Communication from the Commission - Ensuring efficient, safe and sound derivatives markets {SEC(2009) 905 final} {SEC(2009) 914 final}
Date: 2009-07-03
Institutions: European Commission
Subjects: bankruptcy, credit institution, disclosure of information, economic recession, impact study, price stability, supplies contract

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COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 3.7.2009 
COM(2009) 332 final 

COMMUNICATION FROM THE COMMISSION 

Ensuring efficient, safe and sound derivatives markets 

{SEC(2009) 905 final} 
{SEC(2009) 914 final} 

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COMMUNICATION FROM THE COMMISSION 

Ensuring efficient, safe and sound derivatives markets 

(Text with EEA relevance) 

1. 

INTRODUCTION 

The  ongoing  financial  crisis  has  brought  derivatives  to  the  forefront  of  regulatory  attention. 
The  near-collapse  of  Bear  Sterns  in  March  2008,  the  default  of  Lehman  Brothers  on  15 
September  2008  and  the  bail-out  of  AIG  on  16  September  highlighted  the  significant  role 
played by derivatives in general and Credit Default Swaps (CDS) in particular.  

There is broad agreement about  the benefits and risks of derivatives markets as  exposed by 
the  financial  crisis.  The  report  of  the  High  Level  Group  chaired  by  Jacques  de  Larosière 
demonstrated the risks associated with the rapid explosion of the use of credit derivatives and 
stressed  the  need  to  address  the  lack  of  transparency  in  the  market.  To  this  end,  the  report 
recommended  action  to  simplify  and  standardise  over  the  counter  (OTC)  derivatives  and  to 
introduce  central  counter  party  (CCP)  clearing.  The  G20  Summit  in  London  in  April 
committed  to  promoting  the  standardisation  and  resilience  of  credit  derivatives  markets,  in 
particular  through  the  establishment  of  central  clearing  counterparties  subject  to  effective 
regulation  and  supervision.  The  European  Council  on  19  June  2009  also  called  for  further 
progress to be made to ensure the transparency and stability of derivatives markets. 

Since  October  2008  the  Commission  has  been  working  actively  on  an  in-depth  review  of 
derivatives markets. As announced in the Communication "Driving European Recovery", this 
Communication presents the findings of that review and prepares the ground for forthcoming 
measures to address the problems identified. In parallel the Commission will continue to work 
constructively with industry to ensure the implementation of its commitment to introduce EU-
based  central  clearing  by  end-July  2009.  The  Commission  will  take  full  account  of  the 
measures taken by industry in designing the follow-up. 

This Communication is accompanied by a Commission Staff Working Paper, which contains 
an  overview  of  (i)  derivatives  markets,  (ii)  OTC  derivative  market  segments,  and  (iii)  an 
assessment of the effectiveness of current measures to reduce risks, notably as regards Credit 
Default Swaps (CDS). 

The Commission welcomes the feedback of stakeholders on the orientations presented in this 
Communication  and  in  particular  on  the  specific  questions  set  out  in  more  detail  in  the 
accompanying  Consultation  Document.  Responses  should  be  sent  to  the  Commission  by  31 
August 2009.  

2. 

DERIVATIVES AND DERIVATIVES MARKETS 

This  chapter  explains  what  derivatives  are,  the  benefits  they  have  for  the  economy  and  the 
risks they may entail. The latter have been at the centre of the financial crisis. 

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2.1.  What are derivatives? 

Derivatives  are  financial  contracts  that  trade  and  redistribute  risks  generated  in  the  real 
economy, and are accordingly important tools for economic agents to transfer risk. They can 
be  used  both  for  hedging  risk  and  to  acquire  risk  with  the  aim  of  making  profit.  They  are 
called derivatives, as their value is "derived" from an "underlying", e.g. a financial instrument, 
a commodity, a market variable or even a service.  

