The European Council on Wednesday adopted a regulation aimed at increasing transparency in derivatives and reducing risk in the over-the-counter (OTC) derivatives market.
Adoption of the regulation follows an agreement reached with the European Parliament. Accordingly, the Council accepted all amendments voted by the Parliament at first reading on Tuesday.
The regulation requires the clearing of standardized OTC derivative contracts through central counter-parties (CCPs) in order to reduce counter-party risk, i.e., the risk of default by one party to the contract.
This is aimed at preventing the default of one market participant causing the collapse of other market players, thereby putting the entire financial system at risk.
To be authorized, a CCP will have to hold a minimum amount of financial resources. Specifically, the regulation requires a CCP to have a mutualised default fund to which members of the CCP have to contribute - the reporting of all derivative contracts to trade repositories (i.e. central data centers). Trade repositories would have to publish aggregate positions by class of derivatives, thereby offering market participants a clearer view of the derivatives market.
The European Securities and Markets Authority (ESMA) will be responsible for the surveillance of trade repositories and for granting and withdrawing their registration.
ESMA will also be responsible for the identification of contracts subject to the clearing obligation, while national competent authorities, in coordination with a college of supervisors, will be responsible for authorization and supervision of CCPs, except in the case of CCPs from third countries, which will have to be recognized by ESMA, provided they meet certain conditions.
If a contract is not eligible for clearing by a CCP, the regulation requires the application of different risk management techniques, including the exchange of collateral and the holding of additional capital.
The obligation to clear OTC derivatives contracts through a CCP and report them to trade repositories applies to financial firms, while non-financial firms will only be subject to the clearing obligation, provided their OTC derivatives positions reach specified clearing thresholds.
The regulation, which will apply from the end of 2012, is intended to implementcommitments made by G-20 leaders in September 2009. One year after the collapse of Lehman Brothers - a major player in OTC derivatives markets - G-20 leaders agreed in Pittsburgh that all standardized OTC derivative contracts should be cleared through CCPs by the end of 2012, while non-centrally cleared contracts should be subject to higher capital requirements. They also resolved that OTC derivative contracts should be reported to trade repositories.
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