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European Parliament approves stricter requirements for over-the-counter derivatives

The European Parliament has voted in favour of stricter regulation of the over-the-counter (OTC) derivatives market, which it says will make it harder for parties to default on the complex financial instruments.02 Apr 2012

Under the European Market Infrastructure Regulation (EMIR), all OTC derivative contracts will have to be cleared through central counterparties (CCPs). CCPs sit in the middle of a trade between two parties and assume the counterparty risk, ensuring financial performance of the trade if one party does not meet its commitments.

In addition all derivative contracts, including OTC derivatives, will have to be reported to central ‘trade repositories’.

The European Commission drafted the new rules in the wake of the financial crisis and the collapse of major financial services firm Lehmann Brothers in 2008. The firm was a leading player in the OTC derivatives market.

Internal Market and Services Commissioner Michel Barnier said that the vote was a “key step” in the EU’s efforts to make European financial markets safer and more secure.

“We need to restore trust in the financial sector,” he said. “With this new regulation, we are taking a big step towards financial stability. We are reducing the risk of a future financial crisis, with all its consequences on the real economy, growth, jobs and public budgets.”

He added that European lawmakers now needed to focus on “complimentary rules” in other areas of financial regulation, particularly “a swift revision of rules on markets in financial instruments”.

A derivative is a type of financial contract linked to the underlying value of the asset to which it refers, such as the movement of interest rates or currency value, or the possible bankruptcy of a debtor. OTC derivatives are those not traded on a regulated stock exchange, but are instead privately negotiated between two parties. EMIR will apply to all derivatives trades which are not “executed on a regulated market”. These account for over 95% of the derivatives market, according to EU figures.

The European Securities and Markets Authority (ESMA) will regulate the new trade repositories, or central data centres with which all derivatives transactions must be registered, and which will publish derivates registers broken down by class of transaction. This is intended to give traders a clearer view of the market. ESMA will be responsible for registering trade repositories and potentially blocking the authorisation of CCPs, although these will be authorised at a national level.

EU traders will only be able to use counterparties from third countries where the third country in question provides an “effective equivalent system for recognition”.

EMIR will come into force once technical standards, which will be developed by the European financial supervisory authorities, are fully adopted. This must be by the end of 2012 in order for the EU to meet its commitments to the rest of the G20 leading world economies. CCPs will have to apply for authorisation under the new regime within six months after the standards are adopted.

The Commission will assess the EMIR’s effectiveness, including with regards to how CCPs are authorised and supervised, within three years after the rules come into force.