European commission outlines derivatives reforms

Brussels is seeking to enhance transparency in the unregulated derivatives market to improve financial stability

Elena Moya guardian.co.uk,
Friday 3 July 2009 19.10 BST

The European commission has called for more transparency and safety in the unregulated derivatives market, proposing the use of clearing houses to improve financial stability.

The derivatives market – over-the-counter contracts linked to assets, such as shares, loans or asset backed securities – exploded over recent years. It grew well contracts were linked to, multiplying the risk of losses.

Aiming to bring order and safety to this market, the European commission is consulting until the end of August and may introduce legislation later this year.

"Derivatives play an important role in the economy but are associated with certain risks," the commission said. "The financial crisis – notably the events surrounding Bear Sterns, Lehman Brothers and AIG – has highlighted that these risks are not sufficiently mitigated in the over-the-counter part of the market."

The US investment bank Lehman Brothers and the insurance company AIG were both big issuers of derivatives contracts. Lehman's failure last year left counterparties around the world exposed to losses, while AIG was rescued by the US government in order to prevent a cascade of losses among investors who had bought derivatives contracts issued by the firm.

The commission has proposed the use of standard contracts, central data repositories, the trading of contracts on public exchanges and the use of clearing houses where participants put up collateral that can be used in case they go bust.

The industry broadly welcomed the commission's proposals, especially its consultative nature. The openness to debate over the next few months is different from the planned hedge fund and private equity firms directive, which was not open to industry input, said Andre Allee, a derivatives lawyer at the London-based law firm Simmons & Simmons. The proposals, however, still had "grey areas", such as the sharing of costs from any changes, Allee said.

The International Swaps and Derivatives Association said it "strongly supports" a number of the commission's goals, including increased transparency. "ISDA supports the development of options for users of OTC [over-the-counter] derivatives to undertake their business in the most prudent and efficient manner and to the highest standards of commercial conduct," ISDA said.

The organisation, however, said that limiting parties to trade on exchanges would reduce their choices. "Removing that flexibility, such as by forcing bilateral participants to trade on an exchange or otherwise limiting the availability of customised risk management solutions, would be a step backwards," ISDA said.

http://www.guardian.co.uk/business/2009 ... g-industry