Opinion on derivatives

(96/C 18/01)

On 23 February 1995, the Economic and Social Committee, acting under the third paragraph of Rule 23 of its Rules of Procedure, decided to draw up an Opinion on derivatives.

The Section for Economic, Financial and Monetary Questions, which was responsible for preparing the Committee's work on the subject, adopted its Opinion on 27 September 1995. The Rapporteur was Mr Robert Pelletier.

At its 329th Plenary Session of 25 and 26 October 1995 (meeting of 25 October 1995), the Economic and Social Committee adopted the following Opinion by a very large majority, with one abstention.

INTRODUCTION

The use of derivatives has grown considerably in Europe and worldwide since the beginning of the 1980s. It is now thought that their total value, as listed in the off balance sheet items of credit institutions and investment firms, may in some cases represent ten times the balance sheet total.

Such spectacular growth reflects the growing needs of economic operators due to the increased volatility of interest rates, exchange rates, share prices and commodity prices. Under these conditions industrial and commercial firms have been able, by using such instruments, to hedge their financial transactions so that they can concentrate on their basic activities of production and marketing.

However, recent news stories show that some large industrial and commercial firms, institutional investors, local authorities and banks have made big losses (e.g. Procter and Gamble, Metalgesellschaft, Bankers Trust, Orange County, Kashima Oil and Barings). Such examples are a reminder that derivatives are not without risk, both for final consumers and middlemen.

In the EU Member States (and, more recently, the European Parliament) a debate on the merits of derivatives has begun within national parliaments and the authorities responsible for the supervision and protection of savings. The Commission has also been asked - as Mr Mario Monti, the Commissioner responsible for financial services and capital movements recently pointed out - if it intends to undertake or promote measures to regulate derivatives.

The ESC, which has issued Opinions on the prudential directives concerning derivatives (capital adequacy directive, directive on the setting-off of off balance sheet items), has thought it worthwhile to prepare an own-initiative Opinion on this matter.

Such an Opinion must enable the ESC to define an overall framework for its reflections and guidelines which it will be able to use in the future to respond to any requests for Opinions on specific texts (directives, recommendations, codes of conduct, ...).

The ESC is well aware that such instruments have a major impact on monetary policy, the development of the financial industry, savers' confidence and company financing. Such items are crucial to the success of the Single Market and Economic and Monetary Union. However, to be effective and avoid any distortion of competition between operators and geographical areas, solutions to these problems can only be sought at international level, through the adoption of harmonized measures. It is essential for Europe to play an active part in the consultation process which has already begun in the Basle Committee, the Bank of International Settlements' (BIS) Eurocurrency Committee and the OICV ().

In this Opinion we have deliberately restricted ourselves to analysing the risks and uses of derivatives, considering existing rules and framing recommendations which the ESC could make regarding rules for their use. We shall not consider the essential but much wider issue of the need to stabilize the international monetary system by implementing appropriate economic and monetary policies in the different states and strengthening international coordination in this area.

1. Derivatives: risks and uses

1.1. Definition

1.1.1. Derivatives are financial instruments which allow investors to cover themselves against an adverse variation or benefit from an anticipated variation in the price of an 'underlying' asset, such as shares, commodities, stock indices, exchange rates or interest rates.

1.1.2. These products are considered as complex because their price trends depend on those of their underlying asset; hence their name: 'derivatives'.

1.1.3. They are explicitly listed in the Annex to the Investment Services Directives () (ISD), Section B, as follows ():

- financial-futures contracts, including equivalent cash-settled instruments;

- forward interest-rate agreements (FRAs);

- interest-rate, currency and equity swaps; and

- options to acquire or dispose of any of the financial instruments referred to above, including equivalent cash-settled instruments. This category includes in particular options on currency and on interest rates.