There are  many types of derivatives. Some are standard products  (e.g. futures) while  others 
are  not,  as  each  contract  is  tailored  to  the  specific  needs  of  the  user  (e.g.  swaps).  The 
standardised  derivatives  are  typically  traded  in  organised  trading  venues  where  prices  are 
publicly  displayed  (e.g.  derivatives  exchanges)  while  the  non-standardised  derivatives  are 
traded  off-exchange  or,  as  commonly  called,  over-the-counter  (OTC)  where  prices  remain 
private.  

Their use has grown tremendously over the last decade. This growth has materialised in OTC 
transactions, as illustrated by the graph below.  

The size of derivatives markets: on- and off-exchange 

$trn

Exchanges

Exchanges - Europe

OTC

800

700

600

500

400

300

200

100

0
Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

Jun-06

Jun-07

Jun-08

Note: The figure shows the notional amounts outstanding in on- vs. off-exchange market segments in USD trillions in 1998-2008. The trends 
show  outstanding  amounts  worldwide,  where  European  exchanges’  market  share  is  shown  separately  (no  similar  geographic  breakdown 
exists in OTC data). Source: Bank for International Settlements (BIS). 

OTC derivatives are generally divided into five broad segments: foreign exchange derivatives, 
interest rate derivatives, equity derivatives, commodity derivatives and credit derivatives, of 
which credit default swaps is the most important. The graph below depicts the relative weight 
of these  segments. Chapter 3  of  the  Staff Working Paper presents these segments in further 
detail  and  describes  the  different  characteristics  and  risks  involved  in  the  different  types  of 
OTC derivatives. 

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OTC derivative market segments 

Notional amounts outstanding, USD trillion, December 2008 

418,678

41,868

6,494

4,427

Foreign exchange contracts

Interest rate contracts

70,742

Equity-linked contracts

Commodity contracts

Credit default swaps

Unallocated

49,753

Source:  BIS (2009)

2.2. 

Derivatives benefit the economy… 

No  economy  can  flourish  if  no-one  is  willing  to  take  risk.  An  entrepreneur  setting  up  a 
business  is  taking  the  risk  that  the  business  may  fail.  A  bank  that  is  lending  money  to  that 
business risks not receiving the full repayment of its loan. Without the entrepreneur setting up 
the business, however, the saver that has deposited his funds with the bank would have one 
opportunity less to earn a decent return on his or her savings. The saver knows that the higher 
the return, the higher the risk of the project he is funding. The funding of investment projects 
therefore depends on whether somebody is willing to bear the associated risk. Nobody likes 
taking too much risk and it is therefore beneficial if risks can be shared. 

This  is  what  derivatives  can  do.  They  share  or  redistribute  risks  and  they  can  be  used  as 
protection  against  a  particular  risk  ("hedge")  or,  as  a  tool  to  take  speculative  positions.  In 
particular, commercial entities, such as airline companies, manufacturers, etc. use derivatives 
to cover the risk of a price increase in the basic materials they use to run their business and to 
better plan their future needs. 

2.3.  …but can put it at risk… 

Institutions  participating  in  derivatives  markets  can  cover,  or  'hedge',  the  risks  they  face  by 
using derivatives. However, if risks are hedged on OTC markets, it is hard, in the absence of 
reliable  public  information  about  those  markets,  for  market  participants  and  supervisors  to 
determine whether those risks have been effectively hedged. 

When  traders  in  derivatives  are  neither  market  makers  nor  do  they  have  any  interest  in  the 
underlying  they  facilitate  speculation,  volatility  and  the  building  up  of  risks  in  the  system 
.Derivatives  can  then  be  used  as  a  means  of  leveraging  the  balance  sheet  of  those  who 
intervene in derivatives markets as they allow market participants to take positions with less 
capital than the one required for investing in cash markets. 

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Moreover, if a counterparty defaults it may be difficult to find other counterparties to replace 
a hedge. These may either be in distress themselves or reluctant to enter into a trade in view of 
wider uncertainty. In markets with few participants this problem is amplified.  

In sum, when concluding an OTC contract, it is difficult to assess the risk that a counterparty 
may  default.  In  highly  interconnected  financial  markets,  such  an  assessment  would  in 
principle  require  any  market  participant  to  have  good  knowledge  about  all  other  market 
participants. As OTC markets have little public information, such knowledge is incomplete.  

