COMMISSION STAFF WORKING DOCUMENT 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) 1059}
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) 1058 

COMMISSION STAFF WORKING DOCUMENT 

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) 1059} 

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TABLE OF CONTENTS 

1. 

2. 

2.1. 

2.2. 

2.3. 

2.4. 

Introduction .................................................................................................................. 5 

Procedural issues and consultation of interested parties .............................................. 7 

Lead DG ....................................................................................................................... 7 

Political mandate and basis in the work programme ................................................... 7 

Impact assessment and opinion of the Impact Assessment Board............................... 8 

Consultation of interested parties................................................................................. 8 

2.4.1.  External expertise......................................................................................................... 9 

2.4.2.  Stakeholder consultation .............................................................................................. 9 

2.4.3.  Public conference ....................................................................................................... 10 

3. 

Problem definition...................................................................................................... 11 

3.1. 

Problems related to the functioning of the OTC derivatives market ......................... 11 

3.1.1.  Overview of derivatives and the derivatives market.................................................. 11 

3.1.2.  The role of derivatives in the financial crisis ............................................................. 13 

3.1.3.  Problem 1: Lack of transparency on OTC derivatives positions and exposures........ 14 

3.1.4.  Problem 2: Insufficient mitigation of counterparty credit risk................................... 16 

3.1.5.  Problem 3: Insufficient mitigation of operational risk............................................... 19 

3.1.6.  The problem tree ........................................................................................................ 22 

3.1.7.  The combined effect of problems 1, 2 and 3.............................................................. 23 

3.2. 

3.3. 

Economic magnitude of the problem ......................................................................... 24 

How would the problems evolve without EU action? ............................................... 24 

3.3.1.  Current initiatives in the area of problem 1 ............................................................... 25 

3.3.2.  Current initiatives in the area of problem 2 ............................................................... 26 

3.3.3.  Current initiatives in the area of problem 3 ............................................................... 28 

3.4. 

Treaty base and subsidiarity....................................................................................... 30 

3.4.1.  Treaty base, competence ............................................................................................ 30 

3.4.2.  Subsidiarity ................................................................................................................ 31 

4. 

4.1. 

4.2. 

The objectives ............................................................................................................ 32 

General, specific and operational objectives.............................................................. 32 

Consistency of the objectives with other EU policies................................................ 33 

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5. 

Policy options and policy instruments ....................................................................... 34 

5.1. 

Policy options and their scope.................................................................................... 34 

5.1.1.  Options for objective 1 – Obtain complete and comprehensive information on OTC 

derivatives positions................................................................................................... 34 

5.1.2.  Options for objective 2 – Increase the use of CCP clearing ...................................... 35 

5.1.3.  Options for objective 3 – Improve bilateral clearing practices .................................. 35 

5.1.4.  Options for objective 4 – Increase the standardisation of OTC derivatives contracts 

and processes.............................................................................................................. 36 

5.2. 

Policy instruments...................................................................................................... 36 

5.2.1.  The available set of policy instruments...................................................................... 36 

5.2.2.  The preferred policy instrument(s)..............................Error! Bookmark not defined. 

6. 

Analysis of impacts and choice of preferred options and instruments....................... 38 

6.1. 

Analysis of impacts .................................................................................................... 38 

6.1.1.  Options for operational objective 1 (information on positions)................................. 38 

6.1.2.  Options for operational objective 2 (use of CCPs) .................................................... 45 

6.1.3.  Options for operational objective 3 (bilateral clearing) ............................................. 51 

6.1.4.  Options for operational objective 4 (standardisation)................................................ 53 

6.2. 

The preferred policy options and instruments............................................................ 55 

6.2.1.  The preferred policy options ...................................................................................... 55 

6.2.2.  The cumulative impacts of the preferred policy options............................................ 55 

6.2.3.  The impact on retail investors and SMEs .................................................................. 56 

6.2.4.  Social impact.............................................................................................................. 56 

6.2.5.  Environmental impact ................................................................................................ 56 

6.2.6. 

Impact on third countries ........................................................................................... 56 

6.2.7.  The preferred policy instrument................................................................................. 57 

6.2.8.  The scope of legislation ............................................................................................. 60 

7. 

The OTC derivatives market and financial market infrastructure ............................. 63 

7.1. 

Central counterparties ................................................................................................ 63 

7.1.1.  Background ................................................................................................................ 63 

7.1.2.  The political mandate................................................................................................. 66 

7.1.3.  The problems.............................................................................................................. 66 

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7.1.4.  The policy objectives ................................................................................................. 71 

7.1.5.  The policy options and policy instruments ................................................................ 72 

7.1.6.  Analysis of impacts and choice of preferred policy option(s) ................................... 74 

7.1.7.  The preferred policy instrument................................................................................. 81 

7.2. 

Trade repositories....................................................................................................... 81 

7.2.1.  Background ................................................................................................................ 81 

7.2.2.  The political mandate................................................................................................. 81 

7.2.3.  The problems.............................................................................................................. 82 

7.2.4.  The objectives ............................................................................................................ 83 

7.2.5.  The policy options...................................................................................................... 83 

7.2.6.  Analysis of impacts and choice of preferred policy option(s) ................................... 84 

7.2.7.  The preferred policy instrument................................................................................. 86 

8. 

Monitoring and evaluation ......................................................................................... 87 

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1. 

INTRODUCTION 

The financial crisis has brought over-the-counter (OTC) 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  the  following 
day highlighted the shortcomings in the functioning of the OTC derivatives market. 
Within  that  market,  regulators  devoted  particular  attention  to  the  role  that  credit 
default swaps (CDS) played during the crisis.1 

Since  October  2008  the  Commission  has  been  working  actively  to  tackle  the 
shortcomings  that  the  crisis  brought  to  light.  In  order  to  do  so,  the  Commission 
followed a two-pronged approach: 

•  in the short term it 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) by the end of July 2009. This process 
lead to important results.2 

•  In the medium term it focused on an in-depth review of derivatives markets. In the 
Communication of 4 March 2009,3 the Commission committed to deliver, on the 
basis of a report on derivatives and other complex structured products, appropriate 
initiatives to increase transparency and to address financial stability concerns: 

−  On  3  July  2009  the  Commission  adopted  a  first  Communication4  that 
examined the role played by derivatives in the financial crisis, looked at the 
benefits  and  risks  of  derivatives  markets,  and  assessed  how  the  identified 
risks can be reduced.5 

−  On 20 October, the Commission adopted a second Communication6 that set 
out the future policy actions the Commission intended to propose to increase 
transparency,  reduce  counterparty  and  operational  risk,  enhance  market 
integrity  and  oversight  in  derivatives  markets.  It  also  announced  that  the 
Commission would come forward with legislative proposals in 2010. 

1  

2  
3  

4  

5  

6  

For example, the report of the High Level Group chaired by Jacques de Larosière,  published in February 
2009, highlighted 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  OTC  derivatives  and  to  introduce  CCP  clearing.  The  report  is  available  at 
http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf (see p.25). 
See section 3.3.2. for further details. 
“Driving European Recovery” - COM(2009) 114. The document is available at 
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2009:0114:FIN:EN:PDF. 
“Ensuring efficient, safe and sound derivatives markets” - COM(2009) 332. The document is available at 
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2009:0332:FIN:EN:PDF. 
The  Communication  is  accompanied  by  a  Staff  Working  Paper,  which  contains  an  overview  of  (i) 
derivatives markets and (ii) OTC derivative market segments, as well as an assessment of the effectiveness 
of  current  measures  to  reduce  risks,  notably  as  regards  CDS.  The  document  is  available  at 
http://ec.europa.eu/internal_market/docs/derivatives/report_en.pdf. 
“Ensuring  efficient,  safe  and  sound  derivatives  markets:  Future  policy  actions”  -  COM(2009)  563. 
Available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2009:0563:FIN:EN:PDF. 

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Furthermore, in the context of the Commission's work on the food supply chain, the 
Commission  published  on  28  October  2009  a  Communication7  that  announces 
legislative  proposals  to  improve  the  oversight  and  overall  transparency  of 
agricultural  commodities  derivatives  markets.  In  particular,  the  Communication 
announces  i)  the  extension  of  appropriate  transparency  and  reporting  requirements 
(including position reporting by categories of traders) to all agricultural commodity 
derivatives, including those traded OTC; and ii) the Commission's intention to assess 
the possibility of enabling regulators to set position limits to counter disproportionate 
price movements or concentrations of speculative positions. 

This impact assessment report accompanies part of the proposals announced by the 
Commission,8  namely  those  that  look  at  increasing  transparency  and  reducing 
counterparty and operational risk principally through the use of post-trading market 
infrastructure  (i.e.  CCPs  and  trade  repositories).  The  remaining  proposals  will  be 
tackled  in  other  legislative  initiatives  and  will  therefore  not  be  examined  in  this 
report. 

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“A  better  functioning  food  supply  chain  in  Europe”  -  COM(2009)  591.  The  document  is  available  at 
http://ec.europa.eu/economy_finance/publications/publication16061_en.pdf. 
See Annex 2 for a full overview of the foreseen Commission proposals. 

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2. 

PROCEDURAL ISSUES AND CONSULTATION OF INTERESTED PARTIES 

2.1. 

Lead DG 

The Directorate-General for Internal market and Services (hereinafter: DG MARKT) 
is the Lead DG of this process. 

2.2. 

Political mandate and basis in the work programme 

At the EU level, as detailed in the introduction of this report, a number of reports and 
Commission Communications set out the Commission's main priorities in the area of 
derivatives and already provided some insight into the more detailed actions that the 
Commission intends to undertake. 

The Council also outlined, on several occasions, its views on this particular topic. On 
19 June  2009 the European  Council  called “for further progress  to  be  made in the 
regulation  of  financial  markets,  notably  on  […]  the  transparency  and  stability  of 
derivatives markets.” Furthermore, in the ECOFIN roadmap adopted on 20 October 
2009  as  an  annex  to  its  conclusions  on  strengthening  EU  financial  stability 
arrangements,9 the Council calls for “[i]ncreasing the safety for "over the counter" 
derivatives  markets,  by  the  clearing  of  standardized  OTC  derivative  contracts 
through  central  counterparties  and,  if  not,  higher  capital  requirements;  [and]  the 
reporting  of  non-standardized  derivative  contracts  to  trade  repositories.”  Finally, 
the  Council  outlined  more  detailed  views  on  the  topic  in  its  Conclusions  of  2 
December 2009.10 

The European Parliament also expressed it views on the topic of derivatives. During 
the  June  2010  plenary  session,  the  European  Parliament  adopted  a  Resolution  that 
“[w]elcomes the Commission’s initiative for better regulation of derivatives, and in 
particular  OTC  derivatives  with  a  view  to  reducing  the  impact  of  the  risks  in  the 
OTC derivatives markets for the stability of financial markets as a whole, and backs 
the  calls  for  legal  standardisation  of  derivatives  contracts  […],  the  use  of  trade 
repositories and centralised data storage, [and] the use and strengthening of central 
clearing houses […]”.11 

The EU initiatives are part of the international effort to increase the stability of the 
financial  system  in  general,  and  the  OTC  derivatives  market  in  particular.  The 
foundations for a coordinated approach on this issue were laid down at the 2 April 
2009  G20  summit  in  London,  where  the  leaders  of  the  G20  agreed  to  promote  the 
standardisation and resilience of credit derivatives markets, in particular through the 
establishment  of  central  clearing  counterparties  subject  to  effective  regulation  and 
supervision.12 This commitment was confirmed and spelt out in further detail at the 

9  
10  
11  

http://www.consilium.europa.eu/ueDocs/cms_Data/docs/pressdata/en/ecofin/110617.pdf. See p. 15. 
See Annex 3 for details. 
“Report  on  derivatives  markets:  future  policy  actions”  (henceforth  “Langen  report”).  The  report  is 
available  at  http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//NONSGML+REPORT+A7-
2010-0187+0+DOC+PDF+V0//EN. 

12   Declaration 

on 

strengthening 

the 

financial 

system.  The 

document 

is 

available 

at 

http://www.londonsummit.gov.uk/resources/en/PDF/annex-strengthening-fin-sysm. See p.3. 

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26 September 2009 summit in Pittsburgh. In particular, the statement of the leaders 
of  the  G20  says  that  “[a]ll  standardized  OTC  derivative  contracts  should  be  […] 
cleared  through  central  counterparties  by  end-2012  at  the  latest.  OTC  derivative 
contracts should be reported to trade repositories. […]”13 

The  importance  of  an  internationally  coordinated  approach  cannot  be  overstated. 
Given  the  global  nature  of  the  OTC  derivatives  market,  the  lack  of  internationally 
coordinated  action  would  only  lead  to  regulatory  arbitrage.  This  would  severely 
curtail the effectiveness of measures to increase the safety of the financial system in 
any individual jurisdiction. The need of a coordinated approach has been recognised 
by the G2014 as well as by the Council15 and the European Parliament.16 

In accordance with what announced in the second Communication and following the 
political mandate given by the Council, the preparation of a legislative proposal on 
the  derivatives  market  was  included  in  the  Commission's  work  programme  for 
2010.17 

2.3. 

Impact assessment and opinion of the Impact Assessment Board 

Work on the Impact Assessment started in January 2010 with the first meeting of the 
Steering  group  on  9  February  2010,  followed  by  3  further  meetings,  the  last  one 
taking  place  on  12  May  2010.  The  following  Directorates  General  (DGs)  and 
Commission  services  participated 
the  meetings:  Agriculture  and  Rural 
Development,  Climate  Action,  Competition,  Economic  and  Monetary  Affairs, 
Energy,  Industry  and  Entrepreneurship,  Legal  Services,  Secretariat  General,  and 
Trade. 

in 

The  report  was  sent  to  the  Impact  Assessment  Board  on  19  May  2010.  The  Board 
discussed the report on its hearing on 16 June 2010. Following the hearing, changes 
were made to the Impact Assessment in order to reflect the Board's comments. 

2.4. 

Consultation of interested parties 

Since  October  2008  the  Commission  has  been  engaged  in  almost  continuous, 
extensive  consultation  with  representatives  from  the  great  majority  of  stakeholders. 
The interaction has taken the form of bilateral and multilateral meetings, two written 
public consultations and a public conference. Through this process the Commission 
has obtained a wealth of information about the functioning of the derivatives market 
and  its  various  segments,  as  well  as  views  on  the  issues  to  be  solved  and  how  to 
solve  them.  An  important  part  of  this  information  has  already  been  used  in  the 
preparation of the two aforementioned Communications. 

