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This year we have seen the finalisation of a number of regulations and technical standards surrounding the clearing and collateralisation of derivatives that will come in to force in 2017. So what is changing and how it will impact you as a user of derivatives for the purpose of hedging?
The key change
Many will hear the words Dodd Frank or European Market Infrastructure Regulation (EMIR) and think, additional paperwork. Reporting trades, agreeing portfolio data, getting confirms signed in a timely manner, and all manner of forms to be completed with very little commercial impact. Unfortunately, from 2017 this is set to become even more onerous for some.
Under EMIR, many investors will have to clear certain derivatives such as interest rate swaps in all major currencies. This means that an investor would have to post additional cash collateral each time the swap falls in value, on a daily basis. And, if a swap or other derivative isn’t standard enough to be cleared (e.g. a more structured swap or an option), both counterparties are required to enter into bilateral agreements for the posting of cash collateral anyway. Similar rules apply under Dodd Frank, and indeed parallel regulations all around the world that are due to come in force.
Am I caught by the regulations?
You are only caught if you classify as a 'Financial Counterparty' (FC) under EMIR, or you are over the clearing threshold, which is €3bn of interest rate derivatives or €3bn of FX derivatives (there are other limits for other derivative asset classes). Currently, derivatives held for the purpose of hedging don’t count toward that threshold, making it difficult to breach.
An Alternative Investment Fund (AIF) is classified as an FC. However, if you place assets, financing and hedging into Special Purpose Vehicle (SPV) subsidiaries, it is not classified as an FC, and is unlikely to have €3bn of any type of derivative so is not likely to get caught. Hence ‘non-fund’ clients and those who only place hedging in SPVs can breathe easy for now.
The bottom line is if you are an AIF who hedges at the fund level, from next year your new derivatives will fall under the new regulations and you will need to make arrangements to post cash collateral when the market moves adversely in respect of these contracts.
If I am caught, how significant is the impact?
The extent of the impact depends on market movements. It could have no impact at all, but one only needs to look at what happened to the value of a €100m 5Y interest rate swap entered into on 30 September 2008 to understand the potential impact. Six months later, its negative mark-to-market value stood at in excess of €9m. In the context of €100m, this is a significant amount of cash required as collateral in the first six months after the asset acquisition and financing; assuming it doesn’t lead to a rather embarrassing capital call to investors, it is still likely to wreak havoc on achieving stated Internal Rate of Return (IRR) targets.
Funds who acquire, finance and hedge with swaps at the fund level, now face a catch 22 situation. Choosing to remain unhedged introduces significant risk in the event rates rise, whereas hedging with a swap could give rise to significant cash calls and IRR impact if rates fall.
Fund level FX hedging would suffer from a similar requirement to post cash collateral, following large sustained FX moves, making the fund beholden to calm and favourable currency markets which are usually anything but. Even for funds who use a rolling forward strategy and are accustomed to posting cash on a monthly or quarterly basis, this is still much more onerous. Collateral requirements will need be calculated on a daily basis and posted within a day. Moving money through fund structures may prove to be very impractical on such a timescale.
One potential silver lining will be the upfront cost of options. The cash premium for purchasing an option could be recycled back to the fund through the cash collateral arrangements depending on how freely that cash can be used under your collateral posting arrangements.
When does this come into force and will my current derivatives be affected?
The good news is that all derivatives entered into prior to the regulations coming into force will be exempt from the requirement to post or collect collateral.
The requirement for collateral posting arrangements is anticipated to come into force across most jurisdictions on 1 March 2017 for the majority of derivatives. There is an exemption in European regulations for FX forwards, FX swaps and cross-currency swaps either until MIFID II is in force (expected in early 2018) or the end of 2018 if not.
However, regulators have recently decoupled in their timelines. The European Commission (EC) signalled the delay of the above implementation deadlines for the EU including the UK.
