The European Commission is calling for the creation of a data warehouse, more standardized contracts and automation of key aspects of transactions, to reduce risk in the free-wheeling over-the-counter derivatives market.
Taking a cue from similar moves in the United States, a communique released by the EC to financial market participants today highlight how the complexity of derivatives and credit default swaps make it difficult to understand, disentangle and contain risk in the aftermath of a default.
"The characteristics of OTC derivative markets - the private nature of contracting with limited public information, the complex web of mutual dependence, the difficulties of understanding the nature and level of risks - increase uncertainty in times of market stress and accordingly may undermine financial stability," says the EC.
Greater understanding can be achieved by encouraging broader use of standard contracts, as well as electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes, says the EC.
The EC also calls for the creation of European version of a central data repository modeled on the Depository Trust & Clearing Corporations initiative in the United States - the Trade Information Warehouse - for credit default swaps.
The Committee of European Securities Regulators is currently carrying a feasibility study for a data repository based in the European Union. The European Commission says it will decide the next steps to take when the study is complete.
The Commission also set a July 31 deadline for dealers to sign up to use a central counterparty (CCP) service for credit default swaps and says that it will "incentivize" the broader use of such services in other OTC derivatives markets wherever possible. CCPs guarantee the completion of a trade in the event of the default of one of the counterparties.
On the question of shifting off-exchange OTC trading to centralized trading venues - a solution favored by US regulators - the Commission is more circumspect. While such a measure "would improve price transparency and strengthen risk management...it could come at a cost in terms of satisfying the wide diversity of trading and risk management needs," the commission said in its Communication to financial market participants.
The commission, which acts as the executive branch of the European Union, says further study is needed to ascertain the most appropriate outcome, "taking into account the bespoke and flexible nature of OTC derivatives markets and the regime applicable to cash equities."
The Commission says it will hold a public hearing on its communique on September 25.
"Taking into account the outcome of the consultation, the Commission will draw operational conclusions before the end of its current mandate and present appropriate initiatives, including legislative proposals as justified, before the end of the year to increase transparency and ensure financial stability," the communiqué stated.
This article can also be found at SecuritiesIndustry.com.
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