12 Feb 2010, Matt Cameron, Risk magazine
Derivatives dealers should not be allowed to own stakes in central counterparties (CCPs) or their risk management systems, and CCPs should not be allowed to compete with each other, according to advice from the European Parliament's committee on economic and monetary affairs (Econ). If parliament members vote in line with the advice, it would force dealers to divest stakes in clearers Ice Trust and LCH.Clearnet - an outcome bankers have attacked.
"It's ludicrous. Clearing houses were mutual organisations. They were originally mutually owned and their job is to mutualise risk, so to say users shouldn't have any influence or ownership of governance or direction just betrays complete ignorance of what the function of a
clearing house is and how a clearing house can be built and become operational," says the head of market structure at one investment bank.
The demand echoes proposed legislation in the US, where the House of Representatives passed the Wall Street Reform and Consumer Protection Act in December, which contained a clause known as the Lynch amendment. This would restrict major swap participants and dealers to collectively owning a maximum of 20% of a clearing house.
Proponents of ownership restrictions believe if derivatives dealers own stakes in clearing houses they would have too much influence on the market - either clearing too few trades or too many. But others disagree. "It is our money in the default fund of the clearing house. For dealers to have some kind of oversight or some kind of say in the functioning of the clearing house is entirely reasonable," says the head of market structure. "We're not going to support a clearing house if we're not satisfied with the risk management processes it operates. To think the smart way to make this all happen is to remove the big dealers from the process is just dumb."
The advice, known as an ‘own initiative' report, was circulated to committee members by rapporteur Werner Langen on February 11 and will be provided to members of parliament to inform their vote on forthcoming European Commission (EC) legislative proposals on derivatives markets. The EC is expected to introduce its legislation into parliament mid-year. The Langen report has been translated from the original German version and is due to be presented to Econ for consideration at an extraordinary meeting in the second week of March.
"The report is intended to set out the stall of the committee on what our preferred position will be with regard to regulation in this field. It holds a lot of sway," says one member of the committee.
Given the perceived influence of the report, its author has come under criticism from industry lobbyists, who have attacked the consultation process for being too narrow. According to industry sources, Langen declined to meet any financial institutions or canvass their opinions, only meeting with one European derivatives exchange and a few German corporates. Langen failed to respond to requests for comment by press time.
In addition, the report mandates that all credit default swaps contracts be subject to independent central clearing - the EC's proposals and other global legislative proposals have only called for standardised contracts to be cleared. The advice adds that individual types of derivatives with "cumulative risks" should be subject to special requirements or, in some cases, banned outright.
It also stressed that derivatives rules be uniform and internationally co-ordinated, but added the caveat that in the case of doubt, Europe should pursue independent derivatives regulation.
In other ways, the report reflects the intentions of the EC. It supports the call for contract standardisation, the establishment of trade repositories, an increased role for central clearing houses and more extensive reliance on organised markets.
It also addresses the issue of an end-user exemption, noting that proposed regulations should make a distinction between derivatives used to hedge corporate transactions and those traded by financial institutions.
"The proposed regulations should not result in palpable disadvantages for companies hedging their risks. Although derivatives need to be priced on more market-orientated terms in the future, corporate liquidity must not be restricted. In contrast to the derivatives of financial institutions, corporate derivatives did not contribute substantially to the financial market crisis. A balanced approach is therefore urgently required," states the report.
Corporate end-users of derivatives claim proposed clearing requirements will hamper their ability to hedge, not only in terms of having to post initial and variation margin, but also in their ability to meet hedge accounting requirements.
The report makes no mention of a foreign exchange exemption, which was included in the US House bill passed in December.