Reforming UK derivatives markets - A UK perspective | Practical Law

Reforming UK derivatives markets - A UK perspective | Practical Law

This article is part of the PLC Global Finance January 2010 e-mail update for the United Kingdom.

Reforming UK derivatives markets - A UK perspective

Practical Law UK Legal Update 0-501-3506 (Approx. 3 pages)

Reforming UK derivatives markets - A UK perspective

by Simon Lovegrove, Norton Rose LLP
Published on 26 Jan 2010
This article is part of the PLC Global Finance January 2010 e-mail update for the United Kingdom.
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HM Treasury and the FSA have published a joint paper (Reforming OTC Derivative Markets - A UK perspective) responding to the recent European Commission Communication on ensuring efficient, safe and sound derivatives markets. In this paper they set out their thinking on the measures that need to be implemented to address systemic shortcomings in OTC derivative markets, the key points of which are summarised here.
HM Treasury and the FSA have published a joint paper which was entitled Reforming OTC Derivative Markets - A UK perspective. In this paper the Treasury and the FSA (the Authorities) responded to the recent European Commission Communication on ensuring efficient, safe and sound derivatives markets by setting out their thinking on the measures that need to be implemented to address systemic shortcomings in OTC derivative markets.
Key measures include:
  • Greater standardisation of OTC derivative contracts. The FSA will work with international regulators to take steps to identify and agree which products can be further standardised, both in terms of underlying contract terms and operational processes, and ensure that this is implemented on a timely basis.
  • More robust counterparty risk management. All OTC derivative trades, whether or not centrally cleared, should be subject to robust arrangements to mitigate counterparty risk. For all financial firms this should be through the use of CCP clearing for clearing eligible products. For trades that are not centrally cleared these should be subject to robust bilateral collateralisation arrangements and appropriate risk capital requirements.
  • Consistent and high global standards for central counterparties (CCPs). In Europe, the UK has been leading calls for a Clearing Directive and will press to ensure that this is an effective tool in mitigating any risk that CCPs will pose to the financial system.
  • International agreement as to which products are 'clearing eligible'. This will require assessment by both regulators and CCPs in deciding which products are eligible for clearing.
  • Capital charges to reflect appropriately the risks posed to the financial system. These should be higher for non-centrally cleared trades and the Authorities are working through the Basel Committee to deliver a proportionate approach.
  • Registration of all relevant OTC derivative trades in a trade repository. The Authorities are working through the OTC Derivative Regulators Forum to deliver this across a number of asset classes.
  • Greater transparency of OTC trades to the market. Consideration should be given to using existing reporting channels to minimise costs.
  • On-exchange trading. Once the above steps have been taken the Authorities do not see at this stage the need for mandating the trading of standardised derivatives on organised trading platforms.
The Authorities' approach is broadly supportive of international moves towards clearing solutions and to the extent these are not available other risk mitigation techniques. The underlying message is that Europe and the US should be in step and a lot of detailed work will be needed to decide on the criteria for clearing eligibility and that a "carrot rather than stick" approach is preferable.
The Authorities' approach of seeking to encourage the use of OTC derivative clearing rather than mandating it differs from the approach of the European Commission in its October communication. There is also no enthusiasm for mandating on exchange trading of derivatives with a clear argument that the decision to remain in the OTC environment or to trade on platform should be left to the industry. Again this strikes a different note to the mandatory approach to on platform trading struck by the European Commission communication.