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. 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."
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.
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
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,
primarily as a reaction to their suggested role in the recent
Greek deficit crisis. The Financial Stability Board
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
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
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
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.
London alone accounts for 39% and 44% of these respective global
markets (City of London Corporation, p 78).
The US has 24% of the value of the global OTC derivatives market.
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.
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
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
and CRD". 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
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.
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 derivativesa
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).
· Foreign exchange (FX) derivativesthe
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 derivativesexchange-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 derivativesthese
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
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 derivativesThe
largest part of the OTC market (in terms of notional amounts)
is made up of interest rate derivatives.
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 derivativesThe
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 derivativesDerivatives
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 derivativesDerivatives
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 derivativesOTC
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)
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
· 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. 
21. The first Communication also launched a consultation
about policy toolsstandardisation,
central data repository, CCP clearing,
trade executionhat 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".
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
· 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.
in bilateral clearing: Legislation will be proposed to require
financial firms to provide initial margin and variation margin
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.
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.
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. 
The European Council of 19 June 2009 also called for further progress
to be made to ensure the transparency and stability of derivatives
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. 
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
COM (2009) 563. Back
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
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
The Financial Stability Board is an international body which is
intended to work toward increasing financial stability. Back
Parties to derivatives contracts are often referred to as counterparties. Back
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
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
City of London, Current Issues Affecting the OTC Derivatives Market
and its Importance to London (April 2009) p. 1. Back
Bank of Japan, Results of the Regular Derivatives Market Statistics
in Japan (December 2009), p. 1. Back
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
CRD-The Capital Requirements Directive (COM (2006) 49) sets minimum
levels of capital for financial institutions and has recently
undergone several revisions. Back
City of London, Current Issues Affecting the OTC Derivatives Market
p. 5. Back
A full breakdown of this data can be found in Box 1. Back
See Bank of International Settlements OTC derivatives market by
risk category and instrument in June 2009 (http://www.bis.org/statistics/otcder/dt1920a.pdf) Back
COM (2009) 332. Back
Standardisation refers to the standardisation of the OTC derivatives
contracts to increase comparability and transparency. This is
explained in detail in Chapter 4. Back
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
COM (2009) 563. Back
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
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
EU Sub-Committee A, Correspondence with Ministers: http://www.parliament.uk/hleua Back
Leaders' Statement: The Pittsburgh Summit, 25 September 2009. Back
De Larosière report, Report of the High-Level Group on
financial supervision in the EU, 25 February 2009, p. 25. Back
for a summary of recent US OTC derivatives proposals in the House
of Representatives, Senate and executive branch. Back