EU UNVEILS CRACKDOWN ON DERIVATIVES / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

EU unveils crackdown on derivatives

By Nikki Tait in Brussels

Last updated: September 15 2010 10:45

The European Union has unveiled tough new rules to control derivative trading and restrict short-selling in response to the financial crisis.

The proposed rules covering over-the-counter derivatives will require standardised contracts to be cleared centrally – a move that officials hope will reduce risk in the market.

They will also require OTC contracts, bilateral contracts between buyers and sellers, to be reported to “trade repositories” or data banks, and for this information to be available to regulators.

OTC derivatives usually involve banks on at least one side of the deal, and so have not been traded through exchanges in the past. But in the wake of the confusion that surrounded the collapse of Lehman Brothers two years ago, regulators decided that they needed better oversight of this huge market.

G20 leaders agreed last year that all standardised contracts should be cleared through central counterparties and traded on exchanges or electronic trading platforms where appropriate. The new proposals will closely align rules in the EU with the new regime, which is coming into force in the US.

The new EU rules will need approval from member states and the European Parliament, but the aim is for them to operate from the end of 2012.

“No financial market can afford to remain a Wild West territory. The absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences,” said Michel Barnier, EU internal market commissioner, on Wednesday.

“Today, we are proposing rules which will bring more transparency and responsibility to derivatives markets – so we know who is doing what and who owes what to whom”.

The new rules will apply to all OTC derivatives, whether based around commodities or financial instruments. However, where they are used by non-financial firms – such as manufacturing companies – for genuine hedging (or risk mitigation) purposes, they will be exempt from the central clearing requirement.

Non-financial firms have been lobbying hard to ensure their exemption from the clearing requirement, and will want to watch the precise legislative wording carefully.

In Wednesday’s rules, officials are proposing a dual system for deciding which contracts have to be cleared centrally – either “bottom-up”, in which a central counterparty (CCP) applies to the authorities, who then decide whether this should occur on a pan-EU basis, or “top-down”, when the authorities impose a clearing requirement on the industry.

A large portion of the rules deal with standards and governance conditions for CCPs themselves, so that risk is not simply passed on to these organisations.

Although there has already been extensive industry consultation and the principles behind the legislation are generally accepted, formal publication will start a fresh process of negotiation and debate.

Another fundamental issue centres on ensuring that CCPs have adequate resources and governance, so that risk is not simply transferred to them – so the conditions placed on them will be thoroughly scrutinised.

Another issue is interoperability and the ability of users to move business around different CCPs. Regulatory agreement will be needed for interoperable arrangements, and the proposals do not extend provisions on interoperability to any other instruments other than cash securities.

Even so, exchanges worry that this could increase systemic risk and that any extension into the equities market could lead to a consolidation of the more liquid trading and leave smaller exchanges hosting uneconomic trading in smaller stocks.

Finally, there may be debate over the fairly substantial role planned for the new European Securities Markets Authority, which will have a key role in deciding which contracts must be cleared and overseeing the trade repositories.

ESMA is being created under the EU’s overhaul of financial supervision, legislation that finally won approval this month. But some EU member states – including the UK – are wary of giving the new pan-EU supervisory authorities too much direct supervisory power, and thereby undercutting national oversight.

Separately, the commission unveiled its proposed rules to restrict short-selling and trading in credit default swaps. It proposes that investors must disclose significant net short positions to regulators once these amount to 0.2 per cent of the issued share capital and to the market at a higher 0.5 per cent threshold.

There will also be a specific regime for telling regulators about significant net short positions in CDS positions related to EU sovereign debt issuers. And if the price in a financial instrument falls by a significant amount in a day, national regulators will have the power to restrict short-selling in the instrument until the end of the next trading day.

In order to tackle naked short-selling, investors will have to have either borrowed the instruments concerned, entered an agreement to borrow them or have an arrangement with a third party to locate and reserve them, so that they are delivered by the settlement date.

National regulators would also be given clear powers in exceptional circumstances to temporarily restrict or ban short-selling in any financial instrument, subject to co-ordination by ESMA.

ESMA itself could also adopt temporary measures itself under specific emergency conditions.

The rules – which are somewhat milder than some of the ideas discussed earlier – are still likely to run into some resistance among traders and hedge funds. They are not opposed to the mandatory reporting requirements to regulators, but are unhappy about reporting to the market. They argued that this may give a confusing picture and dissuade funds from engaging in some deals, so reducing market liquidity and price discovery.

Copyright The Financial Times Limited 2010