EACT Comments in response to the Public Consultation on

The European Association of Corporate Treasurers
Interest Representative Register ID: 9160958318-89
Comments in response to the Public Consultation on Derivatives
and Market Infrastructures
Issued by the Internal Market and Services Directorate General of the European
Commission on 14 June 2010
The European Association of Corporate Treasurers (EACT)
The EACT is a grouping of national associations representing treasury and finance
professionals in 17 countries of the European Union. We bring together about 8,100
members representing 4,600 groups/companies located in the EU. We comment to the
European authorities, national governments, regulators and standard-setters on issues faced
by treasury and finance professionals across Europe. We seek to encourage the profession
of treasury, corporate finance and risk management, promoting the value of treasury skills
through best practice and education.
Our contact details are provided on the final page of this document.
This consultation response is supported in particular by the following companies, who have
contributed to it: Bayer, BMW, Daimler, EADS, E.ON, Lufthansa, MAN, Rolls Royce, RWE,
Volkswagen.
This document is on the record and may be freely quoted or reproduced with
acknowledgement.
Executive summary:
The EACT and the companies supporting this submission welcome the Commission
consultation on OTC derivatives and its question on non-financial counterparties.
We favour transparency and support the information threshold provided certain simple and
pragmatic conditions are met.
In serious contrast, we think the clearing threshold is not just unnecessary but also
systemically dangerous. Instead of preventing the next crisis its implementation could
trigger it. Furthermore, it would create a regulatory divergence with the US very detrimental
to European companies.
We offer an alternative solution, involving national supervisors and ESMA, which we believe
would be both efficient and workable.
General comments
As already stressed in our comments last year on the possible initiatives to enhance the
resilience of OTC derivative markets, the EACT supports the European Commission’s focus
on strengthening financial stability and welcomes any initiative that can lead to greater
market efficiency.
Furthermore, the EACT is most grateful to the European Commission for having organised
this consultation in the current political context.
We did consider this consultation indispensable in any case, but if anything its interest is
further enhanced by the recent conference on the Dodd/Lincoln Senate Bill & House Bill
HR4173, which produced as regards non-financial companies a text radically diverging from
the options that explicitly or implicitly emerge in the EU consultation document. The EMIR
initiative is a direct consequence of the decisions taken by the G20 in Pittsburgh in
September 2009, which were all about global regulatory convergence; it would be
paradoxical, unfair and damaging to European non-financial companies to adopt a draft EU
regulation in an isolated and disjointed way.
For reasons explained hereunder, the current thinking which seems to underline the
consultation, with two automatic quantitative thresholds of which one triggers a clearing of all
derivative trades, would create immense cash collateral demands. This would result in an
increase in liquidity risk that most companies simply could not handle.
Whatever the substance of the draft Regulation adopted by the European Commission in
September 2010 will be, we very much hope that the Impact Assessment Study attached to it
will carefully assess the risk of a regulatory divergence between EU and US, and properly
analyse its consequences in line with the “better regulation” principles.
The experience of the AIFM Directive has underlined to the EACT the importance of the
Commission consistently adhering to the high standards expected of it in all Impact
Assessment Studies.
Why non-financial companies are fundamentally different in terms
of the use of derivatives
The US is about to adopt a bill which would grant a large carve out to non-financial
companies. There is one obvious political reason for this: non-financial companies played no
role whatsoever in triggering the crisis which started with the Lehman Brothers collapse in
September 2008 but like the economy at large were victims of it.
There are also numerous economic reasons.
First, apart from exceptional and often fraudulent cases, non-financial companies use
derivatives for reducing risks and not for speculative purposes. Typically, a manufacturing
company would hedge the foreign exchange risk created by a large export contract between
its commitment and the receipt of the sales value of the goods; and an airline, unable to
reprice tickets sold for future travel, would hedge against its substantial exposure to the
volatility of oil prices. When done properly, hedging reduces the overall risk in the system.
Second, and this is also specific to derivative usage by non-financial companies, hedges
must frequently be tailor-made. If the hedges cannot be customised a fundamental risk is
2
likely to be created (termed ‘basis risk’), in essence because the intended risk mitigation for
the business is imperfect.
By way of simple example, when a manufacturing company exports say 1,350 trucks or
23,600 taxis to Asia, it needs to hedge the foreign exchange risk corresponding to the
precise sale value and date of these trucks or taxis and not be limited to a multiple of
whichever standardised contract. More generally non-financial companies need hedging
instruments which completely fit the complex and specific nature of each forecast or actual
large commercial contract.
