End users, such as insurers, face a squeeze on liquidity and a potential increase in cost of hedging resulting from new OTC derivatives central clearing obligations under both EMIR and Dodd-Frank.
US and EU-based end users of derivatives are struggling to get to grips with the impact that both the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) central clearing obligations will have on their ability to use those products in the future. End users are discovering a range of unintended consequences around rules focused on collateral and clearing exemptions. Companies are concerned that these will significantly raise the cost of hedging or make it entirely non-cost effective.
For example, US insurers are beginning to assess the impact of Dodd-Frank requirements that they post collateral for their derivatives transactions on both their investment policies, as well as their cash flow. Their European counterparts will soon be chewing over the same difficult issue, as the technical standards of EMIR are finalised later this year. Although most insurers think of themselves as end-users of derivatives, they are considered to be financial counterparties in both Europe and the US.
“If there is one area where you could see an insurance company trip up, it is, funnily enough, derivatives,” says Neil Chapman, a director at Towers Watson in London. Previously, many insurers dealt mostly over-the-counter directly with banks when they engaged in derivatives transactions, with high collateral thresholds for high credit ratings in their collateral agreements, which were often less strict.
Under the new rules, insurers will be required to post collateral with nearly all of their derivative transactions because they will be required to do them through centralised clearing. “That’s the whole point of a centralized clearing house – they have a standard set of criteria, they have a standard set of rules for collateral and netting and that’s just the way it is,” says Ed Toy, capital markets bureau chief at the National Association of Insurance Commissioners (NAIC). “In the past, the insurance industry, at least here in the US, has benefitted from the fact that from a solvency and a capital standpoint it is a very strong industry, and so counterparties have frequently allowed for situations where they don’t require collateral or they’re much more lenient in terms of the collateral rules that the insurance companies need to follow.”
This collateral will need to be composed of very liquid securities, such as US Treasuries or government agency debt – securities that most insurers, particularly those on the life insurance side of the business – previously held in smaller quantities because of their relatively low returns. As well, insurers, with their long investment and return timeframes, traditionally have not had the same liquidity concerns that banks have had.
So insurers will now have to hold a much greater share of highly liquid securities on their balance sheets than they have in the past.
The other problem the collateral requirement could create is a liquidity pinch, if the firm doesn’t have enough liquid securities on hand. Says Chapman, “Insurers shouldn’t be too complacent about this. If a company has a lot of derivatives positions, because insurers are gradually getting more sophisticated in their hedging, something they need to consider is that liquidity problems just can’t happen.” In fact, AIG’s collapse was caused by banks’ requirement that it post collateral on the credit default swap (CDS) positions it had entered into, when AIG was downgraded. While AIG’s CDS positions were so large they constituted a separate business line, regulators are conscious of the principle involved – that if a firm doesn’t have enough liquid securities and it can’t sell its more illiquid holdings because of market turbulence, then there is a problem.
Insurers are already making moves to adjust to a new, post-Dodd-Frank and EMIR world. “The move to clearing is pretty high up our clients’ agenda these days. What we are hearing is that this is tending to increase the value of liquidity for insurance companies,” says Simon Hotchin, managing director and head of the strategic solutions group, debt capital markets HSBC. “What we are seeing now is that insurers are much more explicitly recognising the liquidity value of their asset portfolios, and a number of insurers are wanting to increase the liquidity of their portfolios for those reasons.” The insurance industry has also been working with the Securities and Exchange Commission (SEC) and the Commodities and Futures Trading Commission (CFTC) on proposals that would permit insurers to use AA corporate bonds, which are so-called “benchmark” issues, as collateral. These proposals, which have not been finalized, would provide a slightly higher return than other liquid securities – insurance firms are worried about the impact of the new rules on the performance of their investment portfolios.
Regulators are keeping an eye on how the challenges around collateral evolve. “At this stage we don’t see that it is a major issue for insurance companies, and yet at the same time it is clearly something that we’re focusing on, and talking to companies about because of changes that are coming out as a result of Dodd-Frank,” says the NAIC’s Toy. “It does raise some questions.” According to analysis performed by the NAIC on 2010 insurer annual reports, 223 companies participated in the derivatives markets, with a total of about 48,600 derivatives positions estimated at $850 billion notional value. Toy also says that the NAIC is looking to enhance disclosure on insurers’ derivatives position and levels of posted collateral.
Another sticky issue – this time for European non-financial counterparties, but also for those companies outside of the EU undertaking relevant transactions with EU entities – is how the operations framework surrounding clearing exemptions from EMIR will work. This is a particularly EU issue as there is no such threshold contained in the Dodd-Frank Act in the US, but it would impact firms seeking to do derivatives transactions with EU firms.
Under the current proposals from the European Securities Markets Authority (ESMA), non-financials are exempt from clearing unless their derivatives positions exceed a certain threshold, and they are not considered under the rules to be genuine commercial hedging. Just what is considered to be “objectively measureable as reducing risks directly linked to commercial activity or treasury financing activity” is the subject of consultation and was included in the 16 February discussion paper on technical standards issued by ESMA.
EU commodity and energy firms are particularly concerned about how this threshold is defined at the moment, because many of them say they will find themselves forced into central clearing, based on current proposals. Companies such as E.ON, Cargill, and EDF Trading responded to the ESMA consultation, as did a wide range of energy trading industry associations. “Our experience is that the end users are more exercised about this than the buy side at the moment,” says Jonathan Herbst, a partner at Norton Rose in London. “I think they are more aware of it, and they recognise that it is a great threat to them. They really care about it and they are really thinking about it. Where the threshold is set, and what does and does not count as hedge trading, becomes tremendously important.”
An important related issue is how financial firms will be able to ascertain that a clearing obligation exists among end-user organisations – at the moment the ESMA proposals require banks to determine if a company has a clearing obligation or not, a suggestion that has been widely criticised. “It has suddenly dawned on a lot of us that the whole structure doesn’t make a lot of sense,” says Herbst. “For example, if you are a bank, and you deal with an oil company, how are you going to know if that oil company falls within the exemption or doesn’t, generically. ESMA talks in the consultation paper about a disclosure document. Effectively what we have is a regulation that no one has thought about. There is no register, there is no public mechanism, so how are firms going to know? This was a Level One problem that was not solved, and now Esma is going to have to solve it through secondary legislation, essentially.”
European Banking Federation (EBF) suggests that, in the interest of legal certainty, the fact that a non-financial company has become subject to a clearing obligation needs to be a matter of public matter knowledge. For example, a public register with the legal entity identifiers (LEIs) of the non financial entity that are required to clear their transactions could be maintained by ESMA. “The obligation is for the non-financial to ensure it qualifies for the exemption,” says Joe McHale, financial markets advisor at the EBF. “It shouldn’t be up to the bank itself to make sure that the non-financial actually qualifies for the exemption. It should be up to companies to control themselves, it shouldn’t be up to banks to supervise them or to monitor them.”
