While there is talk of an EMIR 3, one may worry about a backward step. “Back to the future”? After the recent crises that we have just experienced, and the review launched by ESMA, two things could come to the fore and modify the EMIR regulation. On the one hand, the end of the exemption from reporting inter-company transactions and on the other hand, the review of the definition of "hedging". These are two things that treasurers cannot tolerate as they make no sense. We must fight to make our position heard and why these provisions or proposed changes would be a double misguided idea. A particular problem, i.e., the liquidity crisis of the energy companies, should not impact all the industries and other businesses. ESMA and EU Commission do not see the forest for the trees.
Intercompany OTC derivative transactions, principles
The organizational principle of a Multinational Company (i.e., MNC) is quite simple. The Treasury HQ acts as an internal bank (i.e., In-House Bank). All hedging requests (coming from businesses and affiliates) must be directed to the Treasury HQ. For example, if a subsidiary needs USD to pay for an equipment or a commodity purchase, it goes to the treasury center which buys the USD against EUR from a bank (i.e., an external deal) and then it sells the USD to its subsidiary. This is a mirror transaction between two entities of the same group. They are identical (although possibly with a Transfer Pricing at arm's length margin, meaning a spread applied for services). Therefore, before EMIR refit, there were three OTC derivatives transactions to report to the Trade Repository (i.e., 1. the deal of the subsidiary with the IHB, 2. the deal of the IHB with the subsidiary, and 3. the deal with the bank). But it is obvious that inter-company transactions are perfectly off set when consolidated under IFRS. These two transactions therefore do not provide any useful information to the supervisors, nor do they increase transparency. If the inter-company transactions were not cancelled in consolidation, the result would directly impact the P&L. IFRS rules are relentless.
On the other hand, the external transaction must be reported. It is EMIR refit that adequately and logically corrected this useless obligation by authorizing an exemption (if one obtains it individually from each national supervisor in the countries in which they are active/dealing with). So why do we want to remove this exemption, even though it is logical and useful because of the simplification it brings? There is no logical reason given. It would even create a competitive disadvantage for European Corporates. Yet it seems that this is one of the recommendations proposed to improve EMIR in a third version. The best is not always advisable and is sometimes the enemy of the good. For an SME, which no longer had to report its inter-company transactions, it could delegate the reporting to its bankers, who were now responsible for the proper reporting. Removing this exemption would force them to report what they were no longer reporting. They will be penalized by this unnecessary provision.
Definition of what EMIR means by hedging.
The second idea considered by ESMA (during the review initiated even before the war in Ukraine) was the review of the definition of the “hedging” concept. Here again, this seems to us to be a bad idea as the current definition, which could be qualified as "principle-based", is satisfactory. A stricter "rule-based" definition, different from the IFRS notion of "hedging", would be potentially reductive, restrictive, and much more difficult to demonstrate. It seems to be a matter of common sense and to align regulatory reporting with accounting reporting is logical. This makes it possible, during an audit by the national supervisor, which may happen, to demonstrate whether the transaction corresponds to hedging or not. If this were not the case, it would be counted for the calculation of the limits set by asset class (i.e., EUR 1 or 3 billion equivalent). Only OTC derivatives that are not hedging are therefore counted for the calculation of compliance with these limits. Moreover, this limit very rarely poses problems for Corporates as the OTCs in which they invest cover almost 100% of the actual operational underlying exposures. Once again, one may ask what a new definition, probably more restrictive and more precise, would bring to the controls. Again, the IFRS accounting rules are unstoppable. If you cannot demonstrate that the transaction meets all the conditions for hedge accounting (i.e., IFRS 9 - formerly IAS 39), you cannot invoke this accounting treatment exception. The change in "Mark-to-Market" (i.e., Fair Value) will be recognized in P&L, thus directly impacting your net result at the closing date. This seems to us relentless, logical, and ultimately very simple. We therefore see no reason to change a principle that has been working well (until proven otherwise) for almost 10 years.
Change for the sake of change...
If there is one thing to recommend, it is to avoid perpetually changing measures that work. It is healthy and recommended to review financial regulations and guidelines regularly. However, it is not necessary to systematically change a rule, under more "political" pretexts that would suggest that corrective measures should be taken after a crisis. It has come to our attention that the recent energy crisis and the ensuing price surge have greatly disturbed certain players, including energy and electricity production companies. Indeed, they use products on regulated commodity markets (non-OTC/non-regulated by EMIR) that require potentially "collateralizing" the change in "Fair Value" at each observation. Certainly, this market practice has been costly for some well-hedged companies in terms of collateral to be allocated to their counterparties and CCPs. If it turns out that some of them have exaggerated, let's monitor them and focus the controls on those specific players. And then, if you were to post too much cash as collateral for your hedges, you might be well advised to reduce the collateral by unwinding some of the excess hedges, to limit the impact of the requirement to collateralize cash. We have the impression that politicians intend to respond to a particular problem on specific products with a general measure on other more standard products, which did not pose any problem. Overreacting has never been a good idea and has never corrected problems. If politicians feel an obligation to take measures, they should take adapted and specific measures so as not to penalize all the actors.
François Masquelier, CEO of Simply Treasury, your Treasury Strategy Advisor – Luxembourg – July 2023
Disclaimer: This article was prepared by François Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).