The European Parliament’s ECON Committee has adopted the Langen Report on Derivatives calling for extensive transaction reporting, mandatory central clearing and higher collateral requirements for some transactions.

On 2 June 2010, the European Parliament’s Committee on Economic and Monetary Affairs (ECON) adopted the Langen Report, and its amendments, on over-the-counter (OTC) derivatives reforms. The draft Report was published in February 2010 by Member of European Parliament (MEP) Warner Langen (see On the Subject, 19 February 2010).

The European Parliament will vote on the wide-ranging proposals in two weeks time. The Report highlights the ongoing focus of regulators on the derivatives markets as the European Union and United States increase their coordination in bringing about derivatives market reform.

Financial Stability and Market Transparency

The Report provides recommendations to encourage financial stability and market transparency by insisting on full disclosure to regulators of OTC derivative transactions and a ban on speculative credit default swaps (CDSs). This transparency would be achieved through extensive reporting of all transactions, before and after trade execution. ECON has also backed proposals for the compulsory introduction of central counterparty (CCP) clearing.

Financial derivatives concerning public finances in the European Union are a significant focus of the Report, which recommends that these now be standardised and traded on-exchange or on other regulated trading platforms, again to promote the transparency of the derivative markets. The Report also calls for the European Commission to ensure that the valuation of derivatives traded on-exchange is done in an independent and transparent way to avoid any conflicts of interest. This would be achieved through the introduction of a common set of standards adopted by central trade repositories, CCPs, exchanges, financial institutions and national regulatory authorities. Regulators should also be able to set position limits which would counter the disproportionate price movements of derivatives.

Global Standards

ECON supports the Report’s call for the Commission to draw up reporting standards for all derivatives products. These standards would be mirrored on an international level in an effort to achieve cohesion and unity in global legislation. Furthermore, information between CCPs must be traded on a global level, rather than simply country or EU-wide. ECON singled out the work of the OTC Regulators Forum which, in response to a request by the G20, has worked to increase the transparency and robustness of the OTC derivatives markets.

The Report calls on the Commission to secure internationally coordinated and consistent regulation of derivatives, further highlighting the move towards increased cross-border regulation and transparency. The “close and comprehensive cooperation with the G20 countries and the US authorities” is underlined as being necessary to prevent regulatory arbitrage opportunities between countries and to facilitate the fostering of information exchange. The Commission should ensure that national supervisory authorities have real time access to data to systemic risks that might be building up in their own jurisdictions, as well as data from repositories in other jurisdictions.

What is further targeted, and should be globally consistent, are the upper risk limits for derivatives for CDSs in particular, as well as a complete ban on CDS transactions with no underlying credit and which are purely speculative transactions involving bets on credit defaults, thereby leading to systemic risk. All of these measures will only be achieved if there is global cooperation between market participants. A caveat has been added that, in the case of doubt, the Commission should pursue independent derivatives regulation.

Tailored Legislation

ECON is clear on the need for the legislation on derivatives to be tailored, depending on the type of derivative involved and the parties involved in the transaction. Individually negotiated derivatives, for example, are singled out as being necessary to hedge special risks and therefore should not form part of any sort of standardisation of derivatives. Similarly, non-financial small and medium-sized enterprises which use derivative instruments solely in the course of hedging their risk when conducting their principle business, should benefit from exemptions from clearing and collateralisation related capital requirements, provided that the transactions are proportionate and appropriate for the real risks faced by end users. ECON backs the introduction of repositories for all derivatives positions, but these would be distinguished by asset class.

Bilateral derivatives contracts are also distinguished. ECON supports the Commission proposing higher capital requirements for financial institutions dealing with bilateral derivatives contracts that are ineligible for central clearing, based on a risk-proportionate approach, and taking into account the effects of netting, collateral, initial margin and other counterparty risk management techniques. If the underlying risk is being hedged, however, an exemption will be made for the bilateral derivatives contracts, and lower capital requirements will be imposed.

European Securities and Markets Authority

The Report encourages the widening of the European Securities and Markets Authority’s (ESMA) remit, namely by giving it a strong role in the authorisation of European clearing houses and the competence to tackle dysfunctions in the derivatives markets, for example, by temporarily banning naked short selling of CDSs; however ECON have also proposed that ESMA should set position limits for derivative positions. Any derivative position, whether or not it is then taken up by a particular financial or non-financial institution would have to be cleared by a CCP if it exceeds the thresholds specified by ESMA. Additionally, ESMA should set guidelines to combat market manipulation, to avoid market “squeezes” and “corners”.

Conclusion

The European Parliament will adopt its final position on the Report during the week commencing 14 June 2010. In the meantime, clearing houses, exchanges and financial institutions, derivative regulatory bodies and general market participants must be alert to the findings of the Report and its focus on bringing about stricter and tighter regulation to promote increased transparency and stability of not only the OTC derivatives market, but of global financial markets as a whole