Werner Langen MEP has published a draft report on over-the-counter derivatives reforms to be considered by the European Parliament’s Economic and Monetary Affairs Committee in its decision on how the European derivatives markets should be regulated going forward.

On 11 February 2010, Member of the European Parliament (MEP) Werner Langen published a draft report on the over-the-counter (OTC) derivative market reforms in the European Union. The Langen Report (the Report) is due to be discussed by the European Parliament’s Economic and Monetary Affairs Committee on 22 February 2010.

The Report generally supports the mandatory clearing of standardised derivatives through independent clearing between financial institutions. It further endorses the need for greater risk management, transparency and the use of independent central counterparty (CCP) clearing.

Distinction Between Corporations and Financial Institutions

The Report emphasises the need to distinguish between the use of OTC derivatives by companies and the trading of these derivatives by financial institutions. Langen is of the opinion that corporations depend on the ability to hedge their risks cost-effectively, and should be differentiated from pure capital market transactions, which financial institutions engage in. Langen is also of the view, however, that any derivatives which are seen as risky and are entered into by non-financial institutions should be regulated in the future.

Need for Risk Management and Transparency

Langen calls for greater risk management and transparency in the OTC market and argues the need for these to be made “guiding principles” going forward. Langen assumes that the European Commission (Commission) will continue to permit financial institutions to clear bilateral trades, as long as reasonanable risk assessments are made and guaranteed tiered regulatory capital requirements fulfilled. Further, the Report supports the Commission’s plans for exemptions and lower capital requirements for small and medium-sized enterprises.

In addition, Langen advocates the requirement for trade repositories to be introduced for all transactions completed and positions taken off-exchange. The Report also recommends that the Commission draft reporting requirements, ensuring that the transmission of the reports prepared pursuant to these requirements is actually made to trade repositories, and that the European Securities and Markets Authority (ESMA) is given access to the data contained in these reports.

Clearing

One of the ways of tackling risk is through the use of CCPs. Langen is of the opinion that counterparty credit risk can be reduced by these CCPs, in addition to increasing capital requirements for those OTC derivatives which are not CCP-cleared. Langen further suggests that these clearing houses, and their risk management systems, should not be owned by their users, nor should they be allowed to compete with each other. This move would force many dealers to divest their stakes in clearing houses, such as LCH.Clearnet.

European Securities and Markets Authority

The Report backs the Commission’s intention to make ESMA responsible for the authorisation of clearers operating in the European Union. Further, it seeks to expand ESMA’s remit to include the supervision and regulation of trade repositories.

Conclusion

Langen encourages the development of a uniform and international regulation of the derivatives market and, in view of this, doubts the need for a separate European regulation on derivatives. The conclusions in the Report are based in large part on the opinion that OTC derivatives have contributed to the financial crisis, but recognise the need of corporations to meet their financial and operational risk requirements. However, the move for further independence in CCP ownership has not found favour with some financial institutions which currently have CCP stakes