24. November 2010 
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EU Regulation could cause €65bn of collateral damage on the property sector
Proposed EU rules on derivatives could take an estimated €64.9 billion of working capital away from Europe’s real economy as property businesses risk being required to collateralise their interest rate hedges with cash. This is the main conclusion of a Chatham Financial study1 commissioned by the European property sector to assess the impact of the European Commission’s proposed Regulation on OTC derivatives, central counterparties and trade repositories released last month.
One of the proposed Regulation’s core requirements is that businesses deemed to be ‘financial’ entities must post cash collateral into margin accounts to provide cover in the event of default. ‘Non-financial’ businesses, which use derivatives for hedging commercial risks associated with a normal operating business, are rightly excluded from these requirements. However, EPRA is concerned that, absent urgent clarification, property businesses, (which use interest rate swaps to protect against fluctuating interest rates), risk being misclassified as ‘financial’ and subject to onerous margin calls designed for entities which speculate with derivatives - rather than ordinary businesses that use interest rate swaps for risk management.
Gareth Lewis, EPRA Director of Finance said: “Using interest rate swaps to reduce uncertainty associated with fluctuating interest rates is critical to property businesses because interest payments are often their single largest expense and funding is required over long time periods and different economic cycles.”
The fears arise because the European Commission’s view of what is a ‘financial’ is still uncertain and needs clarification. The Regulation’s definition of ‘financial counterparties’ refers to “alternative investment funds as defined in the AIFM Directive”, but the scope of the AIFM Directive, which is targeted at private equity and hedge fund managers, remains unclear with regard to its application to 'normal' operating corporate groups, including listed property companies. This point is critical as it may determine whether these entities would be considered financial entities under the new derivative rules.
One of the proposed Regulation’s core requirements is that businesses deemed to be ‘financial’ entities must post cash collateral into margin accounts to provide cover in the event of default. ‘Non-financial’ businesses, which use derivatives for hedging commercial risks associated with a normal operating business, are rightly excluded from these requirements. However, EPRA is concerned that, absent urgent clarification, property businesses, (which use interest rate swaps to protect against fluctuating interest rates), risk being misclassified as ‘financial’ and subject to onerous margin calls designed for entities which speculate with derivatives - rather than ordinary businesses that use interest rate swaps for risk management.
Gareth Lewis, EPRA Director of Finance said: “Using interest rate swaps to reduce uncertainty associated with fluctuating interest rates is critical to property businesses because interest payments are often their single largest expense and funding is required over long time periods and different economic cycles.”
The fears arise because the European Commission’s view of what is a ‘financial’ is still uncertain and needs clarification. The Regulation’s definition of ‘financial counterparties’ refers to “alternative investment funds as defined in the AIFM Directive”, but the scope of the AIFM Directive, which is targeted at private equity and hedge fund managers, remains unclear with regard to its application to 'normal' operating corporate groups, including listed property companies. This point is critical as it may determine whether these entities would be considered financial entities under the new derivative rules.
