The real impact of derivatives regulation: time to challenge ESMA with the realities?

ESMA invited comments on the technical standards for reporting under article 9 of EMIR. I sense that amongst corporate practitioners there is a profound sense of weariness – a weariness borne not just out of the volume of work created for them but also the sheer frustration of dealing with the uncertainties and inconsistencies that dog the implementation of at least the trade reporting aspects of EMIR.

That volume of work is incidentally (and in my view) contributing neither to the greater good of treasurers, their employing organisations nor I suspect regulators.

But the EACT does not allow itself to become weary and in our response to ESMA we make two fundamental points: that there should be sufficient lead time to implement future changes in reporting requirements; and that reporting should be focused on areas of increased inherent risk and exclude transactions that are not systemically risky.

On the first point we highlight the problems caused by the rule changes and adaptations that are still being made. We argue for a stop to future large scale reporting changes, for proper time to allow trade repositories to test enhancements etc. We also stress that new reporting requirements should apply only to new transactions and not to those previously reported but not reconciled.

For the second point we return to the core issue of the need for an EU wide exemption of intragroup transactions and for clarification of the scope of an FX derivative to exclude FX contracts used for commercial/hedging purposes by corporates.

The elephant in the room here is of course the question as to whether the panoply of derivatives regulation as applied to corporates (ESMA’s non-financial counterparties) is actually contributing to a reduction in systemic risk linked to the financial sector. Since the beginning of the regulatory tsunami in 2009 I have argued that the proposals for derivatives were fundamentally misguided to the extent that civil servants, politicians and regulators believed that the corporate sector is a real source of systemic risk.

All of which brings us to EMIR v2. I’m sure there will eventually be an EMIR v2 even though it is already behind schedule. The EACT’s shopping list will include the exclusion of intragroup transactions, a switch to one-sided reporting and above all a better coordinated and consistent global approach. One can only dream.

ESMA’s stakeholder involvement – time to challenge?

Since the establishment of ESMA treasurers have been trying to get representation on the various stakeholder groups that ESMA operates. You might reasonably expect that end-users of the financial system, the non-financial counterparties of EMIR’s language, should be given appropriate stakeholder involvement. Senior corporate treasurers have since 2010 regularly applied for membership of these groups; we have been consistently rejected.

Early in the life of ESMA I raised this issue with its newly appointed chair, Steven Maijoor. I came away with the strong impression that he felt that in the approach to stakeholder involvement errors had been made and that under his stewardship this would change. Regrettably there has been no change, as exemplified by the most recent appointments to the Securities and Markets Stakeholder Group (SMSG).

We are so frustrated by this failure of stakeholder involvement on ESMA’s part that we have now launched a formal complaint to the European Ombudsman. I am in new territory here and we no doubt face a lengthy and possibly unsatisfactory process. I am however convinced for at least two reasons that we should go down this route: firstly, we should never relax our focus on the failures in Brussels and elsewhere to take proper account of the role of the real economy as end-users of the financial system; and secondly, it must always be right to shed light on some of the more absurd outcomes of EU governance – especially so if it proves to be the case here that EU political correctness rather than logic has driven the approach to stakeholder involvement.

In the last round of appointments to the SMSG, of the 30 members four were described as ‘consumers’ and five as ‘users of financial services’. Closer examination however shows that under the latter category there are only shareholder association representatives – and an additional consumer representative. No other users of financial services were successful. Ten ‘financial market participants’ were appointed but amongst these there are no representatives of purely non-financial companies. This is the pattern that we have consistently experienced with ESMA stakeholder group appointments.

The substance of our case is that ESMA has failed to ensure the balanced representation of stakeholders as required by the provisions of Article 37 (2) of Regulation 1095/2010, which established ESMA. By rejecting all the applications from non-financial counterparties and corporate treasury representatives ESMA is disregarding a relevant stakeholder group. We reference the relevance of these applications in the context of the use made by the real economy of the financial system and its inclusion within the scope of recent EU financial services legislation.

We also refer to the Ombudsman’s decision on a related complaint made against the European Banking Authority (EBA): in essence this outcome supports our view that ESMA is at fault (and has repeatedly been so) in not ensuring that there is any representation of non-financial counterparties within the category of users of financial services.

