EC addresses bilaterally cleared trades

Higher capital charges and increased collateral requirements for bilaterally cleared trades could lie at the heart of new legislation of the over-the-counter derivatives markets in Europe, to be drafted by the European Commission in 2010.

In a communication released last week, Ensuring efficient, safe and sound derivatives markets: Future policy actions, the EC said it would propose legislation to require financial institutions to post more collateral and hold higher capital against any contracts that cannot be centrally cleared.

"Current collateral levels are too low and do not reflect the risk that bilaterally cleared derivatives pose to the financial system when they reach a certain critical mass. Financial firms need to hold a larger amount of collateral to cover their credit exposure," the EC said, adding it would also widen the difference between capital charges for centrally cleared and bilaterally cleared contracts in the Capital Requirements Directive (CRD), making non-standardised contracts more costly.

The communication makes a clear effort to pacify the concerns of corporate end users, which have expressed fears any new rules could make non-standardised, bespoke derivatives less appealing if capital and collateral requirements increase.

"While most hedging should, in principle, be achieved through non-customised or standard derivatives, tailor-made derivatives will still be necessary. Accordingly, the Commission does not want to limit the economic terms of derivatives contracts, neither to prohibit the use of customised contracts nor to make them excessively costly for non-financial institutions," the EC insisted, although it warned corporate users would face an increased cost for the trading of over-the-counter derivatives.

In a response to the communication, the International Swaps and Derivatives Association emphasised the need to ensure OTC derivatives remain viable hedging tools for corporates. "Companies ranging from automakers to airlines rely on derivatives to manage an array of risks, including interest rate and currency changes. Isda strongly believes increasing collateral requirements for non-financial institutions could be excessively burdensome," it said.

The communication also pledges to make mandatory the central clearing of all standardised derivatives through central counterparties (CCPs), but said it will draft legislation to govern the activities of CCPs, abolish inconsistencies between national legislation on clearing and ensure CCPs abide by a minimum level of risk management.

"Currently, CCPs provide services on a European basis but remain regulated at national level, as there is no community legislation covering CCPs. The commission intends to propose legislation governing their activities so as to eliminate any discrepancies among national legislations and ensure safety, soundness and proper governance," the EC said.

On the issue of trade repositories, the communication left open the possibility of establishing separate trade repositories in Europe. Some European regulators have argued against having a single global trade repository for each asset class, and have said a separate trade repository should be established in Europe for each asset class. Market participants cited data protection issues, data access and the prospect of being unable to provide support should a repository be in danger of collapse.

The communication states: "The European Securities and Markets Authority (Esma) should ensure European regulators have unfettered access to complete global information. In the absence of such access, the Commission would encourage the creation and operation of European-based trade repositories." It goes on to explain that Esma should be responsible for authorising and supervising trade repositories, as repositories provide services on a European, if not global basis.

The communication also requires that it be mandatory to report all transactions to trade repositories, but does not distinguish between cleared and non-cleared trades. However, it did state information on trades made on-exchange or cleared through a CCP can be provided to regulators directly through these entities.

The Commission will propose legislation that will provide a common legal framework for the operation of repositories and is intended to cover issues including authorisation/registration requirements, access and participation to a repository, disclosure of data, data quality, access to data, safeguarding of data, legal certainty of registered contracts and operational reliability. These issues are being discussed at an international level by the OTC Derivatives Regulators Forum, a medium through which international securities regulators and central banks co-operate, exchange views and share information related to OTC derivatives, CCPs and trade repositories.

Although the current EC has undertaken an industry consultation on the package of reforms after outlining the initial proposals in a July 3 communication, it will not be responsible for drafting the formal legislation as its mandate is due to end on October 31, after which it will undertake a caretaker role until the next Commission starts work in early 2010.

However, the EC's paper suggests draft legislation on the governance of CCPs and the regulation of trade repositories will be produced by mid-2010, while amendments to the CRD to include higher collateral and capital requirements for bilaterally cleared contracts should be made by the end of 2010.