In addition, companies that apply hedge accounting under IAS 39 need tailor-made hedges
to meet the strict requirements of this accounting standard. This insulates reported earnings
from the impact of market value changes of OTC derivatives until maturity of the underlying
business risk. Reducing or eliminating the ability of non-financial companies to use
customised derivatives will be extremely difficult to explain to the investor and capital market
community.
Third, the use of derivatives for hedging does not simply reduce operational risks for nonfinancial companies themselves; it also reduces risks for the banks which lend to these
companies and hence contributes to the global stability of the financial system.
In the light of all this, EACT sees no supportable basis to blindly force non-financial
companies to use standardised derivative instruments and clear their transactions through a
CCP.
Unless a more favourable treatment is allowed, non-financial companies that could and
would decide to continue to hedge would end up with a new liquidity risk resulting from the
need to post cash collateral. For non-financial companies their derivative transactions are
(unlike the banks’ deals) one-sided - because they hedge and do not act as market makers;
the cash needs would be enormous, causing grave risk of default due to a company
exhausting the liquidity reserves it must hold for present or possible future major market
moves.
Some of the companies supporting this response estimate these cash needs could reach
100% and more of their market capitalization. Their ability to invest would be more than
seriously impaired. In the event of major future volatility in the currency, interest rate and
commodity markets we have to ask where the funding for margin calls (cash collateral) would
be supposed to come from, especially at a time when banks are under lending pressure.
Obviously the negative consequences of the margin calls may be compounded by a rapid
degradation of the corporate credit rating.
In reality this move en masse is unlikely to happen in practice. Because most non-financial
companies could not afford the burden and because standardised derivative contracts do not
suit their needs anyway, a large number of these companies would considerably reduce their
hedging volumes and possibly stop hedging altogether. As a result their operational risks
would massively increase, and so would the risk they represent for their lending banks and
ultimately for the financial system at large.
Put in simpler terms, instead of preventing the next major crisis, an attempt to shift most if
not all non-financial companies’ derivative transactions to CCPs could well trigger it.
3
This was clearly not the objective of the G20.
If the EU nonetheless decides to go ahead alone in its treatment of non-financial companies,
a likely consequence is that EU exporting companies will have a strong incentive to increase
natural hedging by moving their production to the countries in which they are selling (an
action that can eliminate or largely reduce the currency mismatch). This is not a desirable
outcome for employment or growth in the EU.
Non-financial undertakings (section I.4 of the consultation document)
Do stakeholders share the general approach set out above on the application of the
clearing obligation to non-financial counterparties that meet certain thresholds?
EACT strongly favours transparency and agrees that measures should be adopted to reduce
the risks of corporate failures and fraud. Many recent EU initiatives on this front move in the
right direction and are welcomed by the EACT.
Information threshold
In this transparency spirit, EACT can in principle live with an information threshold, provided
that:
-
this threshold would be set at a significant level and not impose an additional,
unnecessary burden on non-financial companies whose hedging activities could not
conceivably give rise to systemic risk to the financial sector; and
-
the implementation of this information threshold would be pragmatic enough not to result
in a significant regulatory divergence vis à vis the rest of the world.
Many questions around the information threshold obviously need to be dealt with, either in
the EMIR regulation or later at level II or III of the Lamfalussy process. Here are a few of
these questions:
-
-
the information threshold applies to a “position”. What does this position refer to? We
see three possibilities:
•
referring to the notional outstanding is in theory an option but bears no relation to
risk and must be regarded as highly questionable;
•
referring to mark-to-market values, as suggested by section 5 of the consultation
document, is more relevant but carries draw-backs, especially when the markets
become more turbulent and the bid-ask spreads increase; and
•
referring to potential future loss is the most relevant approach, certainly for a
regulation such as EMIR, primarily inspired by prudential and systemic risk
considerations.
would the information threshold work by type of derivative and/or by type of underlying?
4
-
would the information threshold be unique for all instruments or would it be tailored to the
nature of the instrument in terms of liquidity, intrinsic risk and legitimacy? The EACT
would argue for a higher information threshold for interest rate swaps, foreign exchange
and commodities derivatives than for exotic derivatives primarily used for pure
speculative purposes. As for short selling of CDS (naked or not), we would support the
view that the meaningful threshold is zero.
-
how would intra-group derivative transactions be treated?
-
how would regulated financing subsidiaries of non-financial end users be treated, bearing
in mind that the US seems inclined not to force these financing subsidiaries to clear their
derivative deals?
-
what would be the respective role of the European Securities and Markets Authority
(ESMA) and of national supervisors?
