A New Solution for Hedging Used Vehicle Price Exposure Amid Increasing Volatility

by | Nov 8, 2022

EV adoption, transition from record high vehicle prices could result in unprecedented risks for automakers and fleet owners

If you’re an entity that owns a large automotive fleet – a car rental agency or the finance arm of an automaker with a sizable lease portfolio – today’s skyrocketing used car prices have likely pushed your portfolio’s value into the stratosphere.

But what seems like unadulterated good news actually represents a potentially precarious moment for your fleet – and your company. That’s because fleet owners who purchase vehicles for daily rental or to lease them out are essentially making a bet on the future wholesale price of that vehicle at the end of its use. 

If the vehicle’s depreciation is anticipated correctly and the asset is liquidated for the expected wholesale value at the end of its term – either sold at auction or to a dealer – the fleet owner is made whole from a financial perspective. But if the vehicle’s liquidation proceeds are lower than the predicted residual value, the fleet owner realizes a financial loss – perhaps a catastrophic one.

Given current fleet and leasing portfolio sizes, this financial downside is massive. In fact, there is more than $500 billion in unhedged exposure to fluctuations in used vehicle prices across leasing portfolios, rental and other commercial fleets, and subprime auto-loan portfolios. 

This existential threat to the automotive industry presents a unique opportunity for novel derivatives. For over 100 years, LaSalle Street has shown how to manage risk with efficiency, regulation, and transparency. Exponential Exchange, a fintech startup, is bringing this toolkit to the auto finance industry and aiming to mitigate the wholesale vehicle price uncertainty plaguing automakers and fleets.

The firm, established by seasoned veterans from the auto finance and derivatives industries, has created first-of-their-kind tradable indices that accurately track the used vehicle market. Working with key stakeholders in the auto finance and derivatives markets, Exponential is designing cash-settled index futures and options contracts that will open the doors for an entirely new asset class in wholesale used vehicle values.

While pandemic supply chain issues triggered the current era of record high vehicle price volatility – exceeding 20% across the industry – Exponential’s founders are no strangers to vehicle price shocks in the automotive industry. Paul Fortin, Exponential’s Head of Index Products, has managed auto-residual risk across a 24-year career spanning Mercedes-Benz Credit, LeasePlan, and used vehicle leasing & subscription portfolios. 

“It’s no secret that used vehicle price shocks are a huge threat to auto finance companies and rental fleets,” Fortin said. “In fact, we need only to look at the exuberant growth of leasing in the 1990s, which was brought to an abrupt halt almost exclusively by vehicle price corrections at the turn of the millennium.” 

Indeed, this downturn found the major banks realizing that they lacked the risk-management tools and data to properly mitigate this exposure, resulting in a mass exodus from the leasing market that left only automakers in the business of providing vehicle leases – a fundamental shift that exists to this day.

Given the magnitude of this exposure on the automakers’ balance sheet, they are prohibited from leasing more than 30% of their vehicles without setting aside substantial capital reserve accounts or facing a downgrade of their corporate debt rating. 

As the chart above shows, rising prices for used vehicles over the past three years have led us to a precipitous moment – with perhaps more room for price declines than ever before. Making this scenario even more relevant is the reality that we’re at the doorstep of a major revolution in transportation, creating a new set of unknowns that promise to make managing residual value exposure without proper protection nothing short of a high-wire act without a net.

The EV Revolution Ushering in a High-Volatility Era

The automotive industry is currently experiencing the greatest transformation in 100 years, driven by rapid technology advancements. While the transition to electric vehicles and eventuality of autonomous fleets will bring innumerable benefits to consumers and the environment, this transportation revolution is also expected to dramatically increase price volatility and risk concentration in the automotive sector.

Akin to Moore’s Law predicting an exponential decrease in computing costs and Swanson’s Law foretelling an exponential decrease in solar panel costs, production scaling effects are driving accelerating cost reductions and performance improvements in battery technology.

Given that an EV’s battery represents an outsized percentage of its cost (15%-40%), rapid and uncertain changes in battery technology are expected to drive continual shocks and increasing volatility for both EVs and legacy internal combustion vehicles.

Aware of these risks, many consumers are concerned about purchasing electric vehicles and being exposed to the impact that advancements on newer model years will have on the resale value of their older vehicle. That’s why electric vehicles are leased at over twice the rate of internal combustion vehicles, according to a Bloomberg study. “When there’s new technology coming out, and it’s coming out so rapidly, and you’re improving on it so constantly, typically people only want to lease it,” Steve Center,  a Honda vice president, said at the 2017 New York Auto Show. 

This dynamic leaves automakers in a precarious position: how to achieve aggressive EV adoption goals when their most powerful tool for doing so – leasing – increases their risk concentration, threatens their corporate debt rating, and even raises the specter of bankruptcy. What they need is a way to finance leases that both reduces risk concentration and systemically mitigates overall market risk – precisely the function Exponential Exchange aims to provide.

