EN    EN EN 
EN    EN  EUROPEAN COMMISSION 
Brussels, 15.9.2010 
SEC(2010) 1059 
  
COMMISSION STAFF WORKING DOCUMENT 
SUMMARY OF THE IMPACT ASSESSMENT  
 
 
Accompanying document to the 
  
Proposal for a 
 
REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL 
 
on OTC derivatives, central counterp arties and trade repositories 
  
{COM(2010) 484 final} 
{SEC(2010) 1058}  
EN 2   EN Derivatives are an important build ing block of modern finance. In essence they are financial 
contracts that facilitate the trad ing and redistribution of risks. Th ey owe their name to the fact 
that their value is derived from  an underlying, such as the pric e of a financial instrument (e.g. 
a share of a publicly traded comp any) or a commodity (e.g. oil). Since they redistribute risk, 
they can be used either to insure (hedge) onese lf against a particular risk or, conversely, to 
take on risk (invest or speculate). They can also be used to arbitrage between different 
markets. 
Derivatives can range from those (e .g. futures) that have fully standardised parameters, such 
as notional value or maturity, to those (e.g. swaps)  that are fully tailored to the specific needs 
of a particular user. The type of derivative usua lly also determines how a derivative is traded: 
fully standardised derivatives are typically trad ed on organised trading ve nues, i.e. derivatives 
exchanges, while customised (or bespoke) deriva tives are traded bilaterally, i.e. off-exchange 
or, as commonly called, ove r-the-counter (OTC). 
The financial crisis has brought the OTC derivatives market to  the forefront of regulatory 
attention. The near-collapse of Bear Sterns in March 2008, the de fault of Lehman Brothers on 
15 September 2008 and the bail-out of AIG the fo llowing day highlighted the shortcomings in 
the functioning of this market. Within this cont ext, regulators devoted particular attention to 
the role that credit default swap s (CDS) played during the crisis. 
Since October 2008 the Commission has been work ing actively to tackle the shortcomings 
that the crisis brought to light. In the shor t term the Commission focused on the CDS market 
and obtained a commitment from the major dealer s in the market to start clearing European-
referenced CDS transactions on a central counterparty (CCP). In the medium term it focused 
on an in-depth review of derivatives market s that resulted in the publication of two 
Communications on derivatives markets, respectively in July and October 2009. 
The first Communication examined the role play ed by derivatives in the financial crisis, 
looked at the benefits and risks associated with derivatives markets and assessed how the 
identified risks could be reduced. The second Communication set out the future policy actions 
the Commission intends to propose to increase tran sparency of the deriva tives market, reduce 
counterparty credit risk and ope rational risk in trading and enhance market integrity and 
oversight. 
This impact assessment report accompanies part of the proposals announced by the 
Commission, namely those that look at increasing transparen cy, and reducing counterparty 
credit risk and operational risk through th e use of post-trading ma rket infrastructure. 
Transparency 
By its very nature, the OTC derivatives market is opaque. This is because OTC derivatives are 
privately negotiated contracts and consequently  any information concerning any one of them 
is usually only available to  the contracting parties. 
The financial crisis highlighted a lack of information on positi ons and exposures of individual 
firms in OTC derivatives. On the one hand, this l ack of information prevents regulators from a 
timely detection of risks building up at individual  institutions and in the system as a whole. It 
also prevents them from accurately assessing the consequences of a default of a market 
participant and therefore from  responding in an appropriate manner should such a default 
EN 3   EN occur (Lehman's case was a clear demonstration of  this). On the other hand, it helps fuelling 
suspicion and uncertainty among mark et participants during a crisis. 
Counterparty credit risk 
Derivative contracts bind count erparties together for the dur ation of an OTC derivatives 
contract. Throughout the lif etime of a contract, counterpartie s build up claims against each 
other, as the rights and obligati ons contained in the contract evolve with the underlying that 
the contract is derived from. This gives rise to  counterparty credit risk, i.e. the risk that a 
counterparty may not honour its obligations u nder the contract when  they become due. 
Clearing is the function by which these risks are managed over time. It can be carried out 
centrally, through a CCP, or bilaterally. Althou gh both types of clearing are used in the OTC 
derivatives market, bilateral clearing is the most used form of the two. 
The crisis highlighted th at the level of counterpa rty credit risk related to OTC derivatives was 
much higher than both market participants a nd regulators had previous ly thought. To put it 
differently, the amount of collateral used to mitig ate counterparty credit risk was insufficient. 
The main reason for this lies in inadequate collat eralisation in the part of the market that is 
cleared bilaterally, either becau se some market participants are not required to provide 
