I should of course acknowledge that some political leaders have broken their holidays – for a day or two at least – to show a face to the media and suggest that the levers of power are indeed being pulled with authority from the beach or the mountains or, as is the case for most of my fellow countrymen, the Tuscan villa or the gite in France.

Meanwhile there is a huge crisis throughout Europe. About that I will not attempt to blog other than to suggest that, as a committed European but deep sceptic about the foundations of the eurozone, I am not the least bit surprised.

The EACT and the corporate community in Europe have their own treasury management crisis to handle. Actually the community has of course several to face but the one I am most preoccupied with today is the threat contained in the CRD IV proposals (already on the table) and the changes to MiFID (not yet published but due in the coming months). I blogged about this earlier and the threats I highlighted then have not gone away.
The EACT is sufficiently concerned about these threats that we are mobilising to produce once again an open letter to the EU Commissioners and others in Brussels. We have done this before; in January 2010 a similar open letter was signed by more than 160 European companies and I would like to think this acted as a catalyst for ensuring that a more sensible approach to the European regulation of derivatives (EMIR) has slowly emerged.

The focus of the new letter is not just on the risks that CRD IV and MiFID will undo all the good that was negotiated into the derivatives regulation through the corporate end user exemption. We particularly want the letter to highlight the continuing failure of Brussels to engage properly with the real economy in its approach to financial regulation. The voice of the financial sector has been powerful for too long, even if now seriously discredited in the eyes of politicians; this has encouraged what often looks like a blind eye approach to financial regulation, in which its impact on the real economy is relegated to become an afterthought.

In the US the Chairman of the Federal Reserve and the Acting Comptroller of the Currency have acknowledged that they cannot know the overall effect on the real economy of all the changes that are being made. I see no reason to expect the position in Europe to be very different. The real economy generates employment, drives the demand for productive investment and will always be critical to economic growth. The financial sector by contrast creates uncertain employment for many and has little interest in investment in good old-fashioned productive capacity. I won’t enter into the debate about the true value-added of much of the financial sector but you can probably surmise my views.

We are currently collating names for the open letter and I am hopeful that with the return from holidays underway we will have a powerful list capable of underlining to the Commissioners why a more open debate is still needed in Brussels on financial sector regulation.

We have now had (unofficially, of course) sight of the European Commission’s proposals in CRD IV for the future capital requirements regime for banks – the EU’s implementation of Basel III. We had always feared that Basel III would have the economic effect of making the use of non-cleared OTC derivatives economically unattractive, thereby discouraging the real economy from mitigating the financial risk (on currencies, interest rates and commodities) inherent in doing business. The wording of CRD IV confirms those fears.

The CRD IV proposal is due to be adopted by the College of Commissioners on 20 July. The wording of the proposal seems fundamentally flawed and an urgent campaign is now needed to underline this. The essence of this flaw is that CRD IV will, if enacted, penalise bank business in uncleared derivatives more highly than the equivalent business in direct lending. There is no logic to this. A further flaw appears to be that there will be greater reliance on active and liquid credit default swap (CDS) markets, whose use might reduce the impact on some companies of the higher capital requirements. In practice this looks likely to increase rather than reduce systemic risk. For those companies such as SMEs for whom there is no CDS market the implications are bleak.

I am indebted to colleagues for their analysis of the CRD IV proposals and will simply attempt to summarise the core argument. Banks use the concept of a Loan Equivalent Value (LEV) to measure the credit they are extending for any given financial product. Logically the capital requirement should be the same for any given level of LEV. Under the CRD IV mechanism there is no certainty that this will be the case. In determining the LEV a bank will have to look at a historic period of up to 500 days and run calculations that in effect take the highest CDS spread during that period, using a demanding 99% confidence level. For many companies this calculation will embody a much ‘worse’ credit assessment than their current underlying position justifies.

So we look as though we could be back where we began, with non-financial companies discouraged from doing the sensible and right thing, which is to use derivatives to offset some of the otherwise uncontrollable risks they face in doing business. Less hedging through derivatives means greater business volatility, reduced employment and growth. It’s as simple as that.

