Brussels, 20 th October 2009
Derivatives Markets – Frequently Asked Questions
You propose a comprehensive solution for all derivatives markets. Does that not ignore the different risk of different asset segments?
The various derivatives market segments differ in their characteristics, namely in terms of risk, operational arrangements and market participants. At first sight, a market segment specific regulatory approach could therefore seem warranted. However, the boundaries between market segments are blurred, as any derivative contract can be partitioned and reconstructed into different but economically equivalent contracts. Therefore, an asset-specific policy approach would enable market participants to exploit differences in rules to their advantage. The Commission accordingly believes that a comprehensive policy on derivatives is necessary to address the current market failure in the most efficient way.
Moreover, the effect of the policy proposals depends on the effectiveness of current risk mitigation infrastructures. In asset segments where e.g. CCP clearing is already up and running, the effects will be more limited.
What measures exactly is the Commission proposing?
The Commission's objectives are to reduce counterparty credit and operational risks, increase transparency and to strengthen market integrity and oversight. To that end, the Commission proposes a package of actions that will be developed into legislative proposals in 2010.
To reduce counterparty credit risk, the Commission will (i) propose legislation to establish common safety, regulatory and operational standards for central counterparties (CCPs), (ii) improve collateralisation of bilaterally-cleared contracts, (iii) substantially raise capital charges for bilaterally-cleared as compared with CCP-cleared transactions, and on top of this (iv) mandate CCP-clearing for all standardised contracts.
To reduce operational risk, the Commission will work with industry to promote standardisation of the legal terms of contracts and of contract-processing.
To increase transparency, the Commission will (i) mandate that positions and all transactions are recorded in trade repositories, (ii) regulate and supervise trade repositories, (iii) mandate trading of standardised derivatives on exchanges and other organised trading venues, and (iv) increase pre- and post-trade transparency as part of the upcoming review of the Markets in Financial Instruments Directive (MiFID) for all derivatives markets including for commodity derivatives.
To enhance market integrity and oversight, the Commission will propose clarifying and extending the scope of the Market Abuse Directive (MAD) to derivatives and by giving regulators the possibility to set position limits.
Will the Commission consult with other jurisdictions when finalising its proposals?
Yes. The market for derivatives is global, and regulatory arbitrage must be excluded. The Commission wants to ensure a robust and convergent international regulatory outcome. T he proposals are therefore in line with the objective outlined in the G20 meeting of 25 September 2009 .
In order to ensure an ambitious and coherent implementation of these policies across the globe, the Commission intends continue to develop its policy in this area in close cooperation with its G20 partners, and in particular with the US, which is also in the process of designing a new approach to derivatives markets.
COUNTERPARTY CREDIT RISK
What is a Central Counter-party (CCP)?
A CCP is an entity that interposes itself between the counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer.
Why does the Commission propose to mandate more collateral? Aren't current collateral levels sufficiently high?
No. There is a considerable amount of uncertainty surrounding the current level of collateralisation. Moreover, recent studies, notably by the ECB, highlight that current collateral levels are lower than previously thought. It is therefore necessary to require financial firms to supply both initial margin and variation margin when entering into a bilateral deal OTC.
Why is it necessary to further strengthen the favourable regulatory capital treatment of CCPs? Isn't a zero-rating enough?
The current treatment has not provided a sufficient incentive to take up CCP clearing irrespective of the benefits. It is therefore necessary to strengthen the differentiation to ensure that the rules properly distinguish between, on the one hand, the lower counterparty credit risk of contracts that are cleared on a CCP, and the higher counterparty credit risk of those where clearing is done bilaterally.
Why do you propose to mandate CCP clearing on top of capital charges?
Capital charges will provide the necessary incentives toward standardisation and CCP clearing. In order to ensure that the G20 deliberations are respected, the Commission decided to mandate the use of CCPs for standardised products.
How will you implement the mandate to clear standardised contracts on CCPs?
When developing its detailed proposals, the Commission will work with its partners in the G20, and notably the US, to achieve ambitious solutions to the practical issues related to making the requirement operational. This involves, in particular, defining which contracts can be regarded as standardised for central clearing. The Commission will undertake a rigorous impact assessment before finalising its proposals. The impact assessment will take due account of all the costs and benefits, including the impact on competitiveness.
Why does the Commission propose to work with industry to reduce operational risk? Does this not duplicate ongoing global efforts to the same effect?
The Commission considers that more collective action is needed by market participants to increase standardisation so as to reduce operational risk. Therefore, the Commission will further build on the success of the Derivatives Working Group and set ambitious European targets, with strict deadlines, for legal- and process-standardisation. This complements global actions, as the focus will be to ensure that global efforts take due account of European specificities so as to deliver full benefits also in Europe.
What are trade repositories?
A trade repository collects data on contracts traded in one or more segments of the OTC derivatives markets. Through a trade repository one can therefore obtain information on, for example, the number of outstanding contracts, the size of outstanding positions in a particular contract, the exposures of a particular institution, etc. This contributes to improve the level of transparency and knowledge of both supervisors and the public. A repository can also provide other services (e.g. facilitate settlement and payment instructions), thus improving operational efficiency. A trade repository exists for CDS in the form of the Trade Information Warehouse, operated by the US Depository Trust and Clearing Corporation (DTCC).
Do you require trade repositories to be located in Europe?
No, provided that (i) third country repositories are subject to comparable regulation and supervision and (ii) European regulators have unfettered access to the information stored at repositories in third countries. Should such access not be achieved, the Commission will encourage the creation and operation of European-based trade repositories.
Why do you propose to extend post-trade transparency to OTC derivatives? Will it not reduce liquidity?
Derivatives trading can take place on many types of venues, ranging from on-exchange to OTC. This competition is beneficial, provided that the price discovery function for the derivatives market as a whole is supported and information asymmetries are minimised. To achieve that it is necessary to extend transparency requirements to OTC trading as well. However, the increased transparency obligations will need to be measured so as to mitigate any excessive negative side-effects on liquidity.
What is an organised trading venue?
An organised trading venue is a venue where trades are executed in an automated manner according to pre-defined rules and where prices and other trade-related information are publicly displayed. According to the categorisation in the Markets in Financial Instruments Directive (MiFID), organised trading venues are regulated markets, multilateral trading facilities (MTFs) and systematic internalisers.
Why do you propose to mandate trading of standardised contracts on such venues?
This requirement is in line with the global principles agreed by the G20. In the EU, this implies ensuring that eligible trades for exchange-trading take place on organised trading venues, as defined by MiFID. Mandating trading on such venues, together with the introduction of transparency rules, will help to ensure greater efficiency in the trading of eligible products and ensure a consistent framework in how financial instruments, from equities to derivatives, are traded.
MARKET INTEGRITY AND OVERSIGHT
What is the purpose of giving regulators the power to set position limits?
Proposing these powers is part of the Commission's efforts to improve pan-European supervision and oversight. The possibility to impose position limits is an important ancillary tool for supervisors to ensure the stability and soundness of markets. It allows them to limit the concentration of risk, excessive position taking and therefore counterparty risk. Especially in the field of commodity derivatives markets, it can also be a way to curb excessive price volatility, which distorts the orderly functioning of markets.
Why are non-financial institutions affected by the future policy actions?
Non-financial institutions are users of derivatives products and are therefore part of the web of mutual dependence. Inasmuch as non-financial firms have bought protection from a financial firm and in so doing have transferred their risks into the financial system, they have generally benefited from the underpricing of risk in the build-up phase of the crisis. Through the severe decline in economic activity, they have also fallen victim of the financial crisis.
Even though non-financial institutions' use of derivatives is relatively small compared to financial users, history suggests that they may sometimes build up sizeable positions and hence be a risk to their counterparties and possibly to the system as a whole should they default. Non-financial institutions should therefore not be completely excluded from the scope of the forthcoming actions.
Moreover, a principle underpinning the Commission's proposals is that the cost of strengthening the market infrastructure for OTC derivatives should be carried by those who directly enjoy the economic benefit from using derivatives and not taxpayers. This was not the case during this financial crisis and the Commission proposes to address this. Risk will have to be adequately priced. What the precise price will be, is part of the ongoing work and analysis that needs to be done to enable the Commission to define its proposals.
Non-financial institutions' use of derivatives poses less of a risk to the financial system. Will this be taken into account when finalising the proposals?
In view of the different level of risk to the financial system associated with non-financial institutions' use of derivatives, they may not be subject to exactly the same level of obligations as financial institutions. The Commission will take due account of the differences when finalising its proposals. However, although most non-financial institutions are not of systemic importance, legislation should not be undermined by loopholes.
Do these measures not risk hurting non-financial institutions' competitiveness?
The financial crisis is already hurting 'competitiveness'. Potential growth has declined from 1.8% p.a. on average 2000-2006 to 0.7% in 2009. 1 Hence, the crisis has thrown back the Lisbon strategy's objectives. The financial crisis has therefore amply illustrated how vulnerable the real economy is to financial instability and the enormous costs of mitigating the impact. Addressing the root causes for the financial crisis in order to provide a more stable financial foundation for the real economy is therefore a vital interest for us all, non-financial institutions included. Strengthening financial stability will make severe economic crises less likely in the future and put Europe on a more sustainable growth path.
Will European companies be disadvantaged vis-à-vis other countries?
No, the Communication states clearly the need for close cooperation with G20 partners. Also, the forthcoming proposals will be subject to rigorous impact assessments. The Commission will take full account of the impact of any proposal on Europe's competitiveness.
Will companies still be able to hedge?
Yes. The Commission's proposals do not limit the freedom to set the economic terms of derivative contracts. The Commission recognises the vital role of customised derivatives contracts traded OTC in hedging the risks that result from normal business operations. The Commission does neither propose to ban customised contracts nor to make them prohibitively costly. However, the function of prices to allocate resources must be restored: derivatives should be appropriately priced in relation to the risks they entail (including systemic risk), in order to avoid those risks being ultimately passed on to taxpayers.
Will hedging become more costly?
The Commission's forthcoming proposals aim at better management of the risks of derivatives, hence there is an efficiency gain. Initially, however, traditional OTC trades (i.e. bilaterally cleared) are likely to become more costly. However, over time, as more contracts will get centrally cleared, the cost per contract is likely to fall, as economies of scale come into play.
Will financial firms pass on the costs to non-financial firms?
The fee a financial firm charges for a derivatives trade depends on whether its counterpart provides collateral or not. If not, the financial firm has to use its own capital to cover its exposure. This results in a higher fee.
Therefore, if non-financial firms provide no collateral, financial firms are likely to pass on some of their costs to them. However, derivatives markets are competitive and financial firms are unlikely to be able to pass on their costs in full. The measures proposed are also likely to increase competition as the reduction of counterparty credit risks through CCPs may allow smaller players to enter the field. Moreover, the Commission's proposal to increase post-trade transparency is likely to further limit financial firms' ability to pass on the costs. US experience from corporate bonds has shown that intermediation margins fall with more transparency.
Legislation is announced for 2010. What are the next steps?
The Commission will now launch the impact assessments. It will take into account all stakeholders' evidence about the potential impacts, in terms of costs and benefits, of the policy orientations set out below when preparing the impact assessment with a view to finalising its proposals.
DG ECFIN, Quarterly Report on the Euro Area, no 2, 2009, special section on the crisis and potential growth.