UPDATE 1-EU lawmakers stall new derivatives rules

Tue Jan 31, 2012 12:35pm EST

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By John O'Donnell

BRUSSELS, Jan 31 (Reuters) - European lawmakers and diplomats clashed on Tuesday over new rules to overhaul the $700 trillion derivatives market, threatening to delay one of the centrepieces of European financial reform.

The dispute centres on how much power should be given to an EU agency to oversee derivatives, one of the most opaque areas of finance, and once described as "financial weapons of mass destruction" by billionaire investor Warren Buffett.

Derivatives boomed in the decade before the economic crash and were blamed for amplifying the crisis by hiding risks.

But writing laws to regulate them in Europe has divided the region's top powers - Germany, France and Britain - with Britain keen to protect the City of London, which accounts for 9 percent of Britain's economy and dominates the derivatives market, alongside New York.

EU ministers agreed last week to a mechanism that could limit powers given to the European Securities and Markets Authority (ESMA) but the dispute has now spilled over into talks with the European Parliament which has to give its approval.

The parliament is keen not to curb ESMA's powers and wants to change the voting mechanism that could limit its influence.

"Parliament wants a strong role for ESMA whereas some member states are reluctant to give too much power to the supervisor," said one official, speaking on condition of anonymity.

Any delay would be a blow to the European Union's efforts to reform finance, a drive which analysts believe has lost its way as the bloc continues to grapple with problems in the banking industyr and with a sovereign debt crisis.

The United States has been quicker to implement controls, establishing a regulatory framework in 2010 for derivatives, such as those that hedge the risk from price moves on oil, gas or other commodities' markets.

LEHMAN COLLAPSE

Under the new EU regime, which could be in place by the end of 2012, banks, hedge funds and other financial institutions that buy and sell derivatives will be encouraged to move away from the unregulated 'over-the-counter' market, which accounts for more than 90 percent of trades.

It has been common in the past for contracts to be recorded by no more than a fax, with only the parties involved aware of the details.

Instead, trading will be standardised so that it happens on open exchanges and settlement will be cleared centrally. Those that do not shift to exchanges will face higher charges to reflect the extra risk.

The new rules mean that all deals, whether on or off exchange, must be recorded, which supervisors hope will make it easier to monitor the market and intervene to avoid a repeat of the chaos surrounding the 2008 collapse of Lehman Brothers.

"This should prevent another Lehman, whose collapse left those who had signed up to derivatives deals with it carrying the costs," said Graham Bishop, an expert on European financial policy.

"The biggest change is that derivatives will be standardised and cleared centrally - as far as reasonable. That means that capital will have to be retained to cover the risk of these transactions," Bishop added.

The derivatives market is largely organised by fewer than 20 banks and frequently involves institutions designing specialised products for specific client needs. For example, a bank might design a derivative that helps an airline hedge again the risk of a sharp jump in the price of airline fuel.

By definition, derivatives are any financial product, such as an option, future, swap or forward, that derives its price from the underlying asset. A derivative contract can be drawn up between two parties setting out specific variables, including conditions under which the contract may or may not pay out.

Because the market for credit default swaps (CDS), like other derivatives, is unregulated, it has made it difficult to predict how that product would respond to a Greek default or similar dramatic event.

Under the new rules, which were discussed with industry for a year before negotiations moved to the parliament and EU member states, all CDS trades would be recorded, making such predictions easier. (Reporting By John O'Donnell; Editing by Helen Massy-Beresford and Elaine Hardcastle)

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