Brussels launches clampdown on derivatives

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The multi-trillion dollar derivatives market will be moved on to exchanges and will have to be cleared by a third party, according to a European Commission proposal to be unveiled today (15 September). 

The Commission's proposal is part of a global consensus to crack down on a market that regulators believe has exacerbated the financial and economic crisis.

Derivatives are a highly lucrative market of financial products – 605 trillion dollars at the last count – whose value is pegged to an underlying asset which could range from grain to shipping containers.

Subject to the approval of the European Parliament and EU ministers, the Commission wants derivatives to be traded via stock exchanges and processed by clearing houses or central counterparties (CCPs), which will have to comply with stricter governance rules.

In addition, trade repositories – or databases – will be set up to collect data on the status of derivative contracts to give regulators a better insight into potentially risky deals.

The proposal still has some gaping holes, say observers, who criticise non-financial firms' exemption from the rules.

Many non-financial firms, like car manufacturers, use derivatives as an insurance policy against fluctuations in interest rates and foreign exchange prices. Copying earlier legislation from the US, the draft rules do not affect these firms if they do not have "systemic" importance.

Central clearing houses

The other bugbear has been whether central clearing houses or CCPs should have access to central bank liquidity given that they are set to gain more systemic relevance.

A last-minute decision at the European Commission removed some text saying CCPs must have access to central banks funds and allows them instead to turn to commercial lenders if they get into trouble.

"This is a question of moral hazard," says Karel Lannoo, chief executive of the Brussels-based Centre for European Policy Studies.

Lannoo argues that including central banks as sources for bailout money would not incentivise better risk management at banks.

"The big question about the role and the size of the derivatives market remains unanswered," argues Sony Kapoor, an ex-Lehman trader and the founder of the ReDefine think-tank.

Kapoor argues that the regulation should create a single trade repository for each asset class, like credit default swaps or interest rate swaps, "to give regulators instant access to a more global picture," an idea that was also floated by the Depository Trusts and Clearing Corporation.

"Right now regulators will have to talk to Central Counterparties, exchanges and repositories to get a true picture [on the contract]," he added.

UK Liberal Democrat MEP Sharon Bowles, chair of the European Parliament's economic and monetary affairs committee, welcomed the two new proposals, describing them as immediately putting the European Supervisory Authorities to the test, "above all in the linkage between the Securities Authority and the Banking Authority".

"An example of this is in the setting of capital requirements for central counter-parties, the impact on banking capital of moves that may influence the liquidity of sovereign debt, and the sharing of information that may have systemic relevance," she said.

Warning that the potential of central counter-parties to concentrate risk is taken into account, she added that rules must not be made "in a way that does not allow standards of risk management to become a source of competition".

EU Internal Market Commissioner Charlie McCreevy opened an investigation into the derivatives sector in October 2008, a month after the collapse of Lehman Brothers, a bank heavily involved in the $600 trillion global derivatives market.

The advantage of derivatives is that they allow companies and governments to increase their means of managing risk. The disadvantage is that they are the top instrument for speculative operations. If used irresponsibly, they can increase risk at exponential levels, spreading the negative consequences of defaults across the markets.

Establishing central clearing houses is considered a moderate way of reducing systemic risk related to derivatives. Instead of being exchanged privately ('over the counter'), they could be processed through an intermediary, a move which is expected to improve transparency and reduce risk.

The European Commission clearly supported this approach in a communication published in July 2009 (EURACTIV 06/07/09).

 

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