The similarity between OTC derivatives and cheese

I recently chaired a conference focused upon FXMM, or foreign exchange money markets for those unfamiliar.

It’s a strange territory full of hedging and algo’s, but the bit of the day that really caught my attention was when Heather Pilley from the OTC Derivatives and Post-Trade Policy Division of the FSA, presented the plans for new regulations in this area.

She began by saying that the G20 has made it clear that by the end of 2012 there needs to be global regulations in place to ensure that OTC derivatives are traded on regulated exchanges.

This agreement is a drop dead date that the FSA, the EU and the USA are all working to such that, by 31st December 2012 or before, global markets will have fully regulated OTC derivatives markets.

On the 15th September, the European Commission released their proposed European Market Infrastructure Regulations (EMIR), and Heather made it is clear that these are similar, but not the same as, those proposed in the USA.

For example, EMIR includes FX exotics and forwards if they are being used for investment rather than commercial purposes. The US excludes FX forwards, so it’s different.

America restricts bank ownership of CCPs but Europe does not; EMIR instead strengthens the governance and surveillance requirements of CCPs but does not stop banks having ownership.

Similarly, smaller financial counterparties who are ‘not systemically important’ are excluded in American rules, but Europe bases ‘systemically important’ on a clearing threshold rather than the size of the counterparty.

This creates the shadiest area: the actual definition of what is ‘systemically important’.

Equally, a large OTC derivative contract for hedging based upon ‘commercial activity’ is excluded, whilst the same derivative if it is for investment purposes is included. Question: how do you separate and define these activities?

When a contract is made by an airline to hedge against oil price rises, is that commercial activity or investment activity?

This has not been defined in EMIR and are ‘still being worked upon’, hopefully in time for an agreement before the end of 2012.

Other areas that may confuse are that clearing obligations for these contracts are in two forms.

First, from a bottom-up view, the Central Counterparty (CCP) in Europe must be named and authorised by the national regulator, which will be identified through registration with the European Securities and Markets Authority (ESMA). This also determines the competent authority responsible for the contract, based upon the country of the CCP’s location.

Second, from a top-down view, ESMA determines which contracts must be cleared centrally and once a contract is in, it’s in 100%.

This begged the question as to whether that means every contract is reviewed on a contract-by-contract basis, or whether it is by definition of the type of OTC contract being made. According to Helen, it is based upon the class of contract, not every contract one by one.

Bearing in mind the confusion of the above, Helen then said that the legislation is likely to be ready by April 2011, the technical standards by Spring 2012.

With all of these things still to be defined, such as thresholds, this seriously worried the corporates in the room, especially the definition of ‘commercial activity’. For example, Malcolm Cooper, Global Tax & Treasury Director for the National Grid, asked a range of questions including: can we ensure that commercial activity includes cross-currency swaps where there is no trade involved, but it is a valid hedge of commercial activity? Has anyone looked at the cost implications, as few treasury departments will have the resources to cover intraday margin calls if that’s the direction such regulations take?

Heather reassured by saying that most legitimate trading would be allowed and that it is only the systemically important areas that are the focus of the regulation.

This led to Mike Hazell, Group Treasurer with Debenhams, asking whether a $500 million currency swap is systemically important, as that’s a pretty regular and common deal for his firm.

Heather responded that they would be looking at net exposures, and that this still needs further definition.

Another audience member asked why OTC regulations will apply to FX forward contracts for investment purposes which operate on a three-day cycle, but do not apply to FX spot trading which operates on a two-day cycle. Is it fair to exempt one and not the other, just for one day’s difference?

All in all, the whole conversation left me with the sense that those who are developing the regulations really do not know what they’re doing.

There are massive inconsistencies between the European Commission’s papers and views, and those of member states. Equally, there are big incongruence’s between the US view and the EU view.

Finally, the fact that the G20 has laid this down as drop dead by end of 2012, there’s a big danger of creating something so full of holes, that Emmental Cheese will look positively robust by comparison.