Dealing with derivatives

The EU has announced plans to regulate the market for derivatives – complex financial products that helped trigger the financial crisis.

The commission will introduce legislation in 2010 to reduce the risk these securities pose to the economy. The proposals are the latest in a series of steps by the EU to strengthen oversight of the financial industry so as to prevent another crisis.

Financial services commissioner Charlie McCreevy said the plans marked “a paradigm shift away from the traditional view that derivatives are financial instruments for professional use and thus require only light-handed regulation.”

As it draws up the legislation, the commission will work with G20 nations to ensure coherence in global policy. The Group of 20 top economies recently agreed to clamp down on derivatives, and the US administration has already introduced legislation to that effect.

Derivatives get their name from the fact that their value is derived from the price of an underlying asset such as interest rates or oil. The EU plan concerns over-the-counter derivatives or OTCs – securities that are privately negotiated and traded directly between two parties.

Trading in these derivatives has exploded in the last decade, with the global market now in the hundreds of trillions of euros. But in the years leading up to the crisis, traders underestimated the risk of default.

The EU wants to shed more light on the market by requiring standard versions of these instruments to be traded through central clearinghouses (CCPs) that absorb much of the risk of default. All other deals would have to be recorded.

The new rules will also require financial institutions to post more collateral and hold more capital against deals that do not clear centrally.

On a related issue, the commission is seeking public comment on how to prevent troubled banks from threatening the broader financial system and forcing taxpayers to bail them out. A spate of bank failures during the financial crisis brought home the need for new legal tools to cope with their cross-border impact.

Saying, “no bank will ever be immune to failure”, commissioner McCreevy called for “a robust set of arrangements” to detect and avert a bank's collapse if possible, and if not, to reorganise it.