After two weeks on a road-trip in the US I might naïvely have hoped to return to greater certainty with the progress of derivatives’ regulation on both sides of the Atlantic. Naïve I clearly would have been, since this whole saga has dragged on far longer than those ‘wise people’ that drove the original G20 commitments could possibly have imagined. And wise – I would argue – those people cannot have been if the attribution of ‘wisdom’ implies deliberation and contemplation, rather than the adoption of precipitate initiatives driven by political agendas.

One scenario that is receiving little attention but which could just threaten the whole end-user exemption (from clearing and therefore margining) is emerging as a result of US moves.  We now understand that ‘FX swaps’ will fall outside the regulatory (mandatory clearing) scope of the Dodd-Frank legislation. Whether or not this can be seen as good news might depend on your faith in the overall progress of regulation in Washington and Brussels.

An exemption for FX swaps is very much easier to promote (in the face of widespread and understandable discomfort with the complexities of the issues around the use of derivatives) than is the idea that ’hedging’ is somehow a wholly legitimate activity and one that should not be adversely impacted by new regulation. This discomfort might not matter, were it not the case that the whole campaign for an end-user exemption hinges (in my view) on the importance of safeguarding what well-run corporate treasury teams do routinely – which is to hedge and mitigate the impact of financial risk on business in the real economy. This supports company viability, employment and growth…..all core ‘values’ that I and others have been pushing from the outset.

Hedging is difficult to debate with those for whom the concept is unfamiliar, with many wanting to suggest that hedging (as it is explained to them) is actually speculative; not a credible argument to those that accept that the essential purpose of corporate risk management is to reduce the quantum of uncertainty (risk) being faced. But the argument easily gains traction. So when the regulatory drafting of both Dodd-Frank and EMIR struggles with building suitable language around the definition of hedging, as the basis for the end-user exemption, we should be worried.

This difficulty is exactly what is being seen in Brussels and perhaps to a lesser extent in Washington. We might be able to live with that, and indeed we, as the EACT working with a number of corporates in Europe, have been trying to help MEPs and the member state teams as they respectively go through EMIR amendment debate and Council working group drafting.

The real worry is that Europe is still grappling with fundamental areas in EMIR that lack definition, have a profound impact on end-users and are ‘sensitive’ in terms of whether the combined forces of the Commission, Parliament and Council are willing to leave them to ‘Level 2’ work rather than to settle now in Brussels.  These areas include:

- ‘backloading’ – the extent to which the regulation could lead to what we describe as clearing shock, which is the need to put into clearing existing derivative contracts as a consequence of an end-user breaching the clearing threshold;

- the very concept of a clearing threshold (which many of us criticised at the outset) is looking fragile and likely to be replaced by something more sensibly based on information and reporting – but this creates its own uncertainty;

- intra-group and financing transactions – where the use of derivatives must be safeguarded as fundamental to corporate risk management.   Politicians and civil servants are suspicious of corporates – through lack of understanding – on this issue as well as on other ones. Their fear of ‘loopholes’ leading to abuse is founded in this inadequate appreciation of how end-users manage risk but there is real doubt as to whether the final outcome will be sensible;

- the treatment of funded, defined benefit pension funds, whose use of derivatives to manage inflation, longevity and interest rate risk is essentially the same as that of the real economy end-user; and

- most fundamentally, the very definition of what transactions satisfy the core definition of hedging and therefore qualify for exemptions as drafted.  Here the politicians have flirted with international accounting standards as a test of hedging, and despite many attempts seem unable to accept that such a test is incomplete and inadequate; as a basis for regulation accounting standards – changeable and impermanent – are (politely stated) flaky.

So here we have Europe struggling with EMIR and the US at risk of being seduced by the simplicity of an exemption for FX swaps (notwithstanding the very powerful, organised and successful corporate lobbying). In the meantime the US timeline is coming under huge pressure and the original June 2011 deadline for Dodd-Frank implementation seems to be being pushed rapidly back to the end of 2012.

There is further confusion – at least for those not immersed in the US situation – from the proposals of a group of agencies including the Fed, the FDIC and the Comptroller of the Currency, that appear to open the door for imposition of mandatory margining on non-financial end-users.

So this is my doomsday scenario. In the US the battle for a clean end-user exemption runs aground in the face of delays, conflicting and irreconcilable positions within the regulatory structure, and political suspicion of anything that might be tainted with the banks that put us where we are in the first place. In Europe there is great friction in the resolution process between the various EU bodies and at best some key points are lost by end-users; there is also unresolved conflict between definition in Level 1 or delegation to Level 2 authority. The US takes the easy way forward and leaves end-users with just an FX swaps exemption.

Washington, the G20 and IOSCO put huge pressure on Europe to conform with the US and avoid regulatory arbitrage. The EU heaves a sigh of relief and an amended EMIR proposal drops the concept of hedging as a basis for end-user exemption and conforms with an unacceptable (for the real economy) US implementation of Dodd-Frank. We will see.