CDS  are  particularly  vulnerable  in  all  these  respects.  While  most  derivatives  depend  on 
observable market prices (e.g. interest or the exchange rates), CDS are different. The risk they 
cover – credit risk – is not immediately observable but requires specific information about the 
borrower, which typically only banks have had. However, over the last decades credit risk has 
become more tradable, e.g. through securitisation. Assessing the risk remains difficult, which 
may  lead  to  situations  where  the  market  all  of  a  sudden  faces  a  significant  default  event. 
Moreover,  the  risks  associated  with  CDS  are  further  amplified  by  the  fact that  the potential 
obligations that come with them are extreme.1 These risks are not unique to CDS: they apply 
to derivatives generally, although to a less dramatic extent. 

2.4.  …as highlighted by the financial crisis 

The  financial  crisis  has  illustrated  that  these  risks  are  not  theoretical  but  real.  Bear  Sterns, 
Lehman  Brothers  and  AIG  were  important  players  in  the  OTC  derivatives  market,  either  as 
dealers or users of OTC derivatives, or both. The trouble they experienced originated outside 
the OTC derivatives markets, it entered the derivatives market via the CDS written by these 
three  institutions  and,  because  of  these  institutions’  central  role  in  all  OTC  derivatives 
markets,  it  spread  beyond  CDSs  and  affected  the  world  economy.  The  opaqueness  of  the 
market prevented, on the one hand, other market participants from knowing exactly what the 
exposures of their counterparties were to these three entities, which resulted in mistrust and in 
the sudden drying up of liquidity. On the other hand, it also prevented regulators from being 
able to identify early the risks building up in the system, the extent to which risks were being 
concentrated and consequently the effects that their default would have for financial stability. 
The light regulatory coverage of the market exacerbated this problem as supervisors did not 
have sufficient information.  

In sum, the crisis has highlighted how derivatives in general and CDS in particular created a 
web  of  mutual  dependence  that  was  difficult  to  understand,  disentangle  and  contain  in  the 
immediate  aftermath  of  a  default.  Therefore,  the  crisis  has  clearly  shown  that  the 
characteristics  of  OTC  derivative  markets  –  the  private  nature  of  contracting  with  limited 
public information, the complex web of mutual dependence, the difficulties of understanding 
the nature and level of risks – increases uncertainty in times of market stress and accordingly 
poses risks to financial stability. 

1 

The cash flows related to a CDS are 'discontinuous', i.e. while in normal times the seller of a CDS earns 
a steady flow of fees he nevertheless face the risk that the entity on which the CDS is written defaults, 
which will force him to pay out the full principal amount minus the value of the defaulted obligation. 
That has made some to misuse CDS as financing instruments. 

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3. 

MANAGING COUNTERPARTY RISKS 

These  risks  can  be  mitigated  by  the  way  trade  and  post-trade  functions  are  structured.  At 
trading  level,  risks  can  be  reduced  by  improving  operational  efficiency,  e.g.  ensuring 
electronic  trade  execution,  affirmation  and  confirmation.2  This  would  have  the  effect  of 
making OTC trade execution more similar to the way transactions are handled on-exchange. 
Improving  operational  efficiency  has  been  the  focus  of  regulatory  attention  prior  to  the 
financial crisis and has contributed to e.g. ensuring that CDS are today increasingly affirmed 
and confirmed electronically.  

However,  while  operational  efficiency  is  necessary  it  is  in  itself  insufficient.  To  effectively 
address  the  risks  outlined  above,  it  is  important  to  strengthen  post-trade  functions  as  well, 
notably  clearing.  Clearing  is  the  way  by  which  the  risks  outlined  above  are  mitigated.  It 
accordingly plays an essential role in derivative markets. Clearing can either occur bilaterally 
between the two counterparties to a particular trade or at central market level, by means of a 
Central  Counter-party  (CCP).  On-exchange,  clearing  is  almost  exclusively  done  by  CCPs. 
Off-exchange, bilateral clearing remains the norm, even though some market segments have 
CCP clearing as well (most notably interest rate swaps).  