1.1.4. More recently certain so-called 'bespoke' derivatives have appeared. These are made-to-measure products resulting from a combination of securities (bonds, negotiable claims or debt) and a group of derivatives, without any restriction as to the underlying assets. Investors may thus profit from market globalization by indexing their portfolio's performance to a stock index, a basket of indices or to the relative movements of exchange and interest rates in several countries. So, bespoke derivatives seek to respond to more specific needs. The resulting financial structures are all the more complex and specialized.

1.2. Classification

Derivatives are usually classified in two ways: by market (i.e. the nature of the markets where they are traded) or by contract type.

1.2.1. Market types

Over-the-counter (OTC) markets differ from organized or regulated markets, which have a clearing house and on which dealers' positions can be monitored. The risks on OTC markets are therefore greater than on organized markets.

1.2.1.1. On OTC markets derivatives are not standardized, so they can be tailored perfectly to customers' needs. Deals are concluded by contract between two parties; no clearing house is involved and the market does not physically exist (no open outcry).

1.2.1.2. On organized markets such as the Chicago Mercantile Exchange-International Monetary Market (CME-IMM), Simex, NYFG, LIFE, Tiffe, Matife and the Deutsche Terminboerse (DTB), derivatives are standardized in terms of maturity, size and rules for settlement. A clearing house steps in between the two contracting parties, which reduces or does away with counterparty risk. As there is a functioning market structure, contract liquidity is greater.

1.2.2. Contract types

There are two main contract types:

1.2.2.1. Contracts for future settlement:

- Swap: an exchange of financial flows between two parties, concluded only on an OTC market.

- Forward contract: a contract to buy or sell a product or financial instrument for delivery on a predetermined date at the price ruling on the day on which the deal is made; such contracts are concluded on OTC markets.

- Futures contract: an exchange-traded contract to buy or sell a commodity or financial instrument at a price laid down for delivery on a predetermined date.

1.2.2.2. Options

Contract giving the right, but without imposing any obligation, to buy or sell a commodity or financial instrument at or before a fixed date in exchange for a premium; if this right is not exercised, the option expires. Options may be traded on an exchange or an OTC market.

The underlying assets concerned are basically interest rates, shares, exchange rates, indices or primary commodities.

Such contracts can become highly complex, as they may combine several elements (e.g. 'swaptions', which are a combination of swaps and options) or be based on several underlying assets or indices.

1.3. Players on the derivatives market

These fall into two main categories: middlemen and end users.

1.3.1. Middlemen (banks, investment firms) act either for third parties, in which case they are merely brokers and undertake no risks themselves, or on their own account as counterparties. The two roles may be performed simultaneously.

1.3.2. The main end users () are:

- Banks or financial middlemen using derivatives as part of their asset management activities;

- Institutional investors, investment funds, insurance companies, pension funds, ...;

- Industrial and commercial companies;

- States and local authorities. Many states and international organizations use derivatives, as do British, French and American local authorities.

1.4. Trading volume

1.4.1. International statistics as set out in the BIS tables below give only an approximate idea of trading volume.

1.4.2. This is because they are based on notional contract values and not on real positions. There are two sources of inaccuracies:

- contracts are added together in cases where they should instead be set off against each other (this effect should disappear once a form of bilateral netting or multilateral clearing is adopted); and

- the figures are only a partial estimate due to a lack of accurate data on OTC trading.

1.4.3. According to Forex data 49% of foreign currency transactions consist of very short-term positions of between 30 minutes and 5 hours duration.

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1.4.4. According to the Wall Street Journal total amounts outstanding amounted to 10 000 billion dollars in 1993, 16 000 billion dollars in 1994 and are estimated at between 35 000 and 40 000 billion dollars for 1995.

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1.5. Usefulness of derivatives

1.5.1. Tailor-made financial tools

For any firm wishing to use them, derivatives may be a flexible tool for covering their loans, managing their treasury or investment portfolio or for managing foreign currencies due to be received or paid in financial or trading transactions. They can also be used in industrial activities or trade involving goods and foodstuffs.

