October 2010

OTC DERIVATIVES AND NON-FINANCIAL COMPANIES

1. What are derivatives?
Spot markets are the ones where the quantity and price are agreed upon by the parties and the clearing and settlement happen immediately after the transaction. Deri ati es! is a generic name which co ers all other markets. "he three main subclasses are# $ futures# the parties agree about quality and price but for deli ery in the future% typically a few months later. "he biggest futures& market is the one for foreign e'change% but futures are also widespread on fi'ed income markets (i.e. bonds)% equities and commodities* $ options# in the simplest form of options% the parties agree that% in e'change for an upfront payment% one of them has the right to either buy (call! option) or sell (put! option) a certain asset in the future at a certain price if certain conditions are met. +ombinations of options between calls and puts enable to hedge against comple' risks , or speculate on subtle occurrences* $ swaps# the parties e'change% at conditions set from the outset% future flows of payment. - Swap can relate to currencies (.&ll recei e / in the future% you&ll recei e 0% let&s e'change these flows at an agreed and fi'ed e'change rate) or to interest rates (.&ll recei e fi'ed interest in the future% you&ll recei e floating interest% let&s e'change them at a pre$agreed rate , different and higher than the fi'ed rate). 1ike options% swaps ha e de eloped o er time into new and sometimes ery sophisticated markets. "he most famous one is the +DS market% which stands for credit default swap# one of the parties wants to hedge against the risk of default of an issuer (or speculate on it) and the counterparty accepts to take o er this risk against a premium* philosophically% +DS are ery close to insurance contracts.

2. What are OTC derivatives?

O"+ stands for o er the counter!# these deri ati e contracts are not traded on an e'change (such as 23S4 4urone't% the 1ondon Stock 4'change or Deutsche 56rse) but instead negotiated bilaterally between two parties on terms which may not be standard. "hey are not centrally cleared but this does not mean that anything goes!# most non$financial companies trade with banks within a legal framework such as the .SD- model or the 7erman 8aster$-greement and transaction confirmations happen typically within one day.

. Wh! d" #"#-$i#a#%ia& %"'(a#ies #eed derivatives?

2on$financial companies need deri ati es to reduce operational risk. "ypically% if you sell 10%000 trucks for deli ery in 2019% or 100 planes for deli ery in 201: or a power plant for deli ery on 201;% you ery often create a risk because the customer is going to pay the largest amount due upon deli ery. "his risk is often a foreign e'change risk% but it can also be an interest rate one% or a risk of default. .f the company finds a counterparty willing to assume this natural risk% which is called hedging% it can focus on its industrial business and de elop its order book without <eopardi=ing its balance sheet.

>istorically% deri ati es ha e been created precisely for this purpose# to reduce risk.

?ith the e'ception of rare and often fraudulent cases% non financial companies reduce risk when they hedge% which keeps them more liquid and more sol ent% and ultimately helps reduce the risk they represent for their lending banks.

). Wh! d" #"#-$i#a#%ia& %"'(a#ies #eed OTC derivatives?

2on$financial companies need O"+ deri ati es for two main reasons# $ $ because their needs are for long term deri ati es% whereby the centrally cleared markets rarely go beyond a couple of months* because commercial operations can be comple'% non$financial companies cannot use standardi=ed deri ati es* they need tailor$made! ones.

.n order to a oid creating a huge default risk at the center% centrally cleared markets function with margin calls# when a new transaction is cleared% participants are asked to post a deposit called initial margin call , typically 9@ of the nominal alue of the transaction. ?hen the market then mo es against a party on one side of the transaction , and it always does , that party is required on a daily basis to post an additional deposit to maintain the margin at 9@ after deduction of the potential loss. -s opposed to banks% whose market making business is to match their risks (if they do a transaction one way on the foreign market with counterparty A they immediately try and do the opposite deal with counterparty 3)% non$financial companies do all their transactions one way and hence do not benefit from clearing# if for instance a company sells in / and produces in 0% it will only be the / selling and 0 buying counterparty and its transactions relating to foreign e'change futures. Begardless of the purpose of their transactions% this makes the use of clearing houses far more onerous for non$financial companies than for banks. Cor a market participant in this hedging position% margin calls can become an enormous drain on cash reser es and% ironically% create new financial risks for the non$financial company and for its lending banks. .t should be noted that no industrial company e er created a financial crisis because of legitimate deri ati e transactions (i.e. transactions with a hedging purpose)# some people mention 4nron in this conte't but this company collapse was due to fraud and accounting failures. .t is also worth keeping in mind that both the non$financial companies and their banking counterparties ha e an interest in keeping their mutual e'posure to a low le el. "ypically% a non$financial company with yearly sales of 0 10 bn or more would ha e at least 90 counterparties for its O"+ deri ati e transactions. Cinally% and most importantly% transactions in ol ing non$financial companies represent according to 5.S less than ;@ of all O"+ transactions and this percentage tends to decrease.

