BRUSSELS, Jan 31 (Reuters) - 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 Brothers.
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 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.”
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)