13  
14  
15  
16  
17  

http://www.pittsburghsummit.gov/mediacenter/129639.htm. See third bullet of paragraph 13. 
See paragraph 12 of the aforementioned Pittsburgh Summit statement. 
See paragraph 2 of the aforementioned Council conclusions of 2 December 2009. 
See recital U of the Langen report. 
http://ec.europa.eu/atwork/programmes/docs/cwp2010_en.pdf. 

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2.4.1.  External expertise 

In  line  with  the  two-pronged  approach  described  in  the  introduction,  the 
Commission’s attention was initially focused solely on the CDS market. In order to 
facilitate  the  monitoring  of  the  major  dealers’  commitment  in  this  area,  the 
Commission created a group, the Derivatives Working Group (DWG), that included 
representatives from all the financial institutions that signed the commitment,18 from 
market  infrastructures  and  other  service  providers  that  had  developed  /  were 
developing  solutions  for  the  CDS  market  (CCPs,  trade  repositories),  from  other 
market  participants,  from  relevant  European  (ECB,  CESR,  CEBS  and  CEIOPS)19 
and  national  (AMF,  BaFin  and  FSA)20  authorities,  as  well  as  the  relevant 
Commission  services.  In  addition  to  the  formal  meetings  of  the  DWG,  the 
Commission  held  separate,  ad-hoc  bilateral  and  multilateral  meetings  with  a  large 
number of stakeholders in the CDS market. 

The work surrounding derivatives in general had a less formal structure. Most of the 
information was gathered through ad-hoc bilateral and multilateral meetings with the 
various stakeholders. Only one formal group, the Member States Working Group on 
Derivatives and Market Infrastructures, was created at the end of 2009. The group is 
mainly  constituted  from  experts  representing  Member  States.  The  ECB,  CEBS  and 
CESR  also  participate  in  its  meetings.  The  group's  objective  is  to  advise  the 
Commission on the forthcoming legislative proposal. 

The  Commission  has  also  gained  valuable  information  by  actively  participating  in 
various  international  fora,  in  particular  the  OTC  Derivatives  Regulators  Group  and 
Basel’s Risk Management and Modelling Group. The Commission has recently also 
gained observe status on the steering committee of the joint CPSS-IOSCO21 working 
group  that  is  currently  reviewing  the  recommendations  for  CCPs  and  preparing 
recommendations for trade repositories. In addition, the Commission has engaged in 
frequent  dialogue  with  non-EU  authorities,  in  particular  US  authorities  (the  CFTC, 
the SEC,22 the Federal Reserve and the US Congress). 

2.4.2. 

Stakeholder consultations 

In parallel with the publication of the first Communication, DG MARKT launched a 
first  public  consultation23  on  3  July  2009  (it  was  closed  on  31  August  2009)  and  a 
second  one24  on  14  June  2010  (it  was  closed  on  10  July  2010).  Stakeholders  were 
informed about the availability of the two public consultations on the website of DG 

18  

The letter of commitment and the list of signatories of the letter can be found on DG MARKT’s website at 
http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm#cds. 

19   Respectively  the  European  Central  Bank,  the  Committee  of  European  Securities  Regulators,  the 
Committee  of  European  Banking  Supervisors,  and  Committee  of  European  Insurance  and  Occupational 
Pensions Supervisors. 

20   Respectively the Autorité des marchés financiers, Bundesanstalt für Finanzdienstleistungsaufsicht and the 

Financial Services Authority. 

21   Respectively  the  Committee  on  Payment  and  Settlement  Systems  and  the  International  Organisation  of 

Securities Commissions. 

22   Respectively the Commodity Futures Trading Commission and the Securities and Exchange Commission. 
23  
24  

See http://ec.europa.eu/internal_market/consultations/2009/derivatives_en.htm. 
See http://ec.europa.eu/internal_market/consultations/2010/derivatives_en.htm. 

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MARKT  through  the  publication  of  a  Commission  press  release25  and  frequently 
asked  questions26  respectively,  and  through  electronic  mail,  either  directly  or 
indirectly (through their associations). 

The  Commission  services  received  111  and  210  responses  respectively.  Those  that 
had  been  authorised  for  publication  have  been  consequently  published  on  the 
respective  consultation  websites.27  The  summary  of  responses  including  an 
introductory  analysis  of  the  first  public  consultation  is  available  on  DG  MARKT’s 
website28 and is annexed to this report (see Annex 4). A summary of responses to the 
second  public  consultation  is  annexed  to  this  report  (see  Annex  5).  The  two 
consultations  followed  the  standards  as  set  out  in  the  Part  III  of  the  Impact 
Assessment Guidelines of 15 January 2009. 

All contributions have been thoroughly examined and relevant information contained 
in them has been taken into account throughout the text of this report. 

2.4.3.  Public conference 

The  first  consultation  period  was  closed  by  a  public  conference  organised  by  DG 
MARKT and held in Brussels, on 25 September 2009.29 Three panels of academics, 
industry representatives and regulators, coming from the EU and the US, presented 
their views on the need (or lack thereof) to reform the OTC derivatives market. The 
conference  by  and  large  confirmed  the  views  obtained  through  the  first  public 
consultation. 

25  

26  

27  

28  
29  

http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/1083&format=HTML&aged=0& 

http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/10/256&format=HTML&aged= 

See 
language=EN&guiLanguage=en. 
See 
0&language=EN&guiLanguage=en. 
See  http://circa.europa.eu/Public/irc/markt/markt_consultations/library?l=/financial_services/derivatives_ 
derivatives&vm=detailed&sb=Title 
http://circa.europa.eu/Public/irc/markt/markt_consultations/ 
and 
library?l=/financial_services/infrastructures&vm=detailed&sb=Title respectively. 
See http://ec.europa.eu/internal_market/consultations/docs/2009/derivatives/summaryderivcons_en.pdf. 
The  conference’s 
http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm#conference. 

recordings  and  documents  are  available  on  DG  MARKT’s  website  at 

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3. 

PROBLEM DEFINITION 

This section looks at the three main problems related to the functioning of the OTC 
derivatives  market  that  were  already  identified  in  the  October  2009  Commission 
Communication. They are i) the lack of transparency on positions and exposures, ii) 
insufficient  mitigation  of  counterparty  credit  risk,  and  iii)  insufficient  mitigation  of 
operational risks. 

3.1. 

Problems related to the functioning of the OTC derivatives market 

3.1.1.  Overview of derivatives and the derivatives market30 

Derivatives are an important building block of modern finance. In essence they are 
financial  contracts  that  facilitate  the  trading  and  redistribution  of  risks.31  They  owe 
their name to the fact that their value is derived from an underlying (e.g. the price of 
a share of a publicly traded company). Since they redistribute risk, they can be used 
either to insure (hedge)32 oneself against a particular risk or, conversely, to take on 
risk  (invest  or  speculate).33  They  can  also  be  used  to  arbitrage  between  different 
markets. 

Derivatives  can  range  from  those  that  have  fully  standardised  parameters,  such  as 
notional value or maturity, to those 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  most  common  types  of  derivatives  traded  on  an  exchange  are  futures  and 
options. Conversely, the most common types of OTC derivatives are swaps, forwards 
and (exotic) options.  

The  use  of  derivatives  has  grown  exponentially  over  the  last  decade.  Most  of  this 
growth  was  driven  by  OTC  transactions  (see  Figure  1).  At  the  end  of  December 
2009,  the  size  of  the  OTC  derivatives  market  by  notional  value  equalled  to 
approximately  $615  trillion,  a  12%  increase  with  respect  to  the  end  of  2008. 
However, this was still 10% lower than the peak reached in June 2008. 

30   A more detailed description of derivatives and their use, as well as of derivatives markets can be found in 

31  
32  

Annex 6. 
From those not willing to hold it to those who are. 
For example, companies use derivatives to cover the risk of a price increase in the raw materials they use 
in their production, to protect themselves from adverse currency movements and, more in general, to better 
plan their future needs. Farmers use them to protect themselves from the risk of a fall in the price of their 
crops or to protect themselves against poor harvests caused by drought or frost. 

33   Hedging and speculation are often two faces of the same coin: in most cases, little or no hedging would be 

possible without the existence of speculators. 

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Figure 1: The size of derivatives markets: on- and off-exchange34 ($ trn) 

Note: The figure shows the notional amounts outstanding in on- vs. off-exchange market segments in 
USD  trillions  in  1998-2009.  On-exchange  data  shows  outstanding  amounts  worldwide  and  in 
Europe(no similar geographic breakdown exists in OTC data).  

Source: BIS. 

While  notional  amounts  provide  a  measure  of  market  size  and  a  reference  from 
which  contractual  payments  are  determined  in  derivatives  markets,  they  do 
correspond to amounts truly at risk. Gross market values35 provide some measure of 
the financial risk from OTC derivatives. At the end of 2009, the total gross market 
value stood at $21.6 trillion, one third lower than at the peak reached a year earlier.36 
The  corresponding  credit  exposure37  was  $3.52  trillion,  about  22%  lower  than  the 
peak reached a year earlier.38 

OTC  derivatives  are  generally  divided  into  five  broad  segments:  foreign  exchange 
derivatives,  interest  rate  derivatives,  equity  derivatives,  commodity  derivatives  and 
credit derivatives (credit default swaps are the most important type of contract in this 
segment). As can be seen in Figure 2, interest rate derivatives are by far the largest 
segment, followed by foreign exchange derivatives and credit derivatives.39 In April 
2007, the EU accounted for 63% of the interest rates derivatives market and 54% of 
the foreign exchange derivatives market.40 In comparison, the US accounts for 24% 
and 15%, respectively. 

34  

35  

36  

38  
39  

Please note that, as indicated previously, the OTC market does not fully benefit from the netting effects 
provided by a CCP. This means that the size of the market is somewhat inflated, since offsetting trades are 
not netted out. 
The sum of the replacement values of all open contracts that are either in a current gain or loss position at 
current market prices. 
Since  gross  market  value  depends  on  market  prices,  the  fall  it  registered  is  a  direct  reflection  of  the 
reduction in market prices from the "panic" levels of end 2008. 

37   Defined by the BIS as the gross value of contracts that have a positive market value after taking account of 

legally enforceable bilateral netting agreements. 
The logic explained in footnote 44 applies here as well. 
See Chapter 3 of the aforementioned Commission Staff Working Paper for more details, including the risk 
characteristics, on each segment. 

40   BIS(2009), Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2007 – 

Statistical Annex Tables. http://www.bis.org/publ/rpfxf07a.pdf. See p.127 and 129. 

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Figure  2:  OTC  derivative  market  segments  notional  amounts  outstanding  (left)  and 
gross market values (right); $ trillion (% of total), December 2009 

Equity-linked
Equity-linked
6.6 (1.1%)
6.6 (1.1%)

Commodity
Commodity
2.9 (0.5%)
2.9 (0.5%)

Equity-linked
Equity-linked
0.7 (3.3%)
0.7 (3.3%)

Commodity
Commodity
0.5 (2.5%)
0.5 (2.5%)

Credit default swaps
Credit default swaps
32.7 (5.3%)
32.7 (5.3%)

Unallocated
Unallocated
73.5 (12.0%)
73.5 (12.0%)

Foreign exchange
Foreign exchange
49.2 (8.0%)
49.2 (8.0%)

Interest rate
Interest rate
14.0 (64.9%) 
14.0 (64.9%) 

Credit default swaps
Credit default swaps
1.8 (8.3%)
1.8 (8.3%)

Unallocated
Unallocated
2.4 (11.3%)
2.4 (11.3%)

Foreign exchange
Foreign exchange
2.1 (9.6%)
2.1 (9.6%)

Interest rate
Interest rate
449.8 (73.2%) 
449.8 (73.2%) 

Source: BIS 

3.1.2.  The role of derivatives in the financial crisis 

Many  views  have  been  put  forward  as  to  the  role  played  by  derivatives,  and  in 
particular OTC  derivatives, in  the financial crisis. As the  Commission stated in the 
two  aforementioned  Communications  on  derivatives  markets,  derivatives  were  not 
the  cause  of  the  crisis.  However,  the  Commission  is  also  of  the  view  that  OTC 
derivatives, in particular certain types of CDS, played an important role in the crisis. 
The  crisis  clearly  demonstrated  how  the  improper  use  of  derivatives41  can  risk 
turning  them  into  “financial  weapons  of  mass  destruction”,  as  Warren  Buffet  has 
dubbed  them.42  Indeed,  the  crisis  has  shown  that  -  in  certain  situations  -  the 
combined  effect  of  the  very  characteristics  that  make  derivatives  (in  particular 
leverage)  and  the  OTC  derivatives  market  (high  level  of  customisation,  lack  of 
transparency,  high  market  concentration,  high  interconnection  of  large  market 
participants, and lack of regulation) so attractive can have devastating consequences 
for the financial system. The example of AIG is highly illustrative in this respect (see 
Box in section 3.1.4. for details). 

While not causing the crisis, the OTC derivatives market contributed to the spreading 
of the crisis beyond its point of origin (the US sub-prime mortgages43 market) and to 
magnifying  it  into  a  full-blown  global  financial  crisis  that  almost  brought  the 
financial system, and with it the global economy, to its knees. The channel through 
which  the  initial  shock  from  the  sub-prime  market  spread  to  the  OTC  derivatives 
market was provided by CDS contracts (in particular those that were used to insure 
their buyers from losses in the sub-prime market). Once the shock reached the OTC 
derivatives market it rapidly spread throughout the system using the complex web of 
interconnections  that  characterise  this  market.44  The  high  level  of  concentration  in 
the market did the rest.45 

41  
42  

For example, the excessive accumulation of leverage through the use of derivatives. 
See  Berkshire  Hathaway 
for 
http://www.berkshirehathaway.com/letters/2002pdf.pdf. 

shareholder 

letter 

financial  year  2002,  p.15.  Available  at 

43   A sub-prime mortgage is a type of mortgage that is normally made out to borrowers with a lower credit 
capability, i.e. borrowers considered as having a larger-than-average risk of defaulting on the loan. Due to 
the  higher  risk  involved,  the  interest  rate  on  subprime  mortgages  is  higher  than  that  of  a  conventional 
mortgage. 

44   Moody's has claimed that trade replacements have proven to be a strong indirect contagion channel in the 
crisis (no estimates of the costs were provided). Several market participants that had Lehman Brothers as a 
counterpart  incurred  significant  losses  in  novating  their  trades  (see  section  7.1.1.  for  an  explanation  on 

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3.1.3.  Problem 1: Lack of transparency on OTC derivatives positions and exposures 

3.1.3.1.  Background 

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. 

