Sunday, September 30, 2012

The European Market Infrastructure Regulation (EMIR) – The beginning of the end of OTC derivatives?

French people (probably like any other people) love their summer holidays. They take the time to relax and to enjoy (most oftentimes French) beach holidays. This year, however, the European legislator had prepared a nice present for finance professionals in Europe: Just some days before the summer break, it adopted a new regulation on OTC derivatives, central counterparties (CCP), and trade repositories. 59 pages long which, as you might expect, feel much longer when reading.

I will try to summarize the main elements today. The topic of the regulation can be broken down into 3 questions:

  • Under which conditions are companies and banks obliged to trade financial derivatives via CCP?
  • If these conditions are not met, which rules are they obliged to respect when trading on a one-on-one basis?
  • How must CCPs and trade repositories be organized?

Clearing Obligation via CCP – Cumulative Conditions

To evaluate whether you must clear derivatives via a CCP, you should follow the below steps:

1. Classified OTC Derivative

EMIR identifies 5 types of OTC Derivatives:

  • Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash
  • Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities which may be settled in cash or, under specific conditions, physically
  • Derivative instruments for the transfer of credit risk
  • Financial contracts for differences
  • Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash

To fall under the clearing obligation, a financial instrument must not only qualify as an OTC derivative but also be added by the European Securities and Markets Authority (ESMA) to a class of derivatives that must be cleared via CCP. The derivative classes will be available in a public register on ESMA's website.

When identifying classes of derivatives to be cleared via CCP, ESMA shall take into account the following criteria:

  • Degree of standardization of the contractual terms and operational processes
  • Volume and liquidity
  • Availability of fair, reliable, and generally accepted pricing information
  • Interconnectedness between counterparties using the relevant class of derivatives
  • Impact of using the relevant classes of derivates on the levels of couterparty credit risk
  • Promote equal conditions of competition within the internal market

2. Date of trade of the derivative

The directive itself is applicable since 16 August 2012. However, the clearing obligation only applies to those derivative contracts concluded

  • after the date of application specified by ESMA for the class of derivatives in question or
  • after the admission of a CCP for a class of derivatives but before the above date of application if the derivative's maturity exceeds a minimum maturity to be specified by ESMA.

The clearing obligation ceases if an authorized CCP for the class of derivatives is no longer available.

3. Counterparties

Eligible financial counterparties are

  • Investment Firms
  • Credit Institutions
  • Insurance Undertakings
  • Assurance Undertakings
  • Reinsurance Undertakings
  • UCITS including respective Management Companies
  • Institutions for Occupational Retirement Provision
  • Alternative Investment Funds

Eligible non-financial counterparties refer to any undertaking which is not a financial counterparty and whose average derivative contracts position over 30 working days exceeds a clearing threshold to be specified by ESMA in its regulatory technical standards.

For both financial and non-financial counterparties, non-EU entities are included if they would be subject to a clearing obligation were they established in the EU.

4. Exceptions

Five types of derivatives / counterparties are exempt from the obligation to clear via CCP:

  • Derivatives concluded with member states' bodies managing public debt
  • Derivatives concluded with public sector entities benefiting from explicit central government guarantees
  • Derivatives concluded with the BIS, multilateral development banks, the EFSF, and the ESM
  • Derivatives concluded until 16 August 2015 with pension scheme arrangements (institutions for occupational retirement provision, occupational retirement provision businesses – to be specified by the member states)
  • Intragroup transactions

OTC Derivatives not cleared via CCP

Except for intragroup transactions, EMIR specifies the following obligations for both financial and non-financial counterparties:

  • Appropriate procedures and arrangements to measure, monitor, and mitigate operational and counterparty risk (confirmations, reconcile portfolios and manage associated risk, dispute resolution, valuation of outstanding contracts)
  • Daily marking-to-market or, exceptionally marking-to-model
  • Risk-management procedures that require timely, accurate, and appropriately segregated exchange of collateral or, in case the risk is not covered by collateral, holding appropriate and proportionate amounts of capital

These rules will be specified by ESMA's upcoming regulatory technical standards.

