Chatham Financial is a leading, independent consulting firm that advises end users of derivatives on managing interest rate, commodity and currency risks. We are a global firm with operations in Europe, the United States and Asia, and we work with over 1,200 clients from virtually all business sectors, including nonfinancial corporations, real estate companies, infrastructure investors, energy producers, and micro-finance funds. Our clients use derivatives to reduce risk associated with operating and investing in the real economy. They do not use derivatives for speculative or investment purposes. We assist our clients with all facets of the hedging process, from analyzing risk, to structuring and executing hedges, to providing ongoing valuations, reporting, accounting and regulatory support.
Our comments are focused on variation margin as most of our clients would not exceed the €8 billion notional threshold of aggregate outstanding OTC derivatives positions that would require the posting of initial margin. Several of Chatham’s client sectors are financial counterparties (FCs) that will be disproportionately affected by the requirement to post variation margin for uncleared trades. The joint ESA consultation states that “the exchange of variation margins seems to be common practice among financial institutions” (point 146, page 78). However, unlike almost all other FCs under EMIR, the full exchange of variation margin would represent an entirely new and substantial obligation for entities that invest in physical or illiquid assets, including real estate funds and microfinance investment vehicles (MIVs). We therefore strongly urge the ESA’s to consider tailoring the variation margin requirements in such a way as to reduce the disproportionate burden the new requirements will have on these and other sectors that invest in physical or illiquid assets.
• Real Estate Funds: Real estate funds that invest internationally have currency risk and they use OTC derivatives products including physically delivered currency forwards, NDFs, and currency options to hedge their exposure. By industry estimates, there are approximately 350-400 real estate funds in Europe that will have a fund manager authorized under the Alternative Investment Fund Managers Directive (AIFMD) and will therefore be considered FCs under EMIR. These funds raise capital from a range of sources (e.g., pension funds) and typically invest those funds as equity or debt in real property. They draw funds from investors only once they have agreed to purchase specific assets, which they in turn pledge to lenders in order to obtain financing to facilitate the asset purchases. Real estate funds would be disproportionately hindered from conducting business by margin requirements as they (1) do not themselves hold capital pledged to the fund by investors, (2) pledge their real estate assets as collateral to obtain financing, and (3) do not invest in securities that could be pledged to satisfy margin requirements.
• Microfinance Investment Vehicles: MIVs serve as a source of capital for microfinance institutions that provide loans to small businesses and entrepreneurs that lack access to traditional banking or related financial services. Because MIVs provide loans to microfinance institutions in their local currencies, they have significant currency exposure they seek to hedge through physically delivered currency forwards, NDFs and currency options. In addition, MIVs use interest rate hedging products, including cross-currency swaps, to mitigate the risk associated with lending to microfinance institutions at fixed rates while providing floating rate returns to investors. According to a 2013 survey of MIVs, there are 111 active MIVs globally, and a majority of their portfolios are invested in Latin America, Eastern Europe and Central Asia. The vast majority of these MIVs are domiciled in Europe and subject to EMIR. On average, a MIV reaches 136,689 active borrowers with an average loan of approximately €1,500. MIVs generally raise funds from public sector entities such as development finance institutions, institutional investors such as pension funds and non-profit organizations. Like property funds, MIVs do not hold cash reserves, and they do not have access to pools of highly liquid securities to pledge as collateral for their OTC derivatives. Consequently, MIVs would be disproportionately burdened by margin requirements.
Due to the nature of their investments in real and illiquid assets, the imposition of a variation margin requirement would have a significant and adverse impact on the real estate funds and MIVs that would cause serious damage to their ability to hedge risk. As their derivatives activity is purely linked to their commercial risk profile, real estate funds and MIVs do not pose a risk to the stability of the financial system. Moreover, their derivatives portfolios are very small relative to most financial counterparties.
An obligation to post variation margin would either lead to a dramatic reduction in commercial hedging or the elimination of hedging altogether in our sector. A reduction or a complete termination in hedging by these sectors will have adverse consequences that we believe are neither intended by policymakers, nor consistent with the overall objectives of EMIR specifically and derivatives regulatory reforms generally.