Why go down this route? For me it is the familiar tune that has been a recurring theme through all the post-crisis story of financial regulation. Too often the role of the real economy as a user of the financial system is at the outset neither understood nor given proper focus by the legislators and regulators.

EMIR – and to think that we are just beginning……

After being heavily involved from the beginning in the lobbying over what became EMIR in Brussels, defending corporates’ use of derivatives for hedging, I thought that with the adoption of the Regulation and the Regulatory Technical Standards the biggest hurdles could have been behind us. As the reporting start date of 12 February came closer it however became clear that the EMIR saga was far from being finished and that there were still some chapters in reserve. It seems that despite the year and a half since the entry into force of EMIR nobody was really ready for the reporting: ESMA, national supervisors, trade repositories, banks and non-financial counterparties still had far too much to digest on their plates at the eve of the reporting start date. Words like “mess” and “chaos” predominated in the way corporates described the outcome.

Finding the culprit will not help the corporates struggling with ongoing implementation issues but some general reflections on what went wrong might serve for the future.

Firstly, it is quite clear that 90-day lead-time to reporting start from the approval of the first trade repositories simply disregarded realities and was far too ambitious to allow for a smooth implementation. One of the main issues reported by our members has been the readiness level and the consequential technical and other difficulties of the actors they depend upon, i.e. trade repositories and banks. Also, and not surprisingly, in many cases non-financial counterparties concluded that they were not being given the same level of attention (or priority) as financial counterparties.

Secondly there seems to be a fundamental disconnect between the post-crisis objective of financial system supervisors globally – for which meaningful and standardized data is needed to allow them to keep a watchful eye on risk concentrations and therefore financial stability – and the willful leaving of so many aspects of EMIR unclarified and of course unharmonised. The list is lengthy: the lack of consistency and guidance from ESMA on key reporting elements such as the UTI (where issuing some form of guidance the evening before the start of the reporting can hardly be qualified as helpful), as well as the recent awakening by ESMA to the absence of harmonisation of the definition of derivatives that are subject to EMIR. ESMA’s lack of engagement with non-financial counterparties as financial service users is a whole issue in itself but it has become clear that equipping the parties subject to the reporting obligation with the necessary tools for compliance has been very low on ESMA’s to do-list.

As I write most corporates are still trying to solve multiple issues on reporting and will be doing some for the months to come. At the same time most of us continue to wonder what contribution to financial stability many aspects of EMIR will really make; and we find no less than mind-boggling the prospect of supervisors drawing any meaningful conclusions from the mountains of irrelevant or barely relevant data being reported to them daily by non-financial counterparties.

Right now from corporates’ perspective the cost of implementing and running reporting under EMIR compared to the parlous benefits that all this will bring is simply enormous. Corporate treasurers would be particularly keen to see the two-sided reporting obligation disappear, the reporting on intra-group trades dropped and FX forwards contracted for commercial purposes move outside the scope of the reporting obligation. The recent request from ESMA to the Commission to clarify exactly which FX derivatives are in scope seems to have opened the possibility for the policy-makers to move EMIR into a more reasonable and business-friendly direction; but it remains to be seen whether this opportunity will be used by the Commission. The EACT would naturally favour excluding from the reporting obligation FX forwards that are risk mitigating; such a move would especially benefit the smallest companies that find themselves subject to EMIR reporting. We look forward to the inevitable and necessary reassessment of EMIR, at which time the EACT will again be forthright in highlighting to the regulators why there continue to be so many failings in the current approach. But then that is where we started in September 2009; and look what a battle it was just to get to where we ended up.

And we thought the CVA exemption was safe…..part II

I blogged a couple of months ago about the future of the CVA exemption within CRD IV/CRR – the EU implementation of Basel III.  I was flagging concern about the attitude of the large US banks and the pressure being exerted by them on their trade association (SIFMA), on the US Treasury and through both these channels on the BIS.

I wrote in the name of the EACT to JPMorgan seeking reassurances that the bank was not seeking to “kill” the CVA exemption.  You can read my letter here.  The reply from the bank is available here.  The bank‘s corporate customers will I am sure decide for themselves whether they feel comforted by what is said.