collateral to secure their OTC derivatives trades  or because of issues  related to the risk 
management processes of those market pa rticipants that do provide collateral. 
Operational risk 
An OTC derivatives trade goes th rough several processing steps from the point at which two 
parties agree to a trade to th e point where the transaction ha s been confirmed. Furthermore, 
during the lifetime of an OTC derivatives contra ct several events (e.g. collateral management 
and settlement of cash payments), stemming fr om the rights and obligations of the contract, 
need to be managed. 
Given that the OTC derivatives market allows for a high degree of flex ibility in defining the 
economic and legal terms of derivatives contr acts, there are a number of highly bespoke and 
complex contracts. Such contracts still require  significant manual interv ention in many stages 
of the processing. This increases operational risk, and may lead to legal risk, may limit 
transparency and may even lead to an increase of counterparty credit risk. 
The objectives 
The goal of this impact assessment is to i nvestigate the possibility  of finding Community-
level solutions to the problems outlined above. The general objective is to reduce systemic risk increasing the safety and efficiency of th e OTC derivatives market. As mentioned earlier, 
reaching this general objective requires the rea lisation of three specific policy objectives, 
namely i) increasing transparency, ii) reducin g counterparty credit risk, and iii) reducing 
operational risk associated with  OTC derivatives. As these object ives are still rather broad, 
more operational objectives need to be defined: 
1. obtain complete and comprehensive in formation on OTC derivatives positions; 
2. increase the use of CCP clearing; 
3. improve bilateral clearing practices; 
EN 4   EN 4. increase the standardisation of  OTC derivatives contracts. 
Preferred policy option(s) and policy instrument(s) 
The IA then analyses the impacts of each po ssible policy option associated with the above 
operational objectives and compares them with a baseline scenario to determine the most 
appropriate course of action. Fo llowing this analysis, the IA concludes that the largest net 
benefits would be achieved through the adoption of measures that would: 
1. require market participants to report all the necessary information on their OTC 
derivatives portfolios to a trade repository or , if that would not be  possible, directly 
to regulators; require the publicati on of aggregate position information; 
2. require the use of CCP clearing for OTC deri vatives that meet predefined eligibility 
criteria; 
3. set specific targets for the bilateral clearing of OTC derivatives transactions; and 
4. set specific targets for lega l and process standardisation. 
In view of the preferred options and of the need  to ensure that the legislative framework is 
applied throughout the EU with exactly the same  scope, without any go ld-plating and without 
allowing residual powers to national legislators, a Regulation is deemed as the most suitable policy instrument to achie ve the desired objectives. 
Post-trading market infrastructure 
The decision to require the use of CCPs and trade repositories will further increase the 
systemic importance of the former and will provide a systemic role to the latter (to the extent 
they did not already have one). This imposes an ob ligation to ensure that this infrastructure is 
safe and sound, in order to prev ent the situation in which its use would actually increase 
systemic risk instead of decreasing it. In order to achieve this goal, th e IA recognises that the 
outstanding issues that have been identified in  relation to the functioning of CCPs and trade 
repositories need to be addressed. 
Central counterparties 
A CCP is defined as an entity th at interposes itself between c ounterparties to contracts traded 
in one or more financial markets, becoming the buyer to every seller and the seller to every 
buyer. Due to its central role in the market, a CC P normally bears no market risk (the latter is 
still borne by the original parties to the trade) . However, as counterparty to every position, the 
CCP bears credit risk in the event that one of  its counterparties fails. Similarly, the CCP’s 
counterparties bear the credit ri sk that the CCP might fail. A CCP mitigates its counterparty 
credit risk exposure through a number of reinfo rcing mechanisms, typically including access 
restrictions, risk-management tools (such as co llateralisation), and loss mutualisation. These 
mechanisms are jointly known as the “risk waterfall” of the CCP. 
By virtue of the risk-mitigation role they pla y, CCPs are a critical component of the market 
they serve. Consequently, their failure becomes a potential systemic event. In view of their 
systemically important role, CCPs are subject  to strict regulation. In the EU, CCPs are 
regulated at the national level.  Since rules for regulating CCPs differ from one Member State 
to another, the resulting lack  of playing field makes the cr oss-border provision of CCP 
EN 5   EN services more costly and potentially less safe th an would be desirable a nd represents a barrier 
to the integration of the EU financial market. 
In view of this, the Commission considered the possibi lity of introducing EU legislation for 
CCPs in 2006, but decided against it and opted instead for a combination of industry self-
