BRUSSELS Jan 31 The European Union is
expected to announce an overhaul of regulations governing the
$700 trillion derivatives market on Tuesday, introducing rules
to make one of the most opaque areas of finance easier to
monitor and less risky.
Michel Barnier, the European commissioner in charge of
financial reform, is expected to unveil the new rules once
negotiations with the European Parliament, which have run for
more than a year, have concluded later on Tuesday.
The regime, which could be in place by the end of 2012, will
overhaul a market that boomed in the years before the economic
crash but was blamed for amplifying the crisis by complicating
financial structures and hiding risks from regulators.
Under the new rules, 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.
Instead, trading will be standardised so that it happens on
open exchanges, with settlement cleared centrally. Those that do
not shift to exchanges will face higher charges to reflect their
extra riskiness, which will make it more expensive to trade.
The new rules mean that all deals, whether on or off
exchange, must be recorded centrally, 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
Agreeing the new rules will be a milestone in 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 at its banks and with a sovereign debt crisis.
The United States established a similar framework for
derivatives, such as those that hedge the risk from price moves
on oil, gas or other commodities' markets, in 2010.
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.
That has contributed to the riskiness and lack of
transparency in the marketplace. For example, 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.
Under the new rules, all contracts would be registered
centrally and could be examined by regulators. Supervisors think
that will make it easier to limit excessive risk.
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 forecasting
such a fallout easier.
"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
"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
Writing laws to regulate finance has led to deep divisions
between 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, from excessive regulation.
On derivatives, France and Britain have clashed over the
powers that a pan-European watchdog will have, with Britain
pushing to keep its autonomy in supervising London, which
together with New York oversees the bulk of derivatives trades.
George Osborne, the British chancellor of the exchequer, had
argued to limit the powers given to the EU regulator, the
European Securities and Markets Authority (ESMA).
Ultimately, ESMA is responsible for taking the final decision
on regulation to bring order to the derivatives market.
But last week, EU finance ministers agreed safeguards,
introducing a voting mechanism among national supervisors, that
could prevent ESMA getting the final say on whether a clearing
house can clear trades in a foreign market.
(Reporting By John O'Donnell; Editing by Helen Massy-Beresford)