Whatever the pressure from the US banks there are undoubtedly reasons to worry about the future of the CVA exemption.  Buying into the theory that smoke is generally linked with fire, we hear stories suggesting that central bankers in a number of key countries are unhappy with the [favourable] treatment of uncollateralised bilateral derivative contracts.  it seems an age ago that we were making the arguments about focusing on systemic risk and encouraging regulators to recognise that non financial companies do not of themselves create systemic risk within the financial system.  Maybe we need to promote the same debate one more time.

More encouragingly, I understand that Brussels is ‘solid’ on the CVA exemption, even if it never had the support of the European Commission.  Equally clearly there are good grounds for believing that pressure on Europe from the US (through Basel) will fall on barren ground.  Such pressure would be seen in the context of the apparently large area of disagreement (outing this politely) that exists between Washington and Brussels on the next but crucial issues around extraterritoriality and global consistency in derivatives regulation.

So the real risk for the CVA exemption must be that the central bank community seeks to impose a purist implementation of Basel III.  Watch for signs of fire and not just smoke.

Financial Transaction Tax: I should have seen what was coming

My letter to the Financial Times on 22 May produced a modest firestorm of response in letters to the paper.  I guess I should have been prepared for that: when I gave evidence to ECON in the European Parliament back in February 2012 I was assailed from all corners with hostility, with the three other speakers being vehemently in support of the original proposal (for an FTT in all 27 Member States).  The MEPs in the chamber seemed in denial by political dogma, prejudice or whatever; and nobody was willing to support any of the concerns that I was highlighting over the real economy impact.

How greatly things have changed since then.  There’s much wider acceptance that there are profound problems with the nature and the implementation of FTT.  I feel much less isolated in expressing the views that we hold in the EACT.  But the reactions now to my FT letter seem to reflect a reanimation of some of my old demons.

I had said: “…[FTT’s] avowed aims – to seek some recovery from the financial system for the taxpayer costs of the crisis and to discourage non value-added transactions – are ones with which the real economy has some sympathy…”.  I’m not sure I could have pinned my personal feelings more overtly to the mast.

Lord Myners – for whom I have huge respect – wrote in response on 28 May that “…Richard Raeburn misses the point. There is no evidence that high levels of equity trading bring any benefit to investors or corporations; indeed a great deal of evidence, including the performance over longer time periods of passively managed funds versus most actively managed diversified portfolios, suggests the reverse”.

In fact I entirely agree with Lord Myners and my personal money is where my mouth is – I pursue a passive investment strategy.  But in the letter I was neither directly nor indirectly linking FTT to this important issue.  For the real economy there is plenty of credible evidence to show how the tax will substantially raise the cost of derivatives and of financing.  The underlying activities giving rise to the need for derivatives and financing are nothing like as controversial as is active trading by investment managers – indeed they are central to what companies need to do to reduce financial risk and assure the supply of liquidity for fixed and working capital investment.

I believe that the way to cut the active trading by investment managers that generates little or no real value for those carrying the cost is to work harder to demonstrate the case for passive strategies.  I don’t think that the passive trading argument is sufficient in itself to justify the implementation of FTT.

On 3 June 13 Sharan Burrow of the International Trade Union Confederation wrote to say that “…Politicians, we are told by Richard Raeburn, have backed “a monster that threatens their children. In Europe, the monster is not the FTT. It is the oversized and subsidised European banking sector, which populates more than half of the official Group of 20 “too big to fail” list”.

Of course I wasn’t commenting on the banking sector and, probably much to Ms Burrow’s surprise, I actually agree with much of her core sentiment.  But FTT is neither sufficient nor necessary to get everyone to address the fundamental and still unresolved issue of the monstrous problem of banking.  I’m with Ms Burrow in believing that this is of huge concern and that the EU and governments generally have still not adequately addressed how to protect the taxpayer, with its generational burden from the crisis and that threatened by further crises.

In my view the real argument against FTT still remains intact: this is a tax that will largely not be paid by the financial sector but will be borne by all of us – companies, individuals, pension funds – who must deal with that sector as it is now.  I’m aligned with Lord Myners and Ms Burrow in wanting an economy in which non value-added activities in the financial sector are discouraged and where the taxpayer will not stand yet again as bailer-out of last resort for poor management within excessively large banks.

