Transmission

Last weeks communication from the European Commission on the derivatives markets delivered few surprises. Unexpectedly, transparency was the common thread which ran throughout, from regulatory scrutiny where regulators and supervisors are to have full knowledge of OTC derivatives transactions, to trade execution where MiFIDs transparency regime would be extended to cover derivatives.The Commission made four specific proposals on which it has requested market input prior to making formal legislative proposals by the end of September:- Standardization of CCP eligible OTC derivatives: where possible derivatives contracts should be standardized, therefore making them eligible for trading onto regulated electronic trade execution platforms or exchanges.- Establishment of a central data repository: collecting data on CCP eligible and non-eligible trades, possibly also providing such services as facilitating settlement and payment instructions.- Clearing through a CCP located in Europe , therefore replacing the bi-lateral model normally used.- Trade execution: as referred to earlier, possibly extending the MiFID transparency regime to cover derivatives and introducing transaction reporting for OTC-traded derivatives.While not stating it explicitly, the paper certainly seemed to imply that the Commission favours trading on electronic execution venues or exchanges and it is likely that, viable candidates in Europe will be identified to provide suitable trading venues prior to it being recommended as a mandatory feature of the market. Central clearing of OTC derivatives was also heavily recommended within the paper as a means of increasing transparency and improving levels of counterparty risk. One the one hand this makes a lot of sense, it creates a more harmonized and orderly market as the rules of the CCP have to be followed by its members; settlement volumes are reduced; counterparty risk is substituted for credit quality of a central counterparty; and regulatory transparency can be created as the CCP can provide a macro view of the market. That said, there are some shortcomings to the theory. First, central clearing is only possible for standardised instruments and OTC derivatives, by their very nature are bespoke, as such there are many OTC instruments that will never be eligible for central clearing. Second, pricing/trading transparency cannot be provided through central clearing as CCPs operate in the post-trade space and therefore do not record pricing. Despite these problems, it is clear that the Commission is committed to central clearing and will use the stick of increased capital charges against non-eligible derivatives contracts to ensure that where possible, OTC derivatives are cleared through CCPs.The most encouraging theme that came from the paper was the evidence of global co-operation (and Im not just saying that because I predicted such an outcome in this very blog a few weeks back). The OTC derivatives market is global and much of what the Commission said, echoed proposals on OTC derivatives made by Geithner a good few weeks back. We havent arrived at a global marketplace yet, but this is certainly a step in the right direction.

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