The European Commission has adopted a Communication on ensuring efficient, safe and sound derivatives markets, following a commitment made in the Communication on ‘Driving European recovery’.
The Communication looks at the role played by derivatives in the financial crisis and at the benefits and risks of derivatives markets, and assesses how risks can be reduced.
The Communication highlights four key areas of change in the derivatives market:
Standardisation: According to the EU Commission, this would enhance operational efficiency and reduce operational risks. It could be achieved by encouraging broader take up of standard contracts and electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes. However the Communication points put that this requires investments and it may therefore be necessary to incentives these investments.
Central data repositories : Such repositories collect data on, for example, number of transactions and size of outstanding positions. The Communication states that this increases transparency, knowledge and contributes to operational efficiency. Currently, such a repository exists for Credit Default Swaps (CDS), and could potentially be used for other derivatives segments as well. European securities regulators (CESR) are currently carrying a feasibility study for data repository based in the European Union. In the light of the forthcoming CESR report, the Commission will decide on appropriate actions.
Central Counter-party (CCP) clearing: CCPs have proven their worth during the financial crisis. In view of those benefits, the Commission has since October 2008 worked with industry to ensure that clearing of CDS takes place on European CCPs. Industry has as a result committed to achieve CCP clearing by 31 July 2009. If industry is unable to deliver on this commitment, the Commission will have to consider other ways to incentivise the use of CCP clearing. The Commission also considers that the broader use of CCPs in other OTC derivatives markets should be incentivised, wherever possible.
Trade execution on public trading venues : For standardised derivatives that are cleared by a CCP, the question arises whether the trading of these contracts should take place on an organised trading venue where prices and other trade-related information are publicly displayed (e.g. a regulated market). According to the Commission, this would improve price transparency and strengthen risk management. However, it could come at a cost in terms of satisfying the wide diversity of trading and risk management needs. The Commission will examine, taking into account the bespoke and flexible nature of OTC derivatives markets and the regime applicable to cash equities, how to arrive at a more transparent and efficient trading process for OTC derivatives. In this respect the Commission will further assess (i) the channeling of further trade flow through transparent and efficient trading venues and (ii) the appropriate level of transparency (price, transaction, position) for the variety of derivative markets trading venues.There has already been industry response to the Commission. The Futures and Options Association (FOA) issued its support for the drive to improve regulatory oversight, however it noted that MiFID, in relation to cash equities, abolished the concentration rule (whereby transactions were required to be executed on a central exchange) and allowed customers, in return for increased transparency, to choose for themselves whether they wished to trade on a regulated exchange, an MTF or bilaterally with their preferred dealers. Consumers have always had this freedom across the whole range of their economic activities and there is no reason why, against the background of much closer market oversight, they should not continue to be able to exercise that right as regards OTC transactions.
Anthony Belchambers, Chief Executive, said The Communication emphasises that derivatives are an important tool for economic agents to transfer risk and it is essential, therefore, that this programme for regulatory repair, while totally necessary and understandable, does not impair the ability of OTC markets to meet that functional responsibility. It is worth noting that the drive to secure CCP clearing in OTC markets had already commenced before the current financial crisis a momentum that was driven by the industry of its own volition. Moreover, it has always been open to customers and counterparties to enjoy the benefits of greater transparency and central regulation by executing, where possible, their risk management transactions on exchange. The lessons of the crisis have made market users more aware of the importance of adding these values to their trading activities.
Following the public consultation which this Communication launches, the Commission will host a public hearing on 25 September 2009. Taking into account the outcome of the consultation, the Commission will draw operational conclusions before the end of its current mandate and present appropriate initiatives, including legislative proposals as justified, before the end of the year to increase transparency and ensure financial stability.