regulation (it invited the industry to agree on a Code of Conduct) and Member States 
cooperation (it called for the completion of th e ESCB-CESR recommendations for CCPs) to 
ensure a safer and more efficient provision of CCP services in the EU. 
Since then, it became apparent that the approa ch chosen by the Commission would not be 
sufficient to eliminate the problems related to CCP s, partly because of th e shortcomings of the 
approach itself and partly because of the emergence of new problems. The former refer 
mainly to the realisation that recommendations  cannot achieve the same results in terms of 
harmonising regulation as legislation at EU level. The latter include obstacles to the 
establishment of links, the emergence of the dang er of competition on risk between CCPs, and 
the problem of the porta bility of collateral in the CCP environment. 
In view of the problems highlighted above, the IA  investigates possible ways of increasing the 
safety and efficiency of the EU  post-trading infrastructure and of investor protection. To this 
end it sets out four specific objectives, namely i) increasing the safety of CCPs, ii) establishing a level playing field for the provision of CCP services; iii) facilitating the establishment of links between CCPs; and iv ) providing additional safeguards for market 
participants accessing CCPs indirectly. The sp ecific objectives listed above require the 
attainment of the followi ng operational objectives: 
1. remove obstacles to cross-borde r provision of CCP services; 
2. remove obstacles to the estab lishment of links between CCPs; 
3. prevent CCPs from competing on risk; and 
4. facilitate the portability of client  positions and associated margins. 
The IA then analyses the impacts of each po ssible policy option associated with the above 
operational objectives and compares them with a baseline scenario to determine the most 
appropriate course of action. Fo llowing this analysis, the IA concludes that the largest net 
benefits would be achieved through the adoption of measures that would: 
1. introduce a passport for CCP services, relying on national authorisation and 
supervision of CCPs, with a strengthened role for the college of supervisors; 
2. introduce common requirements and procedures  for establishing a right for CCPs to 
become interoperable provided that risks are addressed and competent authorities 
approve the link; 
3. introduce common, strict risk standards for CCPs; and 
4. require CCPs to offer indirect participants  the possibility of having their margins 
placed in segregated (omnibus or nomi nal) accounts, while leaving indirect 
participants the choice of whether or not to take advantage of the offer. 
EN 6   EN Regulation is deemed as the most suitable policy instrument to achieve the desired objectives 
in this case as well. 
Trade repositories 
A trade repository is a centralised registry that  maintains an electronic  database of open OTC 
derivative transaction records (contracts). In  addition to this primary activity, a trade 
repository may also engage in ot her services, such as contract  events management and trade 
processing services. They are a ve ry recent addition to the fam ily of market infrastructures 
(the first one was launched at the end of 2006) and were, up until very recently, not regulated. 
The primary public policy benefit of a trade repository is the increased transparency allowed by its record-keeping function and the integrity of information it maintains. 
The main problem that arose during the crisis  concerned the speed with which regulators 
could access the information stored  in the credit derivatives trade repository (the only trade 
repository that existed at the time). With the sy stemic role that trade repositories will gain 
because of the reporting requirement, the ques tion of access to information by regulators will 
become even more important. In addition, se veral other aspects of a trade repository's 
business will need to be addressed because of the reporting requirement. 
The IA explores ways to provide safe, sound and efficient trade repositori es that will provide 
the necessary support for the reporting requiremen t, and ensure that competent authorities 
have the necessary information to perform th eir duties. In order to  reach this general 
objective, the IA sets out three more specific po licy objectives, namely i) ensuring the safety 
and integrity of data stored in a trade reposito ry; ii) establish a level playing field for the 
provision of trade repository services; and iii) ensuring th at competent authorities have 
unfettered access to the information stored in tr ade repositories. The IA then specifies a single 
operational objective, namely the introduction of  common rules governing the activities of 
trade repositories. 
The IA then analyses the impacts of each po ssible policy option associated with the above 
operational objectives and compares them with a baseline scenario to determine the most 
appropriate course of action. Fo llowing this analysis, the IA concludes that the largest net 
benefits would be achieved th rough the adoption of legisla tion governing the activities of 
trade repositories with re gistration and surveillance done at EU level by ESMA. 
Regulation is deemed as the most suitable policy instrument to achieve the desired objectives 
in this case as well.