In  addressing  the  issue  of  availability  of  information,  it  is  important  to  make  a 
distinction between information available to regulators, to market participants and to 
the  general  public.  The  law  usually  gives  regulators  the  right  to  request  from  the 
entities  they  regulate  any  kind  of  information  (including  exposures  to  single 
counterparties  and  positions  in  particular  types  of  contracts)  they  need  to  carry  out 
their responsibilities, while giving, at the same time, regulated entities the obligation 
to provide this information. 

Information available to the public is usually much more limited (to aggregate data 
because individual information is extremely sensitive). However, this does not mean 
that there is no publicly  available information on OTC  derivatives  at all. There are 
actually a number of sources that publish aggregate information, with different levels 
of geographical and product coverage and different levels of detail.46 

Market participants are somewhere in between the regulators and the public as on top 
of the publicly  available information they also know their positions with respect to 
the other market participants. 

3.1.3.2.  The issues 

While regulators can obtain detailed information about the individual positions of the 
entities  they  regulate,  they  lack  a  full  and  clear  picture  of  the  market  as  a  whole. 
There are two aspects to this issue. First, regulators literally do not know the exact 
size  of  any  of  the  segments  of  the  OTC  derivatives  market  as  none  of  the  sources 
mentioned  earlier  provides  a  comprehensive  picture  of  the  various  segments  of  the 
OTC derivatives market. The only one that comes close to full coverage of a market 
segment  is  the  Warehouse  Trust,  which  contains  information  on  almost  all 
outstanding  CDS  contracts.47  Regulators  could  not  gain  a  full  picture  by  piecing 
together  the  data  from  the  various  sources  either,  as  the  data  published  by  those 
sources are not comparable.48 

novation) from Lehman to other market participants in the days preceding and following Lehman's default 
failure. See A. Yavorsky, "Credit Default Swaps: Market, Systemic and Individual Firm Risks in Practice", 
Moody's, October 2008. 

45   Bear Sterns is a good example of how lethal the combination of high market concentration and high level 
of  interconnectedness  can  be.  Its  bail-out  was  deemed  necessary  because  US  authorities  feared  the 
contagion  that  would  result  from  its  failure.  In  other  words,  Bear  Sterns  was  deemed  to  be  "too-
interconnected-to-fail". 
See http://www.isda.org/statistics/otc.htm for a (non-exhaustive) list of available sources. 

46  
47   According  to  the  information  provided  by  the  Warehouse  Trust,  the  percentage  of  all  outstanding  CDS 

48  

contracts registered in its trade repository is in the "high 90s". 
Even  surveys  with  similar  market  coverage  lead  to  different  results  due  to  different  samples  and 
methodologies used. 

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Second, the regulators usually do not know the detailed breakdown of the positions 
of the counterparties of the entities they regulate. Since the OTC derivatives market 
is global, a regulator would inevitably need to seek at least part of this information 
outside of its jurisdiction, usually with a third-country regulator. The actual amount 
of information and the timeliness with which the regulator would be able to obtain it 
would, in such case, depend on a series of factors, among which the existence of an 
enforceable  information  sharing  agreement  with  the  third-country  regulator  and  the 
type  of  information  usually  collected  by  the  latter  regulator.  Alternatively,  the 
regulators might find this information in a trade repository, provided that one exists. 
However, this solution may not be without its problems as well. Due to data privacy 
issues, for example, the trade repository may not be able to provide the data to the 
regulators, or it may not maintain all the information that regulators may need(in the 
case  of  the  one  existing  trade  repository  at  the  time  of  the  crisis,  the  Trade 
Warehouse, the second problem was partially present).49 

The  problem  of  market  participants  is  almost  identical  to  the  one  of  regulators.  As 
stated earlier, a market participant in principle always knows its own exposure to its 
counterparties. What it does not know, however, is what the exposure of any of its 
counterparties  is  to  other  market  participants  including,  most  importantly,  its  other 
counterparties.  In  other  words,  a  market  participant  knows  the  direct,  but  not  the 
indirect exposure that is created when it enters into an OTC derivative contract. 

3.1.3.3.  The practical consequences 

The lack of transparency on positions has two practical implications for regulators. 
First, it does not allow regulators to understand how big, compared to the market as a 
whole,  the  risks  building  up  on  the  balance  sheets  of  the  entities  it  regulates  are. 
Second, it does not allow them to gain a clear picture of the interconnectedness of the 
positions  of  those  entities.  This  can  prevent  regulators  from  a  timely  detection  of 
risks building up both at individual institutions and in the system as a whole. It can 
also  prevent  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  occur  (as  it  happened  in  Lehman's  case).  In  short,  it  prevents  them 
from doing their job properly. 

The  practical  implications  for  market  participants  are  also  two.  First,  as  the 
counterparties to an OTC derivative contract know only the direct exposures to one 
another, the collateral set aside to secure the exposure is by definition inadequate as 
it is calculated using incomplete information. Second, as the financial crisis clearly 
demonstrated,  in  distressed  market  conditions the lack  of transparency on  positions 
can generate mistrust among market participants and lead to a drying up of liquidity 
in the market. 

49   According  to  information  provided  by  the  dealers,  a  number  of  contracts  they  reported  to  the  Trade 

Warehouse lacked the information on the counterparty because of confidentiality clauses. 

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3.1.4.  Problem 2: Insufficient mitigation of counterparty credit risk 

3.1.4.1.  Background 

Derivative contracts bind counterparties together for the duration of the contract. The 
duration varies depending on product type and market segment, ranging from a few 
days  to  several  decades.  Throughout  the  lifetime  of  a  contract,  counterparties  build 
up claims against each other, as the rights and obligations contained in the contract 
evolve as a function of its underlying. 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 this risk is managed over time. It can be carried out 
centrally (i.e. through a CCP) or bilaterally. Although both types of clearing are used 
in the OTC derivatives space, bilateral clearing is the most used form of the two. 

The  provision  of  collateral  on  the  basis  of  a  bilateral  collateral  agreement50  is  the 
most  frequently  used  method  to  mitigate  counterparty  credit  risk  in  the  OTC 
derivatives  space.  According  to  the  results  of  the  2010  ISDA  Margin  Survey,51  in 
2009,  almost  172000  collateral  agreements52  were  in  place,  covering  70%  of  OTC 
derivatives  trades.  The  survey  further  estimates  that  approximately  $3.2  trillion  of 
collateral was used in connection with OTC derivatives transactions, covering 69% 
of credit exposure.53 Finally, the survey reports that the dominant form of collateral 
was  cash  (82%  of  collateral  received  and  82%  of  collateral  delivered),  with 
government securities a distant second (10% and 14% respectively). As can be seen 
from  Figures  3a  and  3b,  all  the  above  items  have  recorded  significant  growth  over 
the last few years. 

50   A bilateral collateral agreement is an agreement that defines the terms  or rules under which collateral is 
posted  or  transferred  between  counterparties  to  an  OTC  derivative  contract.  These  terms  can  include 
thresholds, minimum transfer amounts, eligible types of collateral, haircuts applicable to eligible non-cash 
collateral and rules for the settlement of disputes arising over valuation of derivative positions. For more 
details on the structure of collateral agreements see, for example, OTC Derivatives: Settlement Procedures 
and Counterparty Risk Management, BIS, September 1998. 

51   Available at http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2010.pdf. 
52  

The  majority  of  them  (92%)  were  ISDA  credit  support  agreements,  known  as  Credit  Support  Annexes 
(CSAs).  Non-ISDA  documents  include,  among  others,  bespoke  margin  agreements  and  jurisdiction-
specific agreements such as French AFB and German Rahmenvertrag. 

53   As stated in the Commission Staff Working Paper, the Commission could not judge the solidity of the data 
provided  in  the  survey,  as  no  information  was  available  about  the  methodology  that  had  been  used  for 
calculating  the  numbers.  A  recent  ECB  study  ("Credit  Default  Swaps  and  Counterparty  Risk",  August 
2009; see p. 48-50) lists several reasons why the actual level of collateralisation of exposures is probably 
lower than what reported in the 2009 survey and estimates the level of collateralisation in the CDS market 
at 44%. 

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Figure 3a: Number of outstanding bilateral collateral agreements (left) and amount of 
collateral used in connection with bilaterally cleared OTC derivatives transactions (in 
$ trillion) (right) 

Source:ISDA 

Figure  3b:  Percentage  of  OTC  derivatives  trades  covered  by  a  bilateral  collateral 
agreement (left) and percentage of credit exposure covered by collateral (right) 

Note: The 2010 ISDA Margin Survey does not provide a breakdown per asset class of the percentage 
of credit exposure covered by collateral. Furthermore, due to changes in the methodology, the overall 
number for 2009 is not directly comparable with the one reported for 2008. 

Source: ISDA 

3.1.4.2.  The issues 

Overall,  collateral  is  only  an  effective  insurance  against  credit  exposure  if  (i) 
exposure is calculated frequently and accurately; (ii) it is effectively exchanged in a 
timely  manner;  (iii)  it  offers  a  comprehensive  coverage  against  overall  potential 
counterparty  credit  exposure;  and  iv)  it  is  legally  enforceable  in  the  event  of  the 
counterparty's  default.  Bilateral  clearing  is  associated  with  a  number  of  potential 
weaknesses in at least three of these aspects. 

First, while daily valuation and (close-to-daily) exchange of collateral is the norm for 
the major dealers, the frequency falls substantially as one moves down to second and 

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third tier institutions. Weekly and even monthly valuation and exchange of collateral 
continues to be an existing market practice.54 

Second,  bilateral  clearing  fundamentally  relies  on  each  party's  own  assessments  of 
the  current  value  of  and  the  risk  associated  with  a  particular  OTC  derivative  or  a 
portfolio  of  such  derivatives.  The  assessment  depends  on  the  quality  of  the  risk 
model used (the crisis has revealed that risk models used by banks were less robust 
than previously thought), on the information that is fed into the model (which, as it is 
argued in the previous section, is incomplete) and on competing considerations, such 
as the quest to maximise commercial opportunities and associated profits. 

Last, but certainly not least, the majority of bilateral collateral arrangements provide 
only for the exchange of variation margin (covering fluctuations in the value of the 
contract),  but  not  of  initial  margin  (covering  the  potential  cost  of  replacing  the 
contract  in  case  the  original  counterparty  defaults).55  Furthermore,  the  level  of 
collateral  required  often  depends  on  the  credit  quality  of  the  counterparty.56 
Typically,  for  an  equivalent  level  of  exposure,  a  counterparty  with  a  high  credit 
rating will be asked to post less collateral than one with a lower credit rating. In cases 
where  one  of  the  two  counterparties  is  a  non-financial  institution  or  a  government-
related  institution  (e.g.  the  debt  management office), the norm appears  to be  not to 
ask  the  latter  to  post  any  collateral.  Figure  4  below  provides  an  overview  of  the 
counterparties of collateralised transactions by type of respondent to the 2010 ISDA 
Margin Survey. 

Figure 4: Counterparties in collateralised transactions (% of total) 

Large dealers 

Medium-sized firms 

Small firms 

54   According to the 2010 ISDA Margin Survey, only 29% of the respondents to the Survey reconcile their 
trades daily, whereas 47% of the trades are still reconciled on an ad-hoc basis or in response to disputes. 
The results are better for large dealers, who perform daily reconciliation on 56% of their trades. 

55   As  stated  earlier,  the  posting  of  initial  margin  is  required  in  the  prime  brokerage  business.  This  is 
presumably  due  to  the  fact  that  a  prime  broker  has  a  similar  role  to  a  CCP.  Much  like  a  CCP,  a  prime 
broker  concentrates  risk  and  responsibilities  for  risk  management.  Indeed,  when  a  prime  broker 
intermediates a trade between a hedge fund and a dealer, it becomes a counterparty to two trades, one with 
the hedge fund and one with the dealer. The lack of posting of initial margin in a peer relationship (e.g. 
between  two  dealers)  is  due  to  the  fact  both  parties  would  have  to  post  the  same  amounts  (as  both  are 
exposed to replacement risk) which would effectively net themselves out.  

56   According to the 2010 ISDA Margin Survey, 86% of all respondents said that sometimes they set collateral 
thresholds  based  on  credit  ratings,  while  only  12%  said  that  they  use  CDS  spreads.  The  corresponding 
shares for large dealers are 100% and 27% respectively. 

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Note:  The  category  'Other'  includes  transactions  with  CCPs,  energy  and  commodity  trading  firms, 
sovereigns  and  supranationals,  and  other  counterparties.  In  general,  each  of  these  categories  of 
counterparties represents at most 1% of the total transactions.  

Source: ISDA 

Concerning  the  legal  enforceability  of  bilateral  collateral  arrangements  in  the  EU, 
this aspect is covered by the Financial Collateral Arrangements Directive.57 

3.1.4.3.  The consequences 

There are several consequences arising from the issues listed above. First, and most 
important, the amount of collateral is, on average, too low compared to the level of 
counterparty  credit  risk  associated  with  OTC  derivatives  exposures.  Based  on  the 
ISDA  survey,  approximately  $1.4  trillion  of  exposures  in  OTC  derivatives  remain 
uncollateralised. In other words, the amount of leverage in the market is higher than 
should be the case given the amounts of collateral. 

Second,  infrequent  valuation  of  exposures  and  exchange  of  collateral  may  lead  to 
large  margin  calls  in  case  of  abrupt  price  movements  between  calculation  dates, 
which may in turn result in high costs for the party receiving the margin call (as it 
may not have the liquidity to meet the call and may need to borrow it) or may even 
lead to its default (if it cannot obtain the necessary resources to meet the call). The 
same reasoning can be applied to situations where the amount of collateral that needs 
to  be  posted  depends  on  the  credit  quality  of  the  counterparty.  AIG's  example 
provides a clear illustration of that. 

Third, the differences in the risk models used leads to situations where disputes may 
and frequently do arise58 between counterparties as regards the mark-to-market value 
associated  with  a  particular  contract  and  the  corresponding  collateral  obligation  it 
gives rise to.59 This leads to unwelcome delays to the collateralisation process. 

3.1.5.  Problem 3: Insufficient mitigation of operational risk 

3.1.5.1.  Background 

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 (see Figure 5). 

2002/47/EC. 

57  
58   No  statistics  on  the  frequency  of  collateral  disputes  could  be  found.  However,  the  fact  that  collateral 

59  

disputes are frequent was confirmed by a number of market participants. 
In other words, a collateral dispute is most likely to arise due to a dispute over the valuation of an OTC 
derivative.  This  may,  for  example,  be  the  result  of  different  valuation  models  used  by  the  two 
counterparties to the OTC derivative contract. Collateral disputes due to differing views on the value of the 
collateral asset pledged are far less common. 