1.5.2. A response to a real economic need

1.5.2.1. Derivatives have been introduced as an insurance against the uncertainties of the financial system, floating currencies and interest rates and the vagaries of stock and commodity markets.

1.5.2.2. Derivatives are means whereby economic operators may protect themselves against identified risks and thus concentrate on their main activity.

1.5.2.3. They also offer a number of other possibilities to customers and financial institutions. Here are some examples:

a) Possibility of firms profiting from a fall in interest rates for their credit transactions

Let us suppose that a firm wishes to finance an investment for a duration of 4 years and is proposed a rate of 7,50%. Observations suggest that during the 4 years it is very probable that there will be a big fall in interest rates, so the firm tries to find a way of profiting from the fall without later being exposed if these same rates should once again rise steeply. Such financing is now offered by a large number of financial institutions in return for paying a slightly higher rate than for a normal loan, such as 7,80% in our example. To do this, financial institutions use derivatives known as caps.

If rates fall to 6,50% the firm will pay 6,80%. With a normal loan it would still be paying 7,50%. So, by initially paying a surcharge of 0,30% the firm has ultimately been able to save itself 0,70% (1-0,30), which translates into an annual saving of 700 000 francs on a 100 million franc loan.

If rates should shoot back up to 9%, the firm will pay no more than 7,80%.

This example also applies for loans to individuals, such as for house purchase.

b) Lower rates for customers due to the opportunity of financial institutions refinancing themselves on a worldwide basis

Interest and exchange rate swaps allow financial institutions to profit from opportunities on foreign markets to lower their refinancing costs. Thus, a financial institution needing to borrow in francs at a fixed rate will be able to profit from the competitive floating rates for dollars. These floating rate dollars will then be exchanged through an interest rate and foreign currency swap for fixed rate francs, allowing a lower rate than taking out a fixed rate loan in francs. Customers can then profit from these savings through lower charges.

1.5.3. Risks which must be controlled

Derivatives do not create any radically new financial risks but they do modify the nature and sometimes the intensity of risk.

Regulators and professionals have identified seven main risks associated with the use of derivatives.

1.5.3.1. Credit (or counterparty) risk is a measure of the risk of the counterparty going bankrupt. Such a risk is generally felt to be almost non-existent on organized markets because the clearing house protects itself against the failure of a trader by requiring all parties to put down a deposit prior to doing business and issuing daily margin calls. However, on OCT markets the risk is real.

1.5.3.2. Market risk is linked to changes in the price of the underlying asset.

With futures or swaps the odds of making a profit or loss depend on changes in interest or exchange rates.

Options introduce additional risks.

- The market risk is not the same for buyers and sellers because in the first case the potential loss is limited to the premium paid, while in the second the loss is unlimited if the sale is not covered.

- Specific risks are involved because the value of the option depends not only on the price of the underlying asset but also on that asset's expected volatility and the time factor. This obliges users to cover the risks of their options positions by other options.

1.5.3.3. Liquidity risk arises when the derivative cannot be sold quickly at a price close to its intrinsic value. The risk is greater on OTC markets.

1.5.3.4. Settlement/liquidity risk arises when delivery of the underlying security does not coincide with the settlement date.

1.5.3.5. Operational risk. Inadequate internal controls and procedures, human error, faults in management systems or fraud may lead to considerable losses.

The setting-up of internal controls which are independent of operators is therefore essential. Recent derivatives-related losses have revealed the problems that some firms and financial institutions have in monitoring such operations.

1.5.3.6. Legal risks depend both on what bankruptcy laws are applicable and on the capacity of one of the parties to enter into a contract, or the rights of the non-bankrupt party in the event of a default by one of the parties.

1.5.3.7. Systemic risk. The growing use of derivatives and its concentration in the hands of a small number of middlemen poses the problem of systemic risk, i.e. the simultaneous failure of major market operators.