•  Bilateral clearing: the two counterparties most often have collateral agreements in place 
that  provide  for  regular  monitoring  of  how  the  value  of  the  contract  evolves  so  as  to 
manage their respective credit exposures to each other. Should the value evolve so that one 
party has built up a claim on the counterparty it is then entitled to ask for collateral. While 
collateral  is  important  to  mitigate  credit  risk,  it  requires  managing  clearing  relationships 
with numerous counterparties. The very nature of this complex bilateral network makes it 
difficult  for  an  institution  to  understand  its  own  credit  exposure  in  view  of  its 
counterparties' exposures to each-other, let alone assessing the cascading implications of a 
counterparty defaulting.  

•  CCP clearing: the CCP steps into each trade by acting as a counterparty to each side of a 
transaction. The obligations of each of the two trading partners are now vis-à-vis the CCP, 
hence each party's exposure in this market is now with one and the same party. There are 
numerous  advantages  of  using  a  CCP.  A  CCP  is  effectively  a  mutual  insurance  with 
mutual defences. It makes collateral management simpler, as it is the CCP that collects and 
manages collateral. It is also safer, as the CCP is the central guarantor and is an institution 
solely focused on managing risks with several layers of protection. This sole focus on risk 
management makes the CCP a neutral party. Being in the centre, it is easier for the CCP to 
understand and manage risk. Moreover, the central information contained in the CCP also 
makes it easier for regulators to supervise risks. In view of the systemic role of the CCP it 
is  essential  that  it  is  professionally  run,  amply  capitalised  and  well  regulated  so  as  to  be 
safe and sound.3  

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3 

See accompanying Staff Working Paper, section 2.2 for further description of these concepts. 
See accompanying Staff Working Paper, section 2.4.2 for a more detailed description of CCP clearing. 

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Bilateral vs. CCP clearing 

Bilateral clearing

CCP clearing

•
•
•

Web of counterparty exposure
Complex collateral movements
Potential domino effect of one dealer default

•
•
•

Hub and spoke with central guarantor
All collateral moves to/from CCP
CCP capitalised to withstand dealer default

Given these benefits, one might wonder why market participants do not universally use CCP 
clearing.  The  first,  and  obvious,  reason  is  that  safety  comes  at  a  cost  for  its  participants,  as 
they  have  to  contribute  to  the  CCP's  layers  of  protection.  Second,  a  CCP  improves 
transparency, which redistributes informational advantages among market participants, to the 
disadvantage  of  those  currently  enjoying  an  information  advantage  (i.e.  major  OTC 
derivatives dealers). It is also true, however, that a CCP cannot always be used. There are a 
number  of  prerequisites,  broadly  related  to  liquidity  and  standardisation,  which  need  to  be 
satisfied before a CCP can be used. In this sense, given that not all OTC derivatives fulfil the 
necessary  characteristics  to  be  cleared  via  a  CCP,  the  Commission  will  also  work  to 
strengthen counterparty risk management in bilateral trades. 

In sum, the risks associated with derivatives vary depending on the market structure. Overall, 
OTC markets are much riskier than regulated trading venues, as the former are more opaque 
and  counterparty  relations  more  complex.  The  effectiveness  of  bilateral  counterparty  risk 
mitigation tools therefore leave a lot to be desired and the way counterparty risk is mitigated 
needs to be substantially improved.  

4. 

ACTIONS ALREADY TAKEN BY THE COMMISSION TO IMPROVE FINANCIAL STABILITY 
IN DERIVATIVES MARKETS 

Whilst derivatives are not outside EU financial services regulation, the huge growth of OTC 
derivatives  markets,  the  increased  volume  of  speculative  positions  built  through  derivatives 
and the greater participation in derivatives markets of non-regulated entities are issues which 
justify  a  review  of  our  regulatory  framework.  Since  the  outbreak  of  the  financial  crisis,  the 
Commission has acted swiftly and taken steps to address some of the most urgent and acute 
risks associated with derivatives.  

