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European Commission sets out tech-driven action plan for derivatives trading

03 July 2009  |  6863 views  |  1 EU building, Brussels

The European Commission is calling for a technology-driven overhaul of the derivatives markets in a sweeping set of proposals aimed at strengthening the safety of the financial system.

In a policy response that broadly mirrors the regulatory initiatives expounded across the Atlantic, the EC says the financial markets should invest heavily in post-trade automation and standardised data management systems to reduce risks in the free-wheeling derivatives markets.

The set of papers released by the Commission highlight how derivatives in general and credit default swaps in particular have created a web of mutual dependence that makes it difficult to understand, disentangle and contain risk in the immediate aftermath of a default.

"The characteristics of OTC derivative markets - the private nature of contracting with limited public information, the complex web of mutual dependence, the difficulties of understanding the nature and level of risks - increase uncertainty in times of market stress and accordingly may undermine financial stability," says the EC.

Greater transparency could be achieved by encouraging broader take up of standard contracts and electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes, says the EC.

It also calls for the creation of central data repositories, modelled on the DTCC's Trade Information Warehouse initiative in the CDS markets. European securities regulators (CESR) are currently carrying a feasibility study for data repository based in the European Union, and the Commission says it will decide the next steps to take when the study is complete.

On central counterparty clearing, the Commission has set a 31 July deadline for the introduction of a CCP for credit default swaps and says that it will "incentivise" the broader use of CCPs in other OTC derivatives markets wherever possible.

On the question of shifting off-exchange OTC trading to centralised trading venues - a solution favoured by US regulators - the Commission is more circumspect. While such a measure "would improve price transparency and strengthen risk management...it could come at a cost in terms of satisfying the wide diversity of trading and risk management needs". It says further study is needed to ascertain the most appropriate outcome, "taking into account the bespoke and flexible nature of OTC derivatives markets and the regime applicable to cash equities".

The Commission says it will hold a public hearing on the Communication on 25 September 2009.

"Taking into account the outcome of the consultation, the Commission will draw operational conclusions before the end of its current mandate and present appropriate initiatives, including legislative proposals as justified, before the end of the year to increase transparency and ensure financial stability."

Comments: (1)

Stanley Epstein
Stanley Epstein - Citadel Advantage Ltd - Modiin | 03 July, 2009, 14:22

I am always concerned when we try to solve our problems (or simply wish them away) by invoking "technology" as the panacea. This item brings to mind all the previous misguided attempts to solve everything by throwing technology at it.

We have previous attempts to manage operational risk by "mining" historic loss data (which often did not exist in digital form anyway) and using this as an indicator of the future losses or the over reliance of VAR. Interestingly, Pablo Triana in his book "Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial markets?" aptly compares VAR to a passenger airbag that works only 95% of the time; unfortunately the other 5% includes the time when the driver is involved in an accident.

In dealing with Money Laundering we really threw the baby out with the bathwater when we abrogated the requirement to "Know your customer" from a real personal knowledge of who your customer was and what his business really was about to the technologists black box and the modern alchemist's book of formulae and often erroneous suppositions.

I most certainly agree that derivatives and credit default swaps have created a web of mutual dependence that makes it difficult to understand, disentangle and contain risk in the immediate aftermath of a default. I am all for using technology to improve the situation.

However, I do really fear that unless we really have a clear understanding of the derivative practices and processes and the potential implications, throwing all this technology at it could end up as a huge waste of money.

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