Property businesses that use swaps to hedge interest rate or other risks must not ignore the European Market Infrastructure Regulation, as Peter Cosmetatos explains

European Market Infrastructure Regulation (EMIR), threatens to treat property businesses as ‘financial' along with banks and hedge funds, forcing them to cash collateralise their swap obligations unless an industry amendment is adopted.

EMIR is the EU's implementation of the G20 decision to regulate the massive and mysterious over-the-counter (OTC) derivatives market. A key element is the requirement for most derivatives to be cleared through a central counterparty (CCP). While the prospect of retroactive application to pre-existing derivatives seems to be receding, the proposals are nevertheless troubling, particularly for property funds and other long-term investment businesses such as pension funds and insurance firms.

A CCP must be shock-proof so the collapse of a major market participant does not present systemic risk to the whole market in the way that Lehman's collapse and AIG's exposures did in 2008. CCPs protect themselves by requiring cash collateral: ‘initial margin' of maybe 2-3% of notional principal, and potentially daily ‘variation margin', reflecting negative mark-to-market value.

Like the parallel US Dodd-Frank rules, EMIR recognises that non-financial businesses generally use derivatives to hedge risks associated with their commercial activities and cannot deal with margin requirements in the way that truly financial businesses can. Generally, non-financial businesses won't have to centrally clear their hedging derivatives.

A property business might fund an asset by borrowing on floating rate terms and use an interest rate swap to ensure its rental income will always cover debt service costs. The value of the swap will fluctuate during its life, but in most cases that will not matter - the aim is to protect the business from rising interest rates. Requiring cash margin when the swap is out of the money would completely undermine the point of the hedge and present a huge liquidity challenge.

The problem is that the European Commission has classified property funds as ‘financial', along with other funds covered by the Alternative Investment Fund Managers Directive (AIFMD) and organisations such as pension funds, insurance firms and UCITS that are regulated by other EU directives. Thanks to a huge lobbying effort by affected industry sectors, it is dawning on policymakers that this approach will not work - but changing it is proving incredibly difficult, mainly because of a fear of creating loopholes.
An added problem for the property industry is that the scope of the AIFMD - and therefore of EMIR's ‘financial' definition - is very uncertain, particularly as regards property companies, joint ventures and wholly owned subsidiaries.

The main political focus has been on saving pension funds from having to cash collateralise swaps used to match up long-term assets and liabilities. Insurance firms and even UCITS arguably merit the same attention.

For property businesses, we want EMIR amended to classify them unequivocally as non-financial - and we are delighted that a number of MEPs have tabled an amendment to that effect. Now we need the European Parliament to adopt the amendment when it votes in May, and for national governments in the European Council to accept it in the final negotiations on EMIR this summer.

If we win these battles, we will not only preserve the ability of real estate businesses to use flexible, efficient and sophisticated hedging strategies. We will also have won recognition in European law that, unlike the hedge funds that the AIFMD was primarily aimed at, real estate funds are part of the real, physical economy, with occupiers, as well as investors, as their clients.

Peter Cosmetatos is director of policy (finance) at BPF