Current Approaches Are Inadequate

Despite such massive risks, current approaches to residual value risk mitigation are largely regarded as inefficient, inadequate, and prohibitively expensive. 

To date, the most common risk mitigation paths are overcollateralization of asset-based securitized debt, residual value risk insurance, and conservative residual value-setting. All of these solutions are highly inefficient, expensive, and unscalable.

In order to protect the bondholders of traditional lease and rental ABS deals, fleet owners bear the entirety of the tail risk and are required to overcollateralize their position with equity capital, a very expensive solution. This was a significant pain point at the outset of the pandemic, which caused strain on rental car companies and other lease-adjacent businesses when cash infusions were needed to cover deteriorating collateral values – precisely at the same time these same businesses were hemorrhaging cash due to a near-societal lockdown. 

Another industry alternative – bilateral residual value insurance – was never a real solution for large fleet owners due to its cumbersome administration and premiums that are extremely high in comparison to the protection they provide. 

The last existing method of residual risk protection involves leveraging conservative residual value predictions in pricing and accounting processes. While this strategy will mitigate residual value exposure, it also leads to uncompetitive pricing, substantial capital inefficiency, and lower market share.

A Derivatives-Based Solution for Wholesale Vehicle Price Risk

For students of markets, wholesale vehicle prices are the perfect forum for a derivatives-based solution. The underlying market size is massive, the risk that needs to be hedged is significant, and there exists a diverse set of natural hedgers and speculators who can see a benefit from participating in a market solution. 

Exponential Exchange’s solution involves a series of cash-settled futures and options contracts based on underlying, proprietary wholesale vehicle price indices. Using wholesale spot market data sourced from automotive auctions, the indices employ hedonic pricing algorithms and modern machine-learning to capture the dynamics of the automotive market. Their indices have been extensively tested across industry shocks against actual fleet portfolios.

“We have worked with multiple treasurers and risk managers across the auto finance industry to ensure our indices have the right correlations with their portfolios so that the cash-settled derivatives will have sufficiently low basis risk,” said Ryan Naughton, CEO of Exponential Exchange. “Our marketwide index has over a 90% correlation with the rental and leasing portfolios’ vehicle price exposure and accurately reflects the shocks, large and small, experienced by the industry.” 

Beyond the marketwide index, additional sector-specific indices – such as an SUV index, a rental index, and an EV index – can provide even better hedging, cross-trading opportunities, and improved price discovery. 

While building these indices to ensure optimum performance, Exponential sought out the assistance of finance professors from the University of Chicago’s Booth School of Business and its associated Center for Research on Security Prices (CRSP). CRSP has extensive experience in designing indices and launching ETFs managed by industry veterans like Vanguard. Exponential has also designed its indices with IOSCO compliance in mind and is planning for formal accreditation in the coming months. 

After an initial OTC period, Ultimately, Exponential Exchange plans to list index futures and options contracts on an established futures exchange, allowing hedgers of vehicle residual risk to benefit from these markets for the first time. 

“With increasing EV adoption and new ways to access mobility options such as rideshare or subscriptions, the automotive industry is currently in a very exciting time, but transformative changes always require new risk-management tools and financing options,” said Klaus Entenmann, former CEO of Daimler Financial Services. “The industry would welcome tools such as derivatives that provide price transparency, regulation, and the advantage of central clearing.”

For speculators and investors, wholesale vehicle value futures would be a new asset class closely correlated with categories they currently trade. In fact, auto prices closely track macroeconomic indicators like inflation, are impacted by oil prices, and will even have an impact on electricity markets due to increasing EV penetration. 

“We are always looking for innovative new products to trade. Wholesale vehicle value index futures contracts are very interesting given the market size and the major changes underway in the transportation industry.” Adam Passaglia, founder of ARB Trading Group.

A remarkable aspect of this market is that there is no dearth of data available for the market to make bets on auto values. Robust information on used car pricing goes back to the early 1990s, with auction houses generating more than 6 million transactions-level data points every year representing more than $100B in annual spot market volume.

The futures market has offered an exciting array of new innovations, with used vehicle derivatives standing as yet another logical entrant to that list. While it takes time for new markets to develop and achieve market engagement, Exponential Exchange is expediting this process by working directly with potential users of the product to give them a strong say in both product development and governance. If they can succeed in building liquidity, their product will offer new levels of financial assurance for hedgers and unlock new trading opportunities for the derivatives industry. 

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About the Author:

Murali Kanakasabai is a co-founder and Chief Operating Officer of Exponential Exchange. Previously, he was part of the founding team of both Chicago Climate Exchange and American Financial Exchange (Ameribor). His 20 year career spans derivative design, building boutique exchanges, structured finance, and environmental finance. 

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