We think that supervisors should have the power to investigate and take appropriate action
against a non-financial company - where they suspect either that it manipulates its accounts
in order to stay below the information threshold or that it helps a financial company, willingly
or unwillingly, to escape its own obligations to clear its derivative trades. This second
possibility of course encompasses special purpose vehicles that certain financial companies
might be tempted to create in order to bypass EMIR but we think attention has to be paid to
already existing non-financial companies as well.
Clearing threshold
For reasons set above the introduction of a clearing threshold would be a regressive step
and the idea is one that we strongly oppose. It would massively penalise European nonfinancial companies for no good reason and create the opportunity for regulatory arbitrage.
As stated above, the implementation of an arbitrary clearing threshold would result in
massive cash needs and generate new, large and inherently unmanageable risks. Most
damaged would be the dynamic exporting companies which are at the forefront of EU
innovation and hence at the very core of the EU 2020 strategy.
The risks would remain even if the clearing threshold was finally set at a relatively ‘high’ level
In order to prevent a passive breach, prudent non-financial companies would secure
borrowing facilities far in advance, in order to combat the dramatic consequences of the
potential breach in terms of cash needs and heavy borrowing at a time when banks may be
unwilling to lend. In turn, these preventive measures are most likely to be negatively
perceived by financial markets, which may be tempted to punish very sound companies for
no good reason. The effect would be similar to the ones mechanistic ratings processes can
trigger on debt, which we understand the Commission now recognises as representing a
serious destabilization danger.
In short, imposing an automatic direct clearing threshold in the EU and the EU only,
regardless of the intention behind the use being made of derivatives, would make no sense
at all; it would destabilise the real economy rather than address systemic risk.
5
Risk-mitigation techniques for non-cleared contracts
First, although it is not a topic raised in the consultation document, we think it is important to
stress that encouraging bilateral collateralisation deals is not a good substitute for clearing.
Some banks have already approached some of the companies supporting this response,
suggesting that such collateralisation should be pursued. The liquidity risk for non-financial
companies is of course in no way reduced.
Second, the EACT takes the view that non-financial companies are not, and should not be
directly concerned by section 5 of the consultation document.
This said, it is more than fair to ask what would or should happen when a company crosses
the information threshold.
We think the information threshold crossing should trigger a multi-step monitoring exercise
primarily aimed at understanding whether the derivative transactions had a legitimate and
risk reducing hedging purpose or another, potentially risk increasing one.
The first step would be to filter out all positions that are compliant with IAS 39 hedge
accounting prerequisites. These have a direct relation to specific underlying transactions and
would not be relevant to a CCP.
If taking these trades compliant with IAS 39 hedge accounting prerequisites out of the
position was sufficient for the company to go under the information threshold again, no other
action would be required other than a yearly reexamination of the situation.
Hedge accounting applicability (IAS 39) is however not the only determinant for nonspeculative derivative transactions as there are numerous derivatives used for hedging that
do not qualify for IAS 39 hedge accounting due to its strict requirements.
For companies that are still be above the information threshold once IAS 39 compliant trades
are taken out, the second step would consist of an analysis of the other, non-IAS 39
derivative transactions. This analysis would be carried out by the company itself and certified
by an independent external auditor. It would result in a binding report submitted by the
company to the relevant supervisory body, either the national one or ESMA. To ensure the
maximum quality and seriousness of these reports the supervisory body may have the right
to carry out sample inspections and ask questions that the company would be legally obliged
to answer.
The third and final step, for companies that have failed to convince the relevant supervisor
their non-hedging derivative transactions are either limited in size or not inherently risky,
would be a possibility offered to ESMA to impose central clearing for all derivative trades that
ESMA considers are not justified by hedging needs.
We think this power should be left to ESMA and not to national supervisors, in order to avoid
intra-EU inconsistencies and hence eliminate the risk of intra-EU regulatory arbitrage.
6
Reporting Obligation (section IV.1 of the consultation document)
What are stakeholders' preferred options on the reporting obligation and on how to
ensure regulators' access to information with trade repositories? Please explain.
Option A, allowing the financial counterparty to report to the trade repository on behalf of a
non-financial counterparty would be the sensible, efficient approach. Financial counterparties
will need to ensure they have sufficient monitoring and reporting processes and systems in
place to report their interbank trades to the relevant repository. Using this infrastructure to
report on behalf of the non-financial would represent minimal extra cost when compared to
the difficulty and expense of replicating this within thousands of SMEs. Similarly, the
additional complexity for the trade repository of dealing with many more reports would seem
to overshadow any perceived benefits.
7