OTC Derivatives Reform In Europe

Author:Mr Will Dibble, Jason Harding and Ash Saluja
Profession:CMS Cameron McKenna LLP
 
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Background

Over-the-counter ("OTC") derivatives contracts have long been viewed as the domain of sophisticated professional investors such as large corporate entities, institutional investors and financial institutions. As such, historically the OTC market has been only lightly regulated, the assumption being that professional investors are sufficiently aware of the risks associated with their various transactions and that such investors have a vested interest in effectively hedging their exposures.

Events since the near-collapse of Bear Stearns and the bankruptcy of Lehman Brothers have raised questions as to whether the OTC derivatives market should be allowed to continue to self-regulate and there is currently a global move towards improving regulatory and supervisory knowledge of, and transparency in relation to, the OTC derivatives market.

The G20 Summit

The main drive for reform has developed at an international level. In April this year, the G20 agreed upon a commitment to "promote the standardisation and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision" and subsequently at their meeting in Pittsburgh on 25 September 2009 adopted the following Declaration:

"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. We ask the [Financial Stability Board] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse."

European Commission

Taking its cue from the international consensus, the Commission has been developing more specific proposals. On 3 July 2009, the Commission published its Communication "Ensuring efficient, safe and sound derivatives markets" (COM (2009) 332) which was issued with an accompanying consultation document upon which stakeholders were invited to comment. The consultation process concluded on 31 August 2009 and a further Communication, "Ensuring efficient, safe and sound derivatives markets: Future policy actions" (COM (2009) 563) (the "October Communication") was published by the Commission on 20 October 2009.

In these Communications, the Commission opted to develop comprehensive policies for the OTC derivatives market as a whole rather than using a market segment-specific (eg. credit default swap only) regulatory approach. The aim in doing this was to prevent (so far as possible) market participants structuring transactions so as to exploit differences in the rules (so-called "regulatory arbitrage"). In recognition that the OTC derivatives market is also a global market, there was an express desire that any regulation or legislation be consistent with non-EU markets and, in particular, that the EU model be consistent with the approach adopted in the U.S., thereby again avoiding regulatory arbitrage.

The Commission recognises that there will be a need to incentivise market-wide adoption of these changes due to the costs for market participants adapting to the proposed new systems. As a result, although the Commission has undertaken to provide proposals for legislative reforms in 2010, it is also committed to carrying out impact assessments before finalising such proposals, taking into account stakeholder evidence with regard to the costs and benefits of implementing each proposal.

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Background

Over-the-counter ("OTC") derivatives contracts have long been viewed as the domain of sophisticated professional investors such as large corporate entities, institutional investors and financial institutions. As such, historically the OTC market has been only lightly regulated, the assumption being that professional investors are sufficiently aware of the risks associated with their various transactions and that such investors have a vested interest in effectively hedging their exposures.

Events since the near-collapse of Bear Stearns and the bankruptcy of Lehman Brothers have raised questions as to whether the OTC derivatives market should be allowed to continue to self-regulate and there is currently a global move towards improving regulatory and supervisory knowledge of, and transparency in relation to, the OTC derivatives market.

The G20 Summit

The main drive for reform has developed at an international level. In April this year, the G20 agreed upon a commitment to "promote the standardisation and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision" and subsequently at their meeting in Pittsburgh on 25 September 2009 adopted the following Declaration:

"All standardized OTC derivative contracts...

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