Q&A-How will the EU regulate derivatives trading?

BRUSSELS Thu Feb 9, 2012 3:55pm EST

BRUSSELS Feb 9 (Reuters) - European Union diplomats and the European Parliament agreed on Thursday to overhaul regulation of the roughly $700 trillion derivatives market, a move that will make it easier to control one of the most opaque areas of finance.

WHAT IS A DERIVATIVE?

A derivative is a financial instrument that derives its value from that of an underlying asset, such as a bond or a commodity like grain or oil. It is often used to protect against fluctuations in prices.

An airline, for example, could buy a derivative to effectively fix a fuel price for a period of time, providing compensation in the event that such costs were to rise.

Japanese rice farmers were among the first to use derivatives, in the eighteenth century, to insure themselves against the risk of a poor crop.

The modern derivatives market was created in the 1990s in London and on Wall Street and the market boomed in the decade before the financial crash.

Many politicians hold derivatives partly responsible for the chaos surrounding the 2008 collapse of investment bank Lehman Brothers, because they are complex and lack transparency. Because the market is largely unrecorded, buying and selling goes unchecked by supervisors. The new EU legislation aims to change that.

WILL THE NEW EU RULES MAKE DERIVATIVES SAFER?

Most derivatives trading takes place on the "over-the-counter" market, where some multi-million euro deals have been recorded with little more than a fax.

Under the new law, regulators will push for more standardisation, reducing the market for individually designed derivative instruments.

More standardisation makes it easier to clear them centrally, on an exchange or through a central counterparty, where they can be recorded and monitored by regulators.

Clearing houses will provide a safety net, by stepping in should either buyer or seller to a trade go bust. Some analysts fear, however, that this structure will concentrate risks.

Those who continue to trade on the informal over-the-counter market face higher capital charges to reflect the risk, adding to their costs.

"The biggest change is that more derivatives will be standardised and cleared centrally," said Graham Bishop, who advises banks on European financial policy.

"That means that capital will have to be retained to cover the risk of these transactions. This should prevent another Lehman, whose collapse left those who had signed up to derivatives deals with it carrying the costs," he said.

"It will make hedging currency shifts, for example, more expensive because capital comes at a cost. But previously, there had not been enough capital in the system to cover the risks."

The new law requires detailed information on over-the-counter derivative contracts to be reported to trade repositories, where they are accessible to supervisors, and which must publish aggregate market positions.

There is also a new code on how much capital the parties to a derivative trade must hold, as well as wider disclosure of prices.

HOW ARE OTHER REGIONS REGULATING DERIVATIVES?

The new EU law is in keeping with a commitment by leaders of the world's top 20 economies in 2009 to herd derivatives traded off exchanges onto regulated platforms from the end of 2012.

The United States already approved a framework law, known as the Dodd-Frank Act, in mid-2010 to enact these pledges, though it must still complete the fine print.

"The EU definitions for driving these trades onto organised platforms will catch more products than Dodd-Frank," said Alex McDonald, chief executive of the Wholesale Markets Brokers' Association.

The derivatives market in Asia is far smaller than in Europe or the United States. Regulators there, who have been waiting for Brussels and Washington to finalise new legislation, want to use those rules as models.

Agreement on the EU framework law allows the European Securities and Markets Authority (ESMA) to draw up implementing measures, a process that will take several months.

ESMA will determine which derivatives contracts can be centrally cleared as well as overseeing the trade repositories where transactions must be registered.

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