Alert October 27, 2009

European Commission Issues Communication on Strengthening the Derivatives Markets

On October 20, 2009, the European Commission published a Communication, along with related FAQs, on strengthening regulation of derivatives markets.  In the Communication, which builds on the European Commission’s July Communication and the G-20 Pittsburgh Leaders’ Statement, the European Commission calls for a “paradigm shift away from the traditional view that derivatives are financial instruments for professional use and thus only require light-handed regulation.”  Sharing priorities with U.S. legislators’ proposed regulation of U.S. derivatives markets, the European Commission identifies four principal objectives: (i) reduce counterparty credit risk; (ii) reduce operational risk; (iii) increase transparency; and (iv) strengthen market integrity and oversight.

Reduce Counterparty Risk.  The European Commission identifies central counterparty (“CCP”) clearing as the “main tool” to manage counterparty risk, and it plans to propose legislation mandating central clearing for standardized derivatives through CCPs. CCPs, which are currently regulated at the national level, would be regulated at the European Community level and would be subject to new business conduct rules and risk management standards.  The European Commission intends to propose legislation that would heighten collateral requirements by requiring initial and variation margin and imposing capital charges for non-centrally cleared contracts.

Reduce Operational Risk.  The European Commission cites the derivatives markets’ increased use of standard legal documentation and electronic processing of trades in the Communication.  Under the Communication, it commits to “set ambitious European targets, with strict deadlines, for legal- and process-standardisation.”

Increase Transparency.  All non-centrally cleared derivatives transactions would be required to be reported to trade repositories.  The European Securities and Markets Authority (the “ESMA”) would be responsible for authorizing and regulating trade repositories, which would be subject to new authorization, registration, disclosure, and governance requirements.  The ESMA also would be responsible for authorizing the operation of third‑country repositories in the European Union.  Furthermore, all standardized over-the-counter derivatives contracts would be traded on exchanges or electronic trading platforms.  The European Commission also will consider “harmonising” pre- and post-trade transparency requirements for the publication of trades and associated prices and volumes.

Strengthen Market Integrity and Oversight.  On April 20, 2009, the European Commission issued a call for evidence on its review of the Market Abuse Directive, which prohibits insider trading, market manipulation and other abusive behavior.  In the Communication, the European Commission states that the review of the Market Abuse Directive in 2010 “will extend relevant provisions in order to cover derivatives markets in a comprehensive fashion.”  The European Commission also intends to enable regulators to set position limits “to counter disproportionate price movements or concentrations of speculative positions.”