EC looks to move standardised OTC derivatives onto exchanges

The proposal to encourage greater use of exchanges for the trading of derivatives could prove the most significant in the long term, as it would involve a great deal of standardisation to make complex OTC products exchange-tradable. The EC argues that once standardised contracts are being cleared through a central counterparty (CCP), the next logical step would be for them to be traded through a regulated exchange or alternative trading venue.

Whilst admitting that the type of standardised contracts typically traded on exchanges "may not cater for the full range of derivative users' risk management needs", the EC said it would examine options for the channelling of more trades through "transparent and efficient trading venues".

"There is a societal preference for transparent trading venues, as public and standardised as possible for the purpose of risk assessment and price determination," the EC asserted.

The move is in step with the US Treasury's recent whitepaper, Financial Regulatory Reform: A New Foundation, published on June 17, which also called for standardised parts of the OTC market to be moved onto regulated exchanges and trading venues.

In a statement, the International Swaps and Derivatives Association publicly backed the EC report. But it stopped short of endorsing the call for greater use of exchange trading, a move that would be at odds with Isda's implicit position of protecting the integrity of the OTC markets.

The EC also highlighted its initiatives to enhance the stability of the derivatives market. These include: the push to centrally clear European credit default swaps (CDSs) by July 31; a review of the capital requirements directive (CRD) to force a securitisation retention charge on issuers and enhanced due diligence on investors; the possibility of higher capital charges for trading book activities; the creation of the European Systemic Risk Board to identify and contain excessive risks in the system; and tighter regulation of credit rating agencies and alternative investment management firms.

The report also highlights further areas needing to be addressed. Firstly, it calls for the standardisation of derivatives not only as a prerequisite for CCP clearing but as a desirable development for all instruments. "For non-CCP eligible OTC derivatives, operational efficiency would be strengthened, and operational risks reduced, by further standardisation," the EC said, adding that it would incentivise any industry investment to promote standardisation of complex products.

Secondly, the EC supported the use of a central data repository to improve transparency and efficiency by collecting trade data on both standardised and non-standardised contracts, but said it would wait for the results of a feasibility study by the Committee of European Securities Regulators before taking action.

Thirdly, the EC welcomed the progress being made towards the central clearing of CDSs, but said it would consider strengthening the incentives to use CCPs either through changes to regulatory capital rules in the CRD or through the introduction of European legislation. "Market participants have a natural incentive to use CCP clearing, as it reduces counterparty credit risk and allows regulatory capital savings. However, these incentives have not been sufficient in overcoming commercial incentives favouring bilateral clearing," the report said.

See also: Obama reform plans show no progress on OTC derivatives clearing
Geithner outlines regulations for over-the-counter market
Net benefit
Counterparty maze