First, as regards CDS, in October 2008, Commissioner McCreevy called for (i) a systematic 
look  at  derivatives  markets  in  the  aftermath  of  the  lessons  learned  from  the  financial  crisis, 
and (ii) concrete proposals as to how the risks from credit derivatives can be mitigated.4 As a 

4 

McCreevy, C. (2008). "Time for regulators to get a better view of derivatives", 17 October 2008, 
SPEECH/08/538. 

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result, CDS dealers committed to start clearing eligible CDS  on  European reference  entities 
and indices on these entities through one or more European CCPs by 31July 2009.5 

Second, some of the problems related to securitisation and to the excessive risk transfer and 
risk  mispricing  have  been  addressed  by  the  review  of  the  Capital  Requirement  Directive 
(CRD).6 This proposal notably states that firms (known as 'originators') that re-package loans 
into tradable securities will be required to retain some risk exposure to these securities, while 
firms that invest in the securities will be allowed to make their decisions only after conducting 
comprehensive  due  diligence.  If  they  fail  to  do  so,  they  will  be  subject  to  heavy  capital 
penalties.  

Third, as regards the systemic risk related to speculative  trading,  the  Commission  will soon 
adopt  a  proposal  on  the  capital  requirements  applied  to  the  trading  book  of  financial 
institutions and to securitisation and re-securitisation positions. The increased levels of capital 
foreseen in this proposal will very likely avoid excessive short term risk taking by financial 
institutions.  

Fourth,  the  Commission  is  in  the  process  of  reviewing  its  approach  to  the  supervision  of 
financial markets. In proposing the creation of a European macro-financial supervisor Europe 
will  give  itself  the  capacity  to  identify  excessive  risks  building  in  the  system  and  act  to 
contain those risks. The European Systemic Risk Board will be instrumental in avoiding that 
the  risks  associated  with  derivatives  markets  pose  a  problem  to  the  whole  financial  and 
economic system. 

Fifth,  as  Credit  Rating  Agencies  (CRAs)  failed  to  adequately  assess  the  risks  posed  by 
complex instruments, in particular due to the conflicts of interests inherent to the "issuer pays 
model" , it became evident that they could not be left unregulated. In April 2009, the Council 
and the European Parliament approved a regulation proposed by the Commission according to 
which CRAs will have to comply with strict standards of integrity, quality and transparency 
and be subject to ongoing supervision of public authorities.7 

Finally,  the  European  Commission  has  proposed  a  directive  on  hedge  fund  and  other 
alternative investment fund managers (AIFM) that will create a comprehensive and effective 
regulatory and supervisory framework at European level. The proposed Directive will enable 
Member  States  to  improve  the  macro-prudential  oversight  of  the  sector  and  the  micro  level 

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On 17 February 2009, nine global dealers (Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, 
Goldman Sachs, HSBC, JP Morgan Chase, Morgan Stanley, UBS) have committed to use one or more 
central  counterparties  (CCPs)  in  the  European  Union  once  they  are  established  as  systems  under  the 
Settlement  Finality  Directive  (98/26/EC)  to  (i)  clear  CCP-eligible  Credit  Default  Swaps  (CDS)  on 
European reference entities and indices based on these entities, and (ii) back-load outstanding eligible 
contracts. The commitment has been then endorsed by one more dealer (Nomura) and support for this 
initiative has been provided by the European Banking Federation, by the European Public Banks Board 
and by other European banks associations  
COM/2008/0602 final - COD 2008/0191 amending Directives 2006/48/EC and 2006/49/EC as regards 
banks  affiliated  to  central  institutions,  certain  own  funds  items,  large  exposures,  supervisory 
arrangements, and crisis management. 
European  Commission  (2008),  "Proposal  for  a  Regulation  of  the  European  Parliament  and  of  the 
Council  on  Credit  Rating  Agencies",  COM(2008)  704,  as  approved  by  the  European  Parliament  and 
Council on 23 April 2009. 

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supervision, to impose limits to the level of leverage of these entities and to take coordinated 
action as necessary to ensure the proper functioning of financial markets.8 

5. 

