Both at the G20 Summit in Pittsburgh last week and also in a Communication of the European Commission at the beginning of July, reforms were decided for trading with derivatives, which belong to the main causes for the Financial crisis. A public hearing of the European Commission on the planned reforms in derivatives trading took place on the day of the G20 Summit.
What is it, a derivative?
In a derivative contract, the contracting partners commit themselves, independent of the development for example of exchange rates, share prices, loans, rates of interest or commodity prices to make payments at some point in future. A special form of derivative contract is the so-called “Credit Default Swap” (CDS). These agreements were used in case of property market speculations in the USA: one of the contracting partners insures himself against the risk that a loan cannot be paid back and that the property owner becomes insolvent. Up to a certain time, one of the contracting partners continuously pays a certain amount to the insurer. Should the borrower become solvent, the insurer has to pay a certain amount. In order to hedge against this risk, the financial players for example Hedge funds split, bundle and resell CDS contracts. Hence the whole matter becomes confusing and complicated.

Risk not assessable
Often, the participants are no longer able to assess the risk of these “innovative financial products“. Most of the agreements are traded bilateral, over-the-counter (OTC) and the public, in particular the financial supervisors, are not involved. If one of the parties becomes insolvent, it is often not possible to assess the impact on the rest of the financial market. Only a few operators are involved in the derivatives market; these, however, also do business in other financial markets. This was the reason why the crash of the property market in the USA was able to have such an effect on the entire financial market.

In December 2008, the global outstanding volume in CDS, which was traded without supervision, amounted to 38.6 trillion Dollars. From the end of the 90ies (400 trillion Dollars) until the summer of 2008, the total derivatives trading volume has almost doubled (700 trillion Dollars). Due to speculation, the value of these contracts has reached a many times the basis values.

CCP clearing for standardised agreements
In order to make the derivatives market more transparent and safer, the G20 are now demanding that standardised derivative contracts are traded via stock markets or electronic trading platforms. All standardised derivative contracts should be traded via a Central Counter Party (CCP) by 2012 at the latest. The CCP is then buyer for every seller and seller for every buyer. This leads to a reduction of risks a each trade participant only has contractual relations with the CCP. The CCP requests from each trade participant a certain amount as security, in case that one of the parties becomes insolvent. With the release (“clearing”), the CCP confirms the feasibility of the agreement and the solvency of the contracting parties.

At the hearing of the Commission, most representatives of the financial sector came out against a mandatory clearing of standardised agreements. They were of the opinion that it should be mandatory to clear a “sufficiently high” percentage of derivative contracts. Gery Gensler, chairman of the Commodity Future Trading Commission, made the point that he thought all standardised OTC derivatives should be subject to mandatory CCP clearing.

The participants of the Commission hearing agreed that the increased use of the CCP would only be able to reduce, not, however, to eradicate the risk of derivatives trading. A portfolio manager of Deutsche Bank remarked that he saw the problem in the fact that it could happen that the CCP would have to clear financial products, which were so complicated that no models would exist yet.

According to the G20, there should be higher capital requirements for OTC traded derivatives. The G20 instructed the Financial Stability Board to examine the appropriateness of the reforms.

Further standardisation and automation of OTC Agreements
The European Commission too recommends in its Communication that CCP Clearing should be promoted, is, however, in its phrasing less strong than the G20. Without a standardisation (e.g. uniform payment modalities) of the agreements it will not be possible for the CCP to automatically process and clear these. Most of the traded Derivatives contracts are currently not standardised.

Establishing central data collection points
In order to increase the transparency of derivative markets, the G20 and the Commission are requesting the setting up of central data collection points, where every Derivatives Agreement (and not only those which have been CCP cleared) has to be registered and to which the supervisory bodies will have access, which should make it easier for them to control the operators involved and to prevent systemic risks. No agreement was reached at the hearing as to who would be in charge of setting up these data collection points - the financial operators themselves or the supervisory bodies. Some participants voiced their concerns with regard to data protection if the public too would have access to this data.

Development of uniform accounting standards
Both representatives of US-American and European financial supervisors reinforced their opinion at the Commission hearing that the accounting standards, which had played a pro-cyclic role during the crisis, should be uniformed as soon as possible. This request was also included in the statement of the G20 heads of government.

Mandatory code of conduct for speculators
Gery Gensler and other participants of the hearing also requested that the financial speculators would submit themselves to a mandatory code of conduct to prevent fraud and excessive risk taking. He also demanded new, mandatory rules for accounting and reporting for Swaps.

A revised statement of the European Commission on regulating the derivates markets is expected for mid October.

Further information:

Statement of the heads of state and government on the G20 Summit

Communication of the European Commission on derivates markets