1.5.3.8. Risk of increased market volatility. Certain financial products, such as the so-called 'knock-out' options, may increase market volatility, and clients might seek to insure themselves against this.

This market destabilization is magnified by financial operations with a strongly speculative component: this type of product should therefore be subjected to stringent limits and conditions in the form of a good conduct code.

2. Existing rules and reports on derivatives

2.1. Measures taken at EU level

2.1.1. Several directives have been adopted recently which define a prudential framework for monitoring risks associated with derivatives.

2.1.2. The Solvency Ratio Directive (), which came into force on 1 January 1991, specifically deals with the credit risk inherent in off balance sheet instruments concerning interest and exchange rates. The taking into account of market risk was introduced in the Capital Adequacy Directive ().

2.1.3. The Capital Adequacy Directive, which the Member States have to incorporate into their national laws by 1 January 1996 at the latest, deals with market risk for derivatives forming part of a negotiable portfolio. It significantly strengthens the own funds requirements for such instruments and thus responds to certain criticisms made when the solvency ratio was adopted, which alleged that derivatives would receive a favourable weighting.

2.1.3.1. The CAD applies to credit institutions and investment firms on a consolidated basis. It also sets up controls on large market risks.

2.1.4. Both this directive and the Investment Services Directive () lay down very precise rules for credit institutions as regards internal monitoring and daily knowledge of financial positions.

2.1.5. Moreover, the directive on the 'netting' of off balance sheet transactions () has enabled derivatives to be set off against each other, rather than just being lumped together. Such an approach is a fairer reflection of the risk involved.

2.1.6. In 1994 a group of experts chaired by the Commission was set up to look into what measures might be taken in the derivatives field.

2.2. Measures taken by the Basle Committee

2.2.1. The Basle Committee has also drawn up recommendations regarding the extension of the agreement on own funds to market risks. From the end of 1997, or earlier if the national monitoring authorities so request, banks will be obliged to measure their market risks - including derivatives - and apply the own funds requirements to them.

2.2.2. The banks will have a choice of two methods for measuring market risk:

- the first consists of measuring risks in a standardized manner, and corresponds to that laid down in the Capital Adequacy Directive;

- the second is a newer method which allows institutions to use risk measurements obtained from their own internal risk management model.

2.2.3. Internal models

2.2.3.1. Internal market risk management models are based on the following general conceptual framework: data on market variables and trading positions are fed, with certain measurement parameters, into a software model which assesses market risks expressed in the form of a sum exposed to potential risk or loss (the value at risk). This is defined as the estimate, with a certain degree of statistical probability, of maximum possible losses in relation to the portfolio.

2.2.3.2. The model works as follows:

a) Basic data

The measurement systems use the following three major data groups:

- positions resulting from trading activities;

- market variables (interest and exchange rates, share and commodity prices) which make up the risk factors affecting different portfolio positions; and

- measurement parameters: holding period during which the value of positions may change, observation period which is the time horizon during which risk variables have been observed and a decision taken that a level of protection considered to be prudent can be judged to exist.

b) Processing of data

The model uses the data to calculate for each position the potential change in value resulting from fluctuations due to associated risk factors.

Banks generally use three methods to measure their market risks: variance/co-variance analysis, historical simulation or, less frequently, the Monte Carlo simulation, which estimates the value of a portfolio with a wide range of prices.

c) Results

At the end of the analysis process each of the three methods produces a figure corresponding to potential loss.

In addition, the Basle Committee has drawn up recommendations quite separate from own funds requirements, which directly concern the control of derivatives risk.

2.2.4. Guidelines for the management of derivatives risk

2.2.4.1. In July 1994 the Basle Committee and the OICV issued a paper on proper internal risk management practices for the efficient use of derivatives both for dealers and for end users of derivatives.