THE WAY FORWARD: NEW INITIATIVES TO IMPROVE FINANCIAL STABILITY 

The  current  crisis  has  highlighted  the  need  to  deal  with  OTC  derivatives  markets  to  allow 
them  to  fulfil  their  economic  role  in  a  way  which  does  not  endanger  the  stability  of  the 
system. To this end the Commission considers that actions should be undertaken in order to: 
a)  allow  regulators  and  supervisors  to  have  full  knowledge  about  the  transactions  that  take 
place in OTC derivatives markets as well as the positions that are building in those markets, 
b)  increase  the  transparency  of  OTC  derivatives  markets  vis-à-vis  their  users;  in  particular 
more and better information about prices and volumes should be available; c) strengthen the 
operational efficiency of derivatives markets so as to ensure that OTC derivatives do not harm 
financial stability and d) mitigate counterparty risks and promote centralised structures. The 
main tools for achieving these objectives are (i) promoting further standardisation, (ii) using 
central data repositories, (iii) moving to CCP clearing, and (iv) moving trading to more public 
trading venues.9 This section analyses these tools and suggests orientations for future work. 

5.1. 

Standardisation 

For CCP eligible OTC derivatives, standardisation is a prerequisite for the other tools outlined 
below. For non-CCP eligible OTC derivatives, operational efficiency would be strengthened, 
and operational risks reduced, by further standardisation, e.g. by encouraging broader take up 
of  standard  contracts  and  electronic  affirmation  and  confirmation  services,  central  storage, 
automation  of  payments  and  collateral  management  processes.  As  standardisation  is  a 
prerequisite  for  further  actions,  it  will  form  a  core  building  block  in  the  Commission 
endeavour to make derivatives markets efficient, safe and sound. 

But  standardisation  requires  investments.  The  Commission  intends  to  take  forward  work  to 
incentivise  industry's  on-going  efforts  to  make  these  investments  so  as  to  promote 
standardisation  in  the  areas  of  all  OTC  derivatives  that  are  unlikely  to  be  eligible  either  for 
CCP clearing and unsuited to on-exchange trading.  

5.2. 

Central data repository 

A central data repository collects data – such as number of transactions, size of outstanding 
positions  –  for  all  trades  (both  CCP  eligible  and  CCP  non-eligible)  with  the  purpose  of 
increasing transparency and knowledge.10 This not only contributes to transparency, but also 
improves  the  operational  efficiency  of  the  market.  A  repository  could  also  provide  other 
services (e.g. facilitate settlement and payment instructions).  

8 

9 

10 

European Commission (2009), "Proposal for a Directive of the European Parliament and of the Council 
on Alternative Investment Fund Managers", COM(2009) 207. 
The  applicability  of  these  tools  varies  somewhat  depending  on  market  segment.  There  is  marked 
difference of complexity in implementing these tools. A more detailed analysis of the effectiveness of 
current  risk  mitigation  methods  and  the  associated need  for  additional  measures  in  each  OTC  market 
segment are further outlined in the accompanying Staff Working Paper's chapter 4. 
Such a data warehouse exists for CDS in the form of the Trade Information Warehouse, operated by the 
US Depository Trust and Clearing Corporation (DTCC).  

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The  Commission  sees  the  merits  in  terms  of  increased  transparency  and  knowledge  which 
central data repositories can bring for supervisors. This is particularly relevant given the fact 
that CCP clearing cannot easily apply to all derivatives as the necessary prerequisites are not 
always  in  place  and  not  easily  applicable.  For  reasons  of  legal  protection,  supervision  and 
business continuity, the Committee of European Securities Regulators (CESR) will study the 
usefulness of such a facility. The Commission will therefore, in the light of the forthcoming 
CESR report, take appropriate actions to that effect.  

5.3. 

CCP clearing 

Of  the  four  tools  considered,  the  one  that  has  been  subject  to  most  attention  so  far  is  CCP 
clearing. CCPs have proven their worth during the financial crisis, as illustrated by their role 
in  managing  the  consequences  of  Lehman  Brothers'  default.  The  Commission  has  already 
pushed  industry  to  expand  the  use  of  CCP  clearing  and  intends  to  implement  the  relevant 
recommendation of the de Larosière Group as a matter of priority.  

