Documents considered by the Committee on 20 October 2010 - European Scrutiny Committee Contents

4 Financial services



+ ADDs 1-2

COM (10) 484

Draft Regulation on OTC derivatives, central counterparties and trade repositories

Legal baseArticle 114 TFEU; co-decision; QMV
Document originated15 September 2010
Deposited in Parliament23 September 2010
DepartmentHM Treasury
Basis of considerationEM of 22 September 2010
Previous Committee ReportNone
Discussion in CouncilNot yet known
Committee's assessmentPolitically important
Committee's decisionNot cleared; further information requested


4.1 The financial crisis highlighted deficiencies within the over-the-counter (OTC) derivatives markets — a traditionally opaque part of the market traded bilaterally between firms rather than over exchanges. These deficiencies were:

  • counterparty risk — the web of relationships in the OTC market means the fear of default of a major market participant can have systemic implications. The AIG affair highlighted weaknesses in the management of counterparty risk, when a credit downgrade required AIG to post collateral it could not afford; and
  • transparency — the financial crisis, for example, the failure of Lehman Brothers, demonstrated that market participants and regulators did not have sufficient visibility of exposures in the OTC market, causing unwillingness to trade in stressed markets.

To address these issues the G20 agreed at the Pittsburgh summit on September 2009:

"To this end, 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."

4.2 The Commission has examined derivatives markets and their regulation and published in 2009 two Communications suggesting future policy actions for the regulation of derivatives markets at EU level. The first Communication, Ensuring efficient, safe and sound derivatives markets,[14] presented the findings of an in-depth Commission review of the derivatives markets and launched a consultation on the regulation of derivatives markets. The second, Ensuring efficient, safe and sound derivatives markets: Future policy actions,[15] outlined "the policy actions the Commission intends to take in 2010 to ... meet the need for greater stability and transparency in these markets."

The document

4.3 This draft Regulation would be the main way to implement in the EU the G20 commitment on OTC derivatives, central counterparties and trade repositories. The proposal includes six broad measures:

  • requiring central clearing for OTC derivative trades where appropriate;
  • new prudential and organisational standards for Central Counterparties (CCPs);
  • a requirement to report derivative transactions to trade repositories;
  • new arrangements for authorisation and supervision of CCPs following the creation of the pan-EU regulatory authorities;
  • new supervisory arrangements for trade repositories; and
  • a right for CCPs to interoperate in clearing cash instruments.

4.4 Requiring CCP clearing would make CCPs the counterparty for all eligible trades and as 'circuit breakers' in the web of counterparty risk in the event of market stress. The draft Regulation:

  • is broad in scope and could potentially capture all market participants and all forms of OTC derivatives;
  • would, however, give discretion to the European Securities and Markets Authority to devise rules that would exempt non-financial, that is corporate, end users of OTC derivatives where they were hedging commercial risk or were not systemically significant;
  • would have the European Securities and Markets Authority develop objective criteria for adoption by the Commission to assess whether obligatory central clearing would be appropriate for any given OTC derivative product. This process would be initiated when a national regulator approved a CCP's proposal to clear a new type of derivative product;
  • would require the European Securities and Markets Authority, with the European Systemic Risk Board, to develop a list of products, not yet available for central clearing at any eligible CCP, that should potentially be subject to the clearing obligation; and
  • includes measures to improve the risk management of derivative transactions that would remain ineligible for central clearing.

4.5 Given the increased systemic significance of CCPs that would result from obligatory central clearing, the draft Regulation provides for new organisational and prudential requirements for CCPs. The draft Regulation would:

  • set out on the prudential side common standards for the mechanisms that protect a CCP against failure, notably participation requirements, financial resources, margin calls and the overall default waterfall; and
  • set out organisational requirements to ensure CCPs have appropriate governance and risk management arrangements.

4.6 The draft Regulation would:

  • require market participants to report the detail of derivative transactions to a trade repository, in order to address the lack of transparency in the OTC derivatives market and give regulators better access to appropriate data;
  • move responsibility for registration and supervision of trade repositories from national regulators to the European Securities and Markets Authority;
  • require trade repositories be established in the EU, although with scope for recognition by the European Securities and Markets Authority of third country trade repositories that meet specified stringent requirements;
  • set out the relationship between CCPs, national regulators and the new European Supervisory Authorities;
  • provide for national regulators to be the lead body responsible for authorisation and supervision of CCPs, the European Securities and Markets Authority to have a central role in the college of competent authorities responsible for CCP authorisation decisions and the Authority to facilitate adoption of a joint opinion in the event of disagreement within the college; and
  • give CCPs the right to seek interoperability arrangements with other CCPs for clearing cash instruments, provided regulators are satisfied that risks are appropriately managed, with the aim of reducing the fragmented EU post trading infrastructure.

