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European Commission Bent on Post-trade Infrastructure Revamp for Derivatives

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The European Commission has released its proposals for a revamp of the derivatives market in a bid to reduce counterparty risk and improve the transparency of these traditionally opaque instruments. A central tenet of the recommendations, similar to that of the recently proposed US regulatory framework for derivatives, is the introduction of central clearing counterparties (CCPs) for standardised OTC derivatives.

The Commission’s report examines the role that derivatives played in the financial crisis and assesses how the risks posed by these instruments to the financial markets at large can be reduced. To this end, it suggests moves towards greater standardisation of practices within the derivatives market, such as wider adoption of standard contracts, electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes.

“When concluding an OTC contract, it is difficult to assess the risk that a counterparty may default. In highly interconnected financial markets, such an assessment would in principle require any market participant to have good knowledge about all other market participants. As OTC markets have little public information, such knowledge is incomplete,” says the report.

Greater adoption of standards and automation would enhance operational efficiency and reduce operational risks, contends the report. The Commission does note that this is likely to cost time and money for firms to implement, adding “it may therefore be necessary to incentivise these investments”. Just what regulatory carrot will be used to motivate this behaviour is yet to be seen. It does, however, represent great news again for the vendor community – the regulatory overhaul is certainly proving lucrative for those in the risk and regulation solution business.

The report also proposes that incentives should be introduced to encourage the use of CCPs for clearing in the OTC derivatives markets beyond the current remit of credit default swaps (CDSs). The Commission has been working with the industry since October 2008 to move the clearing of CDS onto European CCPs, the deadline for which is 31 July this year. Due to this perceived success, it is keen to apply this model to other, as yet unspecified, corners of the OTC derivatives world.

However, the end of the month CDS CCP deadline is approaching fast and some players in the market have been dragging their heels. This suggests that there may be some resistance to moving yet more areas of the OTC market onto CCPs and the Commission may have its work cut out to convince naysayers of the benefits without a regulatory stick to wield.

In the meantime, Internal Market and Services Commissioner Charlie McCreevy has been banging the drum for CDS clearing: “Derivatives markets play an important role in the economy but the crisis has shown that they may harm financial stability. As regards CDS, the industry has committed to clear CDS on European reference entities and indices on these entities through one or more European CCPs by 31 July 2009. I expect the industry to move clearing of CDS to any European CCP that has received regulatory approval for clearing indices and single names by that deadline.” Exactly what will happen if they don’t acquiesce to his request is as yet unclear.

Another issue with CCP clearing in the current market is that the main contender is based in the US, ICE Trust. European regulators and the Commission are adamant that there should be a European version and McCreevy, for one, has been actively campaigning for just this over the last six months. “There are strong reasons for CCP clearing being located in Europe, relating to regulatory, supervisory and monetary policy concerns. If a CCP is located in Europe, it is subject to European rules and supervision. Supervisors accordingly have undisputed and unfettered access to the information held by CCPs. It is also easier for European authorities to intervene in case of a problem at a European CCP,” says the Commission’s report.

The Commission is also proposing the introduction of central data repositories to collect data on, for example, number of transactions and size of outstanding positions. These repositories are likely to act in a similar manner to the Depository Trust & Clearing Corporation’s (DTCC) Trade Information Warehouse and will be aimed at increasing transparency within the market.

Currently, such a repository exists for the CDS market and the Commission reckons it could potentially also be used for other derivatives segments. The Committee for European Securities Regulators (CESR) is currently carrying out a feasibility study for one such data repository based in the European Union. In the light of the forthcoming CESR report, the Commission says it will decide on further appropriate action once the report is published.

Much like the regulatory overhaul proposals in the US, the Commission is keen for as much of the trade execution to take place on public trading venues as possible. The regulator is keen for the trading of standardised derivatives that are cleared by a CCP to take place on an organised trading venue where prices and other trade related information are publicly displayed. It is hoped that this would improve price transparency and strengthen risk management.

However, the report notes that this measure could come at a cost in terms of satisfying the wide diversity of trading and risk management needs of the market. Accordingly, 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 indicates it will further assess the channelling of further trade flow through transparent and efficient trading venues and the appropriate level of transparency (price, transaction, position) for the variety of derivative markets trading venues.

Multilateral trading facilities (MTFs) have expressed their keenness for such measures to be introduced. Interdealer broker Icap released a statement last week that highlighted its approval of the plans: “The proposals highlight the important role for MTFs to provide efficient electronic trade execution, affirmation and confirmation to our customers and full transaction reporting to central data depositaries. For standardised products this will improve the efficiency of these vitally important markets.” Icap is understandably keen to get some of the execution flow as it already operates MTFs in the credit derivatives, interest rate swap, government and corporate bond markets.

As well as this report, the Commission has also issued two staff working papers: one analysing the OTC derivatives markets and a consultation document containing a more detailed questionnaire. The consultation will be open until 31 August 2009 and responses can be addressed to markt-g2-consultations@ec.europa.eu.

Following the conclusion of this public consultation, the Commission will host a public hearing on 25 September 2009. Taking into account the outcome of the consultation, the Commission says it 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.

The Commission concludes the report with a promise to work closely with US regulators to ensure a harmonised global approach to the derivatives markets. Alex McDonald, CEO of the Wholesale Market Brokers Association (WMBA), reckons this signals a positive step forwards: “The WMBA welcomes the increased level of coordination between US and European regulatory and supervisory bodies. This is crucial, because of the global nature of the OTC marketplace and the essential role it plays in the generation of wholesale financial markets products, which are used widely in developed and emerging economies. Regulators, especially in Asia, will also be keenly aware of the effect of changes made in North America and Europe and their support for any global measures will be important.”

WMBA chairman, David Clark, adds: “It is likely that in order to implement the proposals outlined in the paper, changes to the capital adequacy regime will need to be agreed. In principle, this should be achieved through changes in the Basel II arrangements; otherwise, regional attempts to change Capital Adequacy Requirements would lead to regulatory arbitrage and an uneven playing field.”

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