I received two files today. The first is the list of amendments being considered by ECON. This document runs to 42 pages and over 13,000 words. Presumably the members of ECON felt on top of all this content and took a considered view of each amendment as it was voted on. The second file is an EMIR mark-up incorporating the amendments that were tabled (at least, I think that’s what it is – a clear head and a large virtual desktop is needed to confirm); this file has 83 pages and 32,000 words.

So one hopes that the members of ECON have been earning their keep over the last days and done their homework with review of these two files. Good news indeed if they have managed to be so diligent.

Werner Langen said today that he would not start to negotiate with the Council on an agreement at this stage, indicating that the Council ‘was not ready’; a setback perhaps for the Hungarian Presidency but it is difficult not to be sympathetic. Parliament will now vote on a first reading of EMIR in the week of 4 July. Two scenarios can now be considered:
- Council fully accepts Parliament’s view of EMIR (ie what ECON has endorsed and Parliament later votes on); given the gaps between Council and Parliament this looks unlikely; or
- Council confirms its own ‘Common Position’ on EMIR and eventually reaches agreement with Parliament after a second reading – which could be as late as the first half of 2012.

In the meantime I understand that Commissioner Barnier expressed in ECON the wish that trialogues (the compromise negotiation between Parliament, Council and the Commission) ‘begin soon’ and that legislation on EMIR is passed as quickly as possible.

Time is needed to consider the implications of all that has happened today but one immediate thought: it looks to me to be even more true that rule-making on Dodd-Frank will play an absolutely crucial role in setting the outcome for Europe on EMIR, so long as regulatory convergence sits high on the G20 agenda.

You might well ask, how on earth can ESMA accomplish its difficult task to lead in the implementation of derivatives market regulation (EMIR, in Europe) unless it properly recognises three things:
- very material open issues in the implementation of the new regulation revolve around how non-financial end users should be treated;
- ESMA desperately needs good advice from those who are directly affected by the uncertainties (and potentially, the unintended consequences) of the new regulatory environment; and
- these markets would of course not exist were it not for the underlying risks being managed in the real economy by precisely those people who sought to sit on the advisory group.

I have to admit to being left almost wordless by what has happened. This seems to be a huge snafu on the part of the European Commission and ESMA. Of course, as in most sorry stories it actually gets worse. The background of the seven people appointed to ‘represent users of financial services’ are:
- an Italian trade association representing issuers (could be useful)
- a Portuguese ratings company
- a Spanish hedge fund
- EFRAG – an EU advisory group on financial reporting
- EFAMA – a European trade association representing asset managers
- a German bank (surely some serious mistake?)
- the Shell asset manager for its pension fund

Do we see the real economy – the widget manufacturers and service providers – in this list? Not at all.

To add insult to injury those selected to represent ‘financial markets participants’ are almost entirely drawn from clearing houses and exchanges, with just one banker (an ex-regulator) on this list.

It makes no sense to drag the real economy into financial markets regulation and then fail to invite a single treasurer to become a member of ESMA’s stakeholder group. Whilst that real economy, on which Europe depends for growth and employment, has never been the source of systemic risk it is profoundly impacted by the new regulatory environment.

Others have pointed out that in my litany of the areas of uncertainty I had neglected to refer to CRD IV and Basel III.  True.  I think I am personally starting to suffer from Basel III fatigue syndrome, coupled with intellectual laziness.  But that is not to say that the ‘win the battle but lose the war’ fear has gone away in any sense at all.

The major focus of the EACT, working with a number of large companies across Europe, is now on trying to improve the drafting of EMIR in the areas where the interests of the real economy are still at risk.  We aim to make input to the Hungarian Presidency’s ‘compromise text’, the latest version of which is available here.

The issues remain as I have previously described them: the production of a satisfactory definition of hedging to form the ground stone of the exemption; the treatment of intra-group transactions; the practical definition of time intervals to apply for the clearing obligation to be imposed – and lifted; and the circumstances in which exiting contracts could be forced into clearing if the threshold has been breached (the issue of ‘backloading’).

