Europe Aims to Limit Derivatives Risks

The European Commission has outlined a list of measures that could be used to limit the potential risk posed by derivatives to the EU's financial system.

Derivatives – such as "futures" and "swaps" – are financial products that derive their value from an underlying asset, such as oil, or a market variable, such as an interest rate.

The financial meltdown last autumn brought the $600 trillion (€430tn) market to the closer attention of global policy makers due to concerns over its huge size and opaque nature.

"Derivatives markets play an important role in the economy, but the crisis has shown that they may harm financial stability," internal market commissioner Charlie McCreevy said in a statement on Friday (3 July).

One factor adding to the lack of information on the sector is the largely 'over-the-counter' (OTC) nature of trading.

Instead of going through an exchange, a large volume of trading is conducted directly between the two parties involved, either over the phone or by using electronic networks, allowing greater flexibility but reducing the information entering the public domain.

Credit default swaps (CDSs)– a contract between two parties in which one party offers insurance against a particular credit event such as a bank default – have been singled out as particularly risky due to the sector's high concentration in a small number of banks.

US insurance company American International Group (AIG) nearly collapsed last autumn as a result of the large payouts it had to make to clients who had taken out CDSs against a Lehman Brothers default. Proposed measures

To counter this, the commission document proposes the greater use of clearing houses – intermediary institutions that agree to fulfil the contract if one party is unable to keep up their side of the bargain.

Financial firms operating in Europe have promised Mr McCreevy that CDS trading will be conducted through clearing houses by the end of the month, with the commission also keen to see them used for other derivatives.

Clearing houses "have proven their worth during the financial crisis" as illustrated by their role in managing the consequences of the Lehman Brothers' default, the commission said, while at the same time indicating it would not insist on greater clearing for the moment.

Others proposals to reduce the risk posed by derivatives include product standardisation and the use of central data repositories.

Greater use of standard derivatives that are better understood could help reduce operational risks says the EU executive, whereas central data repositories would collect data on the number of transactions and the size of outstanding positions in a bid to provide greater transparency to the sector.

Emrah Arbak of the Centre for European Policy Studies, a Brussels-based think-tank, said that greater transparency will not solve the problem by itself, however.

"There are many examples of securities where the transactions are extremely transparent...and yet there are big problems," he told EUobserver, giving the sub-prime loan sector in the US as an example.

The launch of the commission proposals marks the start of a public consultation, with a public hearing set for 25 September. After this the commission plans to come forward with concrete initiatives and possible draft legislation before the end of the year.

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