A refined and much better focused FTT that addresses these legitimate aims would be far easier to support and must be the safety route for the politicians who (foolishly, I would argue) jumped on the bandwagon of the Robin Hood Tax.  In this new FTT it should be a given that the burden of the tax remains, so far as this can ever be possible to guarantee, within the financial sector.

And we thought the CVA risk capital charge exemption was safe…..

If anyone ever cares in the future to write the history of the extension of financial regulation to the real economy – so clearly best selling material – it will I hope be remembered how much of a volte-face the EU policy makers performed. At the outset, in the summer of 2009, the official position was adamantly that there would be no special treatment for non-financial users of derivatives. We fought and won, always remembering that our victory in battle could be overcome by the loss of the war.

That war was of course Basel III and its European incarnation, CRD IV / CRR. Funnily enough we won the war as well, especially once we secured support in the European Parliament for the extension of the EMIR exception principle to the CVA risk capital charge in CRR.

So there we are; or at least we think we are there. There are troubling signs of a major pushback in the United States against the CVA risk capital charge exemption. The stage it would be unfair to focus on individual banks; that may come later. What we do know is that the investment banks’ US trade association, SIFMA, has written to the Secretary of the US Treasury. The letter is diplomatically worded but its intent is fairly clear. SIFMA states:

“While we share the concern that the CVA is incorrectly calibrated and in need of major revision, this action is a significant deviation from Basel III and the G-20 principles of uniform application. Not only is this exemption inconsistent with implementation of the Basel III standard, it has the knock-on effect of placing non-EU banks on an unlevel playing field with EU supervised banks…..

We would respectfully request that you raise with the EU that this difference in regulatory treatment runs counter to the Financial Stability Board’s and G20’s stated objectives of promoting internationally coordinated and consistent implementation of its regulatory action plan.”

I believe that the US banks want to kill the CVA risk capital charge exemption as soon as possible. They may be right about the failings in Basel III; but this argument looks like a Trojan Horse masking the real issue, which is about the ability of US banks to compete with other international banks.

Why has the CVA risk capital charge exemption so royally irritated the US banking community? And why is that community so belatedly trying to appear on the side of the good, when it neglected Basel compliance for so long?

Some elements that I have pieced together all revolve around our maligned ‘friend’, the CDS market. My personal, lay understanding is as follows:
– banks can manage their CVA exposure by taking CDS positions
– the CDS market for corporate names is substantially more developed in the US than anywhere else – and the limitations of the market other than in the US severely restrict the ability of banks to hedge the CVA exposures
– compounding the advantages for US banks, they have been, over the last decade, at the forefront of the development of risk management of CVA, e.g. by using CDS

How should we respond to this? Whilst this is still work in progress, my view is that we need to bring the debate fully out into the open (see Financial Times “JPMorgan Under Pressure in Basel Spat”) and make sure that there is real transparency about the issues and the objectives of the major players. We have started that process but there is more to be done before we can have any confidence that the CVA risk capital charge exemption is indeed safe.

Financial Transaction Tax: will the politicians ever get it?

I’ve been spending too much time recently thinking about the financial transaction tax (FTT), the proposal for which is rumbling through the Brussels process under the enhanced cooperation rule. What the latter means is that at least nine member states must be behind a proposal for it to be implemented. At present there are 11 and one of the interesting points to muse on is whether there could actually be at least three member state defections. Metaphors about rats and sinking ships might spring to mind but they would be inappropriate.

I am suffering quite strong pangs of déjà vu, having looked back at the testimony I gave to ECON in the European Parliament in February 2012. The arguments I tried to make then are now being much more widely heard. I suggested that this was a taxation proposal that falls wide of the mark, in that the economic burden will in fact be borne by consumers and the real economy rather than the banks. I was at pains to stress that the core political objective, which then as now is to recover for the taxpayer some of the cost of bailing out the financial system, is one that I and almost everybody must consider reasonable and right. The only problem of course is that the tax fails to make the banks pay. This is all very reminiscent of the much more recent realisation that bail-in has to be a necessary part of saving banks.

