Hedging exemption
EMIR regulates the infrastructure of European financial markets, and one of its main jobs is to mandate the exchange of variation and initial margin for uncleared derivatives — a sort of cack-handed behavioural psychology play to nudge OTC derivatives trading onto exchange. Hasn’t worked. Anyway, we digress.
|
The Law and Lore of Repackaging
|
Posting cash to a counterparty for mark-to-market moves is a painful, and in some respects, stupid thing to do, and some market participants are not well set up to do it, others for which the scale of their trading means it is not worth the bother — and many for which both is true. These are the so-called “non-financial counterparties” — businesses not designed primarily for the financial services industry, and whose incidental activity in OTC derivatives markets does falls below specified thresholds.
Non-financial firms whose derivative activity falls below those thresholds are labelled “NFC-” and are out of scope for EMIR regulatory margin.
EMIR “Hedging exemption”
The question may arise as to whether an SPV is a non-financial counterparty and, if it is, whether article 10.3 of EMIR means you don’t have to engage in all that tedious measuring of notionals to ensure you stay small enough to count as an NFC-. You can do that as long as you are only trading derivatives to hedge your commercial activities; that your swap activity positively reduces the risk inside your organisation.
Here’s what the hedging exemption says:
3. In calculating the positions referred to in paragraph 1, the non-financial counterparty shall include all the OTC derivative contracts entered into by the non-financial counterparty or by other non-financial entities within the group to which the non-financial counterparty belongs, which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or of that group.
Now you might think this is an open-and-shut question: what is a hedge? Surely if you have liabilities in one currency, or rate, or linked somehow to one kind of financial indicator, but your income is denominated in another, and the point of your swap is to match one with the other, then it is a hedge, right?
Repackaging SPVs
And there is no better, cleaner, paradigmatic example of an entity that uses OTC derivatives to match income to outgoings than a secured, limited recourse repackaging SPV. This is literally what a repack SPV does with OTC derivative: no more; no less. Yet, at least according to one magic circle law firm,[1] the matter is “not free from doubt”. Yet, this firm struggles to explain the doubts it has: when you prod or poke at them, they tend to dissolve, like nasty toilet paper, at just the point where you might have wanted them.
“A credit-linked note, you see, doesn’t so much hedge a note, as the note hedges it.”
“Are you serious?”
“... But the better view we think is, ah, it probably is a hedge. Perhaps a credit-linked note is not the best example.”
“So what is the best example?”
We wonder whether the firm might have committed itself to an outcome which on hindsight it realises is a bit potty, but polite comportment means it might now be a bit difficult to reverse-ferret out of.
In any case it seems to us that the idea a repackaging SPV is not hedging, by definition, with any properly-structured[2] OTC derivative it enters, is a faintly preposterous one. Vigorously preposterous, in fact.
There are two ways of arriving at this conclusion: one is via a purposive approach, the other, a literalist one. Now financial services professionals and a fortiori their advisers are a profoundly literal, formalist bunch, so they lean hard into nuanced questions such as “would this qualify for hedge accounting under IFRS?” or “can we say this is directly reducing risks directly relating to the financing activity of the SPV?”, but struggle to stand back and look at the bigger picture. If they did, they might say “imposing a cash margining arrangement with a secured, limited recourse SPV makes no sense at all”.
The formalist argument
Serenity’s prayer, and all that. Now this seems squarely to capture the derivative activity of a limited recourse repackaging SPV, which is entering derivatives to pass the cashflow of an asset, and receiving a cashflow to pay down a note. Even if you muff up the structuring, the “limited recourse” nature of an SPV forces a careful observer to the conclusion that an SPV who transacts derivatives in this way is “objectively measurably reducing risks directly relating it its commercial activity” — it is eliminating them in point of fact — and given the underlying security structure of such a deal (where the SPV secures its rights to the asset whose cashflow it is manufacturing in favour of the dealer to whom it is manufacturing that income stream) requiring the SPV to also post collateral as a credit mitigant makes no sense at all. There is no credit risk. The asset is the perfect delta-one hedge.
Nevertheless, this must have seemed too easy for some of the more curmudgeonly compliance professionals on the continent, and at the time of the EMIR refit the question arose as to whether this would cover SPVs (such as repackaging vehicles whose principal activity is to deal in financial instruments). The ESMA Q&A[3] posed, on page 28, this question:
Can non-financial counterparties (NFCs) whose core activity is to buy, sell or own financial instruments, benefit from the hedging exemption when using OTC derivative contracts to hedge certain risks, for example risks arising from the potential indirect impact on the value of assets the NFC buys, sells or owns resulting from the fluctuations of interest rates, inflation rates, foreign exchange rates or credit risk?
And came forth the answer, on page 30:
Yes. The hedging exemption set out in Article 10(3) EMIR applies to all non-financial counterparties, irrespective of what their core activity is. The list of financial counterparties in Article 2(8) EMIR is a closed list. It does not allow for the treatment of non-financial counterparties as financial counterparties for certain EMIR provisions, such as Article 10(3). That provision itself does not distinguish which non-financial counterparty is allowed to use the hedging exemption depending on that counterparty’s specific activity.
The purposive argument
For those with confidence in the fibre of their expertise, look at it this way:
- The point of uncleared margin regulations is to reduce counterparty exposure: to ensure that, should their counterparties fail, those party to uncleared derivatives are protected against bankruptcy losses for their derivative exposures.
- The second-best form of credit mitigation against a person who owes a future payment derived from a given asset is to obtain from that person the net mark-to-market value of that future payment obligation, daily, in a nice liquid store of value like cash. If you go tetas arriba, I have your money, to the tune of what you owe me (give or take intra-day market moves etc). Hence this is what margin regs require counterparties to do.
- I say “second-best form of credit support”, because there is a better way of mitigating that counterparty credit risk: it just isn’t usually practical in the context of OTC derivatives: A first ranking security interest over the actual asset that that payment is derived from. This is the perfect form of credit mitigation. You don’t need to value it. It is mathematically the same as the present of the derivative cashflow it is derived from.
- This isn’t usually practical because the nature of derivatives is precisely to avoid being obliged to hold assets whose cashflows one is paying — there are learned opinions from QCs about this and everything — and the vibe of derivatives is most definitely not to give people fixed charges over assets whose cashflows you are replicating. This basically kiboshes your ability to finance your trading book.
- But repackaging SPVs are unusual like that. They are always fully funded (that is what the Noteholders are for) so they don’t need to finance their trading book, and they will hold the underlying asset their swap is derived from, and not only can they secure it in favour of their counterparty, but they do. The counterparty has a senior secured claim over the very asset whose cashflows the SPV is paying the return. There is no need for variation margin. Requiring the SPV to pay it would aggravate, not mitigate, the SPV’s credit exposure to the counterparty.
AIFs
Though, trick for the young players — an AIF is a form of financial counterparty, so does not qualify for the hedging exemption.