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Figure 5: An OTC derivatives transaction from trade to confirmation 

Source: BIS. 

The story does not end with the confirmation of a transaction. During the lifetime of 
an  OTC  derivative  contract  several  one-off  (e.g.  the  termination  of  a  contract)  or 
recurring  events  (e.g.  collateral  management  and  settlement  of  cash  payments), 
stemming  from  the  rights  and  obligations  of  the  contract,  need  to  be  managed  (see 
Figure 6). 

Figure 6: Lifecycle elements of an OTC derivatives transaction 

Source: BIS. 

The  processes  that  have  been  developed  to  manage  these  events  tend  to  be  quite 
complex  and  in  many  cases  they  are  highly  interconnected,  i.e.  the  output  of  one 
process is used as an input for another.60 Ideally, in order to avoid that delays in one 
process have a knock-on effect on other processes, a high level of automation would 
be  desirable.  This  does  not  apply  only  to  the  internal  processes  of  individual 
counterparties; it is equally valid for the interaction between counterparties.61 

60  

61  

For  example,  the  collateral  management  process  tells  a  party  to  a  contract  the  amount  of  collateral  that 
needs to be posted to its counterparty at a particular point in time. This information is then used as an input 
into the process used to settle the cash payment involved. 
The overall speed of the bilateral processes will be determined by the slower of the two counterparties to a 
contractual relation. 

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The  level  of  automation  is,  in  general,  directly  proportional  to  the  level  of 
standardisation  of  a  contract:  the  higher  the  level  of  standardisation,  the  more 
automated  processes  can  be  used,  and  vice  versa.62    The  same  logic  applies  to  the 
adoption  of  centralised  infrastructure,  such  as  CCPs  and  trade  repositories:  their 
adoption  requires  relatively  high  levels  of  standardisation  (especially  in  the  case  of 
CCPs). 

The  responses  to  the  first  public  consultation  highlighted  that  one  can  distinguish 
between three different types of standardisation, namely: 

(a) 

(b) 

(c) 

contract  standardisation  (standard  legal  relationships,  confirmation 
agreements, documentation, market conventions on event handling); 

product  standardisation  (standard  valuations,  payment  structures, 
dates); and 

process standardisation (straight-through processing (STP), matching, 
confirmation and settlement). 

As  clearly  stated  in  its  October  2009  Communication  the  Commission  decided  to 
focus  its  attention  on  the  first  and  third  type  of  standardisation,  i.e.  contract  and 
process standardisation. The main reason behind this focus lies in the fact that high 
levels of contract and process standardisation are compatible both with the ability of 
market  participants  to  hedge  specific  risks  and  the  possibility  to  adopt  centralised 
solutions  (trade  repositories  and  CCPs).  Conversely,  high  levels  of  product 
standardisation, while compatible with the adoption of centralised solutions, are not 
necessarily compatible with the hedging requirements of market participants.63 

3.1.5.2.  The issues 

The  OTC  derivatives  market  allows  for  a  high  degree  of  flexibility  in  defining  the 
economic  and  legal  terms  of  derivatives  contracts.  As  a  consequence,  there  are  a 
number  of  highly  bespoke  and  complex  contracts  in  the  market  that  still  require 
significant  manual  intervention  in  many  stages  of  the  processing.  Manual 
intervention becomes particularly problematic once the transaction volumes of a type 
of  contract  start  to  increase  rapidly.  Indeed,  in  the  past,  the  rapid  expansion  of 
volumes in the OTC derivatives market has invariably led to significant processing 
backlogs  of  unconfirmed  trades,  as  the  development  of  post-trading  processes  was 
not  rapid  enough  to  cope  with  the  rising  volumes  and  increasing  complexity  of 
derivatives trades. In spite of the progress made to reduce these backlogs in the past 
few  years,  especially  in  the  area  of  credit  derivatives,  the  problem  has  temporarily 
resurfaced during the crisis. This demonstrated that more needs to be done to foster 
standardisation. 

62  

63  

Standardisation is a sufficient, but not a necessary condition for automation. Indeed, even the processing of 
non-standard contracts can be automated to a certain extent. 
This  does  not  mean  that  product  uniformity  will  not  increase.  The  CDS  market  is  a  clear  example  of  a 
market where all three types of standardisation took place in response to the drive to adopt CCP clearing. 

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An  additional  issue  that  concerns  standardisation  (or  lack  thereof)  is  its  impact  on 
liquidity. In general, the more bespoke the product, the less liquid it is (and hence the 
more difficult it is to sell or replace it, even more so in distressed market conditions). 

3.1.5.3.  The consequences 

Low levels of standardisation of contracts and low automation of processes increases 
operational  risk,  i.e.  the  risk  of  loss  resulting  from  inadequate  or  failed  internal 
processes, people and systems.64 This may in turn lead to increased legal risk, may 
limit transparency and may even lead to an increase of counterparty credit risk. For 
example,  the  failure  to  confirm  a  transaction  because  of  lack  of  automation  may 
jeopardise  its  enforceability  or  the  ability  to  net  it  against  other  transactions. 
Furthermore,  to  the  extent  that  it  allows  errors  in  recording  transactions  to  go 
undetected,  an  unconfirmed  transaction  may  cause  market  or  counterparty  credit 
risks  to  be  incorrectly  measured  and,  most  seriously,  to  be  underestimated.  As 
indicated  earlier,  low  levels  of  standardisation  also  limit  the  level  of  adoption  of 
centralised market solutions (i.e. trade repositories and CCPs). 

3.1.6.  The problem tree 

Figure 7 below provides an overview of the various problems, their drivers and their 
consequences. 

Figure 7: The problem tree 

64  

The  full  definition  by  the  Basel  Committee  on  Banking  Supervision  is  "the  risk  of  loss  resulting  from 
inadequate or failed internal processes, people and systems or from external events". 

EN 

22 

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3.1.7.  The combined effect of problems 1, 2 and 365 

Each  problem  described  in  this  section  can  have  negative  consequences  for  the 
proper functioning of the financial system. However, it is their combined effect that 
can  lead  to  truly  devastating  results.  The  case  of  AIG  is  extremely  telling  in  this 
sense. 

Box 1: American International Group (AIG) 

Derivatives are tools that allow for the trading and redistribution of risk. Due to this 
characteristic, derivatives have often been hailed as a tool that leads to a better (i.e. 
more  even)  distribution  of  risk  throughout  the  economy.  The  financial  crisis 
demonstrated that the opposite can also be true: derivatives can lead to an excessive 
concentration of risk in the hands of a handful of market players. One such player 
was AIG, a US insurance company.  

Through  one  of  its  subsidiaries  (AIG  Financial  Products),66  AIG  managed  to 
accumulate  a  large  exposure67  to  the  US  sub-prime  mortgages  market  by  selling 
highly  customised  CDS,  mainly  to  big  financial  institutions.  In  essence  AIG  sold 
these banks insurance against losses on these securities. Since AIG had the highest 
possible  credit  rating  (AAA),  it  managed  to  negotiate  favourable  collateralisation 
terms (basically, as long as it maintained its AAA rating, it did not have to put up 
any  collateral  to  back  the  CDS  trades).68  Collateral  makes  a  transaction  more 
expensive, so by not having to post it AIG was able to enter into a higher number of 
contracts than would have been possible if collateralisation were required.69 

AIG's  accumulation  of  large  positions  was  facilitated  by  the  lack  of  transparency, 
both towards the market and towards regulators.70 Due to the bilateral nature of the 
contracts none of AIG’s counterparties knew its overall exposure to the sub-prime 

65  

66  

Problem 3 played a less prominent role compared to the other two. The lack of standardisation was mainly 
involved in the context of the lack of transparency on AIG's position. Indeed, the CDS sold by AIG were 
not registered in the trade repository as they were too bespoke. 
The company had a UK banking license. There was also another AIG entity with a French banking license, 
Banque AIG, which made similar deals to the ones of AIGFP, but on a smaller scale. 

67   As Fitch Ratings reported in the fifth annual update of its Global Credit Derivatives Survey (published in 
2007),  AIG  was  ranked  "only"  as  the  20th  largest  counterpart  by  notional  amount,  with  a  gross  sold 
position of $482 billion. However, the problem was that unlike dealers, who tend to run a balanced book, 
AIG was a net seller of protection, with its net sold position being only slightly lower than the gross one 
($384 billion). 
This arrangement exacerbated the pro-cyclicality of the collateral agreement. 
Since capital and collateral are complementary types of protection against losses (the former is supposed to 
cover  "foreseeable"  losses,  while  the  latter  is  supposed  to  cover  "unexpected"  or  "residual"  losses),  this 
situation  may  give  rise  to  questions  regarding  the  proper  capitalisation  of  AIGFP's  business.  However, 
such analysis is outside of the scope of this report. 
70  
The CDS were so highly customised that they were not captured by the trade repository run by the DTCC. 
71   On  15  September  2008,  all  three  main  credit  rating  agencies  (Standard  and  Poor's,  Fitch  Ratings  and 

68  
69  

Moody's) all downgraded AIG's long-term debt rating. 

72   According to a disclosure made by AIG on 15 March 2009, banks received a little more than $45 billion in 
.  The  documents  are  available  at 
and 

payments  related  to  CDS  contracts  underwritten  by  AIG. 
http://www.aig.com/aigweb/internet/en/files/Counterparties150309RELonly_tcm385-155648.pdf 
http://www.aig.com/aigweb/internet/en/files/CounterpartyAttachments031809_tcm385-155645.pdf. 
73   Overall, the value of the package put together by the US government to rescue AIG amounted to $182.5 

billion. http://www.gao.gov/new.items/d09490t.pdf. See p.4. 

EN 

23 

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mortgage  market  and  therefore  could  not  price  the  risk  of  the  contracts  correctly. 
The  lack  of  transparency  coupled  with  a  deficient  cross-border  regime  for  the 
supervision  of  complex  and  large  financial  institutions  prevented  regulators  from 
detecting the build-up of the risk on AIG’s balance sheet (and consequently on the 
balance  sheets of  its counterparties) and hence of the possibility of preventing the 
situation that led to AIG’s unravelling. 

The  severe  deterioration  of  the  sub-prime  mortgage  market  led  to  losses  in 
securities that were backed by pools of sub-prime mortgages. As AIG was the one 
that  “insured”  those  losses,  it  was  called  to  compensate  the  buyers  of  the 
“insurance”.  This  caused  losses  at  AIG  and  prompted  credit  rating  agencies  to 
downgrade  the  company.71  The  downgrade  proved  to  be  the  proverbial  straw  that 
broke AIG’s back. It triggered the special clause in AIG's collateral agreement that 
specified that collateral would be asked if the company would be downgraded. This 
prompted what turned out to be a massive call for collateral that AIG was not able 
to meet and was therefore pushed to the brink of bankruptcy.  The  fact that  AIG’s 
bankruptcy would probably have led to significant losses at big banks,72 prompted 
the US government to intervene and rescue AIG.73  

3.2. 

Economic magnitude of the problem 

While,  as  explained  in  the  introduction,  OTC  derivatives  did  not  cause  the  crisis, 
they played a part in its unfolding. Their exact contribution to the costs of the crisis 
would be difficult to estimate as this would require the knowledge about the share of 
damage to the financial system that could be directly attributed to OTC derivatives.  
Annex 8 attempts to provide a very rough estimate of these costs. By first attempting 
to estimate the overall costs of the crisis (which are defined as the sum of the direct 
costs of intervention in the banking sector and the costs in terms of lost output) the 
analysis concludes that the share of OTC derivatives in total costs is at least several 
billions of euro. 

3.3. 

How would the problems evolve without EU action? 

There  are  currently  several  non-legislative  initiatives,  both  at  European  and 
international  level,  that  aim  at  resolving  the  problems  described  in  section  3.1.  A 
number  of  these  initiatives  have  been  launched  due  to  the  financial  crisis;  some  of 
them  pre-date  it.  The  most  overarching  of  these  initiatives  is  the  one  involving  the 
Operations Steering Committee (OSC),74 a consortium that includes 14 major dealers 
(the  so-called  G14)75  in  the  OTC  derivatives  market,  a  number  of  buy-side 
institutions  and  industry  associations.  The  OSC  has  committed,  through  a  series  of 
letters to regulators, to deliver structural improvements to the global OTC derivatives 
market.76  The  latest  of  these  letters,  dating  from  1  March  2010,  reaffirms  and 
strengthens existing commitments and deadlines and introduces some new ones. The 
commitments  cover  five  main  areas:  i)  developing  and  using  trade  repositories  in 

Previously known as the Operations Management Group (OMG). 

74  
75   Bank  of  America-Merrill  Lynch,  Barclays  Capital,  BNP  Paribas,  Citi,  Credit  Suisse,  Deutsche  Bank, 
Goldman Sachs & Co., HSBC Group, J.P. Morgan, Morgan Stanley, The Royal Bank of Scotland Group, 
Société Générale, UBS and Wachovia Bank. 
The letters containing the detailed commitments can be found at  
http://www.newyorkfed.org/newsevents/otc_derivative.html. 

76  

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24 

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order to increase transparency; ii) increasing the use of CCPs; iii) increasing the level 
of  product,  processing  and  legal  standardisation  in  each  asset  class  with  a  goal  of 
securing operational efficiency and mitigating operational risk; iv) enhance bilateral 
collateralisation  arrangements  to  ensure  robust  risk  management;  and  v)  improving 
operational performance, e.g. via straight-through-processing (STP).77 

The  various  commitments  of  the  OSC,  together  with  other  initiatives  running  in 
parallel,  are  described  in  more  detail  in  the  next  three  subsections.  The  combined 
outcomes of these various initiatives can serve as a baseline scenario against which 
any future EU action can be compared. 

In  terms  of  legislative  initiatives  specifically  targeting  OTC  derivatives,  the 
Commission services are not aware of any such initiatives currently conducted at the 
level of individual Member States. There are, however, legislative initiatives taking 
place in jurisdictions other than the EU, most notably in the United States. These are 
described a bit more in detail in section 3.3.4. 

3.3.1.  Current initiatives in the area of problem 1 

The  existing  initiatives  aimed  at  increasing  the  transparency  on  positions  in  OTC 
derivatives have focused primarily on the use of trade repositories. 