CCP and Trade Repository Regulation

I will keep the explanations short here. Unless you would like to run a CCP or trade repository, these stipulations will be less interesting for you.

With respect to trade repositories, EMIR specifies the following:

  • the registration process for EU trade repositories;
  • ESMA's information, investigation, and inspection rights and supervisory measures towards EU trade repositories;
  • the recognition conditions for non-EU trade repositories;
  • operating requirements.

Now back to the question I asked at the outset: Is this the beginning of the end of OTC derivatives? I don't think so. The new regulation will certainly limit the OTC scope for standardized products but there will always be enough space for structured transactions to be carried out on an OTC basis.


  • EU Regulation 648/2002 dated July 4, 2012 (called European Market Infrastructure Regulation or simply EMIR)

Sunday, September 23, 2012

Public Corporate & Investment Bank – Can France and the UK can learn from Germany’s KfW?

My last post was about the French public investment bank. In the UK, this topic has also been on the agenda of the British Chambers of Commerce which have, on September 3, 2012, called for setting up a state backed business bank.

In this article, I would like to compare both the French and the English proposals to Germany’s Kreditanstalt für Wiederaufbau (KfW).

About KfW

KfW has been founded on 18 November 1948.

Today, it is a public law institution disposing of 3.75 Billion Euro equity capital. Some business lines of the bank are privately organized even though they are held by the public law parent company. Despite its status as a public law entity, KfW is a bank and, as such, is explicitly entitled to designate itself as a “bank” or “banking group”.

It can only be dissolved by way of law.

In the law governing KfW, the German government has given an explicit guarantee for any debt financing (loans and bonds) used the bank. KfW has no deposits as this is explicitly forbidden by the law governing KfW.

The bank can act directly vis-à-vis its clients or put promoting programs in place through other private financial institutions.

The German bank usually provides medium- and long-term financing. As is stipulated in the KfW law, short-term lending shall only be granted exceptionally. Equally, unsecured lending is only exceptionally possible, upon approval of the board of directors.

There is no earnings' distribution at KfW. Any profit will be accounted for as retained earnings.

As KfW does not hold deposits, it refinances its assets trough issuing bonds and raising loans. Short-term refinancing can amount to 10 % of medium- and long-term refinancing at most.

KfW Business Lines

KfW is organized in 5 business lines:

  • SME Banking
  • Retail Banking
  • Municipal Banking
  • Development Banking
  • Export and Project Finance

As shown on the above charts, SME and Retail Banking constitute the largest business lines and together account for more than half of the bank's revenues.

KfW Performance vs. Capital Risk Policy

Comparison Kfw vs. French / UK Public CIB Projects


As shown in the below table, many the ideas of the public investment bank projects in France, Germany, and the UK are quite similar.

In terms of ROE, KfW has recently shown a good performance. This is all the more striking as its Total Capital Ratio is high, compared other universal banks such as Deutsche Bank and BNP Paribas.

The proposal for a public corporate and investment bank in France and the UK should, in my view, not raise any particular objections.


  • Synthèse du rapport de la mission de préfiguration de la banque publique d’investissement (BPI) – July 2012
  • Communication du Conseil des Ministres – 6 June 2012
  • British Cambers of Commerce – The Case of a British Business Bank – 3 September 2012
  • Gesetz über die Kreditanstalt für Wiederaufbau – lastly amended on 31 October 2006
  • KfW Annual Report 2011

Sunday, September 16, 2012

The French Public Investment Bank – A guide on how to write and say (almost) nothing

On July 31, 2012, the French Ministry of Economics and Finance has published a report on the government’s project to set up a public investment bank. This report is meant to be a synthesis of the government’s preliminary work on the project.

While reading the report, I realized that French is a wonderful language for writing without communicating much content. If you read French, please find the 8 page report here:


Please don't get me wrong here, this is not a value judgment on the public investment bank itself. I was just a bit disappointed when reading the French report.

Current situation – Everything ok?

