The future regulation of derivatives markets: is the EU on the right track? - European Union Committee Contents

CHAPTER 6: Summary of Conclusions

129.  We recommend that the Government should invite the Commission to explain in detail which contracts will be covered by the definition of derivatives used in its proposed regulation, and clarify the scope of, and exemptions from, the regulation (para 14).

Derivatives: benefits and risks

130.  Derivatives have sound economic and commercial benefits, and have been and remain necessary to the development of trade and commerce, but the manner in which they are used can pose a risk to the system (para 27).

131.  Derivatives have an important economic function, namely redistribution of risk, but some forms of derivatives can be used as tools for speculation by participants in the financial market who have ownership of the underlying asset. Coupled with a lack of transparency in the market, where build-ups in risk cannot be detected by actors or supervisors, derivatives could help destabilise the financial system, particularly if there is a significant shift in the value of underlying assets (para 40).

Trade repositories

132.  We agree with the future policy actions suggested by the Commission to increase transparency in the OTC derivative markets by supporting the use of trade repositories to record OTC derivatives contracts to ensure all trades in the market are reported. Trade repositories should enhance market transparency for regulators and reduce systemic risk by ensuring that supervisors have a comprehensive picture of market concentrations and exposure within a given asset class and allow supervisors to more accurately identify the misuse of derivatives. Further consideration should be given to access to data held by trade repositories (para 50).

133.  Whilst the regulatory framework for trade repositories should be at the EU level and reflect globally agreed standards, further consideration should be given to the appropriate level of supervision within the EU (para 57).

Standardisation and central counterparty clearing of OTC derivatives contracts

134.  We welcome Commission and industry efforts to encourage standardisation in derivatives products. We agree with the Government and the Commission that standardised contracts can help improve transparency and stability in the OTC derivatives markets. However we note that not all products can be standardised and that room must be left, in an efficient market, for bespoke derivatives that meet the specific needs of corporates (para 62).

135.  We welcome the approach of the Commission in looking at ways to increase the proportion of contracts centrally cleared in order to reduce systemic risk. However, as the Commission recognises, central clearing is not a feasible option for all investors and all contracts. Increased use of CCPs should increase transparency in the sector by providing centralised locations for data on overall market positions, by ensuring that all derivatives contracts are reported and by enabling a clearer view of the total net amount owed on derivatives contracts (para 74).

136.  We agree that standardisation should not lead to compulsory CCP clearing eligibility. Similarly, a lack of standardisation should not necessarily indicate clearing ineligibility (para 83).

137.  The Government should encourage the Commission to define carefully in the final proposal which contracts should be regarded as both standardised and appropriate for central clearing. CCPs should not be allowed to clear a product if they are not prepared to manage the risk. CCPs are privately owned companies, which can currently refuse to clear products where they feel they cannot manage the associated risk and this system has worked well even during the financial crisis (para 84).

138.  Increased standardisation and central clearing of OTC derivatives can increase transparency and stability. However, not all products, nor all standardised products, are suitable for central clearing. Legislation should avoid forcing these products through central clearing as this may increase risk in the system if a CCP cannot effectively manage the risk associated with a product (para 90).

139.  It is important that bespoke products are appropriately risk-managed though the use of capital charges proportionate to risk. The Government may wish to encourage the Commission to impose proportionate levels of capital charges in connection with the trading of non-standardised derivatives. Disproportionate levels of capital charges for non-standardised derivatives could discourage innovation or, at worst, force products through central clearing which are both destabilising to, and unsuitable for, CCPs (para 97).

140.  Non-financial businesses use derivatives for the purpose of risk management but these derivatives are inherently less risky as they are closely related to underlying assets. The Commission proposals could have the effect of adversely penalising the use of this type of derivative. We welcome the Commission's confirmation that the effect any proposals would have on non-financial end-users of derivatives will be considered in the Impact Assessment (para 104).

The EU regulation of CCP clearing houses

141.  We welcome the Commission's acknowledgement of the need to develop a coordinated global approach in line with the work of CPSS and IOSCO. We also recommend that the Commission's Impact Assessment should examine in detail where minimum standards are appropriate and whether specific calculations on risk and margins are best left to the clearing house itself (para 113).

142.  We recognise that the absence of any cross-border fiscal burden-sharing arrangements for failing financial institutions means that supervision of CCPs at EU level is probably unrealistic. It may be appropriate to develop a supervisory system at EU level along the lines of that currently under negotiation for EU banking supervision, in which supervisory best practice is shared and technical standards defined (para 117).

143.  The separation of collateral from clearing houses' other assets can help maintain liquidity in a crisis. We agree with the Commission that proposals to include specific requirements for separation of assets are attractive (para 120).

144.  Supervision will be more effective if it ensures that CCPs compete on quality of service, rather than size of margins (para 124).

145.  Increasing the role of CCPs in the derivatives market increases their effect on market stability. If the number of CCPs operating in Europe falls in the future, as predicted by witnesses, this will also have the effect of increasing the systemic importance of the CCPs that remain. We agree with the Minister that this reinforces the importance of effective regulation and supervision of CCPs (para 128).

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