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Hedging exemption: Difference between revisions
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===Repackaging SPVs=== | ===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 obligation|secured, limited recourse]] [[Repackaging programme|repackaging]] [[Special purpose vehicle|SPV]]. This is ''literally'' what a [[Repackaging|repack SPV]] does with OTC derivative: no more; no less. Yet, at least according to one [[Magic circle law firm|magic circle]] [[law firm]],<ref> | 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 obligation|secured, limited recourse]] [[Repackaging programme|repackaging]] [[Special purpose vehicle|SPV]]. This is ''literally'' what a [[Repackaging|repack SPV]] does with OTC derivative: no more; no less. Yet, ''at least'' according to one [[Magic circle law firm|magic circle]] [[law firm]],<ref>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.</ref> 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''.” | “A [[credit-linked note]], you see, doesn’t so much hedge a note, as the note hedges ''it''.” | ||
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“Are you serious?” | “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?” | “So what ''is'' the best example?” | ||
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“[[I have to hop]].” | “[[I have to hop]].” | ||
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. | 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.<ref>If you have previously insisted on charging for reasoned opinions on the topic to allow your clients to [[get comfortable]], for example.</ref> | ||
In any case it seems to us that the idea a repackaging SPV is ''not'' hedging, ''by definition'', with ''any'' properly-structured<ref>By which I mean it has effective, standard limited recourse terms and has been competently drafted to achieve the intention of overall transaction.</ref> [[OTC derivative]] it enters, is a faintly preposterous one. Vigorously preposterous, in fact. | In any case it seems to us that the idea a repackaging SPV is ''not'' hedging, ''by definition'', with ''any'' properly-structured<ref>By which I mean it has effective, standard limited recourse terms and has been competently drafted to achieve the intention of overall transaction.</ref> [[OTC derivative]] it enters, is a faintly preposterous one. Vigorously preposterous, in fact. | ||
There are two ways of arriving at this conclusion: one | For we should not focus on the [[Financial instrument|instrument]]s 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.<ref>Granted, a rather theoretical one, given [[limited recourse]], but it ''is'' a risk. The limited recourse might not work.</ref> With it, they ''do'', and the NFC has ''less'' risk.<ref>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.</ref> 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==== | ====The formalist argument==== | ||
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====The purposive argument==== | ====The purposive argument==== | ||
For those with confidence in the fibre of their expertise | 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<ref>Give or take intra-day market moves etc.</ref> 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 [[Potts Opinion|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 [[Manufacture|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=== | ===AIFs=== | ||
Though, trick for the young players — an AIF is a form of [[financial counterparty]], so does not qualify for the hedging exemption. | Though, trick for the young players — an AIF is a form of [[financial counterparty]], so does not qualify for the hedging exemption. | ||
{{sa}} | {{sa}} | ||
*[[Repackaging programme]] | *[[Repackaging programme]] | ||