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The joint FSA and HM Treasury response to the European Commission's consultation on strengthening derivatives markets

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Farrer & Co LLP
European Union, United Kingdom
October 31 2009

The FSA has published a joint response by the FSA and the Treasury, to the European Commission's consultation on possible initiatives to strengthen over-the-counter ("OTC") derivatives markets. The UK authorities welcomed the Commission's proposals, and outlined the key steps they have identified to strengthen the OTC derivatives markets, namely:    

  • the application of capital requirements that are proportionate to assumed risks;
  • market-led initiatives that are closely overseen by regulators (authorities need to continue working with market participants to analyse the weaknesses of current market arrangements, consider options for reform and ensure that these are implemented); and
  • further legislative and regulatory measures, if the authorities form the view after an appropriate period of time, that the first two steps noted above have not achieved their objectives. (These measures could include minimum risk management standards, and transparency and reporting requirements).

The UK authorities also strongly supported the greater use of central counterparty ("CCP") clearing arrangements for products that are "clearing-eligible". (For other products, or where market participants are not able to access CCP clearing directly, bilateral collateralisation arrangements subject to robust risk management are likely to remain important.)

The UK authorities have also emphasised the importance of continuing efforts to promote international coordination and consistency in this area with international counterparts, in particular in the USA.

At the Pittsburgh summit on 24th and 25th September 2009, the G20 agreed that, by the end of 2010 at the latest, OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties. It also agreed that OTC derivative contracts should be reported to trade repositories and non-centrally cleared contracts should be subject to higher capital requirements. The G20 has asked the Financial Stability Board to regularly assess implementation of this approach in order to determine whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk and protect against market abuse.

Finally, on 19th October 2009, the European Commission published a summary of responses to its consultation on enhancing the resilience of the OTC derivatives markets. (It may be recalled that the Commission published its consultation in July 2009, following its adoption of a Communication on ensuring efficient, safe and sound derivatives markets.)

Comment: Europe's largest industrial companies now face the prospect of having to raise tens of billions of euros as a result if these and related US proposals in relation to OTC derivatives are implemented, necessitating new credit lines to enable the creation of additional cash reserves. Such companies are surprised by the proposals since their use of derivatives is merely part and parcel of the normal hedging of business risks. If regulators in both the USA and the EU continue to insist that OTC derivatives are moved onto formal exchanges and processed through clearing houses, non-financial companies will be obliged to set aside margin to guarantee their trades. These large companies rarely have to provide a margin at present as they deal directly with the banks. (For example, the Financial Times on 17th October 2009 reported that Rolls-Royce, the UK aerospace group, has estimated that its margin payments for last year alone would have been £2.5bn under these requirements.) The proposals are therefore likely to be very expensive if implemented since many such companies using OTC derivatives at present have good credit ratings, and thus have no commercial reason to provide collateral to the banks. The US Congress now appears to be offering some leeway on its proposals.

On 20th October 2009, the European Commission announced that it has now adopted its Communication outlining the proposed policy actions to increase the safety of derivatives markets.

The proposals in its Communication are aimed at the following objectives:

  • reducing counterparty risk;
  • reducing operational risk;
  • increasing transparency; and
  • enhancing market integrity and oversight.

The Commission will now launch impact assessments of its proposals, in order to start the process of drafting the implementing legislation. It intends to produce legislative proposals for derivatives regulation in 2010.

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