Europe risks corporate derivatives loophole

September 16, 2010

Europe’s corporate treasurers can pop open the champagne. After much lobbying, they have won an exemption from new European Commission rules forcing over-the-counter derivative trades to be centrally cleared. But the decision could create a loophole that allows companies to take on big positions and pose a systemic threat.

The G20 group of leading nations last year agreed that all derivative trades should, where possible, be moved onto clearing houses. The thinking was that central clearing spreads risk, reducing the chance that the failure of a single large counterparty can drag down the financial system.

The plan infuriated companies, who use OTC derivatives to hedge their exposure to short-term movements in exchange rates and commodity prices. Using clearing houses would force them to start posting collateral, sucking up precious cash.

Treasurers argue that corporate derivatives are used for legitimate hedging, not speculation, and did not contribute to the credit crisis. Besides, U.S. companies have already been granted an exemption from new rules.

Nevertheless, giving companies special treatment could distort markets. Speculators could set up non-bank entities in order to circumvent the rules, potentially leaving banks on the hook if trades go wrong.

The EU plan seeks to avoid this pitfall by limiting the exemption granted to companies. If the size of a company’s exposure breaches a yet-to-be-determined threshold, it would have to clear all its trades. Complex derivatives that can’t be cleared would be subject to strict risk management. Derivatives used for hedging won’t count.

The exemption should prevent companies from speculating wildly, but leave them free to hedge business risks. However, there could still be scope for arbitrage if the final rules, which will be determined by the soon-to-be-created European Securities Markets Authority, are not carefully drafted.

Distinguishing hedging trades from speculative ones could also be tricky. The draft law gives companies leeway by not applying the strict definitions of hedging activity used by accountants.

The threshold test prevents a company from building up a big exposure in any one class of derivatives. But as currently drafted it might not prevent a company from building up a range of speculative positions that, in aggregate, could make it an important market counterparty.

Brussels is trying to find a middle ground between ensuring financial stability and not making companies pay too much for it. The danger is that, in doing so, it is sowing the seeds for other future blowups.

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