2.2.4.2. The basic principles are:

- appropriate supervision by the management boards of institutions;

- an adequate risk management process involving prudent risk limits, reliable measurement procedures and information systems, continual risk surveillance and frequent reports to the board of directors; and

- detailed auditing procedures and controls.

2.2.5. Information framework for banking and financial regulators on banks' and investment firms' derivatives activities

2.2.5.1. This report, which was drawn up in May 1995, sets out the type of information which should be available in financial institutions and to which only the supervisory authorities should have access.

2.2.5.2. The first part of the report is a collection of information which is important when assessing derivatives-related risks and which supervisory authorities could use as a basis when extending their reporting systems. It covers the fields of credit risk, liquidity risk, market risk and profits.

2.2.5.3. The second part lays down a minimum common framework for data which should be made available to supervisory authorities.

2.3. Reflections of the professionals: Report of the Group of Thirty

2.3.1. The Group of Thirty (G 30) is a group of thirty banks which specialize in derivatives. The aim of these professionals, who are directly concerned by the stability and functioning of the financial markets, is to explain the practices and principles of these markets.

2.3.2. In a study carried out in July 1993, this group determined the basic management rules for these products so as to define and limit the risks which they generate. Their reflections are complementary to and independent of the efforts of the central banks.

2.3.3. The twenty recommendations made present an opportunity for bring into general use practices which are implicitly recognized as valid by the market. To sum up, they suggest that each trader or end user of derivatives should follow certain principles:

- determine at the highest level of decision the field of activity and the strategy to be applied in the field of derivatives;

- assess positions 'in the market';

- quantify the market risk in disaster scenarios;

- determine the credit risk on the basis of frequent measurements of potential losses or achieved in comparison to credit limits;

- reduce the credit risk by authorising multi-product clearing and making general use of standardized messaging;

- separate risk management from trading;

- authorize only professionals to trade in the markets;

- set up IT systems which are sufficiently sophisticated to measure, manage and monitor derivatives activity reliably and accurately;

- adopt transparent and consistent accounting practices right now, pending the introduction of international standards.

2.3.4. In addition to these principles for operators, the report defines and develops four recommendations for lawmakers:

- lighten the tax system;

- remove legal uncertainties by following market practices;

- recognize multi-product clearing and adapt the Basle agreements as regards capital ratio;

- formalize a standard accounting framework.

2.3.5. This report is the first attempt to identify the problems inherent in the derivatives market. Such worldwide consultation, which is not binding for the moment, will doubtless serve as a basis for laying down international rules.

2.4. The work of the Standing Eurocurrency Committee

Alongside the work of the Basle Committee, the central banks have also been thinking about derivatives within the Standing Eurocurrency Committee. There have been three important studies on derivatives:

2.4.1. The Hannoun Report looks at the impact of derivatives on monetary policy. Its main conclusions are:

2.4.1.1. Derivatives are only one of a number of innovations which have changed the way in which financial markets operate in recent years and are probably a consequence rather than a cause of increased interest and exchange rate volatility.

2.4.1.2. Their effect on the economy and on monetary policy is difficult to isolate. However, they help allocate resources more efficiently and tend to strengthen the economy's capacity to resist shocks. It is improbable that they have had a significant effect on monetary policy transmission channels or the effectiveness of traditional monetary policy instruments, even if they have a potential impact on monetary or credit aggregates. But there is no indication that such an impact is significant in terms of quantity.

2.4.1.3. Moreover, it may be argued that derivatives markets provide central banks with new information for conducting monetary policy and additional tools for implementing it.

2.4.1.4. In conclusion, in an environment which is influenced by derivatives, central banks must see that their policies do not contribute to uncertainty but favour the taking of stable, non-inflationary anticipatory action.

2.4.1.5. However, on some points the report has been unable to reach a clear conclusion because of the lack of sufficient data. But the questions raised are sufficiently important to merit a more detailed analysis in the future by the ESC, especially as regards the role of the future European Central Bank and the instruments to be given special treatment in the field of monetary policy.

