EU Companies Ask for Risk Hedging Exemption in Derivatives Legislation

A consortium of EU non-financial companies has asked the European Commission to carve out an end user exemption from the draft derivatives regulation to allow them to continue to use OTC derivatives to hedge risk. More than 160 companies signed a letter urging the Commission to continue to allow them use OTC derivatives to hedge risk in a mature and prudent manner. Non-financial companies, as end-users, use OTC derivatives to hedge the impact of movements in currencies, interest rates, commodity and other prices.

These end-users are concerned that the unintended consequences of the draft may threaten economic recovery by draining companies’ liquidity into mandatory collateralization of contracts, reducing the amount of hedging, thereby increasing business risk, and raising costs for those prudently hedging their risks. They want any final legislation to preserve their ability to manage financial and market risk exposures by ensuring continued access to reasonably priced and customized OTC derivatives.

Specific proposed reforms to the OTC derivatives market currently being will disadvantage many end users who rely on OTC derivatives to hedge underlying commercial exposures. For example, the intent to drive OTC derivative transactions into central clearing and onto exchanges will increase liquidity risk and funding costs through the requirement to post cash collateral. In turn, this will reduce flexibility to match underlying commercial exposures.

Non-financial companies do not have the same ready access to liquidity that financial institutions have. This lack of access, coupled with the requirement to post cash collateral based on unknown future financial market movements, will place an excessive and inefficient burden on non-financial companies. The economic effect of the requirement to provide cash collateral is to convert the primary risk for companies from that associated with counterparty exposure into liquidity risk. Non-financial companies are highly experienced in managing their counterparty risk with financial institutions; managing liquidity risk in collateral requirements is substantially more difficult for them and is less efficient.

Legislation recently passed by the House of Representatives exempting commercial end users from the clearing requirement. These firms, such as airlines, manufacturers, and other small- to medium-sized businesses, could use derivatives to hedge risk. And, Jose Manuel Barroso, President of the European Commission, has called for the passage of derivatives reform legislation in 2010 along the lines already set forth by the Commission and carving out an exception for companies to hedge risk.

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