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 counterparties and trade repositories   {COM(2010) 484 final} {SEC(2010) 1058}
Date: 2010-09-15
Institutions: European Commission
Subjects: anti-crisis plan, contract, credit institution, economic policy, economic recession, market supervision, reflation

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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 counterparties and trade repositories 

{COM(2010) 484 final} 
{SEC(2010) 1058} 

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Derivatives are an important building block of modern finance. In essence they are financial 
contracts that facilitate the trading and redistribution of risks. They owe their name to the fact 
that their value is derived from an underlying, such as the price of a financial instrument (e.g. 
a share of a publicly traded company) or a commodity (e.g. oil). Since they redistribute risk, 
they  can  be  used  either  to  insure  (hedge)  oneself  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 usually also determines how a derivative is traded: 
fully standardised derivatives are typically traded on organised trading venues, i.e. derivatives 
exchanges, while customised (or bespoke) derivatives are traded bilaterally, i.e. off-exchange 
or, as commonly called, over-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 default of Lehman Brothers on 
15 September 2008 and the bail-out of AIG the following day highlighted the shortcomings in 
the functioning of this market. Within this context, regulators devoted particular attention to 
the role that credit default swaps (CDS) played during the crisis. 

Since  October  2008  the  Commission  has  been  working  actively  to  tackle  the  shortcomings 
that the crisis brought to light. In the short term the Commission focused on the CDS market 
and obtained a commitment from the major dealers 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  markets  that  resulted  in  the  publication  of  two 
Communications on derivatives markets, respectively in July and October 2009. 

The  first  Communication  examined  the  role  played  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 transparency of the derivatives market, reduce 
counterparty  credit  risk  and  operational  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  transparency,  and  reducing  counterparty 
credit risk and operational risk through the use of post-trading market 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 positions and exposures of individual 
firms in OTC derivatives. On the one hand, this lack 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 

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occur (Lehman's case was a clear demonstration of this). On the other hand, it helps fuelling 
suspicion and uncertainty among market participants during a crisis. 

Counterparty credit risk 

Derivative  contracts  bind  counterparties  together  for  the  duration  of  an  OTC  derivatives 
contract.  Throughout  the  lifetime  of  a  contract,  counterparties  build  up  claims  against  each 
other, as the rights and obligations 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  under  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. Although both types of clearing are used in the OTC 
derivatives market, bilateral clearing is the most used form of the two. 

The crisis highlighted that the level of counterparty credit risk related to OTC derivatives was 
much  higher  than  both  market  participants  and  regulators  had  previously  thought.  To  put  it 
differently, the amount of collateral used to mitigate counterparty credit risk was insufficient. 
The main reason for this lies in inadequate collateralisation in the part of the market that is 
cleared  bilaterally,  either  because  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 participants that do provide collateral. 

Operational risk 

An OTC derivatives trade goes through several processing steps from the point at which two 
parties agree to a trade to the point where the transaction has been confirmed. Furthermore, 
during the lifetime of an OTC derivatives contract several events (e.g. collateral management 
and settlement of cash payments), stemming from the rights and obligations of the contract, 
need to be managed. 

Given that the OTC derivatives market allows for a high degree of flexibility in defining the 
economic and legal terms of derivatives contracts, there are a number of highly bespoke and 
complex contracts. Such contracts still require significant manual intervention 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  investigate  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 the OTC derivatives market. As mentioned earlier, 
reaching  this  general  objective  requires  the  realisation  of  three  specific  policy  objectives, 
namely  i)  increasing  transparency,  ii)  reducing  counterparty  credit  risk,  and  iii)  reducing 
operational  risk  associated  with  OTC  derivatives.  As  these  objectives  are  still  rather  broad, 
more operational objectives need to be defined: 

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obtain complete and comprehensive information on OTC derivatives positions; 

increase the use of CCP clearing; 

improve bilateral clearing practices; 

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4. 

increase the standardisation of OTC derivatives contracts. 

