Derivatives’ regulation: unworkable thresholds and goodbye to global convergence?

June 16, 2010

The more I reflect on the derivatives’ regulation consultation – which is on the European Commission website and open until 10 July – the more starkly I see the issues from the standpoint of non-financial end users.  I think we are faced with two fundamental challenges: are the ‘thresholds’ workable; and what happened to global convergence?

The ground is probably familiar by now to most.  The European Commission wrestled with its conviction that end users create systemic risk and set about addressing that with its proposed two threshold levels.  The first (the ‘information’ threshold) triggers what I have frequently characterised as the friendly chat with your local regulator.  Presented with the evidence that derivatives are being used consistently with the company’s policy of risk mitigation, one assumes that the regulator’s nod will be given and the company will continue to use derivatives and to remain outside central clearing.

If the higher (the ‘clearing’ threshold) level is reached then the company concerned will be ‘subject to the clearing obligation for all [their] eligible derivative contracts’.  Now there are huge question marks over the missing detail, such as:

– what is the quantitative measure to be used in setting these two thresholds: notional outstanding (nonsense); or mark-to-market values (could be relevant); or potential future loss (could certainly be relevant)?

– are non-financial end users really equipped to provide data relevant to the thresholds?

– does ‘all’ mean all – or just the relevant asset class?

– will ESMA and the national regulatory bodies be capable of handling the data and the consequences of threshold levels being reached?

– what is the position of regulated financing subsidiaries of non-financial end users?

– how will inter-company derivative transactions be treated?

The EACT and the corporates with whom we are working on a response to the consultation need to grapple with these issues.  We will be trying to do so.

And what happened to global convergence?  Although in the US the reconciliation of the House and Senate bills is now underway (with the mysterious title of ‘conferencing’), there seems to be a degree of certainty as to the shape of the US approach.  This will not involve the use of thresholds but instead rely on what looks like a broad non-financial end user exemption.

Given that, one has to ask the European Commission – which I have previously praised for being open and prepared to listen – why the EU should persist in diverging from a seemingly sensible US approach.

The answer I fear lies in our old friend – however irrational and unsupportable you and I may believe this is – systemic risk.  Brussels refuses to leave the regulatory stage (passing implementation to ESMA) without its last throw of the dice to corral that risk.  It is setting out to do so with a mechanism that is at worst unworkable from the start and is at best a gift of a poisoned chalice to ESMA.

So we have a difficult decision to take.  If one or both of the challenges posed leads us to the conclusion that the concept of thresholds should be resisted, we need to decide to mobilise a very effective response to the consultation, with the ambitious goal of persuading the European Commission that they have just got it wrong…..

3 Responses to “Derivatives’ regulation: unworkable thresholds and goodbye to global convergence?”

  1. Donald Ricketts Says:

    Fully agree Richard – devil in the detail – and we have to await that well beyond Sept publication

  2. Edmund Lakin Says:

    Interesting to note the speech by Cecchetti from BIS last week in which he references end users. This certainly rings true with the concerns you raise on Basel III rules.

    “Current draft legislation in the United States and the European Union requires important financial institutions to trade through CCPs, as is recommended by the group. But end users could be exempt. The argument for the exemption is that, if end users have to use central clearing, they will have to post more collateral, which would drastically increase their cost of using derivatives for risk management. The result would be too little hedging.

    There may be something to this. But the argument implicitly assumes that end users (such as Bombardier in the example I gave at the beginning) are not being charged for the credit risks that their counterparty takes on by not asking for collateral.

    I find it hard to believe that banks do not charge their clients for the services they provide. Just as retail clients pay banks for their free checking accounts in one way or another, I have no doubt that end users are already paying for the services they receive. In fact, bankers are known to derisively refer to these services as “fee checking accounts” because of the hidden nature of the charges. What is true in checking is surely true for derivatives. That is, banks are surely compensated via prices, higher bid-ask spreads or higher costs for other services provided by the bank. Because of the opacity of the OTC market, it is very difficult for end users to know what they are actually paying.

    In my view, end users wrongly perceive central clearing houses as being more expensive than the current solution simply because (i) CCPs allocate costs directly to the services provided and (ii) CCP costs are transparent.”

    • The fundamental error in Cecchetti’s argument is that even if it can be shown that there is an unreasonable credit charge the impact of this is immaterial relative to the liquidity risk that arises if transactions pass through a CCP. The risk is there because of the initial and the unquantifiable future cash requirements in collateral calls. Let’s hope the BIS looks more carefully at the debate.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: