The future regulation of derivatives markets: is the EU on the right track? - European Union Committee Contents

The future regulation of derivatives markets: is the EU on the right track?

CHAPTER 1: Introduction

1.  The derivatives market, along with many other sectors of the finance industry, has come under close scrutiny in the wake of the financial crisis of 2008. The European Commission has responded to the pressure for additional regulation of this sector by publishing two Communications suggesting future policy actions for the regulation of derivatives markets at an EU level.

2.  This report focuses on these two Communications (henceforth "the first and second Communications"). The first Communication, Ensuring efficient, safe and sound derivatives markets, was published in July 2009. It presented the findings of an in-depth Commission review of the derivatives markets and launched a consultation on the regulation of derivatives markets.[1] The second Communication, Ensuring efficient, safe and sound derivatives markets: Future policy actions, published in October 2009, outlined "the policy actions the Commission intends to take in 2010 to ... meet the need for greater stability and transparency in these markets."[2] The Commission Communications did not propose specific legislation. The Commission proposals are expected in spring 2010.

3.  The financial crisis highlighted the significant role played by derivatives in the failures of Bear Stearns, Lehman Brothers and AIG (American Insurance Group) in 2008 and brought derivatives to the forefront of regulatory attention. Criticisms have been made in particular of the complexity and lack of transparency of the derivatives market, which reduced the ability of supervisors to identify risk. We examine in this report whether the Commission's proposed future policy actions will improve this situation. The interlinkages in the financial system created by derivatives contracts have been blamed for spreading problems between financial institutions and we discuss this further in Chapter 2. The Commission Communications attempt to address these concerns by setting out ideas for the regulation of different aspects of derivatives markets.[3]

4.  This report is a short review of the proposals and issues that may arise from the future policy actions suggested by the Commission and does not come to any definitive conclusions on the suggestions of the Communications. The current parliamentary session will be a short one and we had limited time to take oral evidence on this subject but thought it important to inform and to promote debate. The Commission's proposals are still in an early state and we intend to return to this subject again in the next parliament.

5.  In addition to the Communications' proposals on the regulation of derivatives, there has been much discussion of a possible EU ban or further regulation of "naked" Credit Default Swaps[4], primarily as a reaction to their suggested role in the recent Greek deficit crisis. The Financial Stability Board[5] is also working on proposals for the regulation of derivatives markets. We do not comment on these discussions in this report, as we did not take evidence on these issues.

6.  In the report we assess whether EU legislation for the derivatives market is appropriate. We examine what effect the proposals will have on market stability, and in particular whether they will address the criticised opaqueness of the derivatives market.

7.  Some subsidiarity issues may be raised by the proposals when they are published. At this stage, when there are no proposals, we do not comment specifically on the subsidiarity implications.

8.  The membership of Sub-Committee A which undertook this inquiry is set out in Appendix 1. We are grateful to those who submitted written and oral evidence, who are listed in Appendix 2; all the evidence is printed with this report. The evidence taken as part of this inquiry was taken in February 2010. Unfortunately, we were unable to take oral evidence from the Commission as part of the inquiry because it coincided with the end of the mandate of the first Barroso Commission. We are grateful for the supplementary letter the Commission was able to provide as part of this inquiry. There is a glossary in Appendix 4. We also thank the Sub-Committee's specialist adviser Professor Robert Kosowski, Assistant Professor in the Finance Group of Imperial College Business School, Imperial College London. We make this report for information.

What are derivatives?

9.  A derivative is a financial instrument that derives its value from another financial asset, event or condition. Parties in a derivatives contract[6] exchange cash or assets over time, based on the value of the underlying asset. As LCH.Clearnet, a leading clearing house for derivative products, explained, a derivative is "a means of either gaining exposure to or gaining an offset to an underlying asset without either buying or selling the underlying asset" (Q 100).