In the report, the members of the French Ministry of Economics and Finance start off analyzing the current situation:

  • First, the current overall situation in the bank credit market for corporates seems relatively satisfactory but heterogeneous.”
  • Second, the equity investment market seems to stabilize after the turbulences linked to the crisis.”
  • Third, this situation might deteriorate in the medium term because of upcoming reforms of the banking and insurance industry.”

Purpose – Financial services for any needs of companies?

The bank should offer “a panoply of services for any needs of companies, especially fast growing small and middle sized companies and of actors in the social and solidary sector”. Its goal is to ensure the access to financing, especially for exporting and innovative firms.

Strategic choices – Horizontal and vertical? National and regional?

The report offers 4 strategic choices for the public investment bank:

  • It shall offer “general financing for companies (horizontal logic)” as well as “specific financing (vertical logic of industrial politics)”. In terms of size, “it shall serve small and middle sized companies and big companies only exceptionally”. One could also say that it shall offer almost everything to almost everybody.
  • Depending on the situation, the bank should co-finance together with the private sector or finance alone.
  • As regards its regional organization, the bank shall be “a national bank, active in the [French] regions through regional departments”.
  • The bank’s funding needs to be defined. In the report, we can read about almost 20 BEUR equity capital provided by the existing public financing structures. The government “might allocate additional funds”.

Financial Instruments

To fulfill the above purpose, the bank can

  • (co)finance,
  • make minority equity investments, and
  • use additional instruments such as guarantees.

What else?

We can find many key words in the report:

  • Prudential regulation
  • One stop shop taking into account specific needs
  • Increased simplification and efficiency
  • Result driven rather than structure oriented approach
  • Capacity to evolve
  • Increased service quality

The public investment bank should be operational early 2013.

What needs to be done in the short run?

Let me finish this article by quoting the 2 main elements that, in the ministry's view, should be carried out in the short run:

  • To put the public investment bank rapidly in place, the preliminary works should be carried out well.”
  • Certain methodical aspects should be emphasized to ensure that a quick operational start of the public investment bank will be carried out under satisfactory conditions.”

Let's wait and see...


  • Synthèse du rapport de la mission de préfiguration de la banque publique d’investissement (BPI) – July 2012

Thursday, September 13, 2012

Has Germany's Federal Constitutional Court said “Yes” ? – Why the ESM is constitutional only under specific conditions and why this might not be the Court's last word


Germany's Federal Constitutional Court has issued, yesterday, an important decision on the future of the European Stability Mechanism (ESM).

As you can see on the graphs, financial markets were happy about the decision.

Are they right?

Background of the decision

In Germany, political institutions and even private individuals can introduce plaints against federal state laws. This case is one of such proceedings.

The plaintiffs addressed their complaint against

  • the law by which Germany ratifies the treaty on stability, coordination, and governance in the Economic and Monetary Union (The treaty provides for balanced (= structural deficit of 0.5 or 1 % of GDP at most) state budgets, possible correction mechanisms, a capped debt to GDP ratio, and possible economic partnership programs for the Eurozone.);
  • the law by which Germany ratifies the ESM treaty (The ESM protects the financial stability of the Eurozone by providing funding and other financial support to ESM members which face severe financing problems.);
  • the law by which Germany approves the modification of Article 136 of the treaty on the functioning of the European Union (The modification allows the EU member states to put a stability mechanism in place to ensure the stability of the Eurozone.).

Their main argument is that the above laws (and the underlying European legislation) violate the democratic principles as they are fixed in the German constitution. The line of reasoning is that the German parliament would transfer too many sovereignty rights to the EU and, in addition, deprive itself of its budgetary authority.

It is important to emphasize that the Court's decision has been issued in a preliminary proceeding. This means that, if the complaint is addressed towards the ratification of an international treaty (as is the case here), the Court will make “a broad appreciation of the reasons put forward for a violation of the constitution in order to assess whether or not the main proceeding will probably be successful or not”. In other words, as the Court has, today, rejected the complaint, it has told us that it is not highly likely that it will admit the complaint in the main proceedings. This is why today's decision may perhaps not be the final word of the Court.

