7 Financial services
| (30788) 11873/09 + ADDS 1-2 COM(09) 332
| Commission Communication: Ensuring efficient, safe and sound derivatives markets
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| Legal base | — |
| Document originated | 3 July 2009
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| Deposited in Parliament | 14 July 2009
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| Department | HM Treasury |
| Basis of consideration | EM of 24 August 2009
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| Previous Committee Report | None
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| To be discussed in Council | None planned
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| Committee's assessment | Politically important
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| Committee's decision | Not cleared; further information requested
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Background
7.1 Following the financial and economic crisis the Commission
has, at the behest of the European Council, been examining the
need for and presenting various proposals relating to the financial
services sector. We last reported on these activities, in relation
to a Draft Directive on Alternative Investment Fund Managers,
in July 2009.[20]
The document
7.2 The Commission has published this Communication to launch
a public consultation on ensuring efficient, safe and sound derivatives[21]
markets. It calls for responses by 31 August 2009 and plans a
public hearing on 25 September 2009. It will, on the basis of
the consultation, present proposals, if justified legislative,
by the end of the year.
7.3 In the Communication, which is accompanied by
two detailed staff working documents, the Commission outlines
the uses of derivatives and an interpretation of how derivatives
have contributed to the current economic climate. It looks towards
possible solutions for improving financial stability and reducing
systemic risk, in particular counterparty risk, that is the risk
that one side of a transaction will not honour its obligations).
The Commission suggests that the objectives to achieve these aims
are:
- allowing regulators and supervisors
to have full knowledge about the transactions that take place
in over the counter derivatives markets (that is off-exchange
trading, where prices remain private), as well as the positions
that are building in those markets;
- increasing the transparency of over the counter
derivatives markets in relation to their users — in particular
more and better information about prices and volumes should be
available;
- strengthening the operational efficiency of derivatives
markets so as to ensure over the counter derivatives do not harm
financial stability; and
- mitigating counterparty risks and promoting centralised
structures.
7.4 The Commission proposes these objectives can
be achieved by:
- promoting further standardisation
to increase efficiency and reduce operational risks — issues
are the degree to which standardisation of contracts should be
obligatory, how to measure standardisation and the impact on a
firm's ability to hedge risk with standardised contracts;
- enhancing the use of central data repositories,
which provide aggregate information of firms' positions and improve
operational efficiency of over the counter markets by facilitating
payment and settlement instructions and improve market transparency,
especially for the market segments not covered by central counterparties[22]
— the Commission discusses the possibility of extending
central data repositories beyond credit default swaps;[23]
- moving clearing of standardised over the counter
derivatives to central counterparties, which reduces counterparty
risk within the financial system and provides greater transparency
to the market and regulators — the Commission discusses
methods of encouraging the use of central counterparties and greater
standardisation of contracts, for example business incentives,
that is incentives brought about by using a central counterparty,
such as improved risk management and position valuation of its
users, and regulatory capital incentives, as a zero risk weighting
is attributed to counterparty credit risk exposures cleared through
a central counterparty; and
- moving part or all of trading to public trading
venues, for example an exchange, which would improve transparency
and strengthen risk management in the market — the Commission
discusses this point on the premise that an organised trading
venue is the next logical step after standardised contracts have
been put onto central counterparties, but acknowledges that the
type of standardised contracts that are typically traded on public
venues may not cater for the full range of derivative users' risk
management needs.
The Government's view
7.5 The Financial Services Secretary to the Treasury
(Lord Myners) tells us that the Government:
- welcomes the Commission proposals
for enhancing the resilience of over the counter derivatives markets;
- agrees that some aspects of over the counter
derivatives markets have exhibited weaknesses during the crisis,
specifically in terms of counterparty risk management and market
transparency and that steps need to be taken to strengthen these
aspects in order to safeguard financial stability; but
- is of the view that appropriately risk managed
and transparent over the counter derivatives markets have a valid
role to play in today's global financial markets and careful consideration
is needed to ensure that market participants are not deterred
from using the financial instruments which most effectively manage
the risks of their business.
