Two years after the collapse of the fourth-largest US investment bank Lehman Brothers, the Commission this week presented in Brussels two cornerstones of its ideas on regulating the financial markets. Off-exchange derivatives, short selling and credit default swaps are to be reigned in at last. The Commission is not keen on imposing bans: "To ban speculations is as if we wanted to ban the rain", says the responsible French Internal Market Commissioner Michel Barnier at the press conference.

Big Bang led to the deregulation of the financial markets and to the financial crisis

The request for drastically curtailing speculation at international financial markets has been for years one of the basic demands of labour representatives, and indeed of AK and ÖGB. Since the "liberation" of the financial markets from government regulations in the 1970ies ("Big Bang"), a frightening speculation bubble has developed at the stock markets, which no longer has anything to do with real economic development. That this bubble would burst one day on a large scale was to be expected. And it did burst. Now, employees and taxpayers have to foot the bill, which was left behind by the speculators.

2 years after Lehman, the Commission is at last submitting a proposal

It is even more surprising that the European Commission needed two whole years until at last it submitted proposals how to get the wildest speculation excesses under control. First of all, rules have to be introduced for financial instruments, whose names are so strange that at first glance they are difficult to understand by outsiders, but which have developed to such an extent that they could plunge the entire world economy into the abyss: derivatives, short selling and credit default swaps.

Wild West duel for 625 trillion US$

Derivatives are actually bets: does the price of share prices, currencies or interest rates rise or does it fall? If derivatives are traded at stock exchanges, supervisory authorities have at least a reasonable chance of getting a general overview of what is going on. The problem is that only 20% of all derivatives worldwide are traded at stock markets. The remaining 80% are based on bilateral deals between "investors" - over-the-counter or OTC - and no supervisory authority in the world has any insight of what is traded and which risks are taken for the financial system as a whole. The annual trading volume of these OTC derivatives is really quite scary: 625 trillion US$ is the estimate of the Commission, more than eleven times the global economic output. Nobody is able to recognize a reference to the producing industry any more. The comment of the French Commissioner Barnier: "Financial markets should really not behave as if they were in the Wild West".

Derivative jungle should be dragged into the light

The Commission wants to bring light into this grey area at last. For that purpose, it has yesterday submitted a proposal, which must now be negotiated between the Member States and the European Parliament. The basic idea is that a neutral institution will be placed between the two contracting parties of a derivative, which takes charge of processing the transaction (a so-called "central counterparty"). Apart from that, all transactions involving OTC derivatives shall in future be registered with central data collection points (transaction registers), which can be accessed by the regulation authorities and will also be published.

The price of complex derivatives will rise – but when and by how much?

So far so good. It gets more problematic when the question arises which derivatives exactly are affected by such central clearing, as the financial lobby claims that there would be many derivative contracts, which are too tailor-made and complicated for such a clearing. The new European Security and Markets Authority ESMA, which will be in force from 1st January 2011, shall examine on the basis of certain criteria, which derivatives are affected by this claim and which are not. In case the derivatives are indeed to complex, the contracting parties have to deposit more capital in order to offset the higher risk. The catch is: nobody is able to say how much more capital is required as this must first be decided within the scope of the negotiations concerning the new capital requirements provisions for banks.

Industry delighted about generous exemptions

Another drawback concerns the generous exemptions for the producing industry, which, prior to the publication, put the Commission under pressure with a massive lobbying campaign. Its scaremongering argument: industrial enterprises would need derivatives to hedge against fluctuations in the markets concerning their raw materials etc. If the new rules of the Commission would now also apply to them, it would tie up a lot of capital and result in "damages for the real economy".  The energy supplier EON officially expects costs amounting to EUR 10 billion, Siemens EUR billion, MAN 2 billion, etc.

It is without a doubt correct that many industrial enterprises have to hedge against price fluctuations. But it is also the fact that the finance departments of some major corporations have in the meantime developed into mini investment banks, which do not mind using derivatives for speculation purposes to improve their financial result. It is therefore all the more incomprehensible that the Commission wants to show so much generosity towards the industry: it proposes that the trade with derivatives beyond an exemption limit, which concerns the core business of the company, must only be registered and centrally cleared if two further thresholds have been exceeded. The Commission will only determine the amounts of these thresholds in future.

Speculation with government securities opens the eyes of politicians for short selling

European need for action is also required in respect of short selling and credit default swaps. Having been neglected by governments for a long time, in the wake of the frenetic speculation with European government securities (Greek crisis), politicians have become painfully aware that the financial markets are able and sometimes determined to dictate policy. Having learned their lesson from these incidents, some Member States, such as Germany and Austria have put the brakes on and suspended short selling with government securities and bank shares. As the European Commission is now realising the danger of a patchwork of different regulations being created in the Member States, which would lead to competitive distortions, it proposes unified European regulations.

Barroso talks about a ban - Barnier says no ban

Particular attention should be given to so-called uncovered short selling. An "investor" bets on falling prices (e.g. of government securities), but does not have the papers, on which he has placed his bet, at his disposal. A technique, which is popular with hedge funds in respect to currency speculations and which can easily lead to intensifying crises in stress situations. Concerning these purely speculative practices, many had hoped that the Commission would follow the German example and ban "naked" short selling in the EU. And although the Commission President in public speeches declares that the Commission has done exactly that, it is not so - as Internal Market Commissioner Barnier admits. The proposal only provides for a complicated regulation, according to which an agreement between the speculator and a third party must exist, in which the third party promises that the relevant papers, which are the subject of the bet, are "localised" and "reserved" for lending. A ban looks different. But after all, it is not possible to ban rain either.

Further information:

Proposal of the Commission on Derivatives

Proposal of the Commission on Short Selling and Credit Default Swaps

Highly recommended background paper of AK on Derivatives