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Home > Blogs > Anthony Harrington > The end user’s case against OTT (over-the-top) derivatives regulation

The end user’s case against OTT (over-the-top) derivatives regulation

Regulation of Derivatives| The end user’s case against OTT (over-the-top) derivatives regulation Anthony Harrington

The European Parliament’s Economics and Monetary Affairs Committee (ECON) is a very well respected body and has little difficulty in getting industry experts in every area to present their views on matters of importance to the Committee. ECON also does a very good job of taking those views into account when it formulates its response to proposed EU initiatives, such as the regulation of derivatives. On 27 April, Richard Raeburn, the Chairman of the European Association of Corporate Treasures—people who regularly use derivatives to manage corporate risk and who therefore know their onions on this topic—told ECON fairly and squarely that the EU was going to create a ghastly muddle if it pushed ahead with its proposed derivatives regulation un-amended.

So what is troubling Raeburn and his fellow corporate treasurers? In a word, what bothers them is the daft idea that a corporate that wants to hedge its fuel costs should be required to put up collateral to the full value of the hedge, marked on a mark-to-market daily basis, doubtless.

The basic idea that the EU has got between its formidable jaws is that all OTC derivatives trades should be fully collateralised, thereby “de-risking” derivatives trading. You can see where they are coming from. What sank the once mighty US insurance conglomerate AIG was the lamentable management lapse of allowing its derivatives desk to write billions of dollars worth of trades in Credit Default Swaps (CDS) without having the assets to back those trades if the markets went against AIG.

This is the equivalent of an insurer writing tons of premiums for storm damage, hoping to collect the revenues, without once concerning itself with the possibility that it might need to pay out on claims and giving no thought at all to the necessity therefore of putting assets aside to cover such potential claims. To call this bad business is, one might argue, being overly polite. Do this in a different line of work and you’d be dropped in a deep dark cell for the rest of your days as a howling fraudster.

Uncollateralised derivatives, the EU argues, constitute a huge systemic risk right across the financial services sector and therefore it is going to jump up and down on them until they are dead. As I said, one can see where the EU is coming from and why the matter has some heat behind it. However, heat is one thing and logic is another, and what Raeburn and his colleagues (the massed corporate treasurers of 17 EU states and two other European countries) bring to the party is logic.

If you force corporates to both pay the costs of hedging and to tie up large amounts of capital to collateralise their hedging, they are, in the main, not going to hedge.  That is all there is to it.  This matters because hedging is good sound policy. If you are an auto components manufacturer trading with the US, you want to focus on where you add value, not on the wild fluctuating dance of the Sterling Dollar pair. You do not want to find that your 13% profit margin was reduced to 2% by a sharp currency movement against you, even if there is an equal chance that on some happy day an upswing will net you a 24% margin.

You do not want to gamble your future. So you hedge. But you may well be hedging a big number if these contracts are a sizeable proportion of your total turnover. So you can’t hedge if someone in Brussels makes you tie up a huge wodge of capital to back your hedge. What Raeburn was concerned to point out was that no state’s economy is well served by preventing corporates from de-risking portions of their activity: “Derivatives support employment and growth, because they are used to reduce risk rather than to increase it—they are about job security,” he told the committee.

The upshot is that the EU would be making a huge blunder if it fails to exempt end users from its proposed regulation of derivatives. “Without an exemption, companies will reduce hedging; this will leave their businesses, employment and growth more exposed to the uncertainties of financial market movements,” he warned. It couldn’t be said more plainly… In a future blog or two we will look at how this argument plays when viewed from the standpoint of banks—and speculators.

Further reading on the regulation of derivatives

Tags: derivatives , financial crisis , manufacturing , regulation , risk
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