And over and above those issues we would strongly wish that the economic benefit of an exemption under EMIR for the real economy should not be undermined by other financial legislation, in particular in connection with MiFID and CRD IV (Basel III).

As seems to have been the case throughout the debate over EMIR (and before that acronym emerged), a key is the need to have as much consistency as possible in the positions being taken by regulators and finance ministries in France, Germany and the UK.  With 27 member states in the EU, these three are widely described as ‘the only ones that matter’ in this and other debates.  The encouragement we are hearing is to do our best to harmonise those positions through active intervention by the three country’s representatives in the discussions within Brussels.

The next few weeks will show whether all the above is as effective as we would wish.  A key date to watch now is 24 May, which remains on the table for the vote by the European Parliament’s ECON.  Many expect that this could be deferred – another indication perhaps of the wider uncertainty that still supports my doomsday scenario.

One scenario that is receiving little attention but which could just threaten the whole end-user exemption (from clearing and therefore margining) is emerging as a result of US moves.  We now understand that ‘FX swaps’ will fall outside the regulatory (mandatory clearing) scope of the Dodd-Frank legislation.  Whether or not this can be seen as good news might depend on your faith in the overall progress of regulation in Washington and Brussels.

An exemption for FX swaps is very much easier to promote (in the face of widespread and understandable discomfort with the complexities of the issues around the use of derivatives) than is the idea that ’hedging’ is somehow a wholly legitimate activity and one that should not be adversely impacted by new regulation.  This discomfort might not matter were it not the case that the whole campaign for an end-user exemption hinges (in my view) on the importance of safeguarding what well-run corporate treasury teams do routinely – which is to hedge and mitigate the impact of financial risk on business in the real economy.  This supports company viability, employment and growth…..all core ‘values’ that I and others have been pushing from the outset.

Hedging is difficult to debate with those for whom the concept is unfamiliar, with many wanting to suggest that hedging (as it is explained to them) is actually speculative; not a credible argument to those that accept that the essential purpose of corporate risk management is to reduce the quantum of uncertainty (risk) being faced.  But the argument easily gains traction.  So when the regulatory drafting of both Dodd-Frank and EMIR struggles with building suitable language around the definition of hedging, as the basis for the end-user exemption, we should be worried.

This difficulty is exactly what is being seen in Brussels and perhaps to a lesser extent in Washington.  We might be able to live with that, and indeed we as the EACT working with a number of corporates in Europe have been trying to help MEPs and the member state teams as they respectively go through EMIR amendment debate and Council working group drafting.

The real worry is that Europe is still grappling with fundamental areas in EMIR that lack definition, have a profound impact on end-users and are ‘sensitive’ in terms of whether the combined forces of the Commission, Parliament and Council are willing to leave them to ‘Level 2’ work rather than to settle now in Brussels.  These areas include:

-       ‘backloading’ – the extent to which the regulation could lead to what we describe as clearing shock, which is the need to put into clearing existing derivative contracts as a consequence of an end-user breaching the clearing threshold;

-       the very concept of a clearing threshold (which many of us criticised at the outset) is looking fragile and likely to be replaced by something more sensibly based on information and reporting – but this creates its own uncertainty;

-       intra-group and financing transactions – where the use of derivatives must be safeguarded as fundamental to corporate risk management.   Politicians and civil servants are suspicious of corporates – through lack of understanding – on this issue as well as on other ones.  Their fear of ‘loopholes’ leading to abuse is founded in this inadequate appreciation of how end-users manage risk but there is real doubt as to whether the final outcome will be sensible;

-       the treatment of funded, defined benefit pension funds, whose use of derivatives to manage inflation, longevity and interest rate risk is essentially the same as that of the real economy end-user; and

-       most fundamentally, the very definition of what transactions satisfy the core definition of hedging and therefore qualify for exemptions as drafted.  Here the politicians have flirted with international accounting standards as a test of hedging and despite many attempts seem unable to accept that such a test is incomplete and inadequate; as a basis for regulation accounting standards – changeable and impermanent – are (politely stated) flaky.

