EC bids to tame 'wild west territory' of OTC derivatives and short selling

EC bids to tame 'wild west territory' of OTC derivatives and short selling

The European Commission is proposing new regulations aimed at improving transparency and safety in over-the-counter (OTC) derivatives markets and tougher controls on short selling and credit default swaps.

As it grapples with the global economic crisis fallout, the EC has set out separate proposals on derivatives markets and short selling in a bid to tackle what Michel Barnier, commissioner, internal market and services, calls "Wild West territory".

The proposals call for all trades in OTC derivatives in the EU to be reported to central trade repositories. Regulators will have access to these to help them get a better view of potential risks while the new European Securities and Markets Authority (ESMA) will be responsible for surveillance and for granting and withdrawing their registration.

To cut counterparty risks, the EC is calling for OTC derivatives that are standardised, such as a high level of liquidity, to be cleared through CCPs. The Commission also wants to reduce operational risk by cutting the reliance on manual intervention in highly bespoke and complex contracts. It says market participants should use electronic means to measure, monitor and mitigate this risk.

Says Barnier: "The absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from. Today, we are proposing rules which will bring more transparency and responsibility to derivatives markets. So we know who is doing what, and who owes what to whom. As well as taking action so that single failures do not destabilise the whole financial system, as was the case with Lehman's collapse."

Meanwhile, the EC has also adopted a proposal for regulation on short selling and certain aspects of CDS in a bid to create a harmonised framework for coordinated action across Europe.

The proposals would give national regulators clear powers in exceptional situations to temporarily restrict or ban short selling in any financial instrument, subject to coordination by ESMA. In addition, if the price of a financial instrument falls by a significant amount in a day, national regulators will have the power to restrict short selling in in it until the end of the following day.

To crack down on naked short selling, the proposal requires that to enter a short sale, an investor must have borrowed the instruments concerned, entered into an agreement to do so, or have an arrangement with a third party to locate and reserve them for lending so that they are delivered by the settlement date.

The proposal still has to go through the European Parliament and the Council for negotiation and adoption before coming onto force in July 2012.

"In normal times, short selling enhances market liquidity and contributes to efficient pricing. But in distressed markets, short selling can amplify price falls, leading to disorderly markets and systemic risks. Today's proposal will increase transparency for regulators and markets, and make it easier for regulators to detect risk in sovereign debt markets," says Barnier.

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