The delay is primarily to complete necessary legal reviews in time, so there is no notion that the EC is taking its foot off the gas. Other non-European jurisdictions including the US, Canada, Australia and Hong Kong are expected to hold to the original date of 1 March 2017. Therefore, there may be a short period in which a regulatory arbitrage is possible and European banks become notably more viable as financing counterparties than their global peers – but don’t count on this.
As for the clearing of standard derivatives such as major currency interest rate swaps, the relevant deadline is most likely 21 June 2017 (unless the wider group holds more than €8bn of non-centrally cleared derivatives), but ESMA has recently released a consultation on delaying this phase.
How can one avoid these requirements?
The answer is probably with difficulty, but there are measures that can be taken. The root cause of the problem is being classified as an FC, which arises from being a full scope AIF. Some may find there are ways to avoid this classification such as operating under the FCA’s National Private Placement Regime however, legal advisors should be consulted on any such solution.
Funds who want to use interest rate swaps for hedging floating rate loans, but don’t place their assets in subsidiary SPVs, should consider whether to start doing so going forward. They should also contemplate using fixed rate loans if possible, rather than swapping floating rate loans. For fund level FX hedging, some funds use a revolving credit facility which can remove a good amount of cash flow volatility and ensure that capital is only needed from elsewhere in the case of unexpectedly large FX moves. Such a solution is subject to the credit appetite of the bank in question and often, banks will offer one in order to win the FX business in the first place. Those funds who don’t do this already should consider this option in due course with requirements likely to be in force for Europe in 2018.
How will I document new collateral posting arrangements?
Generally, collateral-posting agreements are governed by an addendum to the usual ISDA agreements known as a Credit Support Annex (CSA). For the last two decades, most market participants have used the 1995 ISDA CSA (English law, title transfer) and the 1994 ISDA CSA (NY law, security interest).
In anticipation of the upcoming global requirements, ISDA have drafted a new set of regulatory compliant CSAs based on three popular legal systems (English law, NY law and now also Japanese law). For each one, there will be a ‘VM CSA’ and an ‘IM CSA’, referring to the Variation Margin (VM) and Initial Margin (IM) that counterparties will have to post to each other.
VM, which refers to the value or mark-to-market of a derivative as the market moves, is the collateral requirement we have been referring to and will apply to you if you are caught.
IM, which refers to an 'independent amount' of cash that both counterparties will have to set aside as a continuous buffer against possible losses, is not required for certain FX trades and is mainly a requirement for larger market players. Unless on a group basis, you have over €8bn of non-cleared OTC derivatives you needn’t be concerned with this requirement.
However, if you do need to document a collateral posting arrangement, it will most likely be under the new 2016 ISDA VM CSA, under the relevant law. Clients should take care to understand the commercial, as well as legal, aspects of this document when negotiating it. For those with a number of existing CSAs, ISDA have also released the 2016 ISDA VM protocol which allows quick amendment and/or replication of existing CSAs, which your lawyers should already be getting excited about.
What will be the wider market impact of these developments?
Firstly, this depends on whether global implementation of the rules is harmonised or not. If the EU does delay implementation for a sustained period, expect short-term pricing dislocations as European banks enjoy being the beneficiary of a regulatory arbitrage by other market players and become more competitive in their pricing as flow trade is redirected to them.
Assuming we eventually get to a level playing field, the impact is less clear. There has been a sustained move toward derivative clearing over the past few years and this is likely to continue. This could increase pressure on your hedging costs as a non-cleared OTC derivative user.
If you are caught by the regulation, the increase in pricing due to market trends should be at least offset by the pricing improvement obtained by having a collateral agreement in place with your bank. However, the key issue at hand is whether it is suitable for your business model to have to post potentially painful amounts of collateral at short notice. If it isn’t, you will need to start planning now how your hedging arrangements will reflect this in 2017 and beyond.
Have you got a question about how you hedge your financial risks, or structure and arrange your debt?
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