EU seeks clearing house approval for derivatives

Clearing houses may have to win authorisation from regulators to centrally clear some types of derivatives as part of wider efforts to cut risk in the $450 trillion sector, the European Commission says in a paper prepared for EU member states yesterday (18 January).

The G20 group of leading countries has agreed on wide use of clearing in the huge over-the-counter or privately negotiated derivatives sector and the bloc’s executive European Commission is set to propose a draft law to this end by June. 

“It might therefore be advisable to introduce a process which would reflect the need to exercise a degree of regulatory discipline over the objective to ensure that a significant volume of derivatives contracts is indeed centrally cleared,” the Commission says in a paper prepared for EU member states. 

The EU executive has already said it will propose legislation making it mandatory to clear standardised derivatives that are eligible for clearing. 

Derivatives were found to be at the heart of the credit crunch, tripping up some major institutions such as US insurer AIG and now defunct bank Lehman Brothers. 

The paper indicates how policy can be put into practice through an authorisation process that would determine which derivatives are eligible and suitable for clearing. 

This would avoid “possible incentive mismatch” between owners of clearers who want as much business as possible and some users – such as non-financial corporates – who want to avoid clearing. 

EU outlines authorisation process 

The process would kick off with advice from the EU clearer’s risk committee before seeking authorisation from a regulator to clear a class of derivatives. 

The planned new European Securities and Markets Authority (ESMA) “following objective and public criteria, could accept or refuse that application,” the document obtained by Reuters says. 

If approved, there would be a clearing obligation on that type of derivatives after a certain grace period. 

“ESMA might also be given the authority to take the initiative to identify derivatives for which a clearing obligation should apply,” the document said. 

There could also be merit in setting “challenging targets for clearers to meet, to measure and monitor the coverage of central clearing,” it added. 

Repositories for off-exchange derivatives 

The Commission also wants uncleared derivatives reported to a trade repository within a day to improve transparency and information flow to watchdogs. 

Only the Depository Trust & Clearing Corporation (DTCC) in the United States operates such a repository for off-exchange traded derivatives in the world. 

But unless the EU has “full and unfettered” access to data on European-originated transactions, a non-EU repository may need to establish a physical presence or back-up facilities in the EU, the paper said. 

“As trade repositories provide their services on a pan-European/global basis, ESMA should have a key role in the process for registration and surveillance of TRs.” 

Unfettered access to clearing houses 

The Commission listed the strict requirements it wants hardwired into the new law so that clearers for all securities, not just derivatives, operate according to high governance and financial standards. 

Some fear the sheer size of possible clearing volumes will create new centres of potential destabilisation in the market. 

But there appear to be no plans to slap ownership limits on clearing houses – as a draft US bill wants – but instead ensure all users have access. 

“Central counterparties should apply non-discriminatory, transparent and objective admission criteria. Denial of access to participants meeting the criteria should be based solely on risk factors and explained in writing,” the document says. 

Clearers should maintain default funds for use after collateral from users has been tapped, it added in a step that will raise hackles in the industry. 

The Commission also asks member states if the scope of the draft law should also cover settlement houses so that all post-trading activities are included. 

(EURACTIV with Reuters.

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 financial 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.

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