Risky business

CONTROVERSIAL TRADES

The total gross market value of the over-the-counter (OTC) derivatives market at the end of 2009 was $21.6 trillion (€2.72 trillion), approximately 22% less than in the previous year (because of the financial crisis). Derivatives fall into three broad categories: swaps, options and futures (known as ‘forward contracts' when traded over-the-counter).
OTC-traded derivatives include:
Interest rate swaps: By far the most commonly used form of derivative. It allows two investors to swap their right to receive fixed interest payments, in one case, and floating-rate interest payments, in the other, on an outstanding loan.
Equity option: The most common type of equity derivative. An investor obtains the right to buy, or sell, an agreed amount of stock at an agreed price within a fixed period of time.
Credit-default swaps: A type of derivative in which the seller effectively insures the buyer against default on an underlying asset.

Derivatives allow firms to hedge risks by ensuring that they make money back if the market moves against them. They also allow firms to make profits through speculation (when derivatives are traded by investors with no financial stake in the underlying asset, in order to make money out of market movements).

OTC trading has the advantage for firms that they can acquire tailor-made derivatives suited to their exact needs. Traders can also escape the costs and regulatory requirements associated with exchange trading.

EMPOWERING ESMA

The Commission will propose placing the European Securities and Markets Authority (ESMA) at the centre of the EU's regime for regulating trading in over-the-counter derivatives.

ESMA will be created as part of an overhaul of financial supervision provisionally agreed between the European Parliament and the Council of Ministers last week (2 September).

The Commission will propose that ESMA should be given responsibility for deciding whether central clearing of particular kinds of derivatives should be mandatory.

ESMA would also have the power to settle disputes between national supervisors over how to regulate clearing houses, and to withdraw a trade repository's licence.

The Commission, however, will retain some important powers. The Commission, not ESMA, will determine whether non-EU countries apply regulatory standards to clearing houses and trade repositories that are as rigorous as those applied in Europe. The Commission wants countries to have to pass this test before their clearing houses and repositories will be allowed to provide services in the EU.

CLEARING HOUSES

A clearing house (or central counter-party clearer) is an organisation that places itself in the middle of trades on the financial markets. It acts as the buyer to every seller and seller to every buyer.

Clearing houses protect themselves against default through a series of financial safeguards, including a requirement that firms provide money upfront to prove they can cover the cost of future trading losses.

There are three clearing firms in Europe: Eurex Clearing, based in Frankfurt, LCH.Clearnet, based in London, and ICE Clear Europe, also based in London.