Derivatives provide perhaps the most flexible and powerful tool in financial markets today.  As a financial instrument derivatives can be used for hedging, speculation or arbitrage purposes and allow participants to take long or short positions in a vast range of assets (enabling a positive or negative directional view on a particular asset, industry or market sector).  Derivatives also allow enormous leverage to be introduced into financial positions and in the case of exchange traded instruments provide relatively liquid tradeable financial assets to meet or offset risk positions across a wide range of underlying financial or physical assets.  The most prominent underlying assets in relation to which derivatives trade include interest rates, currencies, equities, credit, commodities, Government bonds and property assets.

The derivatives market has grown at an astonishing rate over the last two decades.  The very success of this financial tool has made the sector a common target for ill informed attacks on the financial markets for many years.  With notional amounts of both exchange traded derivatives and over-the-counter derivatives in the hundreds of trillions of dollars [1] it is not surprising that the derivatives market, deserved or undeserved, has come under significant pressure for reform since the financial crisis in 2007.

The major causes for concern that emerged following the aftermath of the credit crisis related to inadequate transparency as to entity positions in derivatives with the risk that concentrations could build up to dangerous levels undermining the creditworthiness and ultimately the solvency of financial institutions and therefore undermining the stability of the financial system.

In its press release in September 2010 (Making derivatives markets in Europe safer and more transparent) Michael Barnier, commissioner for Internal Markets and Services said "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 suffering from.  Today 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 the Lehman collapse".

The proposals announced by the European Commission in the draft regulation include:

  • information on OTC derivative contracts to be reported to trade repositories and to be accessible to supervising authorities;
  • more information to be reported  to all market participants;
  • that OTC derivative contracts be cleared through central counterparties (CCPs);
  • that the proposals, if adopted by the European Parliament and EU member states apply from the end of 2012.

We will continue to follow the development of the regulatory regime applicable to derivatives in Europe (and where appropriate touch on regulatory issues applicable elsewhere).