Hedging exemption: Difference between revisions

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 {{quote|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.}}
-====Repackaging SPVs====
+===Repackaging SPVs===
-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.
+There are two ways of approaching this. One is a purposive approach, the other a literalist one.  As is the collective wont, financial services professionals are a profoundly literalist, 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 failing to stand back and look at the bigger picture, which is to say “imposing a cash margining arrangement with a limited recourse SPV literally makes no sense”.
+====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 [[SPV]]s (such as [[repackaging]] vehicles whose principal activity is to deal in financial instruments). The ESMA Q&A<ref>Which you can find [https://www.esma.europa.eu/sites/default/files/library/esma70-1861941480-52_qa_on_emir_implementation.pdf here].</ref> posed, on page 28, this question:
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 {{quote|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 PV of the derivative cashflow derived from it.
+This is, [[QED]], what all counterparties to repackaging SPVs have.
+I wonder whether this whole academic inquiry into which instrument is “hedging” what under EMIR (even with CLNs, leverage and so on), has rather lost sight of that fundamental principle.
 ===AIFs===
 Though, trick for the young players — an AIF is a form of [[financial counterparty]], so does not qualify for the hedging exemption.
 {{sa}}
 *[[Repackaging programme]]