Derivatives play an important role in the economy but they are associated with certain risks. Warren Buffet famously referred to them as “time bombs” and “financial weapons of mass destruction” that could harm the whole economic system. The European Commission (EC) believes that the current financial crisis is, amongst other things, proof that these risks are not sufficiently mitigated in the over-the-counter (OTC) markets, including commodities, equities, credit default swaps (CDSs) and interest rates. Consequently, on 3 July 2009, the EC issued Communication 2009/332 (Communication) on ensuring more efficient, safer and highly-regulated derivatives markets.
The Communication marks another step in the EC’s efforts to strengthen the financial system in light of the failings unearthed during the financial crisis. The EC believes that, whilst OTC derivatives markets were not responsible for the onset of the financial crisis, those markets played both a direct and an indirect role in propagating the crisis. The direct role was epitomised by the near-failure of major financial players who were central to the global financial system due to their dealings in OTC markets.
The European Commission’s Actions
According to the Communication, the huge growth of the OTC derivatives markets, the increased volume of speculative positions built through derivatives, and the greater participation in trading in derivatives markets by non-regulated entities are key determinants in justifying a review of the existing European Union (EU) regulatory framework. Since the start of the financial crisis, the EC has taken various steps to address some of the risks associated with derivatives. These steps include:
- With respect to the systemic risk related to speculative trading, the EC will soon adopt a proposal on the capital requirements applied to the trading books of financial institutions, and to securitisation and re-securitisation positions
- The EC is in the process of reviewing its approach to the supervision of financial markets. In proposing the creation of a ‘European Systemic Risk Board’, the EU will give itself the capacity to identify excessive risks building in the system, and act appropriately to contain those risks
- The EC has proposed a Directive on hedge funds and other alternative investment fund managers aiming to create a comprehensive and effective regulatory framework at European level
The European Commission’s Objectives
One of the hallmarks of the OTC derivatives markets is the diversity of the markets, assets and counterparty types covered. According to the Communication, the current financial crisis has demonstrated the need to enable the OTC derivatives markets to fulfil their economic purpose, without endangering the stability of the financial system. Consequently, the EC considers that the following actions should be taken:
- Allow regulators to have full knowledge of the transactions that take place in the OTC derivatives markets, as well as the positions that are building in those markets
- Increase the transparency of the OTC derivatives markets vis-à-vis their users and, in particular, more information with respect to prices and volumes should be available
- Strengthen the operational efficiency of derivatives markets so as to ensure that OTC derivatives do not harm financial stability
- Mitigate counterparty risks and promote centralised structures
The European Commission’s Proposals
The Communication outlines various mechanisms to achieve the objectives listed above and to ensure that the OTC derivatives markets remain efficient, safe and sound. These mechanisms, which may be combined with each other, are as follows:
- Standardisation. This would enhance operational efficiency, and reduce operational risks. It could be achieved by encouraging broader adoption and market acceptance of standard contracts and electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes. The EC intends to incentivise the industry to make further investment to promote standardisation in the areas of all OTC derivatives that are unlikely to be eligible for central counterparty (CCP) clearing, and unsuited to on-exchange trading.
- Central data repositories. These repositories will collect data on, for example, the number of transactions and size of outstanding positions. Consequently, this will improve transparency and knowledge, and contribute to operational efficiency. The EC sees the merits in terms of increased transparency and knowledge which central data repositories can bring for regulators. The Communication states that this particularly is relevant given the fact that CCP clearing cannot apply easily to all derivatives as the necessary prerequisites are not always in place.
- Central Counterparty (CCP) clearing. In light of the benefits that CCPs provided during the financial crisis, the EC has been working with industry participants to ensure that clearing of CDSs takes place with European CCPs. Currently, market participants have a natural incentive to use CCPs, as they reduce counterparty credit risk, and allow regulatory capital savings. However, the Communication states that the existing incentives have not been sufficient to overcome commercial incentives favouring bilateral clearing. In order to strengthen the incentives for market participants to use CCPs, the EC is amending the rules on regulatory capital contained in the Capital Requirement Directive and is providing further regulatory assurances that CCPs are safe by means of future EU legislation where justified, and possibly common supervision. According to the Communication, there are strong regulatory, supervisory and monetary reasons for CCP clearing being located in Europe. A European CCP will be subjected to European rules and supervision and, accordingly, regulators will have undisputed and unfettered access to the information held by the CCP. In addition, it will be easier for European authorities to intervene in the event of trading and clearing related issues at a European CCP. In the CDS area, the major derivatives dealers have committed to move clearing of European CDSs onto one or more European CCPs by 31 July 2009.
- Trade execution on public trading venues. For standardised derivatives that are cleared by a CCP, the question arises as to whether the trading of these contracts should take place on an organised trading venue where prices and other trade-related information are publicly displayed (e.g. a regulated market). This would improve price transparency and strengthen risk management. However, this would come at a cost in terms of satisfying the wide diversity of trading and risk management needs. Consequently, the EC will further access the channelling of further trade flow through transparent and efficient trading venues and the appropriate detail of transparency, relating to price, transaction and position, for the derivatives markets trading venues.
Any resultant proposals that are formalised by the EC will have wide-ranging consequences for participants in the derivatives markets. Even the commodity derivatives markets, which although in some segments are already standardised and subject to CCP clearing, e.g. in relation to listed commodity derivatives, will face increased scrutiny as to transparency, particularly on the OTC side.
The EC welcomes the feedback of stakeholders on the proposals in the Communication and, in particular, on the specific questions set out in more detail in the accompanying consultation document. Responses are to be sent to the EC by 31 August 2009.