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’ ( IP/09/351 ). 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. 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.
This Communication marks another step in the Commission’s efforts to strengthen the financial system in view of the failings unearthed by the financial crisis. It responds to the commitment contained in the Communication of 4 March and is fully in line with the principles adopted by the G20 and the recommendations of the de Larosi è re Group. The Commission stands ready to work with authorities around the world to ensure global consistency of policy approaches and to avoid any risk of regulatory arbitrage. Internal Market and Services Commissioner Charlie McCreevy said "Derivatives markets play an important role in the economy but the crisis has shown that they may harm financial stability. As regards credit default swaps (CDS), industry has committed to clear CDS on European reference entities and indices on these entities through one or more European CCPs by 31July 2009. I expect industry to move clearing of CDS to any European CCP that has received regulatory approval for clearing indices and single names by that deadline."
Taking into account the wide diversity of ‘over the counter’ (OTC) derivatives markets, the Communication outlines the tools to ensure that they do not harm financial stability. These tools, which can be combined with each other, are:
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Standardisation: 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. This requires investments and it may therefore be necessary to incentivise these investments.
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Central data repositories : Such repositories collect data on, for example, number of transactions and size of outstanding positions. This increases transparency, knowledge and contributes to operational efficiency. Currently, such a repository exists for Credit Default Swaps (CDS) 1 , 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.
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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.
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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). 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 channelling 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.
The Communication also highlights the actions already undertaken in response to the financial crisis in the area of derivatives (e.g. CCP clearing for CDS, securitisation, credit rating agencies and hedge funds and other alternative investment management funds, supervision).
T he Commission services have also issued two Staff Working Papers. The first one analyses OTC derivatives markets and the second one is a consultation document containing a more detailed questionnaire. The consultation will be open until 31 st August 2009. Responses can be addressed to markt-g2-consultations@ec.europa.eu.
Background
Derivatives play an important role in the economy but are associated with certain risks. The financial crisis – notably the events surrounding Bear Sterns, Lehman Brothers and AIG – has highlighted that these risks are not sufficiently mitigated in the OTC part of the market, especially as regards CDS.
In an accompanying Staff Working Paper, the Commission services assess derivatives markets in further detail. The paper provides an assessment of (i) derivatives markets, (ii) OTC derivatives market segments, and (iii) an assessment of the effectiveness of current measures to reduce risks .
The Communication and the accompanying staff working paper conclude that t he crisis has highlighted how derivatives in general and CDS in particular have created a web of mutual dependence that made it difficult to understand, disentangle and contain risk in the immediate aftermath of a default. The characteristics of OTC derivative markets – the private nature of contracting with limited public information, the complex web of mutual dependence, the difficulties of understanding the nature and level of risks – increase uncertainty in times of market stress and accordingly may undermine financial stability. The Communication therefore outlines ways to strengthen derivatives markets so as to improve financial stability.