The only trade repository that existed at the moment when the financial crisis started, 
i.e.  the  Trade  Information  Warehouse  (TIW),78  proved  to  be  a  very  useful  tool  for 
increasing transparency.79 Indeed, after Lehman's default it contributed to reduce the 
uncertainty in the CDS market regarding the net exposure of market participants due 
to  CDS  written  on  Lehman,  albeit  with  a  delay.80  In  its  June  2009  letter,  the  OSC 
members committed to reporting all their CDS trades to the TIW by mid-July 2009, a 
task that, according to the Group, has been completed. Given the high concentration 
of  the  market,  this  means  that  the  TIW  now  covers  almost  all  outstanding  CDS 
contracts.81 

Following the positive experience with CDS, the OSC committed itself to creating at 
least  two  additional  trade  repositories,  one  for  interest  rate  derivatives  and  one  for 
equity derivatives, and to reporting all their trades to them. TriOptima was selected 
as the provider of the former, while DTCC/Markitserv was chosen to run the latter.82  

77  

78  
79  

The  automated  end-to-end  processing  of  trades  including,  where  relevant,  the  automated  completion  of 
confirmation,  matching,  generation,  and  clearing  and  settlement  of  orders.  STP  enables  the  entire  trade 
process to be conducted electronically, without the need for rekeying or reformatting data. 
The trade repository was later renamed into Warehouse Trust. 
Interestingly,  the  TIW  was  initially  created  with  a  different  objective  in  mind.  That  is,  to  aid  the  credit 
derivatives industry in reducing the confirmation backlogs plaguing the CDS market. 

80   Before the TIW divulged the information the market new only about the gross exposure, which amounted 
to $400 billion. It turned out that the net exposure, and hence the amount of money that actually changed 
hands  was  a  far  more  manageable  $5.2  billion.  However,  the  information  on  the  costs  that  Lehman's 
counterparties had to incur in order to replace the contracts they entered into with Lehman was never made 
public.  

81   No  official  estimate  is  available.  However  the  consensus  appears  to  be  that  the  percentage  of  market 

coverage is in the "high 90s". 
The selection of the two providers was announced on 16 September and 22 October 2009, respectively. 

82  

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25 

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TriOptima  launched  its  Interest  Rate  Trade  Reporting  Repository  on  20  January 
2010,83  while  DTCC/Markitserv 
its  Equity  Derivatives  Reporting 
launched 
Repository at the beginning of August 2010.84 In addition to the OSC commitment, 
CLS  Bank  has  announced  that  it  is  studying  the  possibility  of  creating  a  trade 
repository  for  foreign  exchange  derivatives.85  There  is  currently  no  information  on 
whether a trade repository for commodity derivatives will be created. 

On  the  public  sector  side,  the  OTC  Derivatives  Regulators'  Forum,  a  group 
comprised of international financial regulators,86 was created in September 2009 to, 
among  other  things,  coordinate  and  articulate  information  needs  of  the  regulatory 
community.  This  includes  considering and developing  common reporting  templates 
and formats, articulating specific expectations, and considering mechanisms for data 
reporting.  

These initiatives should result in a significantly improvement in the transparency of 
the  OTC  derivatives  market,  as  information  on  large  portions  of  the  outstanding 
contracts would be stored in a trade repository. The exact market coverage that will 
be  achieved  through  these  initiatives  depends  on  the  combined  market  share  of  the 
OSC members, which varies from one market segment to another (see Figure 12). 

3.3.2.  Current initiatives in the area of problem 2 

In terms of reducing counterparty credit risk, existing industry initiatives aim both at 
increasing the use of CCP clearing and at improving bilateral clearing processes. 

3.3.2.1.  CCP clearing 

On CCP clearing, significant progress has been achieved in terms of establishing and 
using  new  CCPs  that  clear  OTC  derivatives.  The  CDS  market  is  a  case  in  point. 
Since the beginning of the crisis, regulatory pressure to introduce CCP clearing in the 
market has resulted in the establishment of  several CCPs. Three of those CCPs are 
located in Europe (Eurex Clearing, ICE Clear Europe and LCH.Clearnet SA) and are 
the result of the Commission-led process described in the introduction of this report. 
While all three are actively clearing contracts, most of the volumes are concentrated 
in one of them (ICE Clear Europe).87 Figure 8 below shows the volumes that it has 
cleared since its launch and value of the open contracts it manages. 

Figure  8:  Evolution  of  cleared  volumes  and  open  position  for  European-referenced 
index (left) and single-name CDS (right) at ICE Clear Europe (€ billion) 

83   At  the  end  of  July  2010,  positions  with  a  gross  notional  value  of  $465  trillion  were  registered  in 
TriOptima’s trade repository. Correcting for the double-counting of CCP-cleared contracts, this means that 
approximately 70-75% of all contracts are registered in the trade repository. 
See http://www.dtcc.com/news/press/releases/2010/dtcc_launches_equity.php. 
See http://www.cls-group.com/Media/Pages/NewsArticle.aspx?id=46. 
See http://www.newyorkfed.org/newsevents/news/markets/2009/Appendix_1.pdf for a list of the members 
of the Forum. See also http://www.otcdrf.org/index.htm. 

84  
85  
86  

87   As of end of April, Eurex had an open interest of €95 million, while LCH.Clearnet SA had an open interest 

of a little over €177 million. 

EN 

26 

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Source: ICE Clear Europe 

Furthermore, the crisis has prompted market participants to reassess the advantages 
of using existing CCPs. For example, SwapClear, the main CCP clearing interest rate 
swaps, has registered an important increase in its business since the start of the crisis 
(see Figure 9 below).88 

Figure  9:  Evolution  of  cleared  volumes  ('000  trade  sides)  and  open  position  ($ 
trillion) for interest rate derivatives in SwapClear 

250
250

200
200

150
150

100
100

50
50

0
0

J F M AM J J A S O N D J F M AM J J A S O N D J FM AM J J A S ON D J F M A M J J A
J F M AM J J A S O N D J F M AM J J A S O N D J FM AM J J A S ON D J F M A M J J A

2007
2007

2008
2008

2009
2009

2010
2010

Volumes
Volumes

Outstanding notional
Outstanding notional

Source: SwapClear 

The  take  up  of  CCP  clearing  has  certainly  benefitted  from  the  commitments  put 
forward by the major dealers (i.e. members of the G14). The latter have set ambitious 
targets both in terms of proportion of eligible contracts that would need to be cleared 
and deadlines by which this would need to happen. For example, for CDS, they have 
(collectively)  committed  to  clear  85%  of  both  new  and  historical  eligible  trades  by 

88   According to TriOptima, about 47% of all the contracts registered in its trade repository are cleared by a 

CCP. 

EN 

27 

   EN 

 
 
 
                                                 
the  end  of  June  2010.89  They  have  also  committed  to  broaden  the  set  of  trades 
eligible for central clearing. 

3.3.2.2.  Bilateral clearing 

The  industry  has  also  made  several  commitments  with  respect  to  the  bilateral 
collateral management process. In particular, the industry has committed to develop a 
detailed  roadmap  containing  specific  implementation  steps  and  timeframes  for 
improving  collateral  management.  The  roadmap  was  published  in  200990  and 
updated  in  2010.91  One  of  the  items  of  the  roadmap  concerned  the  development  of 
best  practices  for  collateral  management.  These  were  published  by  ISDA  in  a 
document at the end of June 2010.92 

Another  set  of  commitments  contained  in  the  roadmap  concerns  portfolio 
reconciliation  and  the  ways  to  improve  this  practice.  Market  participants  use 
portfolio  reconciliation  to  facilitate  the  bilateral  collateral  management  process.93 
According to the latest ISDA Margin Survey, most of the respondents to the survey 
(90% compared to 80% in the previous year) use reconciliation services. However, it 
is mainly large dealers  that  tend  to reconcile a high percentage of their trades  on a 
daily  basis  (usually  inter-dealer  trades).  Furthermore,  a  large  proportion  of  trades 
(44%) is still reconciled on a quarterly basis at best (sometimes even only in case of 
disputes). The OSC has in essence committed to extending portfolio reconciliation as 
best practice throughout the OTC market.94 

Although  portfolio  reconciliation  ensures 
the 
composition of their collateralised portfolios, they may still disagree about the value 
of reconciled portfolios, particularly those containing complex OTC derivatives. This 
is why another group of commitments made by the OSC concerns collateral disputes. 
In  particular,  the  OSC  has  committed  to  developing  a  mechanism  to  resolve 
collateral disputes by the end of September 2009. The commitment was fulfilled.95 

that  counterparties  agree  on 

3.3.3.  Current initiatives in the area of problem 3 

The  industry  has  undertaken  considerable  work  to  increase  the  standardisation  and 
increase  the  operational  efficiency  in  the  OTC  derivatives  market.  Some  of  this  is 

89  

For  details  on  the  commitments  for  both  credit  and  interest  rate  derivatives  see  1  March  2010  letter. 
Available at http://www.newyorkfed.org/newsevents/news/markets/2010/100301_letter.pdf. 

90   Available at http://www.isda.org/c_and_a/pdf/ISDACollateralMgmtRoadmap.pdf. 
91   Available at http://www.isda.org/c_and_a/pdf/2010-ISDA-Roadmap-Collateral-Management.pdf. 
92   Available  at  http://www.isda.org/c_and_a/pdf/ISDA-Best-Practices-for-the-OTC-Derivatives-Collateral-

93  

94  

95  

Process.pdf. 
In essence, portfolio reconciliation is the process of arriving at a point where certain pre-identified items 
match between the books and records of two parties with respect to a portfolio of trades between them. Its 
importance for the collateral management process lies in the fact that without agreeing the population of 
trades  and  their  characteristics,  counterparties  cannot  go  on  to  discuss differences  in  the  mark-to-market 
values and the subsequent collateral obligation. Portfolio reconciliation can be done either through bilateral 
arrangements or through the use of third-party vendors that provide a centralised service (e.g. TriOptima). 
See  ISDA  (2010),  Feasibility  Study  Implementation  Plan:  Extending  Collateralized  Portfolio 
Reconciliations.  Document  available  at  http://www.isda.org/c_and_a/pdf/ISDA-Port-Rec-Feasibility-
Study-Implementation-Plan.pdf. 
See ISDA 2009 Dispute Resolution Procedure. Available at http://www.isda.org/c_and_a/pdf/ISDA-2009-
Dispute-Resolution-Procedure.pdf. 

EN 

28 

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related to the OSC commitments. These include targets on electronic affirmation and 
confirmation  (in  view  of  reducing  further  the  backlog  of  unconfirmed  trades), 
automation  of  processes  and  portfolio  compression.96  The  latter  has  seen  a 
substantial increase in its use since the onset of the crisis, especially in the CDS and 
interest rate swaps markets (see Figure 10 below). 

Figure  10:  Volumes  of  portfolio  compression  in  CDS  and  interest  rate  swaps  ($ 
trillion) 

45
45
40
40
35
35
30
30
25
25
20
20
15
15
10
10
5
5
0
0

2005
2005

2006
2006

2007
2007

2008
2008

2009
2009

2010
2010

Interest rate swaps
Interest rate swaps

CDS
CDS

Note: Data for 2010 refers to the situation at the end of August. 

Source: TriOptima 

Some  of  the  work  was  driven  by  the  regulatory  push  for  increased  use  of  CCP 
clearing, for example the launch of the "Big" and "Small Bang" Protocols97 for the 
credit derivatives, and the standardisation of coupons of single-name CDS. 

3.3.4.  Legislative initiatives outside the EU 

The OTC derivatives market is, by its very nature, a global market. As indicated in 
section 2, the G20 set out the basic objectives for action on this market and is now 
coordinating the global effort that is aimed at turning these objectives into concrete 
actions.  Several  initiatives  are  already  under  way.  Apart  from  the  initiatives  in  the 
EU and the  US,  which represent the biggest  share  of the market, several initiatives 
are  underway  also  in  Asia  (Hong  Kong,  Japan,98  Singapore  and  South  Korea).  The 
Commission’s policy proposals need therefore to be considered in this context. 

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Act”), the 
US legislation on financial regulatory reform which also contains measures targeting 
the  OTC  derivatives  market,  was  singed  into  law  by  President  Obama  on  21  July 

96  

97  

In OTC derivatives, participants build up gross positions that far exceed their net risk position as many of 
the  contracts  offset  one  another.  Portfolio  compression  (also  known  as  "tear-ups")  is  a  process  that 
identifies  these  offsetting  trades  and  eliminates  them,  leaving  the  market  risk  profile  of  the  market 
participants unchanged. 
The  protocols  can  be  found  at  http://www.isda.org/companies/auctionhardwiring/auctionhardwiring.html 
and http://www.isda.org/smallbang/ respectively. 

98   Recently, Japan's parliament approved legislation that requires some OTC derivatives trades to be cleared 

by a CCP. See http://www.reuters.com/article/idUSTOE64B07O20100512. 

EN 

29 

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2010.99  The  Act  broadly  covers  all  types  of  OTC  derivatives100  (it  splits  them  into 
two  categories:  swaps  and  security-based  swaps)101  and  all  types  of  market 
participants.102 Most of the obligations set in the Act fall on four categories of market 
participants: swap dealers, security-based swap dealers, major swap participants and 
major  security-based  swap  participants  (“dealers  and  major  participants”).103  The 
areas covered by the Dodd-Frank Act and the objectives it pursues are the same as 
the ones covered by the Commission proposal. Among other things, it: 

•  requires  that  details  on  all  OTC  derivative  contracts  be  reported  to  a  registered 
trade  repository  or,  in  case  a  contract  can  not  be  reported  to  a  repository,  to  the 
relevant authority; 

•  requires that all eligible OTC derivative contracts be cleared through a CCP (the 

Act foresees exemptions104 to this requirement); 

•  introduces  minimal  capital,  as  well  as  initial  and  variation  margin  requirements 
for  dealers  and  major  participants  on  all  OTC  derivative  contracts  that  are  not 
cleared by a CCP; 

•  updates the regulatory framework for CCPs; and 

•  sets up a regulatory framework for trade repositories. 

In  many  instances  the  Act  sets  out  the  main  principles  that  should  apply  to  OTC 
derivatives and to market participant active in the OTC derivatives market, leaving 
the definition of a number of detailed technical standards to the relevant supervisory 
authorities (CFTC, SEC or banking authorities). 

3.4. 

Treaty base and subsidiarity 

3.4.1.  Treaty base, competence 

The competence of the EU derives from Article 114 of the TFEU105 (ex Article 95 - 
harmonisation).  A  second  base  that  could  be  used  is  Article  53  of  the  TFEU  (ex 
Article 47(2) – professional services). The final selection of the Treaty base will be 
determined depending on the content of the draft proposal. 

99   Available  at  http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173 

enr.txt.pdf. 

100   OTC  derivative  contracts  where  one  of  the  counterparties  is  the  government,  one  of  its  agencies  or  the 
Federal  Reserve  Bank,  are  excluded from  the  scope of  the  Act. In  addition,  there  is  a possibility  for the 
Secretary of the Treasury to exempt foreign-exchange derivatives from the clearing requirement (but not 
the reporting requirement). 