There  are  strong  reasons  for  CCP  clearing  being  located  in  Europe,  relating  to  regulatory, 
supervisory  and  monetary  policy  concerns.  If  a  CCP  is  located  in  Europe,  it  is  subject  to 
European  rules  and  supervision.  Supervisors  accordingly  have  undisputed  and  unfettered 
access to the information held by CCPs. It is also easier for European authorities to intervene 
in  case  of  a  problem  at  a  European  CCP.  For  example,  central  banks  do  not  provide  direct 
access to their liquidity facilities to financial institutions located outside their currency areas.11 

In  the  area  of  CDS,  the  major  derivatives  dealers  have  signed  a  commitment  with  the 
European Commission to move clearing of European CDS onto one or more European CCPs 
by 31 July 2009 and are currently working on the necessary standardisation of European CDS 
contracts  to  make  CCP  clearing  possible.  Two  European  CCPs  are  expected  to  be  ready  to 
offer their services on CDS by 31 July 2009, a third one is expected to be ready in December 
2009 and a fourth one has not committed to a firm date. Overall, the Commission welcomes 
the  industry's  efforts  in  trying  to  meet  the  deadline  stated  in  their  commitment.  Indeed, 
industry initiatives have so far proved to be effective on both sides of the Atlantic as far as the 
standardisation  of  CDS  is  concerned.  However,  the  implementation  of  the  solutions  for 
certain  technical  aspects,  such  as  those  related  to  the  restructuring  credit  event,  has  not  yet 
been finalised. Therefore, if industry is unable to deliver on its commitment, the Commission 
will have to consider other ways, as outlined further below. The Commission welcomes the 
industry  initiatives  and  will  take  full  account  of  their  delivery  and  implementation  in 
considering whether any further initiatives are necessary to ensure as broad a usage of CCP 
clearing as possible.  

Incentives to use CCPs already exist. Market participants have a natural incentive to use CCP 
clearing,  as  it  reduces  their  counterparty  credit  risk  and  allows  regulatory  capital  savings. 
However,  these  incentives  have  not  been  sufficient  in  overcoming  commercial  incentives 
favouring  bilateral  clearing.  Therefore,  the  Commission  is  considering  ways  to  significantly 

11 

Currencies  swaps  agreements  may  exists  between  central  banks,  but  because  of  the  absence  of  direct 
access to liquidity facilities, the ECB has expressed its strong preference for the CCP to be located in 
the  euro  area,  as  illustrated  in  a  statement  by  its  Governing  Council  on  18  December  2008,  which 
confirmed that "there was a need for at least one European CCP for credit derivatives and that, given 
the  potential  systemic  importance  of  securities  clearing  and  settlement  systems,  this  infrastructure 
should be  located  within  the euro area."  ECB  (2008), Decisions  taken by  the Governing  Council, 18 
December 2008, http://www.ecb.europa.eu/press/govcdec/otherdec/2008/html/gc081219.en.html 

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strengthen the incentives to use CCP clearing so as to dismantle any commercial hesitation to 
take  up  CCP  clearing  wherever  possible.  This  could  be  done  by  (i)  amending  the  rules  on 
regulatory capital contained in the CRD, and (ii) providing further regulatory and supervisory 
assurances  that  CCPs  are  safe  and  sound  by  means  of  future  European  legislation  where 
justified and possibly common supervision.12 Naturally, this further work does not in any way 
affect  the  deadline  associated  with  the  ongoing  efforts  to  move  clearing  of  European  CDS 
onto one or more European CCPs, i.e. 31 July 2009.  

5.4. 

Trade execution 

In  principle,  for  standardised  derivatives  that  are  cleared  by  a  CCP,  the  next  logical  step 
would  be  for  trading  of  these  contracts  to  take  place  on  an  organised  trading  venue  where 
prices and other trade-related information are publicly displayed, such as a regulated market 
(i.e.  derivatives  exchange)  or  a  multilateral  trading  facility  (MTF)  subject  to  transparency 
requirements. This would improve price transparency and strengthen risk management. 