Tomorrow evening I’ll be participating in a seminar in Brussels to discuss FTT. Unlike my appearance at the European Parliament, when I was surrounded by so much political hostility that I seemed to be in a minority of one, the audience tomorrow should be much more friendly: it is largely made up of representatives of member states that are not FTT enthusiasts. The even better news is that Germany (an FTT supporter) is to be well represented, which is encouraging as that member state must surely be one where common-sense could still prevail (if the little local difficulty of impending elections can be overcome).

Pondering the FTT issues, one nuance rather amuses me and I thought it worth recording.

The political grandstanding around FTT makes the argument about payback from the banks to recompense taxpayer costs. A laudable objective and as implied above, one that I essentially support. All except the banks will pay for FTT and in practice this means all of us, including our pension funds. Do I exaggerate? Maybe just a little, but surely neither the banks’ shareholders nor their employees (through salary and bonus) will carry the cost of the tax.

Amidst all the fire and brimstone associated with political debate about FTT, what the politicians have chosen to overlook is what is arguably a much more serious aspect of the banking system. That is that much of the economic behaviour of banks looks distinctly oligopolistic. I’m sure that most individuals would agree that they are subject to a less than truly competitive market in their dealings with banks. And companies too most often feel that their broader business relationships with banks – whilst often valued and supportive – are perhaps characterised by a lack of true competition. Less self-evident perhaps during those glory days when markets such as London were absurdly over-banked.

A further nuance in this situation is that if the FTT proposal is implemented, it will surely do considerable damage to the business models of FTT zone banks, as well as potentially to all banks within the European Union. So far from implementing a strongly based taxation model that will generate the recompense sought by the politicians, the outcome could be a tax carried by the banks’ customers, enfeebled EU banks and a stimulus to the rest of the world watching with considerable glee as a purely political agenda is pursued here in Europe.

So ECON went and did it: what should the real economy be thinking?

The vote in ECON, in effect rejecting ESMA’s rule drafting for EMIR, is still puzzling many of us. We began with a scratching of heads – from where had come this rather belated push by ECON to protect the interests of the real economy in derivatives regulation?

One cynical answer that has been volunteered to me is that it was primarily a result of aggressive lobbying by ISDA and AFME – the usual suspects, some would add, and not the sort of company that the real economy naturally welcomes or feels comfortable with. And in the next breath the energy companies are mentioned.

That the energy companies have been lobbying hard should not surprise us. These are the companies most affected by the single most egregious piece of drafting by ESMA, which removes the exemption from clearing once a single asset class threshold has been breached. The politicians and lawyers can be left to decide whether in doing so ESMA exceeded its mandate in the Level I legislation. But the asset class breach rule is the one area with which we should be really concerned and grateful to ECON for their resolution.

The next puzzle is over where we go next. There are two stages here. Firstly, we need to see whether Parliament votes through the resolution; we will have the answer on this by tomorrow afternoon. The second stage – assuming that there is sufficient support for the resolution – is described to me by old Brussels hands as ‘uncharted territory’. So no easy signposts there.

The stance of the EACT is becoming clearer:
– we think that ECON has raised real concerns, especially so with the asset class breach rule
– but we have no interest in seeing the whole fabric of ESMA’s rules being put back into the melting pot
– implementation delay, whilst bad for global regulatory progress, may be seen as less bad given the lack of proper preparation for implementation

If we can help Brussels unscramble its somewhat unfortunate mess we would be happy to do so! But first of all let’s see what happens in Parliament tomorrow.

The EMIR confrontation between the European Parliament, Commission and ESMA

I blogged previously on the challenge from ECON in the European Parliament to the detailed rules drafted by ESMA for the implementation of EMIR. Since then a huge number of emails and draft documents have flown around; it’s a real struggle to keep track of who is trying to achieve what – quite apart from speculating as to what might be the outcome.

Maybe it’s time for some home truths. As an amateur observer of the Brussels scene but one with a commitment to fight the corner for the ‘real economy’ in highlighting short-sighted financial regulatory proposals, I note the following:

1 – There is a significant element of ‘politics’ in this, even if the motivation is I believe largely non-partisan. I’m told that members of ECON are determined to flex their muscles vis-à-vis ESMA and therefore the Commission.

