EU courts US dealers with flexible derivatives rules

London dominates the $5-trillion-a-day foreign exchange market, trading twice as many dollars as the United States and more than twice as many euros as the entire euro zone, according to TheCityUK study.

The European Commission presented proposals last Friday (3 July) to strengthen the safety of EU derivatives markets, suggesting that dealers in Europe will be given more flexibility than their US counterparts amid mounting pressure for stricter regulation in the aftermath of the financial crisis.

EU Internal Market Commissioner Charlie McCreevy based his proposals on the principle that derivatives should be exchanged in a safer way, but not in exchange houses as proposed by the Obama administration in Washington.

The United States is seeking to go beyond centrally clearing over-the-counter (OTC) trades by shifting trading onto exchanges or trading platforms where possible. 

McCreevy’s proposals, however, involve the establishment of central counterparty clearing (CCP) in order to offset some of the risks related to over-the-counter operations (see ‘Background’).

“Central counterparty clearings have proven their worth during the financial crisis,” reads a note issued by the EU executive. “The Commission has since October 2008 worked with industry to ensure that clearing of credit derivatives swaps takes place on European CCPs. The Commission also considers that the broader use of CCPs in other OTC derivatives markets should be incentivised wherever possible,” it adds.

Dealers relieved

Dealers breathed a sigh of relief that Brussels was not insisting on exchange trading for now. The bulk of the world’s OTC trading is done in London and New York, and a less strict regime in the EU could attract business from across the Atlantic, industry experts say.

The Commission did not indicate whether the EU should have a single or multiple clearing houses for derivatives, but it seems certain that the two main competitors, Paris and London, will both obtain a clearing seat.

However, it remains unclear what will happen when should a clearer headquartered outside the euro zone encounter problems, such as those in London. “No central bank will provide liquidity to institutions located outside its currency area,” states a note by the Commission.

McCreevy is also proposing to standardise contracts and create a central data depository to store records of trades. Brussels is not ruling out a European central data repository as the best option, but an opinion from national regulators within the CESR is expected to shed more light on the political viability of this possibility.

Internal Market Commissioner Charlie McCreevy said: "Derivatives markets play an important role in the economy but the crisis has shown that they may harm financial stability. As regards credit default swaps (CDS), industry has committed to clear CDS on European reference entities and indices on these entities through one or more European CCPs by 31 July 2009. I expect industry to move clearing of CDS to any European CCP that has received regulatory approval for clearing indices and single names by that deadline."

The International Swaps and Derivatives Association (ISDAsaid those exposed to credit risk should be allowed to choose the type of transaction that best suits them. "Removing that flexibility, such as by forcing bilateral participants to trade on an exchange or otherwise limiting the availability of customised risk management solutions, would be a step backwards," ISDA said in a statement.

The European Banking Federation (EBF)  welcomed the Commission's initiative, saying it is "very supportive of central clearing in Europe for Credit Default Swaps (CDS)". But the EBF also warned against over-regulation, saying that "participants in the OTC markets are already heavily regulated". 

"Innovation and diversity of the product range must not be hampered by the streamlining effects of centralised infrastructures. There must be leeway for bilaterally agreed contracts between clients and banks to give specific answers to specific client needs," said EBF Secretary-General Guido Ravoet

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

Among the first solutions circulated to increase safety in the sector was the establishment of central clearing houses. Under such a system, derivatives would be processed via an intermediary instead of being exchanged privately ("over the counter" in financial jargon), with the aim of reducing costs and risk, while at the same time raising safety guarantees.

'Over the Counter' (OTC) contracts range from credit default swaps (CDS) to contracts linked to interest rates, equities and commodities. The G20 group of industrialised and emerging countries agreed in April that CDS transactions should be centrally cleared.

Clearing is already commonplace in Europe for OTC products like interest rate swaps, and Commissioner McCreevy obtained a pledge from dealers to start clearing some types of credit default swap contracts in Europe from the end of July at the latest (EURACTIV 20/02/09).

  • End of July 2009: Deadline for credit default swap industry to establish central clearing.
  • 25 Sep. 2009: Commission hosts public hearing on its proposals. 

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