However, the type of standardised contracts that are typically traded on public venues may not 
cater for the full range of derivative users' risk management needs. Most market participants 
have  a  commercial  preference  for  trading  OTC.  However,  the  importance  for  financial 
stability of the existence of transparent and operationally efficient markets must be the main 
consideration.  There  is  a  societal  preference  for  transparent  trading  venues,  as  public  and 
standardised as possible for the purpose of risk assessment and price determination.  

A  system  based  on  competition  between  different  trading  venues  (OTC,  exchanges  and 
MTFs), is also advantageous in terms of market efficiency as long as it subjects all venues to 
adequate  transparency  and  organisational  requirements  that  ensure  fair  competition.  This 
choice  for  transparent  and  organised  trading  is  something  not  unknown  for  other  financial 
markets. The Markets in Financial Instruments Directive (MiFID) abolished the rule whereby 
trades  should  be  carried  out  on  regulated  markets  (the  so-called  "concentration  rule"),  but 
subjected  other  trading  venues  (MTFs,  systematic  internalisers)  to  appropriate  transparency 
requirements. Accordingly, for cash equities, competition between trading venues takes place 
under  the  umbrella  of  common  transparency  and  organisational  rules.  However,  MiFID's 
transparency  regime  currently  does  not  cover  derivatives  and  transaction  reporting  does  not 
apply to financial instruments that are not admitted to trading on a regulated market.  

The Commission will examine, taking into account the bespoke and flexible nature of OTC 
derivatives  markets  and  the  regime  applicable  to  cash  equities,  how  to  arrive  at  a  more 
transparent and efficient trading process for OTC derivatives. In this respect the Commission 
will further assess (i) the channelling of further trade flow through transparent and efficient 
trading venues and (ii) the appropriate level of transparency (price, transaction, position) for 
the variety of derivative markets trading venues.  

6. 

CONCLUSION 

Derivatives play an important role in the economy but are associated with certain risks. The 
crisis  has  highlighted  that  these  risks  are  not  sufficiently  mitigated  in  the  OTC  part  of  the 

12 

European  Commission  (2009).  Communication  from  the  European  Commission,  European  Financial 
Supervision, COM(2009)252. 

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market,  especially  as  regards  CDS.  Since  the  beginning  of  the  financial  crisis,  the 
Commission has been working to address the most urgent of these risks.  

But beyond this the Commission will consider further measures to move ahead with increased 
standardisation and transparency of transactions, to consolidate the move to CCP clearing and 
ensure  that  it  becomes  the  norm  for  OTC  derivatives  markets  as  a  whole,  and  to  channel 
further trade flow through transparent and efficient trading venues, wherever possible. 

Following the public consultation which this Communication launches, the Commission will 
host  a  public  hearing  on  25  September  2009.  The  views  and  evidence  presented  by 
stakeholders  will  feed  into  a  detailed  impact  assessment  exercise  which  will  help  the 
Commission to shape its approach. Taking into account the outcome of the consultation, the 
Commission  will  draw  operational  conclusions  before  the  end  of  its  current  mandate  and 
present  appropriate  initiatives,  including  legislative  proposals  as  justified,  before  the  end  of 
the year.  

The  Commission  will  take  full  account  of  industry  efforts,  as  well  as  developments  in  the 
EU's  key  partners  and  in  particular,  the  comprehensive  regulatory  framework  for  OTC 
derivatives announced by the US Treasury. This notably translates into an obligation to clear 
all standardised OTC derivative contracts on CCPs and an encouragement of executing trades 
on  "regulated  exchanges  and  regulated  transparent  electronic  trade  execution  systems  for 
OTC  derivatives".13  The  Commission  will  continue  to  work  on  these  issues  with  US 
authorities, inter alia in the context  of  the  financial services regulatory dialogue, in order to 
ensure global consistency of policy approaches and avoid any risk of regulatory arbitrage. 

13 

See US Treasury Financial Regulatory Reform, 17 June 2009. 

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