101   The former fall under the remit of the CFTC, the latter under the remit of the SEC. 
102   The Act leaves open the possibility to exclude small banks, credit unions and savings associations from the 

103  

104  

definition of financial entity (see footnote 105) and hence from the clearing requirement. 
In principle, non-financial institutions could be captured by one of these categories. This is most likely to 
occur to non-financial institutions with large positions in OTC derivatives. 
If one of the counterparties to an OTC derivative contract is not a financial entity (this includes, among 
others dealers and major participants), uses the contract to hedge or mitigate commercial risk, and notifies 
the competent authority on how it generally meets its financial obligations associated with entering into the 
non-CCP cleared contract, then the contract is not subject to the clearing requirement. 

105   Treaty on the Functioning of the European Union. 

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3.4.2. 

Subsidiarity 

According  to  the  principle  of  subsidiarity  (Article  5.3  of  the  TFEU),  action  on  EU 
level should be taken only when the aims envisaged cannot be achieved sufficiently 
by  Member  States  alone  and  can  therefore,  by  reason  of  the  scale  or  effects  of  the 
proposed  action,  be  better  achieved  by  the  EU.  The  preceding  analysis  has  shown 
that –  

•  although  all  the  problems  defined  above  have  important  implications  for  each 
individual  Member  State,  their  overall  impact  can  only  be  fully  perceived  in  a 
cross-border  context.  This  is  because  the  OTC  derivatives  market  is,  by  its  very 
nature,  a  cross-border  market.  Consequently,  the  effectiveness  of  remedies 
implemented  in  an  autonomous  and  uncoordinated  way  by  individual  Member 
States would likely be very low as such remedies would be able to capture just a 
portion  of  the  market.  Furthermore,  given  the  systemic  impact  of  some  of  the 
problems, uncoordinated action may even prove counterproductive; 

•  certain aspects of the identified problems are partly covered by the existing acquis 
communautaire,  notably  the  Financial  Collateral  Arrangements  Directive,  the 
Settlement  Finality  Directive,  the  Market in  Financial  Instruments  Directive,  the 
Capital  Requirements  Directive  and  the  UCITS  Directives.  Any  new  proposal 
would need to tie in perfectly with these  pre-existing EU  measures. This can be 
best achieved in a common effort. 

Against this background EU action appears appropriate in terms of the principle of 
subsidiarity. 

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4. 

THE OBJECTIVES 

4.1. 

General, specific and operational objectives 

Taking into account the overall effect of the identified problems (see section 3.1.6. 
above), the general policy objective of this exercise is to reduce the systemic risk by 
increasing  the  safety  and  efficiency  of  the  OTC  derivatives  market.  Reaching  this 
general  objective  requires  the  realisation  of  the  following  more  specific  policy 
objectives: 

(1) 

(2) 

(3) 

increase  the  transparency  of  the  OTC  derivatives  market  for  regulators, 
market participants and the public; 

reduce the counterparty credit risk associated with OTC derivatives; 

reduce the operational risk associated with OTC derivatives. 

As  indicated  in  the  introduction,  this  report  is  principally  concerned  with  problems 
that can be solved through the use of post-trading market infrastructure. With this in 
mind,  the  specific  objectives  listed  above  require  the  attainment  of  the  following 
operational objectives: 

(1) 

(2) 

(3) 

(4) 

obtain  complete  and  comprehensive  information  on  OTC  derivatives 
positions; 

increase the use of CCP clearing; 

improve bilateral clearing practices; and  

increase the standardisation of OTC derivatives contracts and processes. 

Counterparty  credit  risk  can  be  managed  either  centrally,  i.e.  through  a  CCP,  or 
bilaterally. In other words, an OTC derivative can be cleared either through a CCP or 
bilaterally.  From the point of view of a single contract, operational objectives 2 and 
3 are mutually exclusive. However, as already indicated, not all OTC derivatives are 
suitable for  CCP-clearing. This  is  why  it is still possible to define both operational 
objectives. 

. Operational objective 4 has an impact on the other three operational objectives in 
the  sense  that  achieving  the  former  facilitates  the  achievement  of  the  latter  (this 
relationship is marked in Figure 11 by the dashed arrows). 

An overview of the various objectives and their interrelations is depicted in Figure 11 
below. 

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Figure 11: The objectives and their interrelation 

General 
General 
objectives
objectives

Specific 
Specific 
objectives
objectives

Operational
Operational
objectives
objectives

Increase the 
Increase the 
transparency of the 
transparency of the 
OTC derivatives 
OTC derivatives 
market
market

Increase the safety 
Increase the safety 
and efficiency of the 
and efficiency of the 
OTC derivatives 
OTC derivatives 
m arket
m arket

Reduce the 
Reduce the 
counterparty credit 
counterparty credit 
risk associated with 
risk associated with 
OTC derivatives
OTC derivatives

Reduce the 
Reduce the 
operational risk 
operational risk 
associated with OTC 
associated with OTC 
derivatives
derivatives

Obtain complete 
Obtain complete 
and comprehensive 
and comprehensive 
information on OTC 
information on OTC 
derivatives positions
derivatives positions

Increase the use of 
Increase the use of 
CCP clearing
CCP clearing

Improve bilateral 
Improve bilateral 
clearing practices
clearing practices

Increase the 
Increase the 
standardisation of 
standardisation of 
OTC derivatives 
OTC derivatives 
contracts and 
contracts and 
processes
processes

4.2. 

Consistency of the objectives with other EU policies 

On  the  one  hand,  the  identified  objectives  are  coherent  with  the  EU  fundamental 
goals to promote a harmonious and sustainable development of economic activities, a 
high  degree  of  competitiveness,  and  a  high  level  of  consumer  protection,  which 
includes safety and economic interests of citizens (Article 169 EC TFEU). 

On  the  other  hand,  these  objectives  are  consistent  with  the  reform  programme 
proposed by the European Commission to drive the EU out of the financial crisis. As 
an  essential  element  contributing  to  a  stable  financial  sector,  attaining  these 
objectives  is  a  prerequisite  for  building  a  sustainable  recovery.106  They  are  also 
consistent  with  the  policies  that  were  announced  in  the  various  Communications 
mentioned in the introduction of this report. 

106   Communication for the spring European Council, Driving European recovery - COM(2009) 114. 

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5. 

POLICY OPTIONS AND POLICY INSTRUMENTS 

5.1. 

Policy options and their scope 

In this chapter we examine the various policy options that have been considered in 
order  to  give  effect  to  the  four  operational  objectives  described  in  the  previous 
section  and  depicted  in  Figure  11.  Although  the  operational  objectives  in  question 
seem to address somewhat different issues, they are in fact intertwined and seek to 
provide coherent and comprehensive solutions to the same underlying issues. Before 
defining the policy options, it is important to point out that these will set out broad 
principles rather than detailed measures. The more detailed measures will need to be 
defined at a later stage, most likely through Commission delegated and implementing 
acts. Their impacts will be analysed in accordance to established rules. 

5.1.1.  Options for objective 1 – Obtain complete and comprehensive information on OTC 

derivatives positions 

Two  aspects  need  to  be  considered  in  the  context  of  objective  1.  The  first  one 
concerns  the  question  about  the  way  in  which  the  information  on  positions  or 
alternatively  the  information  needed  to  calculate  the  positions  should  be  collected. 
The possible policy options addressing the first aspect are the following: 

•  Option 1.1: Rely on existing initiatives (= baseline scenario). 

•  Option 1.2.: Obtain additional commitments from the industry. This option could 
include  the  broadening  of  the  personal  scope,  i.e.  extending  them  to  additional 
market participants, or the material scope of the commitments, i.e. extending them 
to additional types of OTC derivatives, or both. 

•  Option 1.3.: Require market participants to report all the necessary information on 
their  OTC  derivatives  portfolios  directly  to  the  competent  regulator(s).  As 
explained in section 3, regulators already have the power to ask the entities they 
regulate  for  all  the  information  they  need  to  perform  their  duties.  This  option 
should not be read as simply maintaining the status quo, but rather as a change of 
approach from the current "pull" (require the information on an ad-hoc basis) to 
"push" (require regular reporting). 

•  Option 1.4.: Require market participants to report all the necessary information on 

their OTC derivatives portfolios to a trade repository. 

•  Option  1.5.:  Introduce  a  reporting  requirement  combining  options  1.3.  and  1.4. 
This option takes into account the possibility that a trade repository may not exist 
or,  in  case  it  does  exist,  that  it  may  not  be  either  willing  or  able  to  accept  the 
information reported by the regulated entity. 

The second aspect concerns the question of the level of detail of the information that 
each  group  of  stakeholders  (regulators,  market  participants  and  the  public)  should 
receive. Its scope can actually be narrowed to just market participants and the public 
since  regulators  need  to  be  able  to  access  any  information  they  deem  necessary  to 

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carry out their responsibilities. The possible policy options addressing this aspect are 
the following: 

•  Option 1.6: Rely on existing initiatives (= baseline scenario). 

•  Option  1.7.:  Require  the  publication  of  aggregate  position  information.  The 
aggregation  could  be  done  by  market  segment  (e.g.  interest  rate  derivatives), 
product  (e.g.  a  particular  single-name  CDS),  group  of  market  participants  (e.g. 
banks) or any combination thereof. 

•  Option  1.8.:  Provide  both  aggregate  and  individual  position  information.  The 
latter refers to positions of individual market participants that could be published 
either with or without a certain lag (e.g. a month). 

5.1.2.  Options for objective 2 – Increase the use of CCP clearing 

The possible policy options for achieving this objective are the following: 

•  Option 2.1.: Rely on existing regulatory incentives and initiatives to increase the 

use of CCP clearing (= baseline scenario). 

•  Option 2.2.: Obtain additional industry commitments on the use of CCP clearing. 
This  option  could  include  the  broadening  of  the  personal  scope,  i.e.  extending 
them to additional market participants, or the material scope of the commitments, 
i.e. extending them to additional types of OTC derivatives, or both. Furthermore, 
it  could  include  the  "tightening"  of  existing  commitments  (e.g.  increasing  the 
proportion of total trades that would need to be cleared). 

•  Option  2.3.:  Provide  additional  regulatory  incentives  for  the  use  of  CCP 
clearing.107  These  could  include,  for  example,  measures  aimed  at  increasing  the 
safety  of  CCPs  or  measures  facilitating  the  use  of  CCPs  by  smaller  market 
participants. This option should be seen as a complement to options 2.1. and 2.2. 

•  Option  2.4.:  Require  the  use  of  CCP  clearing  for  OTC  derivatives  that  meet 
predefined  eligibility  criteria.  The  criteria  should  include  those  that  are  usually 
used  by  a  CCP  when  it  considers  the  possibility  of  clearing  of  a  particular 
contract.  These  include,  among  others,  the  liquidity  of  the  contract  and  the 
availability of pricing information. 

•  Option 2.5.: Require the use of CCP clearing for all OTC derivatives. 

At least some of the above options are not mutually exclusive. 

5.1.3.  Options for objective 3 – Improve bilateral clearing practices 

The possible policy options for achieving this objective are the following: 

107   Regulatory incentives for the use of CCPs already exist. Certain market participants (e.g. banks) are not 
required  to  set  aside  regulatory  capital  for  exposures  that  they  have  with  a  CCP  complying  with  certain 
conditions.  

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35 

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•  Option 3.1.: Rely on existing initiatives to improve bilateral clearing practices (= 

baseline scenario). 

•  Option 3.2.: Obtain additional commitments from the industry to improve bilateral 
clearing practices. This option could include the broadening of the personal scope 
of the commitments or their "tightening" (e.g. shortening the cycles of the various 
processes) or both. 

•  Option  3.3.:  Set  specific  targets  for  the  bilateral  clearing  of  OTC  derivatives 
transactions.  One  possible  set  of  targets  could,  for  example,  address  the 
measurement,  monitoring  and  mitigation  of  counterparty  credit  risk  associated 
with bilaterally-cleared OTC derivatives. 

•  Option  3.4.:  Prescribe  the  methods  that  should  be  used  in  the  context  of  the 

bilateral clearing of OTC derivatives transactions. 

5.1.4.  Options for objective 4 – Increase the standardisation of OTC derivatives contracts 

and processes 

As  argued  earlier,  the  main  focus  is  on  contract  and  process  standardisation.  With 
this in mind, the possible policy options are the following: 

•  Option  4.1.:  Rely  on  existing  initiatives  to  increase  contract  and  processes 

standardisation (= baseline scenario). 

•  Option  4.2.:  Obtain  additional  industry  commitments  to  increase  contract  and 
processes  standardisation.  This  option  could  include  the  broadening  of  the 
personal scope or the material scope of the commitments (i.e. the processes that 
need  to  be  improved).  Furthermore,  it  could  include  the  "tightening"  of  existing 
commitments  (e.g.  lowering  the  allowed  number  of  outstanding  unconfirmed 
trades). 

•  Option 4.3.: Set specific targets for contract and process standardisation. 

•  Option 4.4.: Require the use of standard legal contracts and processes defined at 

EU level. 

5.2. 

Policy instruments 

5.2.1.  The available set of policy instruments 

In general, the Commission's "toolbox" contains the following policy instruments: 

•  Communication, 

•  Recommendation, 

•  Directive, and 

•  Regulation. 

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The  Commission  can  also  encourage  the  private  sector  to  pursue  self-regulation  in 
certain cases. Finally, the Commission may decide not to pursue any kind of action at 
the EU level (this is the "do nothing" option). 

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6. 

ANALYSIS OF IMPACTS AND CHOICE OF PREFERRED OPTIONS AND INSTRUMENTS 

6.1. 

Analysis of impacts 

Most of the options that will be analysed below (the exceptions are option 1.1. – 1.8.) 
are  subject  to  so-called  network  effects  (or  network  externalities).  This  means  that 
the  more  market  participants  will  adopt  a  particular  process  or  practice,  the  higher 
the  benefits  for  each  market  participant  that  adopted  them  will  be.108  At  the  same 
time, the attractiveness of the process or practice for those that have not yet adopted 
them will increase as well. 

Most of the analysis in this section is qualitative rather than quantitative. To a great 
extent this is due to i) the difficulty in obtaining quantitative data and ii) the lack of 
information  on  certain  parameters  that  will  become  known  only  in  the  coming 
months  as  a  consequence  of  the  definition  of  technical  standards  (as  explained  in 
section  4)  or  of  other  legislative  initiatives  that  the  Commission  will  pursue  in  the 
area of OTC derivatives. 

