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.


Very interesting developments in the long-running saga of the Basel III implementation within the EU – our old friends CRD IV and CRR. The EACT and many corporates have been arguing that it is illogical and unhelpful to allow CRD IV/CRR to override economically the value of the corporate exemption under EMIR. The issue is specifically over the application of CVA, which in layman terms means how much additional margin is charged on uncleared bilateral OTC derivative contracts, to allow for the higher capital requirements proposed under Basel III and CRD IV/CRR.

When we started to argue that the EU should modify its implementation of Basel III we received essentially the same response that we had faced when we first started lobbying on the derivative regulations. That amounted to a polite (or on occasions, slightly less than polite) suggestion that we take our ball and go away and play elsewhere, as we were wasting our own and everyone else’s time. Naïvely or not we and others have persevered on both issues.

From the outset our argument on CRD IV/CRR has been that there should be a read-across exemption from CVA for EMIR exempt contracts – the economic effect of which would be to make it no more disadvantageous to benefit from the exemption. The first success was to obtain the support of ECON within the European Parliament. Since then the work on the proposals more or less disappeared into the mire that is officially described as ‘trialogue’; the latter is a process that often seems either extremely high-minded and democratic but sometimes looks to outsiders as crude nationalistic horse-trading at European level.

What I have been hearing in the last couple of days is that under the Cypriot presidency we are making real progress to obtain the read-across exemption for which we have been arguing. This is extremely good news for the real economy, even if there is a sting in the tail. That sting arises because the current proposal by Cyprus is to define the exemption in terms of whether or not the underlying transactions qualify for hedge accounting. In other words, the corporate would not be able to rely on the wider (and more sensible) approach under EMIR; that approach uses the test of whether a transaction is “objectively measurable as reducing risk”.

This is somewhat frustrating to see hedge accounting being brought back onto the table. On EMIR we had to argue early in the process that hedge accounting should not be the necessary condition for an exemption. Quite simply, this would be a nonsense for two reasons: firstly, there are sound risk mitigation reasons why on occasion companies will not be able to use hedge accounting; and secondly, it is inappropriate to base a regulation on transitory accounting standards.

On the assumption that what I have been hearing is indeed correct – and all the signs suggest that it is – we in the EACT will now vigorously pursue a campaign to confirm the read-across exemption and, most importantly, to explain why it is vital to remove the hedge accounting test.

As followers of the EACT will know we have been very engaged with Brussels on the post-crisis financial regulatory agenda for nearly three years now. It has been a hugely fascinating and I believe productive time for us. We can claim a direct role in winning support for the exemption of corporates from the most controversial impact of the derivatives regulation; this outcome is immensely significant for the ability of the ‘real economy’ to allocate funds to working capital and productive investment, rather than to holding those funds to meet possible future margin calls as a result of having to use central clearing houses for derivative positions.

The battle has now moved on to the EU’s implementation of Basel III through the capital requirements directive and regulation (CRD IV and CRR). As I write this is a very live issue and will continue to be so for many months if not well into 2013 – but I can say that there are indications that in the European Parliament, Council and increasingly amongst Member States there is an acceptance that there is a real question over the way Basel III (and CRR) imposes ‘punitive’ CVA charges on uncleared derivatives. Our objective is to ensure that EMIR and CRR work consistently, thereby preserving the economic importance of EMIR’s exemption of the legitimate risk-mitigating use of derivatives by the real economy to offset financial risk arising in the business.

The harder we (and treasury associations and companies) work to present the position of the end users in debate about the financial regulatory impact, the greater seems to be the risk that we are malignly alleged to be the mouthpieces of the banks. I find this dispiriting, as it suggests that educating the authorities in Brussels and elsewhere on how financial regulation impacts the real economy remains work in progress and is certainly not complete.

To underline the EACT’s independence from the banks this is a good opportunity to point out areas where we undoubtedly find ourselves on the side of the Brussels authorities and certainly not in the camp of the banks. When investment banks and market intermediaries abuse the market and/or infringe competition law, non-financial companies are among the first victims.

The Commission’s Competition Directorate is currently investigating wholesale financial markets through various means, including the now much publicised LIBOR case. These cases get all the EACT’s attention, and DG COMP’s cartel busters have our full support. If at some point banks are found guilty of any wrongdoing I am absolutely convinced that many EACT members’ companies will seek damages in court – that is their fiduciary duty; but in the short term we will also focus a lot of attention on how banks and market intermediaries have treated and charged the real economy, and on how they will do so going forward.

The Commission’s new Market Abuse directive and regulation proposals are also likely to get our open support. These provide for effective and reinforced administrative sanctions and for the harmonization of EU-wide rules to ensure that Member States adopt minimum criminal sanctions – extending to inciting, aiding and abetting insider-dealing and market manipulation, as well as attempts at these forms of market abuse. We are also likely to endorse the adoption of a horizontal regime for sanctions, as well as consistent application across the 27 Member States of the definitions of what constitutes market abuse and insider-dealing; we will not want to see any intra-EU legal loopholes.

So it should be clear to the Brussels authorities that it is unhelpful and dangerously misleading to portray the EACT and others as the agents of the banks. Those of us who have spent careers in and around corporate treasury will treat the suggestion as barely meriting mention and will be concerned that it should be given any credence in Brussels, at a time when it is so important that the financial regulatory agenda moves forward effectively.

No, I’m not trying to be facetious about the big sleep….oh well, maybe I am but only slightly so. I’ve not been travelling at all during August but to judge from the ‘out of office’ messages I’ve been receiving the three or four week August holiday is still being enjoyed by many across Europe. Now there are slight signs of an awakening; a stirring in the undergrowth of Europe as people return to their homes and their desks. I am again receiving emails with content rather than the dreaded message, the gist of which is ‘I’m off enjoying myself and no I really won’t be thinking about what’s on your mind..….and that state of wilful disinterest will prevail for several weeks’.

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.

The risk of ‘winning the battle but losing the war” on the exemption from central clearing of OTC derivatives for non-financial end users now seems to be coming home to hit us, despite the success we have had in Brussels (on EMIR) and our US counterparts have had in Washington (on Dodd-Frank).

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.