Sizing Up the Impact of Derivatives Regulation on the European Property Sector “While the impact of these requirements on risk management and financing strategies remains unclear, we can say that the cost of managing risk will increase and, as a result, will alter hedging behaviors.” A publication of Summer issue 2014 sponsored by CRE Finance World Summer 2014 39 Many real estate companies have not taken necessary steps to agree to procedures with their banks, and the UK’s financial markets regulator, the Financial Conduct Authority (FCA), indicated that it expects companies to achieve compliance with the risk mitigation requirements not later than this past 30 April. This approach by the FCA – allowing a compliance obligation to take effect but permitting an uncertain grace period before dialing up potential enforcement efforts – may offer clues as to regulators’ awareness of the magnitude of the compliance hurdles the market faces and how these regulatory authorities will approach enforcement with respect to other requirements, such as reporting. In the case of the portfolio reconciliation requirements, the FCA allowed about 7 months of non-compliance before tightening the screws on enforcement. Current State of Play — Transaction Reporting In February 2014, derivatives reporting requirements took effect, with dozens of transaction details needing to be submitted to an authorized Trade Repository (TR). While in the US under Dodd- Frank, the reporting responsibility largely fell on swap dealers, EMIR levied the requirement on both participants to a trade. Many market participants and observers presumed that banks would agree to accept the delegation of their clients’ reporting responsibility. However, a number of banks – including a number of large US banks facing European counterparties – have declined to do so, requiring companies to identify and engage with new reporting service providers, including our firm, Chatham Financial. Just as most derivatives end users were non-compliant with risk mitigation requirements in September, it is widely understood that most endusers remain non-compliant with reporting requirements. The reporting requirements mandate that 85 data fields containing economic and counterparty information be submitted to a TR for each trade. The requirements were structured into stages, such that new trades would need to be reported beginning in February, but certain trades that existed prior to February would need to be reported in stages beginning in May 2014 and ending in 2017. A key administrative requirement associated with reporting is the need to obtain legal entity identifiers and to recertify those identifiers annually. This requirement is intended to give regulators better visibility into the sources of systemic risk and reflects the challenges regulators faced in estimating the impact of failure of large institutions such as Lehman Brothers. On Deck — Requirements Yet to Come While regulatory requirements issued to date have largely been administrative in nature, some requirements yet to be finalized could be more economically intensive. In particular, European regulators are still working to finalize margin requirements on swaps that are not subject to clearing requirements, including those that are not sufficiently standardized to be cleared. While the rules governing margin are not completed, market participants have a good view into their likely form on the basis of a G-20 brokered agreement. That agreement held that FCs would need to post variation margin (VM) to collateralize the mark-to-market (MTM) value of their swaps. While swaps generally have no or de minimis MTM value at the inception of a trade, a swap can take on positive or negative value based on the fluctuation of market rates. A 5-year, €100mm pay-fixed interest rate swap, for example, can accumulate a negative market value as high as €10mm, or even more if interest rates fall precipitously. It is expected that VM will not be applied to NFCs under EMIR, including the SPVs used to hold many real estate assets. In addition large derivatives users will be required to post initial margin (IM). IM serves as a buffer to over-collateralize derivatives trades in the event that margin is not posted when due. Based on the G-20 agreement, FCs will only be required to post IM if the gross notional amount of their derivatives eventually exceeds €8 bn. Counterparties whose derivatives volumes trigger these requirements will be permitted up to a €50mm exposure threshold before needing to post IM. FCs will also be required to transact certain swaps on electronic platforms under requirements set forth in MiFID II. While it is yet unclear as to the final scope of these requirements, similar rules in the US are currently applicable to mortgage REITs, while most other real estate entities are as yet unaffected.
CRE Finance World, Summer 2014
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