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.
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The Law and Lore of Repackaging
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Posting cash to a counterparty for mark-to-market moves is a painful, and in some respects, stupid thing to do. 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 its doubts: when you prod or poke at them, they tend to dissolve, like nasty toilet paper, at just the point where you would most wish them to make things clear.
“A credit-linked note, you see, doesn’t so much hedge a note, as the note hedges it.”
“Are you serious?”
(Pause)“I, I — well, I think so, yes —” (suddenly, sounding less sure of himself) “— but, ah, perhaps, 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.[2]
In any case it seems to us that the idea a repackaging SPV is not hedging, by definition, with any properly-structured[3] OTC derivative it enters, is a faintly preposterous one. Vigorously preposterous, in fact.
For we should not focus on the instruments themselves, but the non-financial counterparty who holds them. Instruments are just instruments. They don’t hedge anything, by themselves. What, and whether, they hedge depends on the assets and liabilities of their owner. Here, the owner is concerned with two instruments: one representing an asset and the other a liability. Their economic profiles are different. Without a contract to marry up those profiles, derivative, these instruments do not offset each other, and the NFC has some risk.[4] With it, they do, and the NFC has less risk.[5] Therefore, quod erat demonstrandum, the OTC derivative objectively, measurably, by definition reduces risk relating to the commercial activity (earning its $100 corporate benefit fee by acquiring the asset and entering into the OTC derivative) and its treasury financing activity (raising money by issuing the note).
There are two ways of arriving at this conclusion: the above literalist one, and an even more robust purposive 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[6] 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 — and for whom that apparently categorical statement from ESMA is still not enough — might look at it this way:
The point of uncleared margin regulations is to reduce counterparty exposure: to ensure that, should one’s uncleared derivatives counterparty fail, one is protected against bankruptcy losses for one’s derivative exposures. As we know, the second-best form of credit mitigation to the insolvency of an entity who owes you a future payment derived from a given asset is for that entity to wire you, in cash, the net present mark-to-market value of that future payment obligation, daily. If the entity goes titten hoch, you have its money, to the tune of what it owes[7] in a ready liquid format.
Hence, this is what the uncleared margin regulations require counterparties to do.
Now I say “second-best form of credit support”, because there is one better way of mitigating future payment credit risk: it just isn’t usually practical: if your counterparty physically owns very asset its payment is derived from, and it pledges that asset to you, then you are really set. A pledge over that asset is, literally, perfect credit mitigation. You don’t need to value it. It is mathematically the same, at all times, as the present value of the cashflow it is derived from.
This isn’t usually practical because whole point derivatives is not to hold assets whose cashflows one is paying — there are learned opinions from QCs about this and everything — and the vibe of derivatives market is very much title transfer: one most definitely not to give people fixed charges over assets if one can avoid it by just collateralise the delta in cash.
But repackaging SPVs are the exception to that rule. Not only do they hold the exact asset whose cashflow they are manufacturing, but they are ok with pledging that asset, and in fact they habitually do. The swap counterparty always has a senior ranking security interest over the very asset whose cashflows the SPV is paying.
There is no need for a repack SPV to pay variation margin. It makes no sense. Requiring it would aggravate, not mitigate, the vehicle’s risk.
AIFs
Though, trick for the young players — an AIF is a form of financial counterparty, so does not qualify for the hedging exemption.
See also
- ↑ We are assured by those in a position to know that there are no less than two magic circle firms of this squirrelish opinion, which makes us hearken for the old days when those able to charge hundreds of pounds for an hour of their time provided something useful by way of return: these salad days seem an increasingly distant memory.
- ↑ If you have previously insisted on charging for reasoned opinions on the topic to allow your clients to get comfortable, for example.
- ↑ By which I mean it has effective, standard limited recourse terms and has been competently drafted to achieve the intention of overall transaction.
- ↑ Granted, a rather theoretical one, given limited recourse, but it is a risk. The limited recourse might not work.
- ↑ Now, almost none: here, even if the limited recourse fails, the counterparty’s claim is defined by the asset, and the counterparty will have no claim once that asset has paid.
- ↑ Which you can find here.
- ↑ Give or take intra-day market moves etc.