So here we have Europe struggling with EMIR and the US at risk of being seduced by the simplicity of an exemption for FX swaps (notwithstanding the very powerful, organised and successful corporate lobbying).  In the meantime the US timeline is coming under huge pressure and the original June 2011 deadline for Dodd-Frank implementation seems to be being pushed rapidly back to the end of 2012.

There is further confusion – at least for those not immersed in the US situation – from the proposals of a group of agencies including the Fed, the FDIC and the Comptroller of the Currency, that appear to open the door for imposition of mandatory margining on non-financial end-users.

So this is my doomsday scenario.  In the US the battle for a clean end-user exemption runs aground in the face of delays, conflicting and irreconcilable positions within the regulatory structure and political suspicion of anything that might be tainted with the banks that put us where we are in the first place.  In Europe there is great friction in the resolution process between the various EU bodies and at best some key points are lost by end-users; there is also unresolved conflict between definition in Level 1 or delegation to Level 2 authority.  The US takes the easy way forward and leaves end-users with just an FX swaps exemption.

Washington, the G20 and IOSCO put huge pressure on Europe to conform with the US and avoid regulatory arbitrage.  The EU heaves a sigh of relief and an amended EMIR proposal drops the concept of hedging as a basis for end-user exemption and conforms with an unacceptable (for the real economy) US implementation of Dodd-Frank.  We will see.

Of course even if the passage of EMIR through ECON (and therefore the European Parliament) is smooth there are the still the bear traps about which I’ve previously blogged to be overcome.  In short order these traps are the process of ‘trialogue’ in Brussels, the rule-making by ESMA and of course the final outcome on Basel III.

The amendments themselves largely address the primary concerns we and individual corporates have been arguing in Brussels and Strasbourg over recent weeks.  We want a sensible approach to what ‘objectively measurable’ means; avoidance of ‘clearing shock’ (backloading); recognition of group financing activities and intra-group activities linked with mitigating external risk; practicality in defining how the clearing obligation can be both incurred and shed; acceptance that certain types of pension funds (as in the UK, Holland and Sweden) need the same treatment as their corporate sponsors; and finally a commitment not to allow CRD IV (leading to Basel III) to undo the advantages of the treatment of corporates in EMIR.

Key dates now are the debate in ECON on 4 April and their vote on 20 April.  There is speculation that this timetable will be unachievable and from leafing through those 977 amendments I must – as suggested above – feel just a little sympathetic.

Trialogue only starts after the completion of the work in the European Parliament and as I understand it could prove either smooth-going or be contentious and political if there are real differences coming to the fore between the three EU institutions whose job it is to make the trialogue work – the Parliament, Council and of course the Commission.

And then we have ESMA – charged amongst all its other roles with the rule-making on EMIR.  At least the most senior appointments in ESMA have been completed.  In the EACT we look forward to working with the team as far as we can and of course contributing to the consultations that will be launched over the next eighteen months.

The outcome on CRD IV / Basel III is the most difficult one to predict.  It is clear to me that there is considerable sympathy in Brussels for the position we have argued – which is that CRD IV (in the first place) should not undo the good work of the corporate ‘exemption’ in EMIR by mandating punitive capital requirements on uncleared, bilateral OTC transactions.  I won’t repeat the arguments here about financial sector systemic risk – or lack of it – associated with corporate risk mitigation.  We will continue to try to influence the Basel III outcome.  I am however by now a slightly battle-scarred if usually optimistic veteran of influencing in Brussels; it is dispiriting to be advised by those with much more experience that Basel is a tougher nut to crack!

