MEPs meeting in Strasbourg appeared to have been unconvinced by industry lobbying to allow a practise known as “netting of derivative contracts” for the purpose of calculating the threshold for central clearing. This financial magic would have exempted most non-financial companies from the “EMIR” Regulation (European Market Infrastructure Regulation). After a late intervention from the European Commission, a motion to delay the new derivatives rules was today withdrawn.
The development defends the “real” part of the real economy. By enforcing transparency and central clearing requirements on all large traders, including those outside the banking sector, it closes a loophole that would have allowed big industrial companies to use their real economy business as a cover for financial speculation by their treasury financing departments. Companies that are simply hedging risks related to their commercial activities can continue to do so, on safer and more stable financial markets.
As a result of the motion being withdrawn, large derivative trades in the European Union will start to be subject to central clearing rules as of summer 2013, significantly reducing systemic risk in derivatives trading. This fulfils an important international commitment agreed by G20 (PDF) world leaders in 2009, in an attempt to address the causes of the financial crisis.
Why is the EMIR Regulation so important?
EMIR implements the G20 agreement to centrally clear derivatives in the European Union. Central clearing is an important mechanism to reduce systemic risk, and helps to protect against a domino effect of defaults in the financial system.
The delegated regulations at stake today were drafted by the European Commission and the European Securities and Markets Authority, and had been presented on 19 December 2012. They implement certain technical details of the EMIR regulation as agreed between the European Parliament and member states in March 2011. Certain Members of the European Parliament contested the Commission’s interpretation of the February 2011 political agreement on EMIR for two of the nine standards concerned – those on the central clearing obligation and on the posting of collateral to central counterparties. The European Parliament had two months to block these measures, and by choosing not to do so in its full plenary session today, allows the new rules to be adopted on 19 February. Central clearing will start to apply in the summer of 2013.
Blocking the rules would have had three important consequences:
1) It would have delayed the implementation of the G20 agreement after the financial crisis to have derivatives centrally cleared as much as possible.
2) It would have opened the doors widely to speculation on derivative markets.
3) It would have made it very difficult for supervisors to monitor compliance with position limits currently proposed in the MiFID proposal (see below for an explanation of what this refers to), as corporates could still build up large positions in commodities by using “over-the-counter”, or bilateral, transactions, which would not be visible to the financial supervisor.
Why did the industry lobby the Parliament to block the Regulations?
During the legislative negotiations on EMIR in 2010-2011, non-financial companies fought hard to be exempt from the central clearing requirement, arguing that banks had caused the financial crisis and that “real economy” corporates like airlines and oil companies should not be considered systemic players on derivate markets. Finance Watch however considers that derivative markets should be protected against excessive speculation, and that all large players on such markets should be subject to transparency requirements and central clearing rules, irrespective of whether they are an investment bank, a non-financial company, or an individual trader. At the time, the European institutions agreed with this approach.
Under the implementation rules drafted for the Commission by ESMA, companies (financial and non-financial) would be able to take up as many positions as they wanted as long as they are proven to be genuine hedging positions. On top of that, non-financial companies can hold up to EUR 3 billion of gross value in derivative contracts without a hedging nature, before being subject to central clearing. This is an exceptional allowance, which allows enough flexibility for non-financial companies to avoid application of the central clearing rules. It does not exist in the United States, the other key jurisdiction that signed the G20 Pittsburgh declaration.
The industry argued that the Commission should have gone further and allowed companies to speculate even more than EUR 3 billion without central clearing by allowing the “netting” of positions across counterparties and asset classes. Their lobbying led to a proposal (the one that the Parliament withdrew today) that would have exempted most large European companies, including large airlines and oil companies, from the central clearing rules, even though some of them are very large players on financial markets.
How can derivatives market regulation be further improved?
Financial markets and in particular those dealing in derivatives linked to foodstuffs, oil and other raw materials, have been created to serve a “real economy” purpose, such as allowing a farmer to insure his income against bad harvests using hedging contracts. Speculators play a useful supporting role as counterparties for hedging but should not become the dominant market force, as this risks disturbing price formation and contributing to price volatility.
Finance Watch is therefore backing proposals for position limits, a measure that would set a maximum limit for any player in a commodity derivatives market. Position limits are currently being negotiated as part of another piece of legislation (Markets in Financial Instruments Directive – read more about our position on MiFID2 here). This is where EMIR comes in. The central clearing mechanism created under EMIR would allow financial supervisors to monitor compliance with position limits and prevent circumvention.