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.


As the derivatives regulatory bandwagon moves forward towards implementation it is unsurprising that the end users of derivatives – aka the real economy – should be encouraged to focus on what implementation of the new regulatory framework requires of them. Events with which I have been involved last Friday and will be tomorrow (12 November) have coincided to highlight for me that there are some significant issues to which treasurers should certainly be paying attention.

On Friday I was at a briefing session with HSBC, which included an excellent run-through of the EMIR background and brought home some of the uncertainties associated with its implementation. I won’t address here the detail of EMIR but simply mention two dates, one of which is in the past but merits some serious attention.

EMIR was passed into law on 16 August 2012. With effect from that date users of derivatives should be compliant with the regulation. There may already be some hollow laughs on the part of those reading this; whereas the large corporates will surely have been focusing on what EMIR means for them, it stretches reasonable credulity to suppose that companies that are not ‘large’ – and certainly the SME constituency – are well briefed on the implications of EMIR.

It’s of course fascinating that whilst EMIR is in legal force much of the practical details of the regulation remain to be confirmed. ESMA has produced its regulatory technical standards (RTS) but these are now being considered by the EU Commission and then have to pass through Parliament and Council. In broad terms this process should be finished by 31 March 2013. This might not matter were it not the case that there are some huge areas of detail included in the RTS that put the meat on the bones of what Brussels put into law back in August.

One could describe the current situation as akin to the EU having announced an entirely new sport and confirmed that, in order to win, a team must score more points. Some of the crucial details as to how one can score those points remain to be communicated.

So if you are a corporate end user and have stopped wringing your hands in despair, it might be worth noting that from 16 August 2012 you should have been in a position to report the copious detail that EMIR/ESMA requires on your derivative contracts to your trade repository. The fact that the trade repository does not exist is worth noting. HSBC stated that a draft format for trade repository reporting is available on the ESMA website (as I write I have not yet located the document).

It was clear from the Friday briefing that banking counterparties will be offering a trade reporting service to their corporate customers. There was some coyness on the part of HSBC as to what this might cost; it looks suspiciously like a vital service for which pricing control will clearly lie in the hands of the banks.

Oh and by the way, the contracts on which a corporate should have been reporting from 16 August 2012 are not just new contracts but also all those outstanding at that date.

The other date that might be worth noting is 1 July 2015. On that date if a trade repository (for the appropriate class of derivatives) is not in place in the relevant member state, then all the affected trades will be reported to ESMA. For those of us that have never been convinced about the systemic risk reduction benefits from real economy end users reporting their derivative trades, this raises the spectre of ESMA drowning in trade data for which the regulatory benefits are less than compelling.

Which brings me to what I am doing tomorrow, Monday. I’ll be in Paris for a meeting at ESMA, to discuss how the EACT can help raise end user awareness of the implications of EMIR. I’m greatly pleased that ESMA has suggested such a meeting, as it underlines that they recognise that the end users in which members of the EACT treasury associations work are completely unused to dealing with this type of financial regulation. This is of course even more the case with SMEs, as ESMA noted in setting up this meeting.

So I look forward to tomorrow’s meeting – and I’ll ask for help in identifying where the draft trading repository report format can be found.

ESMA has been consulting since June on ‘draft technical standards’ on regulation of OTC derivatives, CCPs and trade repositories. Dry it may sound but this is of course the crucial ‘rule-making’ stage of the implementation of EMIR, the European Union’s regulation addressing OTC derivatives in the post-crisis (2008 version) aftermath.

The position we have taken in the EACT is well documented and the exemption won for non-financial end users has provided a breathing space for the use of derivatives in corporate risk management, even if this may not be the long-term solution in the commitment to reduce global financial systemic risk (see blog “Financial regulation: winning the battle and the war; but what about the future?”, 16 July 2012).

