Here to Stay

The ECs long awaited proposals on derivatives were published this week. The announcement was largely in line with expectations and certainly demonstrates that Europe intends to co-ordinate its plans closely with North America, a positive step for the global derivatives market.The dominant theme of the proposals was that policymakers believe that central clearing is the most effective route for mitigating counterparty risk and therefore creating a safer derivatives market. Key proposals included:- Standardised instruments should be traded on an exchange or a MiFID-compliant electronic execution platform- Mandatory central clearing should be undertaken for standardised contracts- Non centrally cleared trades should be registered in trade repositories- Higher capital charges should be placed against non-centrally cleared derivatives- Higher collateralisation levels should be applied to bi-laterally cleared instrumentsWhile these proposals appear to be unequivocal in their support of central clearing, they will be impossible to implement without an agreed definition of what is a standardised contract. Since the start of this debate, there have been many attempts to come up with an agreed definition but thus far, consensus is lacking. The US definition of standardisation, still subject to review and approval by the CFTC or SEC, is any product that a clearing house will support. The issue which surfaces with this definition, is that it is then down to the clearing house to decide what qualifies as standardised, surely it is their interest to avoid the more challenging OTC products? As the Chairman of the CME put it last week, If you are unsure how to handle nuclear material why would you bring it into your house?The most accepted definition to date, and one which seems to be gathering support in Europe, is that the term standardisation is synonymous with Eligibility for Clearing. However, this has its limitations as it excludes the many different indicators that measure the level of standardisation of a contract, both from the perspective of a counterparty or an individual transaction. The debate, Im sure will continue for many months to come.So what will be the impact of such proposals should they reach implementation? It is clear that the ECs intention is to drive more volume on to exchange or electronic execution platforms and to penalise against bi-laterally cleared or OTC-traded transactions. That said, that are many obstacles which need to be tackled before implementation becomes a reality. These include an agreed, global definition of standardisation and indeed, a mechanism for which to charge against non-centrally cleared products. The latter can only be achieved through changes to Basel II and therefore the EC is hostage to the pace at which this Committee moves. There is no doubt that change is afoot, the speed at which it arrives remains to be seen.

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