Sunday, January 03, 2010

EC President Calls for Passage of Derivatives Reform Legislation in 2010

Jose Manuel Barroso, President of the European Commission, has called for the passage of derivatives reform legislation in 2010 along the lines already set forth by the Commission and carving out an exception for companies to hedge risk. The Commission will propose draft legislation increasing the transparency of the OTC derivatives market and dealing with the leverage and interconnectedness that threatens systemic risks to market stability. The Commission believes that a paradigm shift must take place away from the traditional view that derivatives are financial instruments for professional use towards an approach that puts the safety of the financial system first.

Currently, most derivatives are traded over-the-counter (OTC) with contracts concluded bilaterally, and neither the public nor the regulators have much available knowledge about the market. The spectacular growth of the derivatives market over the last decades has therefore created an opaque web of mutual dependence, where huge uncertainty exists when a participant is in distress.

Thus, an important ingredient of reform legislation is increasing transparency. A key problem during the financial crisis was that regulators did not have sufficient information about what was happening in OTC derivatives markets. To correct that, the Commission will propose legislation on repositories where market participants will report transactions and regulators will have access. This will ensure that all transactions are reported and that they are well-managed.

The Commission will also mandate the trading of standardized derivatives on exchanges and other organized trading venues. Trading derivatives on organized venues will increase the transparency of prices and positions to the market.

The Commission proposal will also focus on reducing counterparty risk, which is the risk that a counterparty will default on its obligations. Currently, this risk is high in OTC markets, where organizations using derivatives are exposed to many different counterparties. The Commission proposes to change this by requiring the use of central counterparties (CCPs) for OTC derivatives that are sufficiently standardized. The CCP is a central market infrastructure that interposes itself between buyers and sellers, thereby becoming the single counterparty to all market participants. The CCP thus becomes the buyer to every seller and the seller to every buyer.

Not all derivatives are suitable for central clearing. For those derivative trades that remain outside CCPs, stricter collateral requirements should apply. In addition, to better reflect the risk when not using CCPs, the Commission proposes to increase the capital that credit institutions will have to set aside for such derivative trades.

Similar to legislation recently passed by the House of Representatives, companies will still be able to use derivatives to hedge risk under the Commission’s draft. The proposed legislation will not limit the freedom to set the economic terms of derivative contracts. The Commission recognizes the vital role of customized OTC derivatives in hedging the risks that result from normal business operations.

The Commission neither proposes to ban customized derivatives contracts nor to make them prohibitively costly. However, the function of prices to allocate resources must be restored so that derivatives are appropriately priced in relation to the risks they entail, including systemic risk, in order to avoid those risks being ultimately passed on to taxpayers.

Since the market for derivatives is global, convergent international regulatory efforts are important. In this regard, the Commission proposals are in line with the objectives agreed at the G20 meeting of 25 September 2009. Technical details will be further developed in cooperation with the G20 partners to ensure a coherent implementation of these policies across the globe. Cooperation with the US, which is in the process of designing a new approach to derivatives markets, will continue to be very close.