ESMA’s consultation has raised more issues than I suspected it would. Our response can be downloaded here and it might be helpful to summarise the key issues:

➢ The corporate exemption is based around contracts that are ‘objectively measurable as reducing risks’ and includes the words ‘in the ordinary course of….business’. We would like to see these latter words deleted if at all possible. We are also arguing against the explicit exclusion of hedging contracts associated with stock option plans

➢ Clearing thresholds are central to the operation of the end-user exemption and we identify issues in ESMA’s drafting around the treatment of intra-group transactions and (more fundamentally) the absence of clear alignment between actual and developing proposals in the US and from BCBS/IOSCO (who have a global remit)

➢ The administration requirements defined by ESMA, in the context of what the organisation refers to as ‘risk mitigation techniques’, are seen by us as posing excessive burdens on all non-financial end users but especially on SMEs

➢ Finally (and most crucially) there appears to be a requirement emerging in ESMA’s detailed proposals for all market participants to report daily mark-to-market values to a trade repository. As we say in our response to ESMA, we can see no possible regulatory justification for this and can identify serious administrative implications for large as well as small companies

My overall feeling after drafting our ESMA response? It is that despite all our efforts over EMIR there is still a huge challenge in persuading European authorities that non-financial end users are totally different from the financial sector participants with whom regulators are much more familiar.

So we see a continuing inability on the part of the EU bodies to recognise two things in particular: that the non-financial companies we are discussing do not and have not in the past directly driven financial sector systemic risk; and that the resources, especially IT systems, available to these companies are simply not on a sufficient scale to handle regulatory requirements drafted from the perspective of the financial sector.

The consequences of the first point above are reflected in issues such as the perverse view being taken of hedging of company stock options and the requirement for daily mark-to-market reporting. The second point is reflected in the unreasonable administrative burden being imposed in respect of information that will do nothing to help regulators reduce systemic risk and support the stability of the financial system – which is what they should be doing.

In the EACT we have for nearly three years campaigned vigorously against some of the impact for corporate participants in the financial system of the regulatory reform agenda. We referred to ‘unintended consequences’ for the ‘real economy’ long before those two phrases started to become the common currency of discussion about financial regulation.

We focused first on the regulation of derivatives (EMIR) and then on the implementation of Basel III through the EU’s CRD IV and CRR proposals. With our limited (and volunteer) resources we have also been trying to influence the MiFID II and MiFIR proposals as well as those for the further regulation of the credit rating agencies, CRA III.

On derivatives we argued from the outset that the push to standardise and force transactions onto exchanges and central clearing would place impossible liquidity risk demands on corporates, reduce the incentives to use derivatives to mitigate business risk and introduce further volatility into the global economy. We also stressed that there is no evidence that corporate use of derivatives directly gives rise to systemic risk within the financial system. The crude G20 proposals needed reassessment and under EMIR and Dodd-Frank that was achieved.

The debate then rapidly shifted for us onto the consequences of Basel III; put in its simplest form, the level of CVA included within the Basel proposals would have had the effect of making those very derivatives that had been ‘saved’ for corporates through the battle on EMIR and Dodd-Frank economically unattractive, because of the level of credit charge that would be included. Within Europe our push for some modification to the CVA assumptions within Basel III has led to the European Parliament supporting the proposition that there should in effect be a read-across from the EMIR exemption to the application of CVA under CRD IV/CRR. Whilst nothing is certain at present in Brussels we are reasonably confident that such an exemption from CVA could survive the trialogue process.

So we won the battle (creating the EMIR exemption) and may even win the war (protecting the economic value of the EMIR exemption from the CVA impact in CRD IV/CRR). But where does this leave us in the wider context of a global financial system about which we should be hugely concerned? It is perhaps worth putting down a few markers against which subsequent events can be assessed:

• There will continue to be pressure to shift derivative transactions onto exchanges. My impression is that however cogent were the arguments we and others made for the exemption, the supervisory authorities still don’t ‘get’ why corporates (non-financial end users) are different from the financial players within the financial system. I have argued elsewhere that this is partly because of regulatory capture.
• Corporates are faced with a banking system that is under siege. Credit risks associated with banks are such that many corporates struggle to manage their exposure and (as a non executive director) I see organisations with which I am involved having to debate relaxing their standards or keeping cash under the corporate mattress or its equivalent.
• Bank balance sheets are under pressure and this will only become worse as regulatory initiatives require that increasing amounts of capital are held to support unchanging or reducing levels of business.
• The failure to resolve the Eurozone crisis translates into further uncertainties over the solvency of those banks that would be impacted by radical structural change, as a result of one or more of the seriously credible scenarios for Eurozone disruption.
• The LIBOR ‘crisis’ looks increasingly like the latest and most serious challenge to the view that banks act responsibly – and that their senior management are indeed ‘fit and proper’ to continue to run institutions combining retail, commercial and investment banking with trading.