By way of example, we would like to provide the following scenario.
Opportunity cost is a key concept FCs like real estate funds and MIVs consider in quantifying the impact of a variation margin requirement. Consider a European real estate fund that purchases a senior housing facility in the United States in November 2009. The building costs €100 million ($150 million at the then-current spot rate of 1.50), the fund’s equity contribution (i.e., down payment) is €40 million ($60 million), and the fund borrows €60 million ($90 million). The EUR/USD exchange rate at the time of the investment is 1.50. The fund’s equity investment in the building will be adversely impacted when the dollar weakens against the euro.
• If the EUR/USD exchange rate moves from 1.50 to 1.60 (i.e., euro strengthening, dollar weakening), the fund’s equity investment will decline in value from €40 million to €37.5 million (-6.3%).
• If the EUR/USD exchange rate moves from 1.50 to 1.40 (i.e., euro weakening, dollar strengthening), the fund’s equity investment will increase in value from €40 million to €42.9 million (+7.1%).
In order to mitigate this risk, the fund enters into a five-year currency forward contract to buy euros and sell dollars. For simplicity, we assume the fund enters into a contract allowing them to sell US dollars and buy euros at a rate of 1.50 regardless of the market rate at the time it sells the building and settles the forward contract.
By May 2010, with the EUR/USD exchange rate at 1.20, the US dollar had strengthened considerably against the euro. The currency fluctuation alone caused the value of the fund’s equity investment to increase by €10 million, or 25%. Meanwhile, as designed, the fund’s currency forward contract had declined in value by approximately €10 million, such that the fund’s net equity investment remained at €40 million, unaffected by the significant currency movement. Assuming the real estate asset value remain unchanged, if the fund were to sell the building at that time, it would readily be able to fund the €10 million termination value of the currency contract through the €50 million proceeds obtained when selling the building.
However, in this example we must consider the economic effect of holding €10 million back for margining purposes for each €40 million invested in a building. If the fund’s investors expect a 20% return on investment, the fund would consider its cost of sidelining the €10 million amount as €2 million per annum (20% foregone return x €10 million margin amount). Assuming the fund successfully achieved a 20% return on investment on its underlying real estate investment after one year, this return would be reduced by 20% (i.e., a 20% return would be reduced to 16%, eliminating 4% or 1/5 of the return) on account of the margining requirement on the currency forward contract. This return would be further impacted if the fund manager held back additional funds in order to buffer against further currency movements.
It could be argued that any reduction in investment returns – even a significant reduction like the above – would be a cost worth paying in order to meaningfully reduce systemic risk. However, if the transactions in question have little or no ability to contribute to systemic risk, the policy benefits of broadly applying full variation margining requirements would be significantly overwhelmed by the economic costs. In the case of the microfinance and real estate sectors the economic costs would represent a significant decline in real world investment and job creation. Throughout the financial crisis, financial institutions worldwide lost or wrote down approximately $2.09 trillion (€1.54 trillion at the current spot rate) across all financial products, including loans, CDOs, asset-backed securities, derivatives, etc. Of note, only 3.2% (approximately $67 billion, or €49 billion at the current spot rate) of such losses were the result of derivatives, the majority (55.8%) of which resulted exclusively from AIG. In Europe, 2.2% ($16 billion, or €12 billion at the current spot rate) of financial institution losses resulted from derivatives. Systemically significant derivatives users – especially AIG and monoline insurance companies – comprised the vast majority of these losses. By way of contrast, losses from financial end-user hedgers – including real estate funds and MIVs – did not meaningfully contribute to systemic instability in any sense due to the small size of their transactions.
One possible solution to this problem could be the introduction of a threshold for the imposition of variation margin for non-systemically important financial counterparties. Such an approach would introduce a variation margin requirement in a proportional way by structuring the requirement to consider the systemic risk profiles of those that invest in physical or illiquid assets, including real estate funds and MIVs.
Since 2008, real estate funds and MIVs have typically been required to trade under credit support agreements (CSAs) through which they pledge collateral to their counterparties if their mark-to-market positions exceed thresholds set by their counterparties. These thresholds have served as a sound and pragmatic approach that reduces the counterparty risk faced by banks, while preserving the economic viability of hedging for financial end users like real estate funds and MIVs.
