Brussels, 03/07/2009 (Agence Europe) - On Friday 3 July, the European Commission presented avenues for reflection on how to reduce the risks inherent to financial derivatives markets such as credit default swaps, or CDS. These ideas are put to public consultation until Monday 31 August and will be discussed between interested parties during a public hearing in Brussels on Friday 25 September. After the discussion and debates in parallel with US authorities, the Commission will, before is term of office comes to end, draw conclusions which could take the form of legislative initiatives.
Credit derivatives are financial contracts whose value derives from the value of an underlying asset (e.g. shares, bonds, raw material, credit) or a market variable (e.g. interest rate, stock index). Through payment of a forfeit, they allow financial players to transfer some of their risks to other financial players, a little like an insurance contract. The markets of such derivative products have enjoyed exponential growth since 2001 and were evaluated at nearly $700,000 billion mid-2008. The financial crisis revealed a number of failings: - over the counter markets, or OTC, create opacity, so it is very difficult for a player to have a clear picture of the risks incurred by the entity with whom he is dealing; - too large a concentration of players, mainly on the credit derivatives market where a handful of international business banks hold over 80% of contracts underway (Goldman Sachs, Deutsche Bank, Merrill Lynch, Société Générale, UBS) increases the risk for stability of these markets in the event of a large systemic player failing. “The financial crisis has shown that there is a fundamental concern about the over the counter market for derivatives”, a Commission expert says, saying that the interdependency of the players, their difficulty in assessing the risks of each and of localising the risk is detrimental to the stability of the financial system.
How can risk management be improved on the derivatives market? The Commission is putting forward four complementary mechanisms, the expert says. It would first of all be desirable to have standardisation of the contracts on derivatives in order to reduce the legal risks of such operations and improve the effectiveness of financial transactions. Standardisation could target economic parameters and legal conditions of contracts. “We shall focus on the second section” as this is “compatible with the creation of central clearing houses” for the exchange of derivatives, the expert explains. The Commission takes the view that establishing central data repositories on the number of transactions and size of outstanding positions would improve transparency and contribute to operational efficiency. The Commission takes as an example the Trade Information Warehouse, an electronic database perfected by the American organisation DTCC. It should be noted that the European Securities Regulators (CESR) is currently carrying out a feasibility study for data repositories based in the European Union. Furthermore, the Commission reiterates its wish for industry to set up, by end July, one or several central counter-party (CCP) clearing houses for derivatives, in line with commitments taken early this year (see EUROPE 9930). “These CCPs showed their effectiveness during the financial crisis and have managed to close positions open during the bankruptcy of the bank Lehman Brothers”, the European official said. The Commission went on to call for clearing houses to be generalised for all markets of financial derivatives.
In its proposals for a framework for the national derivatives markets, the United States announces its intention to make it compulsory to have standardised central clearing contracts and to encourage exchange of these contracts on regulated stock exchanges. This is one step that the Commission is still reluctant to take. Although it recognises that the entry of derivatives onto regulated markets would improve and strengthen risk management, the European institution wonders whether standardisation implying the exchange of derivative products on regulated exchanges would be able to meet all the needs of the financial players seeking tailored made contracts. “We are not saying we don't want them, but we think that more analysis is needed first”, the same expert said. Such analyses would cover the appropriate level of transparency - in terms of price, transition and open position - for the variety of derivatives markets. The entry of derivatives onto regulated markets is not to the liking of the major business banks which believe over the counter markets are an important source of revenue. The Commission does, moreover, recognise that “derivative markets have been the main source of growth” of the banks concerned, although it does not wish to give a figure for the “substantial amounts at stake”. (M.B./transl.jl)