management firm, says: "Clearing shouldn't handle every conceivable trade, but things have moved dramatically in the wrong direction and it will discourage correct hedging." Ashish Shah, head of global credit at AllianceBernstein, says that "by definition the non-cleared market will shrink and people will shy away from the uncleared business. Dealers will charge more for using uncleared swaps and clients will ask themselves whether the higher cost justifies their use. While some companies will have an exemption from posting initial margin for a bespoke swap, they are still likely to incur higher costs. That is because swap dealers on the other side of any customer trade will need to post margin, at a time when banks are very focused on capital charges. "We consider the end-user exemption to be a mirage," says Will Rhode, analyst at Tabb Group. Dealers have no intention of footing the bill, the expectation is that corporate treasurers engaging in bilateral swap trades will pay more. A dealer trading with a client will need to enter a hedge and they will not be exempt from initial margin. The Institute of International Finance, which represents 450 banks and finance houses, has also weighed in to criticise the new margin requirement rules on non-cleared derivatives. After an IIF meeting last month, representatives of banks including Barclays and Goldman Sachs and buyside firms including BlackRock and Soros Fund Management warned the cost of hedging could soar under the new rules, hurting everything from foreign-funded infrastructure projects in emerging markets to cross-border trade. The International Swaps and Derivatives Association recently published a report warning that the margin rules in their current form would actually increase systemic risk. ISDA says the much higher margin requirements will become problematic during times of market stress. The most likely outcome, swaps participants say, is that users of derivatives opt for standardised swaps that in turn will not fit exactly with their specific risks. It means that when asset prices shift sharply in the future, an imperfect hedge may not fully insulate a portfolio from downside risk. Call it the risk of the ill-fitting suit.