European Union diplomats and the European Parliament agreed yesterday (9 February) to overhaul regulation of the multi-trillion euro derivatives market, a move that will make it easier to control one of the most opaque areas of finance.
A new regime could be largely in place by the end of 2012, reforming a market that boomed in the decade before the economic crash and was blamed for amplifying the crisis by hiding risks from regulators.
Under new EU laws, banks, hedge funds and other buyers and sellers of derivatives will be encouraged to move away from the unregulated 'over-the-counter' market, which accounts for almost 95% of all trades.
“The era of opacity and shady deals is over,” said Internal Market Commissioner Michel Barnier, announcing the breakthrough in Brussels.
“It is a key step in our effort to establish a safer and sounder regulatory framework for European financial markets,” said Barnier.
Higher price for breaking the rules
In the past, it has been common for multi-million-euro contracts to be recorded by no more than a fax, with only the parties involved aware of the details.
This will change under the new law, which would standardise most trading so it happens on open exchanges. Settlement of such deals will be cleared centrally, making them easier to monitor.
Those that do not shift to exchanges or a central counterparty such as LCH Clearnet in London –intermediaries between buyers and sellers – will face higher capital charges to reflect the extra risk.
Crucially, the new rules mean that all deals must be recorded, whether conducted on or off an exchange.
Supervisors hope that will make it easier to monitor the market and intervene, if necessary, to avoid a repeat of the chaos surrounding the 2008 collapse of Lehman Brothers, where it proved difficult to assess exposure to derivatives.
By forcing increased transparency, the rules are likely to challenge the half a dozen or so large banks that dominate the market now.
These banks, including Deutsche Bank, Barclays, Goldman Sachs, JP Morgan, Bank of America and Citigroup, design such products for customers and trade them among themselves.
The United States has been quicker to implement controls, establishing a regulatory framework in 2010 for derivatives, such as those that hedge the risk from price moves on oil, gas or other commodity markets.
Derivatives, such as options, futures, swaps or forwards, derive their price from the underlying asset; such contracts can be drawn up between parties setting out conditions under which the contract may or may not pay out.
New system, new risks
The market for the instruments once described by billionaire investor Warren Buffett as weapons of financial mass destruction, is largely unchartered.
The opaque nature of the market for credit default swaps (CDS), for example, made it difficult to predict the fallout of a Greek debt default or similar dramatic event.
Under the new European rules, which were discussed with industry before negotiations moved to the European Parliament and EU member states, all CDS trades would be recorded, making such predictions easier.
Writing laws to regulate derivatives in Europe has divided the EU’s largest member states – Germany, France and Britain – with Britain keen to protect the City of London, which accounts for 9% of Britain's economy and dominates the derivatives market, alongside New York.
Some analysts see risks in the new regime and think regulators will be overwhelmed by trying to follow such a huge market.
“By centrally clearing trades, you concentrate risk dramatically into one body, such as a central counterparty,” said Graham Bishop, who advises banks on European financial policy.
“We have to be careful these bodies don't become a financial nuclear bomb.”