Brussels must stick up for the endusers of derivatives

Europe and US split over reform for derivatives

Some developments taking place at EU level which may ultimately have the effect of making it much more difficult and expensive for companies to limit commercial risks through derivatives – and to suggest the most effective ways to raise concerns in this regard.

In short, the European Commission is consulting on a number of regulatory changes to the way in which OTC (or ‘privately negotiated’) derivative contracts are transacted. At present, many interest rate, FX and credit hedges are executed OTC, as this offers the greatest flexibility and the best hedge. The changes are intended to address perceived weaknesses in global market infrastructure. OTC markets have performed well in this period of unprecedented stress, including the first instance of a major OTC derivative counterparty defaulting on its trading obligation, but more can be done to reduce systemic and operational risk (central clearing, standardisation etc).

Everybody will understand the importance of OTC derivatives for hedging corporate risks. The danger is that, while being positive in some respects, the proposals could (a) make it more difficult for companies to find and use those derivative contracts which can most appropriately reduce their business risks, e.g. bond hedges, which might not achieve hedge accounting treatment if not sufficiently customised and (b) make use of such derivative contracts by these companies more expensive, e.g. by requiring collateralization.