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The financial crisis of October 2008 highlighted the excessively risky nature of certain financial products such as derivatives. The Commission therefore considered it necessary to draw up guidelines in this area in order to be in alignment with the objectives laid down at the G20 summit in Pittsburgh in September 2009.
Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the Committee of the Regions and the European Central Bank of 20 October 2009 – Ensuring efficient, safe and sound derivatives markets: Future policy actions [COM(2009) 563 final - Not published in the Official Journal].
This Communication defines ways to make more efficient, safer and sounder derivatives markets. The latter contributed substantially to the financial crisis due to their risky nature and the lack of transparency of the financial markets. The Commission therefore decided to adopt measures aimed at making derivatives more efficient, safer and sounder.
Role of derivatives
Derivatives enable economic agents to transfer the risks inherent in certain economic activities to other economic agents who are willing to bear those risks.
However, derivatives have unreliable aspects in that they allow leverage to increase and interconnect market participants. These aspects contributed towards the financial crisis of 2008.
Mitigating counterparty credit risk
The 2008 crisis showed that market participants did not price counterparty credit risk correctly. The latter may be managed bilaterally between the two counterparties or at central market level, by means of a central counterparty (CCP).
The Commission and the G20 have identified the CCP as the main tool to manage counterparty risks. CCPs are currently regulated at national level. For this reason, the Commission intends to propose a European framework for CCPs laying down standards in matters of security, regulation and operation.
The European CCP framework is to cover the different asset classes for which the CCPs provide services. These asset classes generally include cash equities, fixed income and derivatives.
However, not all derivatives are suitable for central clearing. As a result, the Commission intends to submit a proposal aimed at requiring financial firms to post initial margin specific to counterparty characteristics and variation margin depending on the change in the value of the contract.
The Commission also intends to subject non-centrally cleared contracts to higher capital requirements.
The Commission also intends to make it mandatory to clear standardised derivatives through CCPs.
Reducing operational risk
Operational risk includes legal risk and risk relating to losses resulting from inadequate or failed internal processes or from external events.
The Commission intends to take measures to reduce operational risk by facilitating the standardisation of contracts in terms of processing and standard legal terms.
Over-the-counter or OTC derivatives markets are characterised by a lack of transparency of prices, transactions and positions. This lack of transparency has hindered regulators from supervising the derivatives market.
It therefore appears necessary to report all transactions to trade repositories and to impose new reporting obligations on market participants. These bodies should be regulated and comply with a common legal framework. The Commission believes that the European Securities and Markets Authority (ESMA) should be responsible for supervising these bodies.
During the G20 at Pittsburgh in September 2009, it was agreed that all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms.
At European level, these transactions should take place on organised markets. It appears necessary to increase transparency of trading on these markets.
Enhancing market integrity and oversight
The Commission intends to review the Market Abuse Directive in order to cover derivatives markets effectively
In addition, the Commission intends to propose rules to give regulators the possibility to counter concentrations of speculative positions and disproportionate price movements.
In the light of the considerable development of derivatives on global markets, a robust and convergent international regulatory framework must be ensured. This Communication is in line with the objectives outlined in the G20 meeting of 25 September 2009 calling for the improvement of OTC derivatives markets.