Published: August 01, 2011
Even if corporate treasurers obtain the exemption of OTC derivative reform from the EMIR (European Market Infrastructure Regulation), as we all might reasonably expect, this temporary victory could hide the ineluctable future of the derivative market. Realistically, we can see that derivatives will become more and more expensive over time and that we will have more administration to deal with the various types of financial instruments. The most prudent treasurers would be tempted to say that it would be better to wait for the final outcome of this key reform before shouting ‘victory’. The European institutions and MEPs have accepted the idea of an exemption (despite the fact that some populist tendencies would favour no exception at all). However, the form of the exemption is not yet defined. EACT has heavily lobbied to avoid any exemption based on certain types of products or (even worse), on qualification for hedge accounting. And even if they decide to adopt an exemption based on a defined threshold, there are open questions such as at which level should we fix this threshold and how should we apply it in practice? In case we are above the predetermined threshold (limit), would the whole portfolio be tainted and non-exempted? There are as we can see many open issues even if treasurers succeed in being exempted. [[[PAGE]]]
Unfortunately, the exemption even if finally adopted, will be applied to clearing and to collateral; but it will not cover reporting, which will remain compulsory for all market dealers. For non-standardised and non-clearable contracts, they should be electronically confirmed with auditable monitoring process for all participants and, in this case, no threshold will be applied. Therefore the exemption will remain a partial success for treasurers. No one could contest the aim of having a full picture of each market participant’s full net portfolio situation. The idea is by passing via clearing houses to force market players to secure deals with collaterals and to force a defined reporting to collect all deals netted. For this reporting obligation, all treasurers will have to pass by trade repositories. How does it work? Who are the market players (there are only a few of them e.g., DTTC, ICAP and Clearstream)? Who will pay for it (a priori the corporates will pay for their deals and all banks for theirs)?
If all banks respect BAsel III's new provisions, they will be negatively impacted when no collateral is required for derivatives.
If the recourse to clearing houses is necessary, which one to use? Does it mean that depending on counterparties, we will have to pass via a CCP and via a trade repository? We can expect a connection between all of them in order to multiply intermediary partners. All these very pertinent questions remain unanswered. In practice, all this nicely planned system will imply a lot of technical issues and will necessitate recourse to IT solutions for automating processes. The timing for the reporting being an issue (no later than trade day plus one) would imply an excellent system to produce reporting in due course on a standard that can be a consolidated format. The CCPs and the trade repositories will have to be interconnected and interfaced to exchange the necessary information in real time. Reporting without being able to give a full and comprehensive position won’t be useful for users.
In case we are eventually exempted, then the question will turn around the issue of reporting obligations. We understand that exempted corporations will avoid passing through clearing houses (i.e., CCPs). However, they will have to get deals OTC reported via a trade repository house. ESMA should soon define a standard format for reporting (by the end of June 2012 at the latest).
If the banks are not able to get compulsory collateral with corporates, they will try to enter by the back door, by proposing bilateral CSA agreements. At the end of the day, the risk is to have to provide banks with collateral. Then the CCPs will be a better and more standardised solution. The market will be right and will impose its views and wishes. If corporates refuse to provide them with collateral, they will have to accept a significant increase of hedging cost (the longer a forward period, the more expensive the derivative will be). If all banks respect Basel III’s new provisions, they will be negatively impacted when no collateral is required for derivatives dealing. Basel III clearly is a much more important issue and it will be a ‘killer’ in this respect. If not legally enforced, collateralisation will be required by market players themselves (i.e., banks). In the end, treasurers will be caught by bank regulation. We could end by celebrating a short-term victory as we will all have to place collaterals for derivative dealing.
Optimists might think that corporate treasurers have won an important battle. However, we could reasonably fear that the war is lost in the medium term, because of administration and reporting obligations and cost of hedging which inexorably will increase over time. The risk is clearly to have banks trying to come back with CSA (bilateral) agreements to post collateral. Basel III will certainly affect the OTC derivative market more than the EMIR (European Market Infrastructure Regulation) will. The future of this market is to more adequately price derivatives (which are a type of commodities) including the implied credit risk (which increases over time and depends on the derivative final settlement date). If you want to have whole-market transparency and a full picture of the products dealt (including corporates despite their smaller weight in the total of derivatives), you need to have general rules applied to all or, if there are exceptions, these exceptions should not prevent exempted players from reporting their OTC derivatives via specific vehicles.
There are still many open issues on how everything will function in future (e.g., trade repositories, clearing houses, collateralisation management, etc.). The lobbying led by EACT and made by the corporate treasurers of a couple of large MNCs was necessary but, in my opinion, not sufficient to be fully satisfied in the long run. Treasurers will pay more for derivatives, reporting duties will increase their administrative burden and at the end of the day, the bilateral agreements would be requested by all major banks and would be the only way to reduce the cost of hedging. The dilemma would be whether to hedge with higher costs, or not to hedge at all to reduce the cost of collateralisation. The corporate strategies on hedging will change definitively over the coming years.
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