The campaign to protect the real economy users of derivatives from the ill-considered G20 regulatory instruction to policymakers was right and necessary. It is therefore logical that we should continue to push for the modification to Basel III that will preserve the value of the EMIR and Dodd-Frank exemptions.

But as we look beyond the crisis – and the resultant huge strain that we currently observe on both the financial system and its regulators – what type of financial system is in the interests of the real economy? The structure and the values needed are fairly obvious:

• market risk and return transparency in all financial instruments;
• credit risk transparency for all derivatives’ counterparties;
• stability and effectiveness in regulatory oversight;
• credible market and credit controls within banks (no surprises….); and
• honesty and trust in the marketing of financial instruments (no bundling…).

Will the banking system deliver what the real economy needs? That brings me back to the question I posed above: the battle and the war may be in our pockets but what about the future?

I see a world in which banks will be forced (rightly) to go through major change by splitting out activities that cannot be combined within one overall entity and splitting the marketing of financial products, so that each product is bought by end users based on its merits. So farewell to the proprietary trading that must be underwritten by a combination of traditional retail and commercial banking or the taxpayer or the shareholders (assume any combination of that you consider realistic) and farewell to bundling designed to obfuscate financial transaction costs.

I also see great risk in even getting the banks to the position where they can implement the changes that politicians, regulators and society will demand. Some banks will buckle under the combination of capital requirements and Eurozone change.

And I of course see profound ‘forced’ deleveraging of bank balance sheets notwithstanding all the underlying arguments for economic stimulus that will also be seen as pressing.

Corporates will want to look beyond the traditional financial system for their counterparties – these do not necessarily need to be restricted to financial institutions. Just as individuals and very small businesses have already responded to the opportunity to engage peer-to-peer, corporates and pension funds should engage more directly with each other for both funding and hedging.

The battle over derivatives will therefore be increasingly irrelevant in the longer term. The global financial supervisors will undoubtedly try to erode the exemptions, as these do not ‘fit’ with their view of the world (regulatory capture?). End users in the real economy need to think ahead to the continuation of a flawed and fragile financial system and consider how they can reduce their dependence on it. We need a financial system less dependent on the financial institutions. Such a system would probably be less liquid (so it may not be possible to implement a hedging strategy in seconds) but it would certainly have lower systemic risk: the failure of a counterparty would only affect the other counterparty rather than the financial institutions.

The Langen report on EMIR was adopted by ECON in the European Parliament this afternoon. Well, that is perhaps a piece of good news, but…. Other related aspects of what has happened today are sober reminders of the continuing huge complexity of the issues around the regulation of derivatives – and I make that comment purely from the perspective of what is at stake for non-financial end users. I am mightily relieved not to feel under pressure to master all the other aspects of the EMIR and Dodd-Frank issues.

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.

How seriously is ESMA taking the impact on non-financial end users of the new financial regulatory regime on Europe? The answer now may be….not at all. Over the last few months ESMA has been considering who to appoint to the Securities and Markets Stakeholder Group, a new body established to ‘to help facilitate consultation with stakeholders in areas relevant to the tasks of ESMA’. I should at this stage declare an interest; I was a candidate for appointment, as were the group treasurers of some of the largest companies in Europe. Nobody from this group has been appointed.

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.

After two weeks on a road-trip in the US I might naïvely have hoped to return to greater certainty with the progress of derivatives’ regulation on both sides of the Atlantic.  Naïve I clearly would have been, since this whole saga has dragged on far longer than those ‘wise people’ that drove the original G20 commitments could possibly have imagined.  And wise – I would argue – those people cannot have been if the attribution of ‘wisdom’ implies deliberation and contemplation, rather than the adoption of precipitate initiatives driven by political agendas.

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.