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OTC Derivatives: a Victory or a Battle Lost?
by François Masquelier, Head of Corporate Finance and Treasury, RTL Group, and Honorary Chairman, EACT
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.
Non full exemption
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).
Collateralisation
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.