2.4.2. The Brockmeijer Report was published in February 1995 and analyzes the steps which the authorities need to take to measure the size of the macro-prudential risks involved in derivatives trading.

2.4.2.1. It gives recommendations for setting up supervisory machinery to measure regularly the size and structure of derivatives markets, including OTC markets.

2.4.2.2. Two measures are proposed:

- periodic surveys of a large number of derivatives traders; and

- regular (three or six-monthly) reporting by the fifty main players on the derivatives markets.

2.4.2.3. This would improve derivatives market transparency both as regards individual traders' positions and the size and distribution of risks. In a crisis an absence of transparency could provoke a challenge of some traders, which would cause the latter funding problems.

2.4.2.4. Moreover, a lack of information on accumulated positions and hedging needs could induce traders to base their strategies on unrealistic ideas of market liquidity.

2.4.3. The Fisher Report, published in autumn 1994, asks financial middlemen to undertake to improve the information given their market trading by publishing regularly data on the size and nature of current risks and recorded results.

2.4.3.1. The underlying idea is that the publication of clearer information by financial middlemen enhances market transparency and thus answers the concerns of authorities, counterparties and institutions' shareholders.

2.4.3.2. The report notes that current accounting rules do not allow such information to be provided. However, these risks are already measures and expressed in the internal risk management systems used by institutions.

2.4.3.3. The report therefore proposes to use the information generated by these systems for publication purposes.

2.4.4. The Standing Eurocurrency Committee recommends that all financial middlemen publish information on:

- market risk and performances in managing such risks (through prior risk assessment and the results subsequently obtained); and

- counterparty risk, by separating current risk and potential future risk and by indicating counterparties' solvency.

3. The ESC'S recommendations

3.0.1. The ESC notes that the markets in derivatives have grown spectacularly in recent years.

3.0.2. A major part of this growth has been in products traded over the counter outside organized markets. These products are not standardized but are specially tailored to satisfy customers' needs.

3.0.3. Such growth is justified because it leads to greater efficiency in managing risk. By enabling the implementation of insurance strategies for financial assets they have allowed economic operators to protect themselves.

3.0.4. The risk involved in derivatives trading should not be underestimated, but they are nothing new when compared with traditional financial activities, nor are they greater in money terms than those in other sectors (real estate, sovereign risk, etc.).

3.0.5. There is little doubt about the benefits of derivatives for the management and operations of financial markets. But the costs of imprudent and speculative use must be reduced.

3.0.6. Management techniques make it easier to open multimillion dollar positions in a few seconds, making possible a 'leverage' effect. But in the end these techniques, because of their complexity, make it difficult to assess and monitor the total risk taken.

3.0.7. They are controllable, especially since an effective prudential approach encompassing market and counterparty risk has recently been adopted.

3.0.8. The key factor in controlling risks lies in internal controls and in the risk monitoring procedures followed, in particular, by boards of management and increased monitoring by control bodies, in order to check the effectiveness of internal controls.

3.0.9. Because of the operational risk involved in the daring management practised by a few employees, internal controls are required which ensure that the risks assumed are correctly identified, measured, managed, monitored and taken into account through a scheme which separates management processes from monitoring and control procedures and makes them independent of each other.

3.0.10. Company boardrooms must be involved in framing concrete guidelines on the use of derivatives and in designing banking strategy.

3.0.11. Top management must have a clear understanding of the nature and size of the risks inherent in derivatives trading and must not rely exclusively on the decisions of specialists.

3.0.12. Traders' pay schemes must take into account not only the size of profits but also their regularity over time and the volume of the risks assumed and own funds used.

3.0.13. On the basis of the above analysis the ESC considers that:

- some essential principles must be respected;

- certain regulatory traps should be avoided;

- existing texts should be improved;

- initiatives should be proposed to the professionals; and

- some serious thinking needs to be done.

3.1. Essential principles to be respected

3.1.1. The supervising of derivatives is a worldwide task. It must therefore be subject to rules which are adopted worldwide. With market globalization and the free movement of capital, it would be an error and, at any event, unacceptable to consider imposing measures solely at EU level: such a decision would severely penalize the EU banking industry, especially in relation to its main Japanese and American rivals, and would have disastrous consequences.

3.1.2. The derivatives market is not only an interbank market. The industrial sector is also very much involved. Banks are already subject to very strict rules, while industrial companies are not.

3.1.3. This poses the 'level playing field' problem as well as causing the banks concern in cases where their counterparties are industrial companies.

3.2. Traps to be avoided

3.2.1. The ESC feels that any measures which limit international capital flows would not only violate the EC Treaty but would also run into insurmountable technical and practical problems and lead, in generally open economies, to markets moving offshore beyond the reach of any rules whatsoever, which would defeat the whole point of the exercise. Such measures would also harm the development of the Single Market and Economic and Monetary Union.

3.2.2. Similarly, it is desirable that the prudential rules be adapted to the risks involved. The thing is not to penalize these products, which are a source of innovation compared with other financial techniques, or to curb the initiatives of European middlemen facing fierce international competition, but to set up machinery which enables middlemen and users to acquire a better knowledge of risks and devise ways of controlling and managing them. It is not derivatives which have created risks, but risks (e.g. uncontrolled volatility) which have led to the birth of derivatives.

3.2.3. Moreover, certain proposals made at a specifically European level, such as keeping a register of derivatives or issuing professional cards to traders are based on the assumption that investment firms wishing to obtain a European passport for such activities will first have to be granted proper authorization.

3.2.4. Keeping a register

3.2.4.1. The ESC is sceptical about the idea to draw up a European derivatives register. In particular, making it compulsory to list sophisticated derivatives would oblige banks to reveal their know-how, which is inconceivable. It would also burden banks with extra costs and red tape.

3.2.4.2. The ESC also wonders what useful purpose could be served by such a register. The task of keeping an eye on derivatives is, in the first place, that of the supervisory authorities. For controls to be effective it is essential that they be exercised as close as possible to the institution under supervision. The Capital Adequacy Directive obliges credit institutions to inform the supervisory authorities of their trading portfolio. So, as soon as this directive is transposed into national law the aim of identifying derivatives in terms of portfolio, result and risk will be achieved while at the same time safeguarding the know-how of those institutions which innovate in this area, since information would only be communicated to the supervisory authorities.

3.2.4.3. The ESC therefore feels that the benefits to be gained from such a scheme are very small compared with the inconveniences, and so is opposed to it.

3.2.5. Professional examination

3.2.5.1. Article 11 of the Investment Services Directive lays down that measures must be taken at national level to ensure, in particular, that operators are fair, careful, diligent and competent in their dealings with customers. The ESC considers that for the moment this area must remain the domain of the Member States. However, the European Union could be called in if the steps taken by the Member States turn out to be obviously inadequate.

3.3. Limitation of speculative trading in derivatives

3.3.1. The use of derivatives is already subject to limits: first, the Capital Adequacy Directive, by obliging banks to set aside own funds for the risks they are carrying, links the risk resulting from derivatives to the amount of own funds available; and second, the Large Risks Directive obliges banks not to assume risks borne by a customer or group of linked customers which exceed 25% of their own funds. This directive applies to derivatives.

3.3.2. Moreover, it should be emphasized that a third party cannot distinguish between a hedging operation and a purely speculative transaction.

3.4. Essential improvements which must be made

3.4.1. As far as prudential directives are concerned, the ESC recommends encouraging the setting-up of strict internal procedures for tracking and monitoring derivatives based on the use of internal models by institutions. Such a step should lead to complex risks being controlled properly. Their penalization by a weighting, an idea which might well be adopted by the Basle Committee and taken over by the EU Commission, will discourage research in this area.