Preferred policy option(s) and policy instrument(s) 

The  IA  then  analyses  the  impacts  of  each  possible  policy  option  associated  with  the  above 
operational  objectives  and  compares  them  with  a  baseline  scenario  to  determine  the  most 
appropriate  course  of  action.  Following  this  analysis,  the  IA  concludes  that  the  largest  net 
benefits would be achieved through the adoption of measures that would: 

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2. 

3. 

4. 

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 publication of aggregate position information; 

require the use of CCP clearing for OTC derivatives that meet predefined eligibility 
criteria; 

set specific targets for the bilateral clearing of OTC derivatives transactions; and 

set specific targets for legal 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 gold-plating and without 
allowing residual powers to national legislators, a Regulation is deemed as the most suitable 
policy instrument to achieve 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 obligation to ensure that this infrastructure is 
safe  and  sound,  in  order  to  prevent  the  situation  in  which  its  use  would  actually  increase 
systemic risk instead of decreasing it. In order to achieve this goal, the 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 that interposes itself between counterparties 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 CCP 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 risk that the CCP might fail. A CCP mitigates its counterparty 
credit risk exposure through a number of reinforcing mechanisms, typically including access 
restrictions,  risk-management  tools  (such  as  collateralisation),  and  loss  mutualisation.  These 
mechanisms are jointly known as the “risk waterfall” of the CCP. 

By virtue of the risk-mitigation role they play, 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  cross-border  provision  of  CCP 

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services more costly and potentially less safe than would be desirable and represents a barrier 
to the integration of the EU financial market. 

In view of this, the Commission considered the possibility 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 the 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  approach  chosen  by  the  Commission  would  not  be 
sufficient to eliminate the problems related to CCPs, partly because of the 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 danger of competition on risk between CCPs, and 
the problem of the portability 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  specific  objectives  listed  above  require  the 
attainment of the following operational objectives: 

1. 

2. 

3. 

4. 

remove obstacles to cross-border provision of CCP services; 

remove obstacles to the establishment of links between CCPs; 

prevent CCPs from competing on risk; and 

facilitate the portability of client positions and associated margins. 

The  IA  then  analyses  the  impacts  of  each  possible  policy  option  associated  with  the  above 
operational  objectives  and  compares  them  with  a  baseline  scenario  to  determine  the  most 
appropriate  course  of  action.  Following  this  analysis,  the  IA  concludes  that  the  largest  net 
benefits would be achieved through the adoption of measures that would: 

1. 

2. 

3. 

4. 

introduce  a  passport  for  CCP  services,  relying  on  national  authorisation  and 
supervision of CCPs, with a strengthened role for the college of supervisors; 

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; 

introduce common, strict risk standards for CCPs; and 

require  CCPs  to  offer  indirect  participants  the  possibility  of  having  their  margins 
placed  in  segregated  (omnibus  or  nominal)  accounts,  while  leaving  indirect 
participants the choice of whether or not to take advantage of the offer. 

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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 other services, such as contract events management and trade 
processing  services.  They  are  a  very  recent  addition  to  the  family  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  systemic  role  that  trade  repositories  will  gain 
because of the reporting requirement, the question of access to information by regulators will 
become  even  more  important.  In  addition,  several  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 repositories that will provide 
the  necessary  support  for  the  reporting  requirement,  and  ensure  that  competent  authorities 
have  the  necessary  information  to  perform  their  duties.  In  order  to  reach  this  general 
objective, the IA sets out three more specific policy objectives, namely i) ensuring the safety 
and  integrity  of  data  stored  in  a  trade  repository;  ii)  establish  a  level  playing  field  for  the 
provision  of  trade  repository  services;  and  iii)  ensuring  that  competent  authorities  have 
unfettered access to the information stored in trade 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  possible  policy  option  associated  with  the  above 
operational  objectives  and  compares  them  with  a  baseline  scenario  to  determine  the  most 
appropriate  course  of  action.  Following  this  analysis,  the  IA  concludes  that  the  largest  net 
benefits  would  be  achieved  through  the  adoption  of  legislation  governing  the  activities  of 
trade repositories with registration 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. 

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