Article 11(3) of EMIR requires that “Financial Counterparties shall have risk management procedures that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts that are entered into on or after 16 August 2012.” We believe that Article 11(3) provides the ESA’s Joint Task Force with the necessary flexibility to avoid a reduction or elimination of hedging by non-systemically important financial end users, such as microfinance funds, by permitting a threshold for variation margin, as the WGMR has recommended for initial margin.
We also believe that it would be appropriate for the Joint Task Force to place limitations on this relief such that entities with portfolios of outstanding OTC derivatives that are of a size that could threaten financial stability would not be eligible, similar to the 8 billion EUR threshold in outstanding OTC derivatives introduced for initial margin. This proportionate approach would ensure that the real economy sectors of real estate and microfinance are not prevented from hedging commercial risk entirely.
We believe that the operational nature of the real estate fund and MIV sectors have not been addressed in an appropriate manner.
Real Estate Funds
The real estate sector invests in real assets which are illiquid by their very nature and which support jobs in the real economy. Unlike other “financial counterparties”, real estate funds raise capital for the sole purpose of building and investing in these physical assets. They do not hold cash or liquid securities that could be pledged as collateral. A variation margin requirement will represent a significant, disproportionate and extremely expensive new burden.
Real estate funds raise capital from a range of sources and invest those funds as equity or debt in real property. They hold investments (e.g., buildings) in special purpose vehicles (SPVs) that also serve as party to debt and interest rate derivatives used to hedge the debt. These SPVs are typically non-financial counterparties under EU law that are exempt from central clearing and margin requirements under EMIR.
However, as a real estate investment company, they are subject to the authorization requirements under the AIFMD. The fund itself is therefore considered a “financial counterparty” under Article 2(1)(8) EMIR due to a cross-reference to the AIFMD in this article. Currency risk is often addressed at the fund level when a real estate fund purchases assets. We refer to our answer in Question 1 for an example of how real estate funds use FX forwards to hedge currency risk at the fund level.
Per our answer to Question 1 of this consultation, we believe that this problem could be mitigated by introducing thresholds for variation margin for non-systemically important financial counterparties.
Microfinance Investment Vehicles
Microfinance Investment Vehicles (MIVs) serve as a source of capital for microfinance institutions that provide loans to small business and entrepreneurs who lack access to traditional banking or related financial services. Microcredit is an essential resource for entrepreneurs and small businesses that lack access to traditional banking services, especially in the third world. It has proven a highly effective tool in efforts to alleviate poverty in poor and developing countries.
MIVs raise funds from public sector entities such as development finance institutions, institutional investors such as pension funds, and non-profit organizations. Their investors are typically highly risk averse and seek modest financial returns coupled with measurable social improvements in low income areas. They are subject to the authorization requirements under the AIFMD and for that reason they are considered “financial counterparties” under Article 2(1)(8) EMIR.
As MIVs provide loans to microfinance institutions in the local emerging or frontier market currencies, they encounter significant exposure to currency risk. This is hedged through bespoke products in the OTC derivatives markets. In order to fulfill their social role, they prefer to take on the currency risk at the fund level so as not to overburden and expose the microfinance institutions or their clients to the risk. In addition, they also use interest rate hedging products to mitigate the risk associated with lending to microfinance institutions at fixed rates while providing floating rate returns to investors.
MIVs do not hold cash reserves, and do not have access to pools of highly liquid securities to pledge as collateral for their OTC derivatives. A variation margin requirement will require them to choose either to reduce their investments in microfinance institutions in order to reserve cash to meet collateral requirements or to stop hedging and pass the currency exposure to the microfinance institutions and their borrowers. These microfinance institutions and individual borrowers are far less equipped to handle currency risk exposures. Either of these outcomes will reduce the significant benefits that microfinance funds provide to low-income communities around the world.
As indicated in our answer to Question 1, we believe that the problem posed by variation margin to the microfinance sector can be mitigated by introducing thresholds for variation margin for non-systemically important financial counterparties.