3.4.2. While the reliability of these markets is largely due to the controls which exist on trading, it is also essential that institutions' own internal controls should themselves be properly monitored by the authorities. Operating with tighter margins has always led certain institutions to try and boost their profits by taking risks (e.g. the South American syndicated credits in the years 1975-1982, the Latin American stock markets in 1991-1994). So, it is quite normal than some people should wonder about derivatives in periods of crisis.

3.4.3. Against such a background, such instruments must be subject, at company level, to independent and competent internal controls, special supervision by the boardroom and monitoring by the authorities of compliance with management procedures set up in banks and financial institutions, so as to assess their capability to manage the different types of derivatives trading carried out by them and for their own account.

3.4.4. Continuing the same line of reasoning, an EU-level prudential directive should be adopted for commodity derivatives, since it is not healthy that some instruments should not yet be covered at European level by appropriate prudential rules.

3.4.5. In addition, the procedures and deadlines for amending existing directives are too long and hamper their effectiveness, since such rules have to be applied very quickly in response to market developments and risks.

3.4.6. On the legal side the ESC also stressed, in its Opinion on the netting directive, the need for the European Union to have a safe legal framework concerning such operations in all countries, especially as regards bankruptcy law.

3.4.7. Finally, the EU Commission should propose improvements to the accountancy rules which apply to the different types of derivatives.

3.5. Initiatives to be proposed to the professionals

3.5.1. It might also be desirable for European framework agreements to be drafted by the professional authorities concerned and for margin calls to be introduced on OTC markets. Framework contracts exist in various EU countries but their wording has not always been stabilized and they are not generally used. European authorities can contribute towards this.

3.5.2. Information must be improved by using the support of company annual reports and involving business leaders. Complexity is acceptable if it is understood and there is not too much of it. It therefore seems a good idea for shareholders to be informed of such operations.

3.5.3. The information published by user firms and middlemen must be equivalent, for while the latter must provide the monitoring authorities with all the appropriate information which is necessary, it seems essential that they be allowed to protect their know-how by not having to comply with certain disclosure obligations.

3.5.4. The OTC markets are markets without standards. Order can only be created on them by a specially tailored approach. The professionals are certainly the people best placed to detect needs and propose the most appropriate responses to any problems which might arise. The concept of a code of conduct drawn up by the professionals is one path to be explored. Initiatives are currently being taken in the USA. The thinking of international regulators has been very largely inspired by the expertise of the Group of 30, which groups together big banks which are active in derivatives on an international scale. An application of this approach at European level would doubtless be fruitful.

3.6. Need for some serious thinking

3.6.1. The ESC has deliberately limited itself in this Opinion to considering the implications of derivatives as regards risk and financial information. But it does not underestimate the need for some serious thinking to be undertaken on the repercussions which the growth of these markets is having on the economy and on monetary policy.

3.6.2. Such thinking is all the more important because such instruments will play a decisive role in the transitional phase between the decision to go for EMU and the setting-up of the ECU area.

3.6.3. The ESC is aware of the climate of public alarm in many countries because of certain accidents involving derivatives, and believes that moves to clarify matters - among which this Own-initiative Opinion counts itself - must be backed up by adequate measures which, while not halting the sector's spectacular growth, provide better information about the risks involved.

Done at Brussels, 25 October 1995.

The President

of the Economic and Social Committee

Carlos FERRER

() International organizations of bodies responsible for monitoring securities (SEC, CONSOB, COB, etc.).

() OJ No C 298, 27. 11. 1989, p. 6.

() This list is a guide.

() OJ No C 337, 31. 12. 1988, p. 8.

() OJ No C 69, 18. 3. 1991, p. 1.

() OJ No C 298, 27. 11. 1989, p. 6.

() OJ No C 393, 31. 12. 1994, p. 30.