BRUSSELS Feb 9 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
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
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
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'
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.