The ESMA OTC Derivatives End User Exclusion

ESMA has released a Consultation Paper on the draft technical standards for trade repositories, OTC clearing and CCPs.

Discussion of non-financial counterparty exclusions begins on page 14.

OTC contracts that protect non-financial counterparties against risks "directly related to their commercial activities and treasury financing activities" are entirely excluded from a CCP clearing obligation.  OTC derivatives that do not protect against "directly related" risks but do not exceed clearing thresholds are also exempt from the clearing obligation.

To be "directly related" and therefore excluded from theshold computation, OTC derivatives contracts of a non-financial counterparty must be "objectively measurable as reducing risks directly related to its commercial activity or treasury financing activity or that of its group." There are two alternative tests for exclusion.  The first test is whether the OTC derivatives contract of the non-financial counterparty "individually, or in combination with other derivatives contracts", reduces "the potential change in the value of assets, services, inputs, products, commodities, liabilities that it owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs in the ordinary course of its business, or the potential change in the value of assets, services, inputs, products, commodities or liabilities referred to above, resulting from fluctuation of interest rates, inflation or foreign exchang rates."  The second test is whether the OTC derivatives contract qualifies for accounting treatment of a hedging contract under IFRS principles endorsed by the European Commission.  The rules are clear that whether the contracts consitute hedging under local GAAP rules is the standard, although ESMA expects most local GAAP treatment to meet the proposed definition.

If OTC derivatives contracts are not excluded, they count toward thresholds for clearing.  Clearing thresholds are set by notional amount and by asset class, with 5 asset classes defined: credit, equity, interest rates, foreign exchange, and commodity & others.  Breaching the threhold for any one asset class subjects the non-financial counterparty to a clearing obligation for all derivatives for all asset classes thereafter.  The notional amount thresholds will be phased-in, and periodically reviewed.

Non-financial counterparties will have to confirm OTC derivatives contracts by the end of the second business day following the trade day.

Portfolio reconciliation must be daily if counterparties have more than 500 contracts between them, weekly if between 300 and 500 contracts, and monthly for less than 300 contracts.

Portfolio compression is mandated for all counterparties with more than 500 non-centrally cleared contracts to be done at least twice a year.

Capital treatment will be addressed in a separate set of regulations on Basel III and CVAs.  There is still a significant likelihood that exclusion from clearing will result in a requirement of higher bilateral margin and contract re-pricing to include the CVA.

Much more in there, but this hits the high points.

Hurtling Towards Harmonisation

I spent most of yesterday reading the Financial Stability Board's OTC Derivatives Markets Reforms Third Progress Report on Implementation.  Thrilling stuff if you were desperately awaiting your next installment of regulatory waffle on harmonisation of global regulation and infrastructure for derivatives.

What struck me most powerfully about this report was the weakness of the policy agenda ("improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse" and motherhood and applie pie) and the absoluteness of the policy prescriptions ("[A]ll jurisdictions and markets need to agressively push ahead to achieve full implementation of market changes by end-2012 to meet the G20 commitments in as many reform areas as possible.").  After all, the global financial crisis was not caused by derivatives.  The financial crisis was caused by abusive securitisation of debt (mostly RMBS) which was impelled by preferential capital treatment under the Basel Capital Accords.

Why all?
Why agressively?
Why full implementation?
Why the deadline of end-2012?

I have been troubled by harmonisation of global regulations as an absolute objective for my entire career.  The Basel Capital Accords always struck me as dangerously simplistic in ignoring the national differences in banking systems.  Perhaps I am alone in thinking that different countries that have made different choices about legal principles and economic interest and market structure could reasonably hold different views about regulatory policy, priorities and practices.

A country like Britain whose banks are mostly giant global behemoths of nearly unmanageable size and complexity has a very different risk profile to countries like Russia or Saudi Arabia where most wealth is generated from resource extraction and the priority is protecting investments and ensuring market access.  Derivatives in London are used mostly for speculative trading and market making by intermediaries.  Derivatives in a resource economy will be mostly used for hedging and trade management.  And yet both are being subjected to absolute rules and absolute infrastructure requirements without regard to native interest or the different risk characteristics presented by empircal market practice and experience.

The report recognises that some countries are asserting native interests in requiring local clearing arrangements (e.g. Japan), but does not explore the policy rationale or recognise legitimate methods for protecting native interests.  Instead any variation from the desired consistency with the orthodox interpretation of requirements is treated as threatening the fabric of international markets (unless the US or central banks are doing it).

There is no recognition in the report of the risks of unintended consequences from implementing these reforms, even though much is being aired in the industry as the deadlines near.  Operational complexity will be massively increased for all market participants by parallel implementation of Legal Entity Identifiers and mandatory trading and clearing reforms.  Liquidity risks are growing daily as the shortage of quality collateral tightens amid downgrades and immobilisations.  Clearing houses are competing on lower margin requirements and taking lower quality assets, increasing the risks of a clearing house failure with massive systemic disruption and/or public bailouts.  Markets are suffering from declining liquidity, high volatility and impaired price discovery as end-users and institutional investors decide to sit on the sidelines to see what sort of markets emerge from the reforms.  Lawyers are struggling with renegotiating and redocumenting literally millions of bilateral agreements with varying terms and constraints into the new standardised construct.  And all of this is happening at a time when banks are undercapitalised, more encumbered than ever, stressed and struggling with both markets and regulators.

Why is "one size fits all" regulatory diktat a bad guiding principle for Communism but an excellent guiding principle for global capitalism?  Wouldn't we be more likely to discover what good public policy looks like if we allowed countries to take different views on market regulation and then compared empirical experience?  Both Denmark and Greece apply all Basle Capital Accord and EU directives, but they have very different financial markets with very different risk profiles.  They certainly have had very different experiences.  Shouldn't we ask what Denmark is doing right that Greece is doing wrong and learn from that, even if it is contrary to prevailing orthodoxy?

More generally, is a global financial system that insists on adherence to orthodoxy a strong system or a weak system?  If the policies are conceived and implemented in error - as the Basel Capital Accords may yet prove to be, no matter how many regulatory careers are built on them - then the adherence to orthodoxy weakens the entire construct and exposes everyone to severe systemic risk.

Given the massive cock ups revealed in the past five years, I'd rather have a period where different countries were free to experiment in legislating and regulating their financial systems than a rush to orthodoxy dictated by the same geniuses who caused the massive cock ups in the first place.  But I guess that's why I'm not a regulator anymore.