European Commission publishes proposals on making derivatives markets safer

Written by Ray Clancy

Friday, 17 September 2010 08:00

The European Commission has revealed its proposals for making derivatives markets in Europe safer and more transparent as part of its ongoing work in creating a sounder financial system.

In its draft regulation, the Commission proposes that information on OTC derivative contracts should be reported to trade repositories and be accessible to supervisory authorities.

More information will also be made available to all market participants and the Commission also proposes that standard OTC derivative contracts be cleared through central counterparties (CCPs). It says this will reduce counterparty credit risk, i.e. the risk that one party to the contract defaults.

The Commission’s proposal, fully in line with the European Union’s G20 commitments and the approach adopted by the United States, now passes to the European Parliament and the EU Member States for consideration. Once adopted, the regulation would apply from the end 2012.

‘No financial market can afford to remain a Wild West territory. OTC derivatives have a big impact on the real economy from mortgages to food prices. The absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from,’ said Michel Barnier, Commissioner for Internal Market and Services.

‘We are proposing rules which will bring more transparency and responsibility to derivatives markets. So we know who is doing what, and who owes what to whom. As well as taking action so that single failures do not destabilise the whole financial system, as was the case with Lehman's collapse,’ he added.

Currently, reporting of OTC derivatives is not mandatory. As a result, policy makers, regulators but also market participants do not have a clear overview of what is going on in the market. Under the Commission’s proposal, trades in OTC derivatives in the EU will have to be reported to central data centres, known as trade repositories. Regulators in the EU will have access to these repositories, enabling them to have a better overview of who owes what and to whom and to detect any potential problems, such as accumulation of risk, early on.

Meanwhile, the new European Securities and Markets Authority (ESMA) will be responsible for the surveillance of trade repositories and for granting/withdrawing their registration. In addition, trade repositories will have to publish aggregate positions by class of derivatives to give all market participants a clearer view of the OTC derivatives market.

The proposals also aim to reduce counterparty risks. Currently participants in the OTC derivatives market do not sufficiently mitigate counterparty credit risk, which refers to the risk of loss arising from one party not making the required payments when they are due.

Now, under the Commission’s proposal, OTC derivatives that are standardised (i.e. they have met predefined eligibility criteria), such as a high level of liquidity, would have to be cleared through central counterparties (CCPs).

It says this will prevent the situation where a collapse of one market participant causes the collapse of other market participants, thereby putting the entire financial system at risk. If a contract is not eligible and therefore not cleared by a CCP, different risk management techniques must be applied, such as requirements to hold more capital.

As CCPs are to take on additional risks, they will be subject to stringent business conducts and harmonised organisational and prudential requirements to ensure their safety such as internal governance rules, audit checks, greater requirements on capital etc.

It also aims to reduce operational risk. The OTC derivatives market allows for a high degree of flexibility in defining the economic and legal terms of contracts. As a consequence, there are a number of highly bespoke and complex contracts in the market that still require significant manual intervention in many stages of the processing. This increases operational risk, that is the risk of loss due to, for example, human error.

The Commission’s proposal requires market participants to measure, monitor and mitigate this risk, for example by using electronic means for confirming the terms of OTC derivative contracts.