EU regulation could cause EUR 65bn of collateral damage: EPRA

Proposed EU rules on derivatives could take an estimated EUR 64.9 bn 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 study 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, the European Public Real Estate Association (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.

Gareth Lewis added: 'The consequences of being subject to rules designed for financial entities would be an immediate withdrawal of much needed capital from a sector that is critical to Europe’s physical economy and a reduced ability to manage future financing risk.'

Crucially, for property businesses, the proposed rules would also preclude them from using their physical assets to secure their hedging transactions - only liquid collateral (cash) would be acceptable security for central counterparties.

EPRA says that unless the European Commission clarifies that property businesses will be treated as 'non-financial', the impact would damage EU economic growth and job creation. The lower amounts of capital availability would translate into lost opportunities in development and regeneration projects. Research by Chatham suggests that a EUR 64.9 bn reduction in capital available for investment would translate directly into the loss of 99,000 to 122,100 jobs from the European economy. Germany, France, Italy, and Spain alone would take half of the blow as they collectively account for 50% of the European commercial property debt market.

To put the figure into context, EUR 65 bn would easily finance more than ten of the largest regeneration projects currently underway in Europe. For example, the Thames Gateway/Olympic project price tag in east London is about EUR 12 bn, Amsterdam’s ‘South Axis’ project is about EUR 4 bn and Germany’s HafenCity project in Hamburg about EUR 5.5 bn.

The European Parliament is set to start debating the Commission proposal next week with a likely adoption in mid-2011. Once adopted, the Regulation will be directly applicable in all member states without requiring transposition into national law and is expected to take effect towards the end of 2012.