*. What +",&d have ha((e#ed i$ #"#-$i#a#%ia& %"'(a#ies had -ee# $"r%ed t" %&ear their derivative tra#sa%ti"#s?
.n most cases they would simply ha e stopped hedging% because (i) they need tailor$made! deri ati es which do not e'ist on centrali=ed markets (ii) they could not afford the cash drain resulting from the margin calls. "his would ha e had two consequences% an ironical and a critical one# $ ha ing non$financial companies e'ist deri ati e markets would ha e resulted in the percentage of speculati e transactions increasing from D0@E to irtually 100@% i.e. increasing the gap (some would say disconnection) between finance and real economy. "his was certainly not the idea of the 720 heads of State and 7o ernment when they decided in Fittsburgh in September 200D to do something about deri ati es*

more importantly% operational risks for non$financial companies would ha e shot up. - 4uropean company selling in the / with a 0G/ rate of 1.90 may suffer an enormous loss if at the time of deli ery the rate was say 1.H0.

-nother way to phrase this is that forcing non$financial companies out of deri ati es would turn them into forced de facto speculators. "his is why the IS-% Japan and irtually all other 720 countries ha e recogni=ed the need to grant an e'emption for hedging transactions.

.. Are #"#-$i#a#%ia& %"'(a#ies ha((! +ith the %,rre#t +"rdi#/ "$ EMIR0s 1 Arti%&e 1? "he short answer is yes. ?e ha e already told the +ommission about our gratitude that they listened to our arguments on hedging transactions. 3et the current wording is ague and raises more questions than answers. .t lea es it to e'perts% 4S8- in particular% to decide about not <ust the le els of the information and clearing thresholds but also about the way the system will function in practice. ?e respectfully submit that this wording could easily be impro ed% changing or adding a few words only% and we see no reason why this could not be done now% at 1e el 1 of the 1amfalussy process. "he fi e main points where -rticle K could be impro ed are following# $ we got oral assurance that the financial counterparty to an O"+ transaction% where its non$ financial counterparty does not ha e to clear% would not ha e unilateral obligations itself. ?e suggest that for the sake of clarity this is made e'plicit% or more e'plicit% in the te't* the draft is unclear about the treatment of the clearing obligation in the situation where a company has breached and then again fallen under the clearing threshold. ?e assume that the clearing obligation would cease but would feel much more comfortable if this was made e'plicit* the draft anticipates that all O"+ transactions should be cleared once the clearing threshold is passed. ?e do not understand why the transactions below the threshold% which by definition would not be considered risky from a systemic perspecti e% would start creating this risk when the threshold is passed as a result of other transactions. .n practice the current drafting would result in a clearing shock! for which we can see no <ustification. "he regulation would simply work better if the imposition of clearing applied only to transactions abo e the clearing threshold* finally% we think that the concept of ob<ecti ely measurable! should be related one way or another to e'isting regulations% standards and definitions as well as audit procedures. >ere again% we suggest that the 4-+" submission to the second 4I consultation proposed a pragmatic and sensible approach% drawing inter alia on .-S 9D. - slide e'plaining this approach is anne'ed to this note (-nne' .).

1. CRD IV
+BD .L consultations documents show that it was at some point foreseen to impose puniti e capital requirements on banks for non cleared transactions% but this was at a time when hedging O"+ transactions in ol ing non$financial companies were not e'empted from clearing either. 2ow that they are (sub<ect of course to the co$decision procedure on 48.B)% the +BD .L draft directi e should be brought into line. "here should be no back$door reintegration! of unhelpful punishments of the real economy.

2. A -r"ader 'essa/e $r"' the rea& e%"#"'! -s a result of a financial crisis which they <ust suffered from% non$financial companies will in the future
1

4uropean 8arket .nfrastructure Begulation# it is the future 4I regulation dealing with deri ati es. "he draft was adopted by the 4uropean +ommission on 1; September 2010.

ha e to deal with financial regulators% some of them entirely new. Curthermore% the implementing measures for the new financial regulations that will apply to non$financial companies% may be de eloped by e'perts culturally and operationally much closer to financial institutions. ?e know that the new regulations creating 4S8- and 4SB5 foresee a dialogue with all stakeholders% including non$financial companies% and we are grateful to 4I lawmakers for ha ing thought of this. Still% recent e'perience with e'isting 4I bodies shows that% when in ited to e'press their iews% non$ financial companies are typically under$represented% sometimes massi ely so. ?e therefore ask all 4I .nstitutions and bodies to be careful to take the iews and needs of the real economy yet more into account when drafting further financial regulations% and also further down in the 1amfalussy process% in particular at comitology le el and in its dialogue with other 4I bodies. .n practice% it is indispensable% though not sufficient% to grant the real economy a role in stakeholders& consultation that goes beyond the minima set by the recently adopted 4S8- and 4SB5 regulations.

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