2 – However the MEPs have done their homework and should be credited with this. They argue through the amendments that ESMA has gone beyond its authority from the Level 1 content of EMIR. The chair of ESMA, Steven Maijoor, vigorously denies this in a letter he wrote on 28 January to the chair of ECON, Sharon Bowles – insisting that the drafting for which he is responsible is ‘in line with the Level 1 text’.

3 – Maijoor’s letter (equally vigorously) insists that there is a coherence and balance within the ESMA rules as they impact non-financial counterparties; so his challenge back to the MEPs seems to be that if you reject one rule (such as the use of gross rather than net positions) you are putting back into play all the other rules – the equilibrium will have been upset.

From the standpoint of non-financial counterparties does this spat between European institutions – if that is what it really is – matter greatly?

I would argue that the answer may be largely no – it matters not greatly.

There is one exception to this and that is with the rule on asset class breaches. We and others argued from the outset that it would unhelpful to have the clearing obligation triggered across all asset classes in the event of a single class breach. ESMA disregarded this and wrote the rules in such a way that one breach puts all the entity’s transactions into clearing. The ECON amendments include the challenge that this is in breach of Level 1. Maijoor’s letter to Bowles rejects the challenge, insisting that the approach is consistent with Article 10(3) of EMIR.

The less than veiled threat within Maijoor’s letter is that non-financial counterparties will be worse off (through more restrictive rules) if the coherence and balance of what ESMA has drafted is upset through Parliament’s rejection of the detail.

This should be of concern. But it has to be said that for the great majority of non-financial counterparties such a change would be largely irrelevant. The good news is that ESMA’s drafting – and the content of EMIR – allows for sensible recognition of legitimate hedging (risk mitigation) by corporates and excludes such transactions from the clearing obligation. So long as that fundamental approach remains intact, which it surely must do, non-financial counterparties should be relatively relaxed.

The exception to this relatively relaxed view of the current shenanigans between ECON and ESMA is of course the group of corporates with a combination of conventional treasury risk mitigation and of trading activities (the energy companies, most obviously). For them the asset class breach rules become much more relevant and for that reason if for no other I continue to believe that this is the single ‘hot’ issue in the current debate.

Is the European Parliament really challenging EMIR?

A Reuters story today by Huw Jones is fascinating as much for what it does not say as for what it does. In essence what is being reported is that the European Parliament may be preparing to reject some of the EMIR rule-making by ESMA. The story revolves around the interests of the real economy and the effectiveness of the exemption under EMIR from central clearing. There are references to fuel hedging by airlines, to there being a view within the Parliament that the clearing thresholds have been set too low and to the single asset class breach triggering clearing for all asset classes.

Some of us started to argue over three years ago that there should be an exemption for the real economy from the proposed regulatory approach on derivatives; at the beginning of the campaign we were opposed by every institution from the CFTC in Washington to the Commission and Parliament in Brussels. Whilst I will always be the first to recognise that the latter two were – to their credit – eventually prepared to listen and to change their positions, a huge amount of time and energy was spent to get us where we are today.

With the key exception of the asset class breach rules I consider the outcome in EMIR and the rule-making by ESMA to be essentially sensible and reasonable. I have no idea who is leading this initiative in Parliament – and the Reuters sources are of course anonymous. It would be mealy-mouthed to respond with a sigh, suggesting nonetheless that better late than never can still apply; but it would have been so much better if the EU institutions as a whole had been as sensitive to the interests of the real economy when they started to develop the original EMIR proposals.

We are where we are and I for one would rather that we could now move on to focus our energies on the various other financial regulatory initiatives that have implications for the real economy. Were it not for the continuing concern over the asset class breach rules I would consider debate over the arithmetic level of the clearing thresholds to be of academic interest only. Legitimate risk mitigation through derivatives was never intended to be caught and counted against any clearing threshold. But the issues around asset class breaches do complicate things and it would have been so much better if ESMA had been able to take on board the concerns expressed to them.

We’ll have to watch Parliament carefully, not least because the real economy seems to have some unexpected friends there. So what Reuters reports is probably good news even if its substance will surely mean that the whole implementation process of EMIR is even more protracted.