10.  The International Swaps and Derivatives Association (ISDA) explained that:

    "When a derivative contract is entered, one party to the deal typically wants to free itself of a specific risk, linked to its commercial activities, such as currency or interest rate risk, over a given time period. It is 'hedging'; and the more exact that hedge, the better for the hedging party.

    "The other party to the deal assumes the risk, though it may then 'lay it off' elsewhere, in a process akin to reinsurance. Thus risk passes to those most willing to take it on (including investors, who are used to taking similar risks through other financial instruments)" (p 34).

11.  Airlines provide an example of a derivatives contract, which is explained in detail in paragraph 26. They may take out a futures derivative to purchase some of their fuel in advance of its receipt at a fixed price, in order to lower the risks to their business associated with the volatility of fuel prices. A second example would be that of a company which engaged in cross-border trading, which may wish to take out a currency swap to buy a certain amount of foreign currency at a fixed exchange rate for a fixed length of time. This allows the company to hedge against the risk of volatility in exchange rates.

12.  The European Union accounts for 66% of the global interest rate derivatives market and 60% of the global foreign exchange derivatives market.[7] London alone accounts for 39% and 44% of these respective global markets (City of London Corporation, p 78).[8] The US has 24% of the value of the global OTC derivatives market.[9] While Asia currently constitutes a relative small part of the global OTC market, trading volumes are rising very fast. In Japan, the largest market in the region, the interest rate swap market grew by 47% between June 2007 and June 2009.[10]

13.  The Commission Communications used the following definition of derivatives:

    "Derivatives are financial contracts that trade and redistribute risks generated in the real economy, and are accordingly important tools for economic agents to transfer risk. They can be used both for hedging risk and to acquire risk with the aim of making profit.

    "There are many types of derivatives. Some are standard products (e.g. futures) while others are not, as each contract is tailored to the specific needs of the user (e.g. swaps). The standardised derivatives are typically traded in organised trading venues where prices are publicly displayed (e.g. derivatives exchanges) while the non-standardised derivatives are traded off-exchange or, as commonly called, over-the-counter (OTC) where prices remain private."

14. This definition, however, does not make it clear whether there will be exemptions from applicability of the regulation. For example, it might apply to a forward contract negotiated by a farmer to sell wheat at a specified price on a specified date. If such a contract were to be covered by EU regulations, it may lead to increased costs for the farmer, despite the fact that such a contract poses little apparent risk to the stability of the financial system.

15. The Commission working paper that accompanies the Communication noted that "a significant number of participants in these markets are not financial firms, but commercial producers hedging their price risks. Therefore, legislation designed for the financial sector may not be adequately tailored to their activity and risk profile. Indeed, this is reflected in a number of exemptions from EU financial legislation, such as MiFID[11] and CRD".[12] We discuss the effect of the proposals on non-financial businesses in Chapter 4. We recommend that the Government should invite the Commission to explain in detail which contracts will be covered by the definition of derivatives used in its proposed regulation, and clarify the scope of, and exemptions from, the regulation. We will consider this point further when the proposals are published.

Types of derivatives

16.  Derivatives can be traded either on or off exchange. Off-exchange derivatives are known as over-the-counter (OTC) derivatives. Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. OTC derivatives are often tailored to suit the needs of the parties. As a result they are not standardised (one of the preconditions for liquid exchange trading). In 2007 the market value of OTC derivative contracts was eight times greater than the equivalent value of exchange traded derivatives.[13]

17.  The most common types of exchange traded derivatives are futures and options. Futures contracts are contracts to buy or sell an asset on or before a future date at a pre-specified price. Options provide the right (but not the obligation) to buy or sell a certain quantity of stock at a set price at a specific point in the future. Examples of exchange traded derivatives by asset class include:

·  Interest rate derivatives—a common exchange traded interest rate derivative is an interest-rate futures contract. An interest rate future is a financial derivative with an interest-bearing instrument as the underlying asset. This type of contract is typically used to manage interest rate exposure. A pension fund that holds government bonds, for example, could use interest rate futures as a cost-efficient way of reducing its interest rate exposure without having to sell its bonds. Exchange traded options linked to fixed-income instruments also exist. Interest rate futures and options make up the largest part of the exchange traded derivatives market (in terms of notional amounts).[14]

·  Foreign exchange (FX) derivatives—the most basic exchange-traded form of this derivative are FX futures. An FX futures contract involves buying one currency for another at a fixed rate over a period of time. This derivative is often used by companies who trade in foreign markets to reduce their exposure to fluctuations in the value of specific currencies. If an exporter, for example, will receive a cash flow denominated in a foreign currency on some future date, that business can lock in the current exchange rate by entering into an offsetting currency futures position that expires on same date as the cash flow.

·  Equity derivatives—exchange-traded equity derivatives take the form of futures on equity indices and options on equity indices or individual stocks. Hybrid instruments such as convertible bonds are also traded on stock or bond exchanges. A pension fund, for example, that would like to protect its equity investments against a stock market drop could buy put (i.e. the right to sell at a given price) options that would increase in value as the stock index declines.

·  Commodity derivatives—these are derivatives where the underlying asset is a physical commodity, for example, oil or wheat. Commodity futures are the most common exchange-traded commodity derivative, but exchange-traded options on commodities also exist. A producer that needs to buy agricultural products as ingredients for its products can use cocoa or coffee futures to hedge the risk of unexpected increases in its input prices.

18.  Swaps, forwards and exotic options are the three main types of OTC derivatives. Forwards, like futures, are contracts to buy or sell an asset on or before a future date at a pre-specified price. A forward contract differs from a futures contract in that the futures contract is a standardised contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardised contract written by the parties themselves. Forward contracts exist for all asset classes for which futures contracts exist. Exotic options are non-standard and tailor-made and are typically traded OTC. OTC Derivatives typically differ from their exchange traded counterparts in that they are tailor-made; the contract may have unusual maturities, more complex terms or involve several different types of currencies, for example. A swap is a derivative in which two counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The underlying financial instrument can belong to several asset classes:

·  Interest rate derivatives—The largest part of the OTC market (in terms of notional amounts) is made up of interest rate derivatives.[15] This type of contract is used to manage interest rate exposure. Interest rate swaps account for the majority of the notional amount of OTC interest rate derivatives. They involve a counterparty exchanging a variable or floating interest rate for a fixed interest rate to protect against the risks associated with a variable interest rate. A pension fund with future pension liabilities can use interest rate swaps to reduce its interest rate risk by transforming a floating interest rate liability into a fixed rate liability.

·  Foreign exchange derivatives—The most basic form of this type of derivative is a forward contract which involves buying one currency for another at a fixed rate over a period of time. A currency swap is another type of FX derivative. A multi-national company that plans to repatriate foreign currency holdings at a future date could use a forward contract to reduce the future exchange rate risk.

·  Credit derivatives—Derivatives that derive their value from the credit risk on an underlying bond, loan or other financial asset of a reference entity (the reference entity is the entity that issued the underlying asset and is not party to the swap). Credit Default Swaps (CDS) are the most common form of this derivative. A CDS involves the buyer paying an annual fee to the seller until maturity of the contract, or until a credit event occurs on the underlying entity. For example, a bank (the buyer) may pay a fixed fee to an insurance company on the basis that if a person were to default on their mortgage (the credit event) the insurer (the seller) would pay out.

·  Equity derivatives—Derivatives where the underlying asset is equity. Equity-linked OTC derivatives make up only a small part of the OTC derivatives market. Swaps and exotic options linked to equity are common OTC equity derivatives. Equity swaps could be used to exchange a cash flow linked to an equity index against a fixed cash flow without incurring the transaction costs associated with selling the equity position.

·  Commodity derivatives—OTC Forwards, swaps and options on commodities exist but account for the smallest part of the OTC derivatives market. A large oil-producing country could buy put options on the oil price to protect its revenue stream and fiscal position against an unexpected decline in oil prices.


The size of the OTC derivatives market in June 2009
The Bank of International Settlements (BIS) collects data from the central banks of G10 countries on the OTC derivatives market. The statistics presented below summarise the size of different sectors of the market in June 2009 (the latest figures available) in billions of US dollars. Although individual transactions are not recorded, these figures are constructed using the data central banks receive on the volume of OTC trades from banks. It is not possible to pinpoint specific transactions or risks that arise from transactions using the aggregate data.

Notional amount outstanding ($bn)

Gross market values ($bn)

Foreign Exchange



Interest Rate












Notional amounts outstanding are the gross nominal or notional value of all deals concluded and not yet settled on the reporting date. In other words, the total values of all contracts added together.

Notional amounts attract attention due to their large numerical values, but they are a misleading measure of the economic importance of derivatives markets. This is because derivatives contracts involve periodic payments based on the notional amount, but not the notional amount itself. Neither party to a derivatives contract will typically have to make a payment equal to the total notional value of the contract and so it does not represent credit exposure. The cost to exit the contract is the gross market value, which in 2009 was less than 5% of the notional amount for interest rate swaps. The gross market value may therefore be a better indicator of the economic importance of the contracts outstanding.

Gross market values represent the total outstanding cash between counterparties if all contracts are "netted out" (see Box 5).

Source: Bank of International Settlements, OTC derivatives market activity in the first half of 2009, November 2009

The Commission Communications

19.  The first Communication argued that the huge growth of the OTC derivatives market and the increased volume of speculative positions built through derivatives justified a review of the derivatives regulatory framework. The financial crisis demonstrated that the risks associated with derivatives are not sufficiently mitigated in the OTC market. As the derivatives market is predominately organised in bilateral deals and not reported to any central body, supervisors and markets were not able to detect the risks. CDS pose particular worries as the risk they cover, credit risk, is not immediately transparent and obvious but requires the collection of specific information about the borrower and continuous monitoring.

20.  In the light of these considerations, the Commission Communication set out four policy goals:

·  To enable regulators and supervisors to have an overview of the transactions that take place in OTC derivatives markets;

·  To increase the transparency and visibility of OTC derivatives;

·  To strengthen the operational efficiency of derivatives markets so as to ensure that OTC derivatives do not undermine financial stability; and

·  To mitigate counterparty risks. [16]

21.  The first Communication also launched a consultation about policy tools—standardisation,[17] central data repository, CCP clearing,[18] trade execution—hat could be used to remedy the flaws in derivatives market. The results of the consultation are contained as operational conclusions in the Commission's second Communication, Ensuring efficient, safe and sound derivatives markets: Future policy actions, published in October 2009. This Communication outlined "the policy actions the Commission intends to take in 2010 to ... meet the need for greater stability and transparency in these markets".[19]

22.  The future policy actions outlined by the second Communication are summarised below and we return to them subsequently in detail in each chapter of this report. The proposals aim towards increased standardisation and increased transparency by requiring registration of derivative contracts and encouraging central counterparty clearing of most contracts. The Communication noted that "the proposed measures will shift derivatives markets from predominantly OTC bilateral to more centralised clearing and trading". The following actions were proposed by the Communication:

·  Trade repositories: Trade repositories collect information on trades in the OTC derivatives market. The Commission argued it should be mandatory to report all OTC transactions to trade repositories and that the European Securities and Markets Authority (ESMA, see Box 2) should be responsible for the supervision and authorisation of repositories. Through reporting of trades either through CCPs (for centrally cleared products) or trade repositories, Commission legislation will ensure supervisors will have a complete picture of the derivatives market as all derivatives contracts will be reported.

·  Standardisation: The Commission indentified the increased standardisation of contracts as playing an important role in increasing operational efficiency, the number of products eligible for central clearing and transparency. The Commission regards increased standardisation as a "core building block" in its proposals as it is a prerequisite for other actions.

·  Central clearing: The Communication identified CCP clearing as the main tool to manage counterparty risk. The Commission intends to provide rules to ensure that CCPs ensure high standards of risk management. Possible legislation would also cover supervision and authorisation of EU CCPs and recognition of third country CCPs. ESMA will be responsible for the authorisation, and possibly supervision, of CCPs.

·  Collateralisation[20] in bilateral clearing: Legislation will be proposed to require financial firms to provide initial margin and variation margin[21] on bilateral contracts and to increase collateralisation of products that are not centrally cleared. The Communication noted that these requirements would provide an incentive to engage in central clearing.

·  Capital charges on bilateral clearing: Proposed adjustments to the Capital Requirements Directive will widen the difference between capital charges on centrally cleared and bilaterally cleared products again providing an incentive for the development of central clearing.

·  Mandatory central clearing: The Commission intends to make it mandatory to clear standardised derivatives through CCPs. The Communication does recognise that central clearing is not suitable for all derivatives products, a point made in many responses to the Commission consultation.


European Securities and Markets Authority
The European Supervision and Markets Authority (ESMA) would be one of three new European Supervisory Authorities (ESAs) suggested by the Commission in its proposals for a new supervisory structure for the European financial system. ESMA would be an EU standard-setting body that would replace CESR (the Committee of European Security Regulators).

The other two supervisory authorities would be the European Banking Authority (EBA), and the European Insurance and Occupational Pensions Authority (EIOPA).

The legislation instituting this new system for EU financial supervision is currently under discussion in the European institutions. The Committee discussed the proposals for the reform of EU financial supervision in the letter from Lord Roper to the Lord Myners, Financial Services Secretary to the Treasury, dated 25 November.[22]

23.  The Communications drew on both the conclusions of the September 2009 Pittsburgh G20 summit and the conclusions of the de Larosière high-level group in 2009 on financial supervision in the EU. The G20 concluded:

    All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.[23]

The de Larosière group recommended that the EU simplify and standardise OTC derivatives and also introduce a well-capitalised central clearing house for credit default swaps in the EU. [24] The European Council of 19 June 2009 also called for further progress to be made to ensure the transparency and stability of derivatives markets.


The US and Asian approach to the regulation of derivatives markets
On 17 June 2009, the US Treasury Department released a White Paper entitled Financial Regulatory Reform, which prescribed mandatory clearing for all standardised OTC derivatives and more stringent capital and margin requirements for market participants.

In the US Senate, in September 2009, Senator Jack Reed introduced the Comprehensive Derivatives Regulation Act. This would:

·  Require standardised derivatives transactions to be cleared, but not mandate exchange trading for cleared transactions.

·  Require all OTC transactions to be reported to trade repositories.

In November, Senate Banking Committee Chairman Chris Dodd released a comprehensive financial regulatory reform bill, the Restoring American Financial Stability Act, which would establish a presumption of clearing for derivatives transactions. The bill would also mandate exchange-trading for cleared transactions and would grant the Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC) limited authority to exempt transactions from clearing requirements. [25]

On 11 December 2009, The House of Representatives passed the Wall Street Reform and Consumer Protection Act by a vote of 223 to 202. The Act would;

·  Require clearable swaps to be traded on an exchange or swap execution facility. End-users that use swaps to hedge commercial risks would be exempted.

·  Allow counterparties to request the segregation of collateral.

·  Limit aggregate clearing house ownership among swaps dealers, to 20%.

·  Empower supervisors by requiring all swaps dealers and major swap participants to register with the SEC and CFTC.

Regulators in Asia are keen to reform their OTC derivatives markets to prevent problems such as those that affected OTC derivatives markets in the west from happening in their countries. At the same time they are concerned that the expected fast growth of reformed US- and EU-based clearing houses does not crowd out Asian clearing houses. Japan, India, China, Hong Kong, Singapore, Korea and Taiwan have all set up task forces to study setting up clearing operations for OTC derivatives markets, either by using existing clearing houses or by setting up clearers specifically for OTC derivatives. South Korea plans to follow the guidelines agreed by the G20 which would support global coordination and reduce the risk of regulatory arbitrage. The G20 agreement calls for standardised OTC derivatives to be, where appropriate, cleared and traded on exchanges. The Singapore Exchange, SGX, plans to become a regional hub for OTC clearing and is considering joining forces with other clearers such as the UK-based LCH.Clearnet. At the end of 2009, China launched the Shanghai Clearing house with the aim of clearing financial derivatives products for the Chinese interbank market. Although Shanghai Clearing house has not specified which products will be cleared it has been announced that they will include OTC transactions. On the other hand, some countries such as Taiwan and Australia do not appear to consider setting up a national CCP as a matter of urgency.

1   COM (2009) 332. Back

2   COM (2009) 563. Back

3   In this report we take regulation to be the rules set down in legislation and supervision to ensure that financial institutions abide by these rules. Back

4   A credit default swap is a derivative which involves the buyer paying an annual fee to the seller until maturity of the contract, or until a credit event occurs on the underlying security (bond, loan or other financial asset). A "naked" CDS trade involves buying a CDS without ownership of the underlying security. Back

5   The Financial Stability Board is an international body which is intended to work toward increasing financial stability. Back

6   Parties to derivatives contracts are often referred to as counterparties. Back

7   An interest rate future is a financial derivative with an interest-bearing instrument as the underlying asset. Foreign exchange derivatives have currency as the underlying asset. Back

8   The City of London Corporation noted that these values are based on data from BIS, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2007, the most recent collection of country level data on OTC derivatives Back

9   City of London, Current Issues Affecting the OTC Derivatives Market and its Importance to London (April 2009) p. 1. Back

10   Bank of Japan, Results of the Regular Derivatives Market Statistics in Japan (December 2009), p. 1. Back

11   MiFID-The Markets in Financial Instruments Directive (COM (2006) 31) sets out basic provisions for conduct of business requirements and harmonises certain conditions governing the operation of regulated markets. Back

12   CRD-The Capital Requirements Directive (COM (2006) 49) sets minimum levels of capital for financial institutions and has recently undergone several revisions. Back

13   City of London, Current Issues Affecting the OTC Derivatives Market p. 5. Back

14   A full breakdown of this data can be found in Box 1. Back

15   See Bank of International Settlements OTC derivatives market by risk category and instrument in June 2009 ( Back

16   COM (2009) 332. Back

17   Standardisation refers to the standardisation of the OTC derivatives contracts to increase comparability and transparency. This is explained in detail in Chapter 4. Back

18   CCP clearing is where the derivatives contract is effectively split into two contracts, one between the buyer and the CCP and the other between the seller and the CCP. The CCP keeps track of the value of the underlying asset and pays out and receives collateral from the two counterparties accordingly. This is explained in detail in Chapter 4. Back

19   COM (2009) 563. Back

20   Collateral is assets pledged by a party to secure a loan or other form of credit, and can be seized in event of default. Margin payments are a form of collateral specific to derivatives contracts. Back

21   Initial margin is the collateral counterparties have to set aside at the beginning of a derivatives contract to cover their obligations under the contract. Variation margin is the collateral that changes hands between counterparties based on the changing value of the underlying asset. Back

22   EU Sub-Committee A, Correspondence with Ministers: Back

23   Leaders' Statement: The Pittsburgh Summit, 25 September 2009. Back

24   De Larosière report, Report of the High-Level Group on financial supervision in the EU, 25 February 2009, p. 25. Back

25   See for a summary of recent US OTC derivatives proposals in the House of Representatives, Senate and executive branch. Back

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