Europe Moves to Cut Risk in $505 Trillion Derivatives Market

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Banks and investors in the European Union will have to send trades of some interest-rate swaps to a third party under new rules intended to make financial markets safer.

The banks and major investors that hold the derivatives will have to use a third party called a clearinghouse to process their trades, the European Commission, the EU’s executive arm, said in a statement on Thursday.

“There’s been quite a long delay in getting the European Union to the end point in mandatory clearing,” said Emma Dwyer, a partner at law firm Allen & Overy LLP in London. “People should be reasonably content with this. It hasn’t changed the scope of contracts that are covered and the compromises that were worked out along the way have been largely observed.”

The Group of 20 nations in 2009 mandated clearing for many swaps contracts in an attempt to reduce the damage that would be caused by a major financial institution defaulting on its payments.

“Today we take a significant step to implement our G-20 commitments, strengthen financial stability and boost market confidence,” said Jonathan Hill, the EU commissioner for financial services. “This is also part of our move toward markets that are fair, open and transparent.”

Banks have traditionally traded interest-rate swaps between themselves in over-the-counter, or off-exchange, transactions. By redirecting these transactions to a clearinghouse, the derivatives market should become safer. If a counterparty goes bust, the clearinghouse will spread the losses incurred between all its member firms. Companies have to post collateral with clearinghouses to use them.

Plain Vanilla

Financial institutions held OTC swaps with a notional value of $505 trillion at the end of 2014, according to a survey from the Bank for International Settlements. The real value of the contracts is far smaller because firms often hold contracts which cancel each other out.

The commission has made clearing compulsory for plain vanilla interest-rate derivatives, basis swaps, forward-rate agreements and overnight index swaps traded within the EU. It said that the mandate would be phased in over three years.

The estimated daily turnover in the EU of OTC interest-rate derivative contracts denominated in so-called G4 currencies -- dollar, euro, yen and pound -- was more than 1.5 trillion euros ($1.6 trillion) as of April 2013, according to the commission.

LCH.Clearnet Ltd. is the largest clearinghouse for swaps. The subsidiary of the London Stock Exchange Group Plc has 90 percent of the overall market for swap clearing and a 70 to 80 percent share of clearing for end clients, according to Nathan Ondyak, the firm’s head of products and markets.

The clearing rules were issued as a delegated regulation. The European Parliament and the Council of the European Union, which represents the interests of member states, have three months to object to the standards starting from Aug. 21. In the absence of objections, the rules can enter into force.

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