OPINION OF THE ECONOMIC AND SOCIAL COMMITTEE on derivatives
Date: 1995-10-25
Institutions: European Economic and Social Committee
Subjects: financial instrument, financial legislation, financial management, financial market, monetary policy













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51995IE1152

OPINION OF THE ECONOMIC AND SOCIAL COMMITTEE on derivatives  


Official Journal C 018 , 22/01/1996 P. 0001 





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. INTRODUCTIONThe 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 uses1.1. Definition1.1.1. 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. ClassificationDerivatives 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 typesOver-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 typesThere 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. OptionsContract 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 marketThese 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 volume1.4.1. 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. >TABLE>>TABLE>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. >TABLE>1.5. Usefulness of derivatives1.5.1. Tailor-made financial toolsFor 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 need1.5.2.1. 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 transactionsLet  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 basisInterest 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 controlledDerivatives 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 derivatives2.1. Measures taken at EU level2.1.1. 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 Committee2.2.1. 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 models2.2.3.1. 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 dataThe 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 dataThe 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) ResultsAt 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 risk2.2.4.1. 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 activities2.2.5.1. 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 Thirty2.3.1. 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 CommitteeAlongside 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 recommendations3.0.1. 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 respected3.1.1. 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 avoided3.2.1. 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 register3.2.4.1. 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 examination3.2.5.1. 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 derivatives3.3.1. 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 made3.4.1. 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 professionals3.5.1. 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 thinking3.6.1. 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 Presidentof the Economic and Social CommitteeCarlos 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.