The European Securities and Markets Authority (ESMA) has published draft rules for the regulation of Over The Counter (OTC) derivatives. The rules impose a general requirement to use cleared instruments and to post highly liquid assets as collateral.
However, non-financial corporations can exempt themselves from these requirements, provided that their use of instruments meets defined criteria. For example derivatives that offset and hedge commercial or treasury risks, or qualify for hedge accounting under International Financial Reporting Standards (IFRS) may be excluded. If a business has not adopted hedge accounting, it may face a significant new burden in demonstrating to auditors that derivative contracts are hedges and ‘cover’ specific exposures. The draft rules are highly significant for treasury professionals in the United States as well as Europe, owing to the Dodd–Frank Wall Street Reform and Consumer Protection Act’s mandate to US regulators to harmonize the burden of domestic derivatives regulation with that set by overseas authorities.
“From the point of view of non-financial businesses that use derivatives to mitigate real world commercial and treasury financing risk, ESMA’s draft rules are mostly good news,” said Paul Higdon, Chief Technology Officer, IT2 Treasury Solutions. “The proposed regime enables non-financial users to continue to access tailored derivatives that can most accurately match and mitigate risk, by matching the cash flow schedule of the underlying exposure that is being hedged. If a company already undertakes hedge accounting for its derivatives, much of the work will have already been done. Perhaps most importantly, the rules promote best practices in reporting, regular mark to market and management of counterparty risk. In fact, many corporate users are already ahead of the game, having brought central management of financial risk, risk-mitigating derivatives, and hedge accounting within the single environment of the corporate treasury.”
“In contrast, biannual ‘compression’ is required of the largest global derivatives portfolios, placing a significant burden and cost on the biggest, most complex businesses. Identifying and unwinding accumulated contracts that cancel each other out demands very significant treasury capability.”
“The bigger picture,” says Higdon, “including the total burden of treasury reporting will only become clear following the finalisation of the rules and their anticipated adoption by the Commission in Q4 2012. We can expect to see participants, alongside auditors, both developing compliance approaches and adapting hedging strategies to new market conditions.”