Wednesday, July 21, 2010

CESR Consultation on Standardisation and exchange trading of OTC derivatives

Following the financial market turmoil which began in 2007, a number of regulatory initiatives have been launched to address the problems identified in Europe and the United States in relation to the derivatives traded over-the-counter (OTC). In this regard, the Commission’s communication “Ensuring efficient, safe and sound derivatives markets: Future policy actions” [COM (2009) 332 final] states – among others - that consideration should be given to ensuring that trades eligible for exchange trading take place on organised trading venues as defined by MiFID.

In the U.S., legislative initiatives have been launched in the House of Representatives and the Senate following the Administration’s initiative to strengthen OTC derivative markets through improving risk management and increasing transparency. In this paper CESR explores the need for taking regulatory actions in relation to further standardisation for credit, equity, interest rate, commodity and foreign exchange derivatives both as a means in itself and also in relation to the promotion of trading of these derivatives on organised markets.

This paper does not analyse issues related to post-trading and in particular eligibility for clearing. In relation to standardisation, CESR is of the opinion that firms should be able to retain the flexibility to customise aspects such as standard valuation, payment structures and payment dates given the role that OTC derivatives, and in particular bespoke products, play in meeting hedging needs.

Nevertheless, CESR is of the view that greater standardisation of OTC derivatives contracts can deliver efficiency benefits to the market. In particular, CESR has identified the use of electronic confirmation systems as one measure which could potentially deliver benefits to the market. To date, much of this work has been industry-driven but the question now faced by regulators is whether current progress is sufficient, how best to build on current industry initiatives, and whether regulatory intervention is needed.

As a consequence, CESR is eager to explore with the industry what measures could be taken to foster a higher degree of standardisation. As the degree of standardisation differs by asset class, CESR is keen to solicit views on whether regulators should prioritise their focus on a) a certain element of standardisation and/or b) a particular asset class. CESR particularly invites market participants to provide information on the potential costs of introducing a mandatory electronic trade confirmation requirement for European trading of OTC derivatives so that CESR can take an informed decision when making its final recommendations to the European Commission.

In relation to ‘exchange trading’ of derivatives currently traded OTC, CESR believes that trading on organised markets could deliver a number of benefits like providing a higher level of transparency, enhancing liquidity, ensuring efficiency and risk reduction and providing an easy access for market participants. There are however also a number of limitations or pre-requisites to exchange trading of derivatives that may explain why the OTC segment of the market remains very large: the need for the contracts to be standardised, the inability to customise contracts according to individual customers’ needs and the limited possibility for products innovation.

As a preliminary opinion, CESR is in favour of incentivising the use of organised trading venues but continues to consider whether mandatory usage is desirable, taking into account the discussions currently taking place on this issue in other jurisdictions and international fora. Therefore, CESR would like to further explore with market participants which kind of incentives could effectively promote exchange trading.

CESR invites responses to this consultation paper by 16 August 2010. All contributions should be submitted online via CESR’s website under the heading ‘Consultations’. All contributions received will be published following the close of the consultation, unless the respondent requests its submission to be confidential.

Download the paper:

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