After the leaks……a ‘final’ EC proposal on regulation and cause for celebration

September 15, 2010

So now we have it – the EC ‘final’ proposal on derivatives is out after at least three drafts were widely leaked and seen by us and many others over the last two weeks.  In the document there are comprehensive and reassuring statements about the status of corporate end-users.  The explanatory memorandum includes these key words:

As regards non-financial (corporate) counterparties, they will in principle not be subject to the rules of this Regulation, unless their OTC derivatives positions reach a threshold and are considered to be systemically important. Because their derivatives activities are generally assumed to cover those derivatives that are directly linked to their commercial activity rather than speculation, those derivatives positions will not be covered by this Regulation.

If we try to stand back what should corporate end-users now be thinking about?

The first thing to note – for the record – is that we have come a huge distance since I first became involved for the EACT in this issue, back in July 2009.  At that time I was firmly told by the European Commission that corporates would be required to centrally clear their OTC derivatives transactions – and indeed that these would be standardised so far as possible.  Much of that has now been fully reversed by the EC and this self-evidently testifies to the success of the campaign we started.

Before the celebrations overwhelm us I should sound a first note of caution.  What we have today must still be passed through the European Parliament and the Council.  I have no real feel for how much could be at risk here – although we surely have a firm foundation in that we are now looking at a proposal that meets one absolutely key test, that of broad convergence with the US (Dodd-Frank) approach.  But there will be opposition, at least in Parliament, as I have seen there at first hand some of the emotion surrounding the politicians’ interpretation of what companies ‘get up to’ in their use of derivatives.  That much of this emotion is founded in a combination of little or no understanding of an admittedly technical area and of what looks alarmingly like doctrinaire and dogmatic political prejudice, is relevant but will not help us.

A couple of other key things to say at this early stage.  We are worried by what we can call a ‘clearing shock’ – which will arise under the operation of the proposed clearing threshold as and when a company breaches it.  At that point all – and this means all – eligible contracts will have to go into central clearing.  Such an event could trigger a substantial cash drain on the company concerned, depending of course on the mark-to-market position of the contracts.  Crucial here is the definition of ‘eligible contracts’ and as I read Article 7.4 of the regulation there is an exclusion for all ‘contracts entered into by a non-financial counterparty that are objectively measurable as directly linked to the commercial activity of that counterparty shall not be taken into account’.  A lot will hang on how the implementation of the regulation addresses what is meant by objectively measurable.

The second point that needs to be said is one we have been flagging for some while now.  The major burden of implementing the new regulation will fall on the new European securities regulator, ESMA.  We expect this to be a major challenge for the organisation; we will be looking to make as much input as possible to the process and will be vigilant in ensuring that ESMA meets the requirement of consulting widely – and not just within the financial sector.

But for now a modest celebration is called for!

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