The position we are at now is the regulation (referred to by the acronym EMIR) is passing through co-decision in Parliament and Council.  I summarise below the timetable in Brussels but firstly it might be helpful to note the shape of EMIR as it is emerging from a huge amount of debate both publicly and privately.  The key points are:

- the initial concept of two thresholds looks likely to change and we will be left with a clearing threshold only – this is a simplification that we support

- the recognition that derivatives are essentially used by corporates to mitigate ‘risks directly relating to [the ] commercial activity’ is now embedded in the drafting and forms the basis for the exemption of contracts from central clearing – provided the corporate does not breach the ‘clearing threshold’

- the definition of the clearing threshold remains opaque and may be subject to further scrutiny in co-decision; after that it will be included in the rule-making work of the new securities regulatory body, ESMA (which has a key role in EMIR’s implementation)

- it appears likely that the principle there should be no retroactive application of the clearing obligation once a corporate crosses the clearing threshold will be accepted (but this remains a key issue so long as there is no certainty on the outcome).  The most favourable and right outcome here is that all contracts outstanding at the date of a clearing threshold breach remain outside clearing

- there is however a suggestion (in the latest set of amendments emerging from the Council working group discussion) that if the clearing threshold is breached then all contracts – including those that would previously have been excluded if they are mitigating commercial risk – will be required to go into clearing.  This is not good news

- it is self-evident that we as the EACT and  corporates in general should be seeking to work closely with ESMA as it tackles the detailed work of implementation

- pension funds may well still be caught within the scope of EMIR in respect of their use of derivatives, for interest rate and longevity risk in particular; this is not a good  outcome for corporates in those countries where pension funds are effectively underwritten by and a financial commitment of the sponsoring corporate

- convergence with the US (the Dodd-Frank Act) is still absolutely on the EU’s agenda.  This commitment – and the faster timetable for Dodd-Frank and the CFTC/SEC rule-making, even if delayed – drives an area of further uncertainty for EMIR.  The latest signs from the CFTC however do suggest that the position of corporate end-users is being seen with increasing sympathy

As part of the work of Parliament in the co-decision process the ECON Committee is due to vote on its ‘opinion report’ on EMIR.  The key dates in the run-up to that are:

28 February: second presentation of draft report (including translation)

15 March: deadline for amendments [originally planned for 15 February]

20 April: vote in ECON [originally planned for 22 March]

June 2011: vote in plenary

For the work we are doing as the EACT – with support from a number of corporates across Europe – it is most important that we focus on a limited number of amendment proposals and work with key MEPs on ECON to seek to have these adopted.  This will be our focus over the next weeks.

Meetings I have had over the last week in Brussels and Paris (home of CESR, which Cinderella-like morphs into ESMA on 1 January 2011) suggest that there are many bear traps set to disrupt and even derail what might have been assumed to be steady progress to implementation.  In no particular order these are on my mind:

1)  Will ‘extreme politics’ in Parliament threaten the regulation?  It has been seriously put to me within the Parliament building in Brussels that derivatives are entirely to blame for the crisis in food prices and their use by corporates lies at the heart of said crisis; so, ban all use of derivatives.  Reductio ad absurdum?

2)  Will amendments proposed by ECON (Parliament’s committee) push the corporate exemption away from its current favourable, albeit ill-defined, wording?  There is a degree of eggshell-treading going on at the moment; many of us fear that excessive focus on the loose ends of EMIR will rebound against the interests of corporates, with a narrowing down of the scope of the exemption ahead of rule-making by ESMA.

3)  Will Parliament (ECON) seek to reduce the scope of rule-making by ESMA by seeking greater prescription in the regulation before it is passed out of co-decision?  This is a variant on the point above and my concern reflects what has been said to me about a tension between the role of ‘Brussels’ (defining the regulation) and ‘Paris’ (CESR/ESMA writing the rules).  I should stress that so far as I know this is not a geo-political observation about the working of the EU but rather a fundamental concern over who writes the rules.

4)  Will the US through the implementation of Dodd-Frank preempt the work of ESMA and force convergence with a set of unfavourable (bad) rules?  The risk is clear: the CFTC in the US is doing the rule-writing for the relevant part of Dodd-Frank and must finish this within 360 days of the passing of the Act in Congress.  So by July 2011 the US work will be done, which means either that ESMA’s subsequent decisions will follow the US – to ensure convergence – or that Europe through ESMA will have to elect for divergence in at least some respects.  The good news – I think – is that CESR/ESMA is already working with the CFTC in an unofficial, informal capacity.  And on top of that there has for some time been an evident determination on the part of the Commission, Parliament and indeed now CESR/ESMA to keep convergence on top of agendas.

5)  Will ESMA recognize that key stakeholders in financial regulation extend beyond the financial sector itself and include end users of financial markets – the ‘non-financial counterparties’ in the derivatives arena?  CESR in its current form has at best a modest track record of inclusiveness; it is vital that ESMA establishes genuine conduits to consult and involve the end users, without whose underlying business risks there would ultimately be no derivative markets.

I write this just before attending a London symposium on EMIR at which Jonathan Faull will be speaking.  Jonathan is the senior civil servant in the Commission with responsibility for EMIR; it will be interesting to see how much comfort he provides  on these bear traps.

It is very likely that in the next few months we will want to use a similar letter again to the EU authorities, to provide added support for the approach proposed by the Commission and to argue that the benefits of the exemption route (the thresholds) should not be watered down in co-decision.  What follows is the text of an update email sent today to the companies that signed our first letter – it has also gone to a number of other companies that subsequently confirmed their support for our action:

“This e-mail is addressed to the companies who were signatories to the letter sent by the European Association of Corporate Treasurers (EACT) to the EU Commissioners in January of this year, plus a number of other companies that indicated they would support subsequent letters.  Our letter urged the Commission to take into account the unintended consequences of the initial proposals for the regulation of derivatives, which could have had a dramatic effect on the liquidity of non-financial companies and lead to a reduction in their risk mitigation activities.

The EACT has been working actively throughout 2010 to seek to influence the final outcome of the European Commission’s proposals.  Over the last few months we have received financial support for this from ten large European companies.  With this support we have been able to work with a professional advisory firm, which has made substantial input into our lobbying efforts.  We have of course submitted responses to the two rounds of public consultation; these can be accessed here.

In September the Commission published its regulatory proposal.  This includes a substantial exemption for non-financial counterparties, along the lines for which we have been arguing since the debate began in 2009.  There is however a significant amount of further work to be done, primarily to ensure that the outcome we now have from the Commission is maintained over the coming months during the extended discussions that will take place in Brussels.

During this period the proposals will go through the EU’s co-decision process involving the European Parliament and Council.  We understand that it will be particularly important to maintain contact with MEPs and a range of other Brussels officials.

There are two specific areas of concern in the next stage.  The first reflects the number of uncertainties arising from the Commission’s proposal, particularly in the area of the treatment of a company’s hedging contracts in the situation where an organisation moves into or out of the scope of mandatory central clearing.

The second area of concern reflects the key role that the new European Securities Markets Authority (ESMA) will play in the detailed implementation of the new regulation.  The Commission’s proposals delegate a substantial area of responsibility for this to ESMA and we have already expressed our hope that the organisation will take into account the concerns of non-financial counterparties as well as those of the financial institutions.

It is important also to note that above and beyond what is happening in the EU there is the continuing threat that the new Basel III capital regime will be used punitively with respect to banks’ non centrally-cleared derivative transactions.  The EACT has argued and will continue to do so that it is inconsistent regulatorily to allow an exemption but then make it unattractive for companies to benefit from this because of the pricing applied by banks.  This argument is made in the context of the absence of any evidence that the non-financial sector is a source of systemic risk.

The EACT intends to continue to work with the group of European corporates that have supported our efforts so far by providing funding.  So that we can again involve a professional advisor we will seek to raise additional funding and that is now underway.

At some stage it is likely to be sensible to organise a further letter to the relevant authorities in the European Union, along the lines of our original letter in January.  In that event I hope that the EACT and the national treasury associations will be able to ask you to confirm that your company’s name can be added to the letter.  I cannot overstate how important it is to show widespread support across both large and small companies in Europe.”