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Home > Blogs > Anthony Harrington > EU derivatives regulation—Papering over the cracks

EU derivatives regulation—Papering over the cracks

Finance Blogger: Anthony Harrington Anthony Harrington

The financial derivatives markets, whose instruments were famously labeled by Warren Buffett as “financial weapons of mass destruction,” are now firmly in the sights of the European Commission. Two EU press releases, one issued on July 9th this year and one on October 20th, confirm the Commission’s determination to ensure (and I quote) “safe and sound derivatives markets.”

What bothers the Commission, and indeed regulators around the world, is a famous lack of transparency in the Over the Counter (OTC) derivatives market. This is not because of some dark conspiracy. It is just that when you have a very large number of bilateral trades, with only the two parties involved being privy to the contract, and when, as can be the case, the resulting instruments are sold in part or whole to a number of other parties, it becomes downright impossible for anyone to see at a glance who is holding what, or how much they are at risk to any one counterparty, or indeed to a nested grouping of counterparties.

The idea of forcing as much of the derivatives market as possible into “standardized contracts” all to go through either a Central Data Repository, or a Central Counter-Party (CCP), is designed to create “at-a-glance” transparency. The CCP would record all trades and be the counter-party to both sides of the trade, possibly also managing the collateralization of the trade and the “mark-to-market” practice that would ensure that there was always sufficient collateral to cover the trade in the event of the party who is “out the money” (i.e. the one who is exposed to a liability in the trade) defaulting.

The beauty of this kind of centralized system, when and if it comes to pass—for the devil is very much in the detail here—is that risk officers and, for that matter, company and bank boards and even the poor old shareholders could see with relatively little effort just how much exposure their organization is running from derivatives trading. Without this, what the company or bank is likely to see is the income stream from its derivatives writing business, but not the risk.

Organizations could, of course, implement better reporting even without a CCP for derivatives, which would let both risk officers and senior management see what was going on, and the mind boggles slightly trying to imagine why such information was not to hand before AIG, Bear Stearns, and Lehman Brothers blew up, for example. All it takes is a simple question: “You have written $1.3 billion in premiums from derivatives trading—excellent: what’s our exposure then?” To which the answer might have been: “$890 billion, but don’t worry, the markets would have to crash before that became a problem…” At which point the risk officer might have chipped in with a question: “What, exactly, do we have by way of reserves to meet that kind of liability?”

The point of this little dialogue is to demonstrate that it is not trading transparency alone that is the issue here. If management abrogates responsibility it is a bit much to suggest that external regulators, even with a few colossal CCPs handling trillions of dollars worth of derivatives, will have sufficient clarity of vision to spot each and every under-resourced trade, or even larger pools of under-resourced trades.

This point gets more of a cutting edge when you consider that the Commission is only talking about “standardized” derivatives, and has already conceded that much of the derivatives world lies beyond anything that can be standardized. It will be interesting to watch this debate progress.

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Tags: derivatives , EU , regulation , transparency
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