4.7 The draft Regulation would delegate development of much of the technical detail to relevant European Supervisory Authorities, requiring them to submit draft technical standards to the Commission by 31 December 2012, drawn up in accordance with the European Supervisory Authorities legislation, which requires the relevant Authority to consider the costs and benefits and to consult publicly and the Commission to consult the Council and the European Parliament.

The Government's view

4.8 The Financial Secretary to the Treasury (Mr Mark Hoban) says that the Government believes that the draft Regulation is justified under the principle of subsidiarity because of the need to have consistent application of the clearing obligation throughout the EU, as in the G20 agreement. But, noting that the draft Regulation proposes national supervision of CCPs but supervision of trade repositories by the relevant European Supervisory Authority, he adds that in Council working group negotiations the Government will be keen to ensure that national authorities have a central role in supervising CCPs and trade repositories.

4.9 On the policy implications of the proposal the Minister says that:

  • the Government fully supports the implementation of the G20 commitment to increase the safety of the OTC derivatives market;
  • the draft Regulation is a critical element of the package of regulatory reforms being implemented in response to the financial crisis, addressing some of the fundamental weaknesses revealed by it;
  • transparency in the OTC derivatives market would be transformed by the reporting of transactions to trade repositories and the management of counterparty risk will see a step change enhancement through obligatory central clearing for appropriate derivative products; and
  • the Government is aware of the potential implications of concentrating systemic risk within CCPs and the cost of requiring market participants to hold more collateral against derivative positions to comply with CCPs risk management requirements.

He continues that, overall, the Government therefore believes these aims should be achieved in a way that does not discriminate against UK market participants and infrastructures, ensures the regulatory burden imposed is proportionate to the benefit in terms of systemic risk reduction and supports the introduction of robust prudential standards for CCPs — "thus [it] will be keen to protect the UK position at Working Group." The Minister adds that it is important that reforms are implemented consistently across G20 partners to prevent regulatory arbitrage.

4.10 On some of the detail of the draft Regulation the Minister says that:

  • the Government broadly supports the Commission's proposal, but notes that the impact on market participants and the resulting reduction in systemic risk will in large part be determined by the detailed technical rules the draft Regulation would require the European Securities and Markets Authority and the European Banking Authority (EBA) to develop for adoption by the Commission;
  • given the inherently prudential nature of much of the proposal, the Government believes there are good arguments for a greater involvement of the European Banking Authority in developing and implementing these rules than the draft Regulation currently proposes;
  • the Government supports assigning the European Supervisory Authorities responsibility for determining which products should be subject to the clearing obligation, which is a key part of this proposal and will be concerned to ensure that the European Supervisory Authority has the flexibility and expertise to take these decisions in an appropriate and proportionate way;
  • the Government supports the principle in the proposal that no CCP should be forced to clear a product it is not comfortable risk managing;
  • it supports the proportionate approach suggested by the Commission for corporate (non-financial) market participants, but notes that more work will be required by the European Supervisory Authorities to ensure the detailed implementation of the proposed thresholds is effective in reducing systemic risk, while not imposing unnecessary uncertainty and burden on corporate users of OTC derivatives;
  • the Government believes there may be a case for similar flexibility in applying the clearing obligation to financial firms which do not present a systemic risk;
  • it supports the Commission's proposal to give national regulators the lead role in supervising and authorising CCPs, given the potential fiscal risk they represent; and
  • the Government believes that national authorities should be responsible for the authorisation and ongoing supervision of trade repositories.

4.11 The Minister, noting that the Commission's impact assessment is largely qualitative in nature given the opacity of the OTC derivative markets, says that the Government broadly agrees with the conclusion — that the costs are likely to be outweighed by the benefits of market stability brought about by these proposals. He adds that the exact costs of the proposal will depend on the scope of products that will ultimately be submitted to CCP clearing.

4.12 The Minister tells us that the Government has consulted widely with CCPs, clearing banks and buy-side market participants and their trade associations as this draft legislation has been developed.


4.13 We note that, although the Government is generally supportive of this draft Regulation, there are matters which it wishes to see addressed during negotiation of the proposal. So before considering the document further we should like to hear from the Minister about progress on these matters, including the potential subsidiarity point he mentioned. We should also like to hear about the views of those the Government has been consulting about the draft Regulation. Meanwhile the document remains under scrutiny.

14   See (30788) 11873/09 + ADDs 1-2: HC 19-xxvi (2008-09), chapter 7 (10 September 2009) and HC 19-xxxi (2008-09), chapter 13 (11 November 2009). Back

15   See (31055) 15047/09: HC 5-i (2009-10), chapter 22 (19 November 2009). Back

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