"The Commission believes that a paradigm shift must take place away from the traditional view that derivatives are financial instruments for professional use, for which light-handed regulation was thought sufficient," reads a draft communication on derivatives to be published this week.
According to the document, future regulation in the sector must lead "towards an approach where legislation allows markets to price risks properly". A number of legislative measures will be proposed in the course of 2010, it adds.
Forthcoming EU regulation will first address the issue of derivatives trading. Brussels will propose measures aimed at discouraging bilateral exchanges of derivatives over-the-counter (OTC), a practice which is believed to contribute to price opacity and increase risks for financial markets as a whole.
Central clearing houses
To increase safety in the sector, the Commission is proposing the establishment of European central clearing houses. Under such a system, derivatives are processed via an intermediary instead of being exchanged bilateraly.
This favours transparency and provides more protection against defaults. The Commission will propose legislation to harmonise the work of clearing houses across Europe, in order to allow them to operate at a European level. Their supervision and authorisation will be dealt with by the proposed European Securities and Markets Authority (ESMA).
The over-the-counter market will not become illegal, but it will be regulated in a stricter way and will be subject to extra costs. Indeed, Brussels openly aims "to widen the difference of the capital charges between centrally-cleared and bilaterally-cleared contracts contained in the Capital Requirements Directive (CRD)".
A review of existing legislation is planned in 2010 to take into account this emerging interest, according to the draft communication on derivatives. "Financial firms [dealing with derivatives] need to hold a larger amount of collateral to cover their credit exposure," adds the draft.
Over-the-counter exchanges will also be subject to substantial reporting obligations, with trade repositories set up to fulfil this target. This is expected to increase the cost of bilateral operations, making centralised exchanges more attractive.
For standardised derivatives, the Commission is instead proposing mandatory central clearing. However, debate is still ongoing at international level to define "which contracts can be regarded as standardised for central clearing," according to the draft document.