6.1.1.  Options for operational objective 1 (information on positions) 

6.1.1.1.  Option 1.1. (rely on existing initiatives) 

This  option  involves  no  action  at  EU  level,  but  rather  relies  on  action  at  Member 
States'  or  industry  level.  As  indicated  in  section  3  there  are  currently  a  number  of 
ongoing  industry  initiatives  that  have  as  a  goal  to  increase  the  amount  of  available 
information  on  OTC  derivatives  positions.  The  initiatives  have  already  led  to 
substantial  increases  in  the  transparency  for  credit  and  interest  rate  derivatives.109 
Both  trade  repositories  currently  hold  information  about  the  great  majority  of 
outstanding  contracts  and  are  being  actively  accessed  by  regulators  in  search  of 
information. Since the information is collected in a central point, this facilitates the 
regulators  job,  as  it  spares  them  from  having  to  compile  individual  information  on 
their  own.  Furthermore,  since  both  repositories  publish  aggregate  data  (with  quite 
detailed breakdowns), the transparency for the general public has increased as well. 

According to information available to the Commission services, the average annual 
cost of maintaining a contract in a trade repository (i.e. the price a market participant 
needs to pay) varies depending on the asset class. In case of interest rate derivatives 
it amounts to a few euro cents per contract while for credit derivatives it amounts to a 
few  euro  per  contract.  The  forthcoming  trade  repository  for  equity  derivatives  is 
expected  to  be  positioned  somewhere  between  the  two.  The  differences  in  the 
average prices are mainly due to the services that these prices cover. For the credit 
derivatives  repository  the  price  covers  a  service  package  that  in  addition  to  the 
"recordkeeping"  service  also  includes  several  operational  services  (e.g.  credit  event 
processing,  settlement  calculations).  For  the  interest  rate  derivatives  repository,  the 
price covers solely the "recordkeeping" service. 

108   The telephone network is the classical example used to illustrate network effects. 
109   Once  the  trade  repository  for  equity  derivatives  will  be  up  and  running,  transparency  for  this  type  of 

products should increase as well. 

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While  the  current  initiatives  already  managed  to  deliver  important  results  they  are 
not without shortcomings: 

(1)  Limited scope, both personal and material. As concerns the personal scope, the 
commitments are currently limited to the OSC members. The market coverage 
provided  by  the  trade  repositories  therefore  depends  on  the  market  shares  of 
the OSC members, in particular the G14 (see Figure 12 below for an overview 
of  the  market  shares  of  the  various  categories  of  market  participants).  For 
example,  in  the  CDS  market,  where  contracts  that  have  at  least  one  OSC 
member as a party represent the great majority of the market, coverage is very 
high.110  In  another  market,  where  the  weight  of  OSC  members  might  be 
significantly lower (e.g. interest rates), market coverage would be incomplete. 
As  concerns  the  material  scope,  the  current  commitments  do  not  foresee  the 
creation  and  use  of  trade  repositories  for  foreign  exchange  and  commodity 
derivatives. This means that the current initiatives will not lead to a complete 
and comprehensive coverage of the entire OTC derivatives market. 

Figure 12: Market concentration in the OTC derivatives market: evolution of market 
shares (left) and market shares as of December 2009 (right) 

Note: Data are compiled from a survey among about 55 dealers. Data are "netted" to account for double-counting 
111
resulting from positions between reporting institutions.
 Notional amounts outstanding are adjusted by halving 
positions  vis-à-vis  other  reporting  dealers.  The  data  do  not  distinguish  as  to  whether  these  OTC  contracts  are 
centrally or bilaterally cleared. The left panel does not include data for commodity derivatives. 

Source: BIS, Commission services calculations 

(2) 

Issues related to data protection. Since there is no legal requirement backing 
the  reporting  process,  a  party  to  the  contract  may  be  unable  to  report  the 
identity  of  its  counterpart  because  of  data  protection  issues  (the  counterpart 

110   As long as at least one of the two counterparties to a contract reports that contract to a trade repository, the 

details of that contract will be known. 

111   Reporting dealers are mainly large commercial and investment banks and securities houses that participate 
in  the  inter-dealer  market  and/or  have  an  active  business  with  large  customers,  such  as  large  corporate 
firms, governments and other non-reporting financial institutions. "Other financial institutions" are smaller 
commercial banks, investment banks and securities houses, and in addition funds (mutual, pension, hedge, 
etc.), building societies, leasing companies, insurance companies, financial subsidiaries of corporate firms, 
and  central  banks.  Non-financial  institutions  are  mainly  non-financial  end  users,  such  as  corporates  and 
governments.  

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may not give permission to have his or her name disclosed; it may even be that 
the law prevents this disclosure). If the two parties to a contract both report the 
contract  then  this  situation  could  potentially  result  in  an  artificial  inflation  of 
the overall market size (if neither would reveal the identity of its counterparty, 
then  the  contract  would  be  counted  twice).  If  only  one  of  the  parties  reports, 
the consequences of this situation would be more severe: the usefulness of the 
information  stored  in  the  trade  repository  would  be  reduced  (the  size  of  the 
position would be known while the counterpart to the position would not) and 
would require regulators to seek the information directly. 

(3)  Non-binding  nature  of 

the  commitments.  Not  honouring  a  voluntary 
commitment does not carry any particular sanction with it. Therefore, there is 
nothing that compels a market participant to honour the commitment in full or 
to prevent him or her from walking away from it at any point in time. 

(4) 

Inability  of  a  trade  repository  to  "capture"  a  contract.  Contracts  may  be  so 
bespoke that a trade repository may not be able to process them. In such cases, 
under  the  current  commitments,  such  contracts  would  remain  unreported.  If 
their  number  is  high  enough,  the  overall  transparency  would  be  lower  than 
desired. 

6.1.1.2.  Option 1.2. (obtain additional commitments from the industry) 

On the benefits side, this option would permit to close, either partially or completely, 
the  gaps  in  the  scope  of  the  current  initiatives,  thus  increasing  the  transparency 
compared to option 1.1. Regulators would gain a more complete picture of the OTC 
derivatives  market.  To  the  extent  that  a  certain  level  of  standardisation  would  be 
needed in order to deliver on the commitment, it would increase the standardisation 
in the additional market segments it would cover and could therefore also result in a 
certain amount of streamlining of the processes used by market participants. Finally, 
and  less  importantly,  it  would  also  create  revenues  for  the  operators  running  the 
additional trade repositories. 

On  the  costs  side,  there  would  be  the  one-off  investment  cost  of  creating  the  new 
trade repositories. In terms of costs for market participants, a distinction needs to be 
made  between  those  already  subject  to  an  existing  commitment  and  those  who  are 
not. The former would incur additional costs in the form of connection costs to the 
new  trade  repositories  (both  one-off  and  recurring),  and  additional  fees  that  would 
need  to  be  paid  to  the  new  trade  repositories  for  maintaining  the  information. 
Furthermore, they may incur the cost of hiring additional staff to handle the reporting 
process related to contracts to be reported to the new trade repositories.112 

112   This  would  very  much  depend  on  the  type  of  information  that  would  need  to  be  reported.  In  case  of 
reporting  of  positions,  the  information  should  already  be  available  to  the  reporting  entities,  so  no 
significant additional costs should be involved. If, conversely, information on single contracts would need 
to be reported, the bulk of the work would need to be done at the beginning because of the need to report 
the  details  of  outstanding  contracts.  This  burden  could,  however,  be  distributed  over  a  certain  period  of 
time,  which  would  likely  eliminate  the  need  to  hire  additional  staff.  Once  this  first  phase  would  be 
concluded, the reporting of new contracts should not require any additional resources. 

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The  latter  would  incur  the  same  type  of  costs  and,  assuming  they  would  have  to 
report  the  same  volume  of  information  as  market  participants  already  subject  to  an 
existing commitment, the same level of costs. Both categories would therefore incur 
higher total costs than under option 1.1. 

The information on the fees charged by the existing trade repositories is not publicly 
available, but according to the information provided to the Commission services the 
fees  do  not  appear  to  be  particularly  high.  The  overall  impact  on  the  costs  of  this 
measure  should  therefore  be  relatively  limited.  This  cost  impact,  especially  for 
smaller  market  participants,  could  be  mitigated  significantly  by  allowing  them  to 
delegate the reporting to their counterparties. In most cases the delegation would be 
to  bigger  institutions  with  whom  small  market  participants  usually  enter  into  OTC 
derivative contracts and who are better adapted to shoulder the costs of the reporting. 
In  case  these  bigger  institutions  already  voluntarily  report  their  contracts,  then  the 
marginal cost  of  reporting on behalf of their counterparties would be very small, if 
not even zero. 

Finally, this option would not solve shortcomings 2, 3 and 4 described under option 
1.1. 

6.1.1.3.  Option 1.3. (require direct reporting to regulators) 

This option has a number of benefits compared to option 1.1. Firstly, it would resolve 
shortcomings 2 (data protection) and 3 (non-binding nature of commitment) since the 
reporting would be required by law. It would also resolve shortcoming 4 (inability of 
trade repository to "capture" a contract) as, in principle, a supervisor should be able 
to receive all information, including the one on bespoke contracts. Whether or not it 
would  solve  shortcoming  1  (limited  scope)  would  largely  depend  on  the  ability  of 
obtaining  information  from non-regulated entities (i.e. non-financial  institutions).113 
If  not  all  market  participants  could  be  captured,  then  the  coverage  would  be 
potentially  incomplete.  In  any  case,  the  market  coverage  would  be  certainly  no 
lower, and quite probably higher than under option 1.1. Combining all these elements 
means  that  the  level  of  transparency  under  this  option  would  be  greater  than  under 
option 1.1. 

Secondly,  this  option  should  entail  much  lower  reporting  costs  than  option  1.1. 
Indeed, reporting to regulators does not require the payment of fees and the reporting 
channels  are  already  established,  so  presumably  no  additional  connection  costs 
would  be  necessary.  The  costs  should  be  reduced  even  further  by  the  fact  that  the 
number of competent regulators may in the end be smaller than the number of trade 
repositories.114 

113   The  problem  would  actually  be  limited  to  contracts  where  both  counterparties  are  not  regulated.  Those 
contracts where one counterparty is a regulated entity and the other one is not, would still be reported by 
the former.  

114   The current market consensus view seems to be that there will be only one trade repository per segment, so 
potentially  5  in  total.  On  the  regulators'  side,  a  regulated  entity  could,  in  principle,  report  all  the 
information to a single regulator. The picture may get a bit more complex if transaction reporting is also 
taken into account, as then the regulated entity may have to report to two different regulators (positions to 
one  and  transactions  to  the  other).  For  at  least  some  types  of  OTC  derivatives  (e.g.  energy  derivatives), 
more  then  one  regulator  may  be  interested  in  the  information  which  could  require  reporting  to  multiple 

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41 

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Finally,  in  case  the  information  under  option  1.1.  is  reported  to  a  trade  repository 
located  in  a  jurisdiction  different  from  the  one  of  the  regulator  requesting  the 
information,  then  under  this  option  the  latter  would  not  have  to  enter  into  an 
information-sharing agreement with the regulator of the trade repository to be able to 
access it. 

This option has also a number of disadvantages compared to option 1.1. First, unless 
a  way  would  be  found  to  accommodate115  the  way  reporting  is  done  under  current 
initiatives  it  would  lead  to  a  duplication  of  reporting  channels  and  perhaps  even 
discourage market participants from using trade repositories. To the extent that trade 
repositories  support  other  processes  (e.g.  credit  event  processing  for  CDS),  this 
would not be a positive development. 

Second, it would lead to a fragmentation of information for regulators. Moreover, to 
the  extent  that  different  information  (or  information  in  different  format)  would  be 
reported to different regulators, piecing together a complete picture would become a 
challenging task. This problem would be particularly acute for market regulators and 
systemic risk regulators, but could also prove significant for prudential regulators of 
large groups active in multiple jurisdictions. 

Last, but not least, the resources that regulators currently have at their disposal may 
turn out not to be sufficient to deal with the potential flood of information that would 
result  from this  requirement.  This  would mean that regulators would either need to 
increase their resources (which would mean an increase in costs for them) or risk to 
end up in a situation in which they would be unable to take full advantage from the 
increased transparency. 

6.1.1.4.  Option 1.4. (require reporting to trade repositories) 

Similarly  to  the  previous  option,  this  one  would  eliminate  shortcomings  2  (data 
protection)  and  3  (non-binding  nature  of  commitment)  of  option  1.1.  However, 
unlike  the  previous  option,  it  would  not  eliminate  shortcoming  4  (inability  of  trade 
repository  to  "capture"  a  contract).  Similarly  to  the  previous  option,  whether  this 
option would be able to completely eliminate shortcoming 1 (limited scope), would 
very  much  depend  on  the  ability  of  legislation  to  capture  currently  non-regulated 
market participants. 

In  terms  of  benefits,  therefore,  the  level  of  transparency  under  this  option  would 
probably  be  close  to,  but  slightly  below  option  1.3.,  since  the  number  of  highly 
bespoke  contracts  that  could  not  be  captured  by  a  trade  repository  is  probably  not 
very  high.  An  additional  benefit  would  be  the  centralisation  of  all  the  data,  which 
would  significantly  reduce,  if  not  eliminate,  the  costs  that  regulators  would  incur 
under option 1.3. 

regulators.  This  problem  could  be  mitigated,  at  least  in  part  (depending  on  what  type  of  information  is 
sough by each regulator), through information-sharing agreements between regulators. 

115   For  example,  by  considering  that  reporting  the  information  to  a  trade  repository  is  compliant  with  the 
requirement,  provided  that  the  regulator  has  unencumbered  access to  the  information  stored  in  the  trade 
repository. 

EN 

42 

   EN 

 
                                                                                                                                                         
In terms of costs, it would entail the same type of costs as option 1.2., but probably a 
higher level of overall costs due to the broader scope (however, due to economies of 
scale, the increase in the overall costs should be contained). 

The  above  analysis  presupposes  that  there  would  be  only  one  trade  repository  per 
market  segment.  If  this  out  not  to  be  the  case,  then  the  costs  of  this  option  would 
probably  be  higher  (higher  overall  investment  costs  by  trade  repositories,  lower 
economies  of  scale  and  hence  potentially  higher  fees  charged  by  trade  repositories, 
higher fragmentation of data). 

6.1.1.5.  Option 1.5. (require reporting to trade repositories or, if that is not possible, directly 

to regulators) 

This  option  has  the  same  costs  as  option  1.4.,  but  higher  benefits,  as  it  would 
eliminate shortcoming 4 (inability of trade repository to "capture" a contract). Since 
the  amount  of  contracts  that  could  not  be  captured  by  a  trade  repository  would 
probably  be  limited,  regulators  would  most  likely  not  need  to  employ  significant 
additional  resources  to  deal  with  them.  Provided  that  the  information  on  these 
“residual” contracts would be reported in the same format as the information on the 
contracts reported to the trade repositories, then the effects of fragmentation would 
be limited. 