The Court's reasoning

In the view of the Court, the German constitutional

  • prohibits the transfer of a competence comptence (= the authority to decide on and change its own competence) to the EU;
  • prohibits the assignment of plain authorities to the EU – Authority can only be transferred on a case by case basis;
  • reserves Germany's budgetary authority for the German parliament – It is the German parliament that must decide on revenues and expenses of the German state;
  • restricts the possibility of the German state to assume liability – Inter-governmental liabilities assumed by Germany must be clear, restricted, and subject to prior acceptance;
  • requires that the German parliament be sufficiently informed about inter-governmental liabilities that Germany assumes in order to be in a position to exercise its budgetary authority.

The Court does not answer the question when an inter-governmental liability is too large in size not to allow the German parliament any more to use its budgetary authority. In its view, such appreciation must be carried out by the parliament itself.

The treaty on stability, coordination, and governance in the economic and monetary union (TSCG)

The TSCG is in line with the above criteria: Even though it may limit the government's budgetary authority temporarily, it will also protect such authority in the long-run, the Court says. In addition, the degree of today's necessary limitation is up to the parliament and not to the Court to decide.

Article 136 III of the Treaty on the Functioning of the European Union

In the view of the Court, this new stipulation, by itself, does not affect the budgetary authority of the German parliament. In addition, it does not transfer specific competencies to the European Union.

European Stability Mechanism (ESM) Treaty

This part is the most important part of the decision. Beyond, this part of the plaintiffs claims is rejected only under some specific conditions.

First and foremost, Germany's liability under the ESM treaty is limited to 27 % of its 700 BEUR equity capital, e.g. 189 BEUR. This is the Court's main argument to declare the ESM in line with Germany's constitution.

However, the Court is wondering whether Germany's liability is really capped: On the one hand, article 8 (5) of the ESM treaty provides that “the liability of each ESM Member shall be limited, in all circumstances, to its portion of the authorized capital stock at its issue price”. On the other hand, article 25 (2) says that “If an ESM Member fails to meet the required payment under a capital call made pursuant to article 9 (2) or (3), a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid-in capital needed.”

In such a situation, the Constitutional Court conditions the complaints' refusal with an obligation of the German parliament to clarify the interpretation of the ESM treaty upon its ratification.

Second, article 32 (5) of the ESM treaty fixes the inviolability of its archives, article 34 sets out the obligation of professional secrecy for ESM personnel, and article 35 provides for immunity. In the Court's view, Germany can only be bound by the ESM treaty if it clarifies through the ratification process that the above stipulations will not hamper the German parliament's information rights.


Generally speaking, the decision of the German Constitutional Court is convincing.

In particular, the Court is right to point out that the extent of Germany's liability is not clearly regulated in the ESM treaty. In my view, it is very important to clarify this today: As a matter of fact, only 80 BEUR of the total 700 BEUR ESM capital are paid-in capital. Should additional paid-in capital be needed, all ESM members will be asked to pay their respective additional proportion as fixed in the ESM treaty. The problem, however, is that the ESM member state that asks for help will itself have to participate in additional paid-in capital requests. Now, how likely is it that the state who asks for help will have the cash to fund additional paid-in capital? Then, how likely is it that Germany will be asked to compensate for this amount?

Another important aspect of the decision seems to be the categorical interdiction to transfer any competence competence to the EU, namely as regards the parliament's budgetary authority. As a matter of fact, according to the optimum currency area theory (I have written about this here.), a unique European budget would ultimately be required for the Eurozone to work well. Germany's Constitutional Court seems to be more than reluctant to allow such transfer. This is not good news for Europe's current efforts to ameliorate the design of the Eurozone.


  • German law proposal, dated March 20, 2012, adopting the treaty on stability, coordination, and governance in the Economic and Monetary Union
  • German law proposals, dated March 30, 2012, adopting the ESM treaty and the amendment of Art. 136 of the Treaty on the Functioning of the European Union
  • Treaty on stability, coordination, and governance in the Economic and Monetary Union dated 2 March 2012
  • ESM treaty dated 2 February 2012
  • Decision 1390/12 of the German Constitutional Court dated 12 September 2012

Thursday, September 6, 2012

Financial Derivatives – How are they accounted for under US GAAP?

