It seems that there is no agreement between European Supervisory Authorities and non-financial market participants as regards draft Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a CCP under the Regulation on OTC derivatives, CCPs and Trade Repositories (the draft RTS).
Contributions regarding Joint Discussion Paper on the draft RTS put by market participants show generally that non-financials like E.ON, EdF, CEZ and also firms associated in EFET and ISDA don’t like potential additional mandatory requirements governing their collateral and risk policies. It is indicated that especially non financial counterparties (NFCs) are not willing to modify their credit assessment methodologies. NFCs as a preliminary question point out their negligible role during financial crisis and no need for regulatory interference in that regard.
Draft Regulatory Technical Standards on OTC Derivatives – which OTC derivative contracts are ‘objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity’
The discussion paper and the stakeholders’ contributions are based on the version of the text of the Regulation following an agreement at the trilogue meeting of 9 February 2012, where the European Parliament, the Council and the European Commission reached a political agreement on the Regulation of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories (the Regulation, or EMIR).
In Joint Discussion Paper on the draft RTS the ESAs (European Supervisory Authorities - EBA, ESMA and EIOPA) underline, however, that in the absence of central clearing, collateral and capital requirements are the necessary tools to contain the risk arising from OTC derivatives transactions. ESAs recall moreover that Article 6(8) of the EMIR Regulation primarily requires:
- for Financial Counterparties (FC) and NFCs above the clearing threshold, as referred to in Article 5(7) of the Regulation, to proceed to a timely, accurate and appropriately segregated exchange of collateral for OTC derivative contracts not cleared by a central counterparty (CCP); and
- for FCs to hold capital that is appropriate and proportionate to the remaining risks, i.e. those not covered by the exchange of collateral.
EMIR recognises that non-financials use OTC derivative to protect themselves against commercial risks directly linked to their commercial activities. As a result, these OTC derivative contracts that protect the non-financial against risks directly related to their commercial activities and treasury financing activities as well as those that do not protect against such risk but do not exceed a clearing threshold are not subject to the clearing obligation.
At the point where the clearing threshold would be exceeded, the clearing obligation would apply to all OTC derivative contracts the non-financial counterparty will enter into after the time that the firm has exceeded the threshold.
In order to calculate whether it exceeds the clearing threshold, a non-financial counterparty shall not include in its calculation the OTC derivative contracts which are objectively measurable as reducing risks directly related to its commercial activity or treasury financing activity or that of its group.
To that end, the Regulation mandates the ESAs to determine, in relation to non-centrally cleared transactions, the appropriate level of collateral and capital, the eligible collateral, and the frequency of exchange of the collateral.
In standard practice, collateral posted and exchanged as part of derivative transactions can take the form of variation margin and/or initial margin. Variation margin (VM) represents collateral exchanged by counterparties to reflect current exposures resulting from actual changes in the value of the relevant transactions. Initial margin (IM) collateral is provided to cover potential future exposures arising from the relevant transactions in the interval between the last exchange of margins and the liquidation of the relevant positions.
Upon a default, the collateral can be liquidated or effectively netted by the non-defaulting counterparty to close out the transaction. Without collateralisation, the non-defaulting counterparty would be treated as an unsecured creditor for its claims against the defaulting counterparty. This situation could result in a loss for the non-defaulting counterparty (e.g. a part or all of the replacement costs in the case no IM would be exchanged), which the counterparty would have to cover by its own financial resources.
What contracts are capable of being classed as “derivatives”
In the course of public consultations the opinion was shared among participants that even without knowing the future definitions of OTC derivatives to be cleared, it is expected, that larger part of the OTC derivatives will most likely not be eligible for clearing, because they do not meet the characteristics of being sufficiently standardized, liquid, and with available and reliable price information such as to allow mark-to-market evaluation on a daily basis.
Clarity on what contracts fall within scope of capital or collateral requirements under EMIR by virtue of being classed as “derivatives” is vital and it is the view of stakeholders that this should not include physically settled commodity forwards, no matter where or how they are traded.
Criteria for establishing which derivative contracts are objectively measurable as reducing risk directly related to the commercial activity or treasury financing
By reference to European accounting rules, ESMA considers that an OTC derivative entered into by a non-financial counterparty is deemed to be objectively measurable as reducing risks directly related to the commercial activity or treasury financing activity of that non-financial counterparty or of that group, when, whether individually or in combination with other derivative contracts, its objective is to reduce the following risks:
a. The potential change in the value of assets, service, inputs, products, commodities, liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the ordinary course of its business; or
b. The potential change in the value of assets, service, inputs, products, commodities, liabilities referred to in letter a, resulting from fluctuation of interest rates, inflation rates or foreign exchange rates.
ESMA also considers that an OTC derivative entered into by a non-financial counterparty is deemed to be objectively measurable as reducing risks directly related to the commercial activity or treasury financing activity of that non-financial counterparty or of that group, when, the accounting treatment of the derivative contract is that of a hedging contract pursuant to IFRS principles as referred to in IAS 39 paragraph 71-102 on hedge accounting as endorsed by the European Commission.
Nevertheless, ESMA considers that an OTC derivative which is used for a purpose in the nature of speculation, investing, or trading should not be an OTC derivative objectively measurable as reducing risks directly related to the commercial activity or treasury financing activity of a non-financial counterparty or of a group as provided above.
The source: ‘Discussion Paper Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories’
Besides, when it comes to the scope for EMIR it should also be noted that pursuant to the current text of the Regulation (Clearing Obligation Article 3), counterparties to OTC derivatives that have been concluded between third country entities that would be subject to the clearing obligation if they were established in the EU, are under obligation to clear those OTC derivative contracts that have a direct, substantial and foreseeable effect within the EU, or where such obligation is necessary or appropriate to prevent the evasion of any provision of EMIR.
The general clauses used in this provision are prone to divergent interpretations, thus the delegation to develop draft technical standard has been added at a late stage in EMIR negotiations and ESMA has recently started its analysis also in this respect.
The mandatory posting and collection of margins for all non-cleared products unacceptable
The mandatory posting and collection of margins for all non-cleared products will have an immense impact on business and liquidity. In the energy sector unsophisticated players, large industrials, and small players generally do not possess the infrastructure and the means to put in place bilateral margin agreements (be it IM or VM). Currently in the energy sector IM is only used for counterparties with a very low creditworthiness. Any forced IM requirements would therefore place an additional and unnecessary liquidity strain on energy companies that would increase the cost of business disproportionately, especially given the underlying value of their assets, the strength of their balance sheets and, in many cases, their high credit ratings.