OTC Derivatives

Proposals in the US and EU to reform the OTC (over the counter) derivative markets could have unintended consequences that hinder the ability of companies to hedge many of their normal financial risks.

Following the collapse of Lehmans and AIG in 2008 the regulatory authorities in both the US and Europe were concerned about the systemic risks arising from the build up of positions in OTC derivatives. They were worried that the huge volumes of outstandings and the lack of transparency could mean that in the event of the collapse of a large market participant there could be a catastrophic chain of defaults and the withdrawal of liquidity from the markets.

After much public and private debate during 2009 and 2010 the US has enacted new law in the shape of the Dodd-Frank Wall Street Reform and Consumer Protection Act, while in Europe the European Commission has drafted a proposed Regulation which was adopted on 15th September 2010

Corporate treasurers were concerned that an obligation to put up cash margin as collateral might inhibit companies from using tailored OTC derivatives, including many straightforward transactions such as FX forwards, currency and interest rate swaps, options and commodity forwards. In the event there are exemptions for non financial companies in both the US law and EU proposals, but the thresholds below which the exemptions apply have not yet been set.

Since 2009 companies, the EACT and the ACT have been campaigning to ensure the various regulations are not harmful to companies. The strength of feeling amongst non-financial companies and the importance they attached to this issue was demonstrated by a letter from the EACT to the European Commissioners (dated 6 January 2010) and which was signed by over 160 companies from across Europe.

A summary position paper, prepared with the European Association of Corporate Treasurers, sets out the original concerns on the proposed European initiatives concisely.

On 20 October 2009 the EU commission published its revised proposals which did recognise that the use of derivatives by non-financial companies does not create a systemic risk and therefore went some way in reducing the negative implications for companies from the proposals. In its Press Release responding to the announcement the ACT welcomed this step but warned that dangers still remained.

ACT responses

In response to the US and EU proposals for regulatory reform of the OTC derivatives the ACT has made submissions:

• Commission consultation on derivatives and market infrastructures of 14 June 2010 – ACT response July 2010
• ACT evidence to House of Lords Committee Jan 2010
• Commission communication 20 October 2009 - ACT response
• Corporate concerns about OTC derivative regulation
• European Commission OTC derivatives proposals - ACT Response
• ACT background information on the proposals for regulation of OTC derivatives
• Possible initiatives to enhance the resilience of OTC derivatives markets - EU Proposals
• Reform of OTC derivatives - ACT Response

Further reading

• US Treasury legislative proposals for OTC derivative regulation, 11 August 2009
• Communication from the Commission - Ensuring efficient, safe and sound derivatives markets, 3 July 2009
  High level summary of the issues and possible market mechanisms available to solve these
• Ensuring efficient, safe and sound derivatives markets, 3 July 2009
  A detailed background paper explaining the workings of the various markets an and market mechanisms with data on volumes etc.
• EU commission home page for derivatives
• US proposals: Secretary Timothy F. Geithner
  Written Testimony to House Financial Services and Agriculture Committees Joint Hearing on Regulation of OTC Derivatives - July 10 2009
• ACT letter to FT re OTC derivatives - 6 October 2009
• EACT letter to FT re OTC derivatives - 5 October 2009
• Rolls Royce letter to FT re OTC derivatives - 5 October 2009
• Commission communication on OTC derivatives of 20 October 2009
• ACT letter to FT re use of naked CDS – 9 Mar 2010
• Langen report to ECON Committee re OTC derivatives – Feb 2010
• Report of European Union Committee of the House of Lords on OTC derivatives – March 2010

"The Committee agreed with the views of the ACT and quoted from the ACT evidence that non financial companies should not be subject to mandatory central clearing (para 100)."

• EACT flags real economy impact of regulation