“Wer's nicht einfach und klar sagen kann, der soll schweigen und weiterarbeiten, bis er's klar sagen kann.”

“If you can’t make it simple, stop talking and continue working until you can make it simple.”

Karl R. Popper

Accounting for financial derivatives under US GAAP is technical. Just take a quick look at FASB Codification 815-10 and you will understand what I mean by “technical”. The purpose of this post is to give you the big picture – the basics that you need to understand to read annual reports and to follow the main US GAAP regulations.

The FASB Codification on derivatives and hedging covers 5 main topics:

  • Scope of application
  • Recognition of derivatives on the balance sheet
  • Valuation of derivatives
  • Netting of derivatives
  • Publication of additional information about derivatives

Scope of application

To be qualified as a derivative, the financial instrument must meet the following cumulative conditions:

  • It must have an underlying (such as a price of a financial asset, a price index, a credit rating, a natural condition, or a factual event) whose changes are verifiable.
  • A notional amount must be fixed.
  • It should contain a payment provision.
  • There must be no or, compared to the notional amount, only a small initial net investment.
  • Whatever the details are, a settlement mechanism is to be fixed.

The FASB explicitly prohibits the practice of so-called “synthetic instrument accounting”. This refers to the practice of combining a cash and a derivative instrument in order to ultimately accounting it as a cash instrument and to conceal the derivative instrument.

Moreover, the attempt to avoid application of the FASB Codification by separating transactions into legally autonomous transactions will not succeed if

  • the transactions were entered into contemporaneously and in contemplation of one another;
  • the transactions were executed with the same counter-party or intermediary;
  • the transactions relate to the same risk;
  • there is no economic need nor substantive business purpose for structuring the transactions separately.

Recognition of derivatives on the balance sheet

Derivatives must be recognized on the balance sheet as assets or liabilities.

US GAAP distinguishes 3 types of derivatives, e.g. hedging derivatives, other risk management derivatives, and other derivatives (namely derivatives held for trading purposes).

Hedging derivatives are further subdivided into 3 categories:

  • The fair value hedge mitigates the exposure to changes in the fair value of a recognized asset or liability.
  • The cash flow hedge mitigates the exposure to variability in the cash flows of a recognized asset or liability.
  • The foreign currency exposure hedge mitigates foreign currency exposure.

A word about embedded derivatives (derivatives incorporated in a single contract regulating an overall transaction) here: They are accounted apart from the embedding contract only if the derivative elements may be sold or traded separately.

Valuation of derivatives

Financial derivatives are evaluated at (initial or subsequent) fair value. The subsequent valuation at fair value leads naturally to a recognition of gains / losses in the firm's income statement.

Netting of derivatives

Under US GAAP, such netting is only possible if provided for by a respective master agreement. In addition, a netting will only be recognized under US GAAP if the accounting entity either offsets rights / obligations under a derivative instrument against obligations / rights to provide collateral or if it has agreed with its counter-party on a payment netting.

Such netting mechanism must not only be explained in the firm's accounting policies but also be applied consistently over time.

Publication of additional information about derivatives

The company must publish additional information about its use of derivatives:

  • How does it use derivatives?
  • Why does it use derivatives? Which objectives and strategies does it pursue with derivatives?
  • Which accounting policy does it apply to derivatives?
  • What is the volume of its derivatives' activity? How do they affect its financial position, financial performance, and cash flows?

The aforementioned volume of the company’s derivative activity must be reported

  • on a gross basis (= before application of agreed netting principles);
  • not taking collateral into account;
  • separately for hedging instruments and other derivatives;
  • separately for each type of underlying (interest rates, foreign exchange, equities, commodities, credit, and other).

Let's get back now to where we have started: Should I stop writing and continue working? Honestly, probably yes... There is obviously too much technical jargon in this post to be comprehensible for a “non-specialist” reader. Ultimately, my post shows a form of laziness: To be clear even for an outsider, the post would have been twice as long and it would have taken twice as much time to write it!


  • FASB Codification 815-10 Derivatives and Hedging