EUROPE: Central Counterparty Clearing essential for Derivatives Risk mitigation says EU

Friday July 3 2009

Following on from yesterday `s Funds-Axis webinar on `Clearing Credit Default Swaps in a European Clearing House and its effect on UCITS Funds` , the European Commission has today adopted a Communication on ensuring efficient, safe and sound derivatives markets, following a commitment made in the Communication on `Driving European recovery ` prior to the April 2009 G20 Summit.

The Communication looks at the role played by derivatives in the financial crisis and at the benefits and risks of derivatives markets, and assesses how risks can be reduced. It is accompanied by a Staff Working Paper, which contains an overview of (i) derivatives markets,

(ii) OTC derivative market segments, and

(iii) an assessment of the effectiveness of current measures to reduce risks, notably as regards CDS.

The communication having considered the wide diversity of OTC Derivatives discusses issues relating to clearing of CDSs, standardisation of derivatives contracts, central data depositories and trade execution services considering them to interconnectable tools which can be used to reduce risks in the European over-the-counter derivatives markets.

Standardisation: This would enhance operational efficiency and reduce operational risks. It could be achieved by encouraging broader take up of standard contracts and electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes. This requires investments and it may therefore be necessary to incentivise these investments.

Central data repositories: Such repositories collect data on, for example, number of transactions and size of outstanding positions. This increases transparency, knowledge and contributes to operational efficiency. Currently, such a repository exists for CDSs and could potentially be used for other derivatives segments as well. European securities regulators (CESR) are currently carrying a feasibility study for data repository based in the European Union. In the light of the forthcoming CESR report, the Commission will decide on appropriate actions.

Central Counter-party (CCP) clearing: CCPs have proven their worth during the financial crisis. In view of those benefits, the Commission has since October 2008 worked with industry to ensure that clearing of CDS takes place on European CCPs. Industry has as a result committed to achieve CCP clearing by 31 July 2009. If industry is unable to deliver on this commitment, the Commission will have to consider other ways to incentivise the use of CCP clearing. The Commission also considers that the broader use of CCPs in other OTC derivatives markets should be incentivised, wherever possible.

Funds-Axis had yesterday (2nd July 2009) hosted a webinar in conjunction with Eurex Clearing on the topic of `Clearing Credit Default Swaps in a European Clearing House and its effect on UCITS Funds.

Contact events@funds-axis.com for more details on yesterday`s webinar

Trade execution on public trading venues: For standardised derivatives that are cleared by a CCP, the question arises whether the trading of these contracts should take place on an organised trading venue where prices and other trade-related information are publicly displayed (e.g. a regulated market). This would improve price transparency and strengthen risk management. However, it could come at a cost in terms of satisfying the wide diversity of trading and risk management needs. The Commission will examine, taking into account the bespoke and flexible nature of OTC derivatives markets and the regime applicable to cash equities, how to arrive at a more transparent and efficient trading process for OTC derivatives. In this respect the Commission will further assess

(i) the channelling of further trade flow through transparent and efficient trading venues and

(ii) the appropriate level of transparency (price, transaction, position) for the variety of derivative markets trading venues.

The Communication also highlights the actions already undertaken in response to the financial crisis in the area of derivatives (e.g. CCP clearing for CDS, securitisation, credit rating agencies and hedge funds and other alternative investment management funds, supervision).

This communication launches a public communication which will open until 31st August 2009.

The Commission will also host a public hearing on 25 September 2009. Taking into account the outcome of the consultation, the Commission will draw operational conclusions before the end of its current mandate and present appropriate initiatives, including legislative proposals as justified, before the end of the year to increase transparency and ensure financial stability.

The Communication COM (2009)332 as well as Staff Working Paper SEC (2009) 905/2 will be available soon. We will update this space once the documents have been published.