7.6 The Minister continues that the Government agrees
with the broad aims of the Commission's proposals, saying that
the principal objectives of regulatory reform should be designed
to reduce risk within the financial system, to improve overall
transparency and to maintain financial stability. He says that
in order to achieve these objectives the Government considers
that four key issues need to be addressed:
- increased standardisation of
contract and economic terms, where the Government supports the
Commission's drive for progress in this area, is of the view that
there are a range of benefits that would accrue from the standardisation
of contract and economic terms, including reducing complexity
and operational risk and promoting transparency and liquidity,
and shares the view that greater standardisation should therefore
be pursued whilst maintaining the ability, where necessary, to
adapt contract design, to enable market participants, including
end users, to tailor risks to suit their individual needs;
- greater use of central counterparty clearing
for clearing-eligible products, where the Government supports
the greater use of central counterparty clearing for clearing-eligible
products, sees this as an effective means of reducing counterparty
risk, supports, given good progress has been made with regards
to central counterparty clearing for credit default swaps, efforts
to extend this to other product areas and is of the view that
greater use of central counterparty clearing not only reduces
exposure to counterparty risk, but can ultimately aid market liquidity
and efficiency;
- strengthened risk management for non-central
counterparty-cleared products, where, given that for market participants
unable to directly access central counterparty clearers, or for
non-clearing eligible contracts used to hedge specific risks,
bilateral clearing arrangements will remain important, the Government
is of the view that such arrangements must be subject to robust
risk management, which includes regular valuation and collateralisation
processes, strong legal and operational frameworks and appropriate
capital requirements, therefore supports moves for improvements
in this area and welcomes the progress which has been made through
the co-operation of supervisors and market participants; and
- increased transparency to the market and to regulators,
where the Government shares the Commission's view that some market
participants do not have adequate access to trade information,
supports moves to address this imbalance, is of the view that
here are a range of efficiency and risk benefits from increased
trade and position transparency (specifically greater trade transparency
can help to promote robust liquidity and market functioning),
holds that improved position transparency can help market participants
and authorities assess risks, including risks to the financial
system and the broader economy, thinks the market has made good
progress in improving position transparency in the credit default
swaps market and supports extension of these efforts to other
markets, when supported by a robust cost benefit analysis.
7.7 The Minister then sets out three key methods
that the Government thinks that public authorities can use to
help ensure that these objectives are met:
- application of risk-appropriate
capital requirements substantial international work within the
Basel framework[24] is
already being undertaken to reassess current capital levels and
the Government expects this to deliver the desired outcome;
- authorities must continue to work with market
participants to analyse shortcomings in existing arrangements,
explore specific options for reform, and ensure that reforms are
made — through these efforts a range of improvements have
already been made to the legal, operational and risk management
processes underpinning over the counter derivatives markets, these
efforts should be continued and outcomes should be carefully monitored,
rather than being prejudged; and
- if, following analysis by the authorities, market-led
initiatives are found not to have achieved the public policy objective,
well-targeted regulatory and legislative measures should be taken
— these measures, which should be supported by a thorough
cost benefit analysis, could include imposing minimum risk management
standards, transparency and reporting requirements and complementary
legislative changes that can support broad market functioning.
7.8 Finally, the Minister tells us that the Treasury
and the Financial Services Authority are producing a joint response
to the Commission Communication.
Conclusion
7.9 Clearly, whilst some measures will emerge
from the Commission's consultation process, they will need to
be carefully calibrated and fully justified by cost benefit analysis.
We shall, in due course, consider any such measures that require
Community legislation with that need in view.
7.10 Meanwhile, before considering the present
document further, we should like to see the Government's response
to the Commission Communication and to have an account of the
Commission's public hearing of 25 September 2009. The document,
of course, remains under scrutiny.
20 (30624) 9494/09 + ADDs 1-2: see HC 19-xxii (2008-09),
chapter 3 (1 July 2009). Back
21
Derivatives are financial contracts that trade and redistribute
risks - their value is "derived" from an underlying
financial instrument, commodity, market variable, service etc. Back
22
A central counterparty is an entity that interposes itself between
the counterparties to the contracts traded in one or more financial
markets, becoming the buyer to every seller and the seller to
every buyer. Back
23
A credit default swap is a contract between two counterparties
under which the protection buyer will pay an annual fee (on a
quarterly basis) to the protection seller until the maturity date
of the contract or until a credit event, for example failure to
pay interest due or bankruptcy occurs on the reference entity.
In the latter case, the protection buyer must deliver bonds or
loans of that reference entity for the amount of the protection
(notional value of the contract) to the protection seller and
receives the par value in return. Back
24
That is the Basel Committee on Banking Supervision, see http://www.bis.org/bcbs/.
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