Economic and monetary affairs – 15-06-2010
Proposed EU rules on derivatives trading must be made clearer and tougher, so as to reduce speculative trading and ensure that as many derivatives as possible are traded through open channels that are subject to standards, the European Parliament said in a resolution approved by a large majority on Tuesday. The resolution also suggests ways to regulate who may trade in credit default swaps and to reduce the regulatory burden on corporate end-users of derivatives.
Caught in the eye of the storm of the Greek debt crisis and widely criticised for the opaque way in which they are traded, derivative products are currently being scrutinised at national level, EU level and also by the G20. This resolution comes a few weeks before the European Commission publishes its legislative proposals to regulate derivative trading.
More transparency and also strict rules
The committee resolution advocates "abandoning the prevailing view that derivatives need no further regulation because they are only used by experts and specialists". Instead, it calls for strict rules to prevent inexperienced users and speculators from building up dangerous levels of risk.
The resolution calls on the Commission to study ways to significantly reduce the overall volume of derivatives traded. It also backs proposed rules that would impose higher capital requirements on financial institutions involved in bilateral derivative contracts which are not cleared centrally, but suggests that such requirements may be waived if the clearing system used is deemed strong. It also proposes granting regulators the power to impose trading position limits, so as to counter unsustainable levels of speculation.
The proposed legislation should include rules banning purely speculative trading in commodities and agricultural products. Upper risk limits should be considered for trade in agricultural products and in each specific commodity, including greenhouse gas emission allowances, so as to reduce speculation and help these markets to function transparently, adds the resolution.
Lowering the risk factor
A central tenet of the resolution is that many more derivative contracts need to be dealt with through a process which ensures lower levels of risk building up (through central clearing). To allow this, the resolution also stresses that central counterparty clearing facilities (CCPs) need to be strengthened. It proposes establishing regulatory standards to ensure that they remain resilient even under significant stress, and calls for compulsory standards for their establishment and decision-making and management structures.
The resolution stresses that CCPs must not be organised wholly by users and that their risk management systems must not be in competition with each other. Neither should market players have a controlling influence on CCP governance and risk management. It nevertheless accepts that market players should be included on the risk board and that mechanisms should be proposed to allow them to contribute to the risk management process. In cases where central clearing is not possible, the resolution also urges the Commission not to neglect risk management standards for private trading in derivatives (over-the-counter trades).
The resolution also stresses the need for fair and equal access to CCPs and instructs the Commission to deal with developments which can lead to discrimination.
Corporate end-users
The resolution calls for lighter regulation of over-the-counter trading in derivatives when carried out by corporate end-users, recognising that companies may at times need tailor-made derivatives to better cover the particular risks to which they are exposed. Although more tolerant of such bilateral derivatives contracts, it is suggested that the European Securities and Markets Authority (ESMA) should decide on thresholds beyond which central clearing will always be required.
The resolution also calls on the Commission to differentiate between derivatives, for example according to the extent to which they are used for legitimate hedging purposes. However, it also highlights the need to tackle the use of corporate derivatives by financial institutions as speculative instruments.
The resolution backs a Commission plan to provide exemptions for small and medium-sized enterprises and lower capital requirements for their bilateral derivatives contracts, so long as these are to hedge a risk.
Credit default swaps
The resolution calls for a ban on speculative credit default swap (CDS) trading, demands that financial compensation payout rights resulting from owning CDS are granted only if the bearer also owns the related bonds, and insists that CDS should be centrally cleared though a European CCP.
Finally, the resolution highlights the serious lack of information on the role that sovereign credit default swaps played in some Eurozone countries and calls for very strong guarantees on access to comprehensive information and the empowerment of supervisors.
Next steps
In September, the Commission will propose a legislative text on derivatives. The much anticipated work will then start in earnest in both the European Parliament and the Council, with both institutions sharing decision making power.
