The European Commission's Communication on Strengthening the Safety of the Derivatives Market
October 22, 2009
The European Commission is moving towards stricter regulation of the derivatives markets, which have been blamed for worsening the financial and economic crises.On 20 October 2009, the European Commission (EC) adopted a Communication, which sets out future policy actions the EC intends to propose to enhance market integrity and oversight, reduce operational and counterparty risk in trading, and increase transparency of the derivatives markets (the October Communication).
This October Communication builds upon and strengthens the Communication issued by the EC on 3 July 2009, which examined the role played by derivatives in the financial crisis, the benefits and risks of derivatives markets, and assessed how risks can be reduced. More information on the July Communication can be accessed via the following web-link: http://www.mwe.com/info/news/ots0709w.htm
EC Communication
In its approach to the derivatives markets, the EC is planning a "paradigm shift" towards legislation which allows markets to price risks properly, and away from the traditional view that derivatives are financial instruments for professional use, for which light-handed regulation consequently (and the EC believes, wrongly) was considered sufficient. The EC has stated that derivatives should be appropriately priced in relation to the systemic risk they entail. Internal Market and Services Commissioner, Charlie McCreevy, said: "We cannot afford another situation where the risks of the financial sector are ultimately borne by the taxpayer."
EC's Future Policy Action
It is proposed that the future policy actions will accomplish the following points:
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Enhance market integrity and oversight by proposing rules to give regulators the possibility to set position limits to counter disproportionate price movements or concentrations of speculative positions; and extending the scope of market manipulation, set out in the Market Abuse Directive 2003/6/EC, to derivatives
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Reduce operational risk in trading by promoting standardisation of the legal terms of contracts and of contract processing; and setting ambitious European targets, with strict deadlines, for legal and process standardisation (operational risk relates to losses resulting from inadequate or failed internal processes, or from external events, and includes legal risk)
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Reduce counterparty risk in trading by proposing legislation to establish common safety, regulatory and operational standards for central counterparties (CCPs), (bodies which enable clearing to occur at a central market level instead of bilaterally between two counterparties, and currently are regulated at national level, notwithstanding the fact that services are often provided on a European level); improving collateralisation of bilaterally cleared contracts to reflect the risk that derivatives trades pose to the financial system when they reach a particular critical mass; imposing higher capital requirements on bilaterally cleared contracts to reflect the higher risk that such contracts pose to the wider financial system, thereby strengthening the incentive for market participants to have an increased range of products cleared by CCPs; and mandating CCP-clearing for standardised contracts
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Increase transparency by mandating market participants to record positions and all transactions not CCP-cleared in trade repositories; regulating and supervising trade repositories; mandating trading of standardised derivatives on exchanges and other organised trading venues; and increase transparency of trading as part of the review of the Markets in Financial Instruments Directive (MiFID) for all derivatives markets, including commodity derivatives
Future of Derivatives Market Regulation
During the course of 2010, and following a review of the existing legislation, the EC will propose a range of legislative measures to regulate derivatives. These proposals will be in line with the G20 Pittsburgh Statement (see http://www.pittsburghsummit.gov/mediacenter/129639.htm), and will be accompanied by thorough impact assessments. In order to ensure an internationally consistent approach to this, and thereby minimise regulatory arbitrage, the EC intends to work closely with authorities around the world when finalising these proposals.
