The Commission also proposes that standard OTC derivative contracts be cleared through central counterparties (CCPs). This will reduce counterparty credit risk, i.e. the risk that one party to the contract defaults. The Commission's proposal, fully in line with the EU's G20 commitments and the approach adopted by the United States, now passes to the European Parliament and the EU Member States for consideration. Once adopted, the regulation would apply from end 2012.
Michel Barnier, Commissioner for Internal Market and Services said: "No financial market can afford to remain a Wild West territory. OTC derivatives have a big impact on the real economy: from mortgages to food prices. The absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from. Today, we are proposing rules which will bring more transparency and responsibility to derivatives markets. So we know who is doing what, and who owes what to whom. As well as taking action so that single failures do not destabilise the whole financial system, as was the case with Lehman's collapse.
Key elements of the proposal:
Greater transparency: Currently, reporting of OTC derivatives is not mandatory. As a result, policy makers, regulators but also market participants do not have a clear overview of what is going on in the market. Under the Commission's proposal, trades in OTC derivatives in the EU will have to be reported to central data centres, known as trade repositories. Regulators in the EU will have access to these repositories, enabling them to have a better overview of who owes what and to whom and to detect any potential problems, such as accumulation of risk, early on. Meanwhile, the new European Securities and Markets Authority (ESMA) will be responsible for the surveillance of trade repositories and for granting / withdrawing their registration. In addition, trade repositories will have to publish aggregate positions by class of derivatives to give all market participants a clearer view of the OTC derivatives market.
Greater safety - Reducing counterparty risks: Under the current situation, participants in the OTC derivatives market do not sufficiently mitigate counterparty credit risk, which refers to the risk of loss arising from one party not making the required payments when they are due. Under the Commission's proposal, OTC derivatives that are standardised (i.e. they have met predefined eligibility criteria), such as a high level of liquidity, would have to be cleared through central counterparties (CCPs). CCPs are entities that interpose themselves between the two counterparties to a transaction and thus become the 'buyer to every seller', as well as the 'seller to every buyer'. This will prevent the situation where a collapse of one market participant causes the collapse of other market participants, thereby putting the entire financial system at risk. If a contract is not eligible and therefore not cleared by a CCP, different risk management techniques must be applied (such as requirements to hold more capital). As CCPs are to take on additional risks, they will be subject to stringent business conducts and harmonised organisational and prudential requirements to ensure their safety – such as internal governance rules, audit checks, greater requirements on capital etc.
Greater safety - Reducing operational risk: The OTC derivatives market allows for a high degree of flexibility in defining the economic and legal terms of contracts. As a consequence, there are a number of highly bespoke and complex contracts in the market that still require significant manual intervention in many stages of the processing. This increases operational risk, i.e. the risk of loss due to, for example, human error. The Commission's proposal requires market participants to measure, monitor and mitigate this risk, for example by using electronic means for confirming the terms of OTC derivative contracts.
Scope: The proposal applies to all types of OTC derivatives. It applies both to financial firms who use OTC derivatives but also to non-financial firms that have large positions in OTC derivatives. It also applies to CCPs and trade repositories. However, when non-financial firms (such as manufacturers) who use OTC derivatives to mitigate risk arising from their core business activities ("commercial hedging" used to protect against exchange rate variations for example), they are exempt from the CCP clearing requirements.
Background
A derivative is a contract between two parties linked to the future value or status of the underlying to which it refers (e.g. the development of interest rates or of a currency value, or the possible bankruptcy of a debtor). An over-the-counter (OTC) derivative is a derivative not traded on an exchange but instead privately negotiated between two counterparts. The use of derivatives has grown exponentially over the last decade, with OTC transactions being the main contributor to this growth. At the end of December 2009, the size of the OTC derivatives market by notional value equalled approximately $615 trillion, a 12% increase with respect to the end of 2008. However, this was still 10% lower than the peak reached in June 2008.
The near-collapse of Bear Sterns in March 2008, the default of Lehman Brothers on 15 September 2008 and the bail-out of AIG the following day started to highlight the shortcomings in the functioning of the OTC derivatives market, where 80% of derivatives are traded. In a Communication on Driving European recovery from March 2009, the European Commission committed to deliver, on the basis of a report on derivatives and other complex structured products, appropriate initiatives to increase transparency and to address financial stability concerns.
© European Commission
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