By Tom Riesack and Ute Herzog

In the ‘new normal’ of highly regulated financial markets, corporate treasurers are feeling the reverberations in their daily activities. Corporates are using swaps to hedge their commercial risks, stemming from currency, interest and commodity price exposure. To mitigate such risks treasurers have a whole arsenal of instruments ready to deploy such as swaps, forwards and options as well as individually structured products.

Under current bilateral trading agreements, corporates typically do not put up any collateral with mostly one-way netting agreements in place and sometimes no netting agreements at all. Swap activities and the resulting mark-to-market valuations are covered by extended credit lines of their financial counterparties.

Pending regulations for the financial sector (especially Dodd-Frank Act (DFA), EMIR and Basel III) will have a direct impact on corporates who are classified within these frameworks as non-financial end-users. Whereas Dodd-Frank and EMIR require standardised swaps to be centrally cleared, Basel III introduces the CVA (credit value adjustment) charge which makes bilateral swaps vastly more expensive as the amount of core capital required is three times higher than before.

But corporates are granted exemptions under DFA and EMIR:

• End-user exemption under DFA
  • Exemption from mandatory clearing and trading if swaps are used “to hedge or mitigate commercial risk”
  • Notification to the Commodity Futures Trading Commission required
  • Board approval to opt out of the central clearing requirement
• End-user exemption under EMIR
  • No clearing obligation as long as certain thresholds are not breached
  • Thresholds apply to all trades not “objectively measurable as reducing risks”, which means not used to hedge commercial risks
  • Current thresholds for credit and equity derivatives are € 1bn and for interest rate, FX, commodity and other derivatives, € 3bn

Here’s the catch – no such exemption has been granted under Basel III until now. The result is the application of a CVA charge by financials when calculating the core capital consumption needed for deals with corporates although such trades would not be required to be cleared. The respective cost of trading is likely to be transferred to corporates making their hedging activities more expensive. One estimate by a group of 17 large German corporates  puts this figure at a hike of 200% over today’s costs and consequently there is still industry confusion about which exemptions will be granted. 

The European Association of Corporate Treasurers (EACT) is at the forefront of lobbying efforts to bring in line the CVA charge application with EMIR exemptions. But currently, corporate treasurers’ use of swaps could move in different directions if an exemption under Basel III is not achieved. Firms may:

• Keep going as before and bear the additional cost of trading
• Adjust current processes to enable central clearing of swaps, which would alleviate the cost stemming from the CVA charge but would require corporates to put up collateral that they typically do not have
• Reduce or effectively stop the hedging of their commercial risks to take on the risk rather than the cost.

As David Lawton, Director of Markets at the FSA put it in a recent speech: “These are not challenges that will go away overnight […] I would encourage you to engage as much as possible. Consider whether you need to amend existing or enter into new bilateral credit support documentation to meet new margin requirements. Review existing operational processes to ensure they conform with the new technical standards. Provide notifications in good time to regulators if intending to rely on exemption.”