Table 3: Summary of the impact analysis for operational objective 1 (information on 
positions) – how to report 

Option 1.1. (baseline) 

n.a. 

n.a. 

n.a. 

Impact on stakeholders 

Effectiveness 

Efficiency 

Option 1.2. 
(obtain additional 
commitments) 

Option 1.3. 
(report to regulators) 

Option 1.4. 
(report to trade 
repositories) 

Option 1.5. 
(1.3. + 1.4.) 

(+) regulators gain more 
complete picture 
(+) revenues for trade 
repositories 
(-) higher costs for 
reporting institutions 

(++) regulators gain more 
complete picture 
(+) cheaper to report for 
regulated entities 
(-) costlier to manage for 
regulators 
(≈/-) potential loss of 
revenue for trade 
repositories 

(+/++) regulators gain 
more complete picture 
(+/++) revenues for trade 
repositories 
(-) higher costs for 
reporting institutions 

(++) regulators gain more 
complete picture 
(+/++) revenues for trade 
repositories 
(≈/-) costlier to manage for 
regulators 

(≈/+) While increase scope of 
reporting data protection 
barriers will remain and it will 
be difficult enforcing non-
binding commitments. 
Moreover, some contracts may 
not be captured 
(≈/+) While resolve data 
protection barriers, 
enforceable, capture all 
contracts there will potentially 
be duplication of reporting 
channels and fragmentation of 
information/difficulty gain 
overall picture of market. 
Market coverage depends on 
definition of regulated entity. 

(+/++) It resolves data 
protection barriers, it is 
enforceable but some contracts 
may not be captured by trade 
repositories. Market coverage 
depends on definition of 
regulated entity. Potential issue 
of fragmentation of information 
in case of multiple trade 
repositories 

(++) It resolves data protection 
barriers, is enforceable and 
will capture the great majority 
of contracts. Market coverage 
depends on definition of 
regulated entity. Some 
fragmentation possible, but 

(≈/+) higher set-up and 
ongoing costs would be at 
least offset by the benefits 

(≈/-) lower reporting costs, 
but costly for regulators to 
manage received 
information 

(≈/-) higher set-up and 
ongoing costs, but likely to 
be limited 

(≈/-) set-up and ongoing 
costs, but likely to be 
limited 

EN 

43 

   EN 

 
 
 
(-) higher costs for 
reporting institutions 

likely to be fairly limited. 

6.1.1.6.  Option 1.6. (rely on existing initiatives) 

As  explained  in  section  3,  many  of  the  market  infrastructures  (CCPs  and  trade 
repositories) are already making some sort of aggregate information available to the 
public. Pursuing no action at EU level would not change this. 

6.1.1.7.  Option 1.7. (require the publication of aggregate position information) 

This option could involve two additional benefits when compared to option 1.6. First, 
to  the  extent  that  some  market  infrastructures  do  not  publish  aggregate  data, 
requiring  its  publication  would  increase  the  amount  of  information  available  to  the 
public. Second, in case the publication of data broken down to a more detailed level, 
that is currently not published, would be required (e.g. data on contracts denominated 
in particular currency, or on a particular underlying, or held by a particular category 
of market participants) this would again increase the amount of information available 
to the public. 

This  option  would  not  involve  any  significant  additional  costs  compared  to  option 
1.6.,  neither  for 
information  (either  market 
the 
to  publish 
those  required 
infrastructures or regulators) nor for those receiving it. 

6.1.1.8.  Option 1.8. 

In terms of benefits, the publication of data on individual positions would enable any 
market participant to estimate better the counterparty credit risk it is exposed to when 
dealing  with  a  particular  counterparty  and  would  therefore  allow  it  to  secure  itself 
better against this risk. 

As  for  costs,  similarly  to  option  1.7.,  the  publication  costs  would  be  marginal  at 
worst.  However,  disclosing  information  about  individual  positions  would  mean 
disclosing  the  trading  strategies  of  single  participants  thus  potentially  discouraging 
them  from  trading  in  the  first  place.  One  way  of  addressing  this  issue  could  be  to 
publish data with a lag. However, doing so, especially if the lag would be substantial, 
would rob the data of any meaning. 

Table 4: Summary of the impact analysis for operational objective 1 (information on 
positions) – level of public disclosure of information 

Option 1.6. (baseline) 

n.a. 

n.a. 

n.a. 

Impact on stakeholders 

Effectiveness 

Efficiency 

Option 1.7. 
(Aggregate positions) 

Option 1.8. 
(Aggregate + individual 
positions) 

(+) increase information 
available to public and to 
market participants 

(+/++) more information 
available to the public, 
enable market 
participants to better 
assess counterparty risk 
(-/--) disclose trading 
strategies of market 

(+) more transparency 

(≈) no significant additional 
costs 

(++) more transparency, better 
assessment of counterparty risk, 
which enables better management 
of risk 

(-/--) no significant cost of 
publication, but potentially 
significant impact on 
liquidity of the market 

EN 

44 

   EN 

 
 
 
 
participants 

6.1.2.  Options for operational objective 2 (use of CCPs) 

Before starting the analysis of costs and benefits of each policy option, it may prove 
useful to list the benefits associated with CCP clearing, since these are equally valid 
across the various options. The benefits are as follows:116 

(1) 

it facilitates counterparty credit risk mitigation; 

(2) 

it allows mutualisation of losses; 

(3) 

(4) 

(5) 

(6) 

it has a positive effect on market liquidity; 

it solves disruptive information problems; 

it increases operational efficiency; and 

it allows regulatory capital savings. 

Due to the above, the use of CCPs is expected both to help reduce the probability of 
default of individual members and reduce the probability of market failure due to the 
default of a major market participant. 

From the point of view of individual market participants, the decision on whether to 
use a CCP for clearing a particular class of OTC derivatives as opposed to clearing it 
bilaterally  will  also  depend  on  the  trade-off  between  two  types  of  netting 
opportunities:  bilateral  netting  between  pairs  of  counterparties  across  different 
classes  of  OTC  derivatives,  versus  multilateral  netting  among  many  clearing 
participants across a single class of OTC derivative (e.g. CDS). A market participant 
will  find  CCP  clearing  attractive  if  gains  from  multilateral  netting  will  be  greater 
than the losses in bilateral netting opportunities that would result from the removal of 
the CCP-cleared asset class from the original bilateral netting set.117 

6.1.2.1.  Option 2.1. (rely on existing regulatory incentives and initiatives) 

As explained in section 3, there are various initiatives aimed at increasing the use of 
CCPs for clearing OTC derivatives. The existing industry commitments in terms of 
clearing have already delivered improvements in terms of the proportions of the CDS 
and  interest  rate  derivatives  markets  that  are  being  cleared  (see  figures  7  and  8 
respectively) and all the benefits this brings with it.118 

Since the current commitments apply  to G14 members only (i.e. the large dealers), 
the bulk of the analysis will be focused on their costs and benefits. In terms of one-

116   For more details see Bliss, R. and C. Papathanassiou (2006), Derivatives clearing, central counterparties 

and novation: The economic implications. Available at   
http://www.ecb.europa.eu/events/pdf/conferences/ccp/ BlissPapathanassiou_final.pdf. 

117   Duffie, D. and H. Zhu (2009), Does a Central Clearing Counterparty Reduce Counterparty Risk? 
118  

 According to very rough estimates, the shares (by notional amount) of OTC derivatives that are currently 
centrally cleared are 30% for interest rates, 10-15% for CDS and 20-30% for commodities. 

EN 

45 

   EN 

 
 
                                                 
off  costs,  moving  to  CCP  clearing  has  certainly  required  investment  to  adapt  their 
systems and to connect to the CCPs.119 Dealers also have to pay clearing fees to the 
CCP. An important part of the costs that CCP clearing involves are the net funding 
costs120  of  the  collateral  paid  to  the  CCP  in  the  form  of  initial  margins  and 
contributions  to  the  default  fund  of  the  CCP.121  For  example,  for  the  three  largest 
CCPs  clearing  OTC  derivatives  (ICE  Clear  Europe  and  ICE  Trust  for  CDS, 
SwapClear  for  interest  rate  swaps)  the  combined  default  fund  and  initial  margin 
contributions  of  its  members  (i.e.  the  dealers)  amount  to  approximately  €15.1 
billion.122 Currently, the net funding cost associated with this amount should not be 
more than a few hundred million euro. 

The benefits for CCPs offering clearing solutions for OTC derivatives are in the form 
of clearing fees they receive from their members and from the net interest they earn 
on the collateral posted by their members. 

In  spite  of  the  improvements  associated  with  the  current  initiatives,  they  also  have 
important shortcomings: 

(1)  Limited  scope,  both  personal  and  material.  This  is  the  most  important 
shortcoming  of  the  existing  initiatives.  The  personal  scope  is  limited  to  the 
G14 members. The impact of the limited personal scope of this option is much 
more significant that in the case of the reporting (transparency) commitments. 
The reason is straightforward: a market participant can report the information 
on a particular OTC derivative contract irrespective of whether its counterpart 
does the same. This is not possible in a CCP-clearing environment, where both 
counterparts must agree to the contract's submission to a CCP. Therefore, for 
the same market segment, the coverage of the reporting commitments is going 
to be higher than that of the clearing commitments. Given the personal scope 
of  the  latter,  the  maximum  level  of  coverage  that  can  be  achieved  is  all  the 
contracts between dealers. 

The material scope is limited to credit derivatives and interest rate derivatives 
(there is also a commitment for commodity derivatives, but it is a generic one, 
without any particular targets). In addition, the material scope depends on the 
definition  of  eligible  contract,  since  the  commitments  specify  targets  for 
clearing this type of contracts. To the extent that contract eligibility is defined 
in a way to capture just a subset of the contracts that a CCP can safely clear, 
then less contracts would be cleared than would be possible. 

(2)  Non-binding  nature  of 

the  commitments.  Not  honouring  a  voluntary 
commitment does not carry any particular sanction with it. Therefore, there is 

119   At least in case of interest rate swaps, a substantial portion of the market was already cleared before the 
onset of the crisis, so most of the related costs have been incurred before the crisis as well. Moreover, for 
CDS,  the  major  dealers  leveraged,  to  the  greatest  extent  possible,  the  existing  infrastructure  in  order  to 
minimise these costs. 

120   The  costs  of  borrowing  the  funds  needed  minus  any  interest  that  the  CCP  may  pay  on  the  collateral  it 

receives. 

121   There are no additional costs related to the provision of variation margin as the latter is also used in the 

bilateral clearing model. 

122   This amount currently covers contributions made by all clearing members of the three CCPs involved, not 

just the G14 (although they represent the bulk of the contributions). 

EN 

46 

   EN 

 
                                                 
nothing that compels a market participant to honour the commitment in full or 
to prevent him or her from walking away from it at any point in time. 

6.1.2.2.  Option 2.2. (obtain additional industry commitments) 

This  option  would  consist  in  providing  specific  targets  for  clearing  commodity, 
equity and foreign exchange derivatives, or including market participants other than 
large  dealers  in  the  scope  of  the  current  initiatives,  or  potentially  both.  For  the 
broadening of the material scope, it needs to be pointed out that the target would not 
be  perfect  coverage  since  there  are  OTC  derivatives  out  there  that  are  simply  not 
suited for CCP clearing. 

The expansion to commodity and equity derivatives could probably rely on existing 
CCPs that already provide clearing services for this type of derivatives. For foreign 
exchange derivatives, the service would need to be developed. Hence, the latter case 
would involve higher initial investment costs. 

A  recent  paper  published  by  the  International  Monetary  Fund123  tried  to  estimate 
what would be the cost impact of moving two thirds of the OTC derivatives market 
to  CCP  clearing.  The  author  of  the  paper  comes  to  the  conclusion  that  the  move 
would require and additional $170 billion to $220 billion of collateral (in the form of 
initial  margin  and  contributions  to  the  default  fund  of  a  CCP)  from  large  financial 
institutions.124  This  number  should  be  taken  with  a  bit  of  caution  and  should 
probably be seen as the upper bound estimate of the amount of additional collateral 
needed.125 As the author himself acknowledges, it needs to be noted that the true cost 
of  the  move  would  not  be  the  estimated  amount,  but  rather  the  net  funding  cost 
associated  with  obtaining  it.  Furthermore,  it  is  quite  likely  that  such  high  coverage 
would involve the inclusion of contracts where at least one of the counterparts is not 
a dealer (see figure 12). This means that the amount estimated above would not fall 
exclusively on large financial institutions, but also on their clients. 

There are at least two possible ways to look at the implications of the above estimate. 
One  is  that  the  large  financial  institutions  could  use  the  money  in  alternative  (i.e. 
more  profitable)  ways  (for  example  they  could  lend  it  to  a  business  or  they  could 
engage  in  additional  trading).  This  interpretation  would  mean  that  the  cost  of  the 
move  to  CCP  clearing  would  be  equal  to  the  "net"  opportunity  cost  of  the 
collateral.126 The other is that up to $220 billion in additional money is available to 
prevent  that  a  localised  shock  (the  default  of  a  market  participant)  is  spread  to  the 
entire financial system. 

The impact of expanding the personal scope of the existing commitments would very 
much depend from one type of institution to another. For example, a fund that enters 

123   Singh, M (2010), "Collateral, Netting and Systemic Risk in the OTC Derivatives Market", IMF Working 

Paper. http://www.imf.org/external/pubs/ft/wp/2010/wp1099.pdf. 

124   For the individual market segments, the numbers are $40-$80 billion for CDS, $40-$50 billion for interest 

rate swaps, $90 billion for the remaining market segments. 

125   For example, the estimate does not include the potential savings in collateral coming from higher netting 
efficiency.  Indeed,  including  more  contracts  increases  the  probability  that  more  of  them  will  offset  one 
another and could therefore be netted. 

126   The difference between the foregone return on the alternative investment and the actual return made on the 

collateral. 

EN 

47 

   EN 

 
                                                 
in an OTC derivative contract already has to put up both initial and variation margin 
for  the  OTC  derivatives  contracts  it  enters  into.  This  would  not  change  in  a  CCP 
environment. Nevertheless, there may still be some additional costs involved for the 
fund. In a bilateral clearing situation, the fund's counterparty could use the collateral 
given  by  the  fund  quite  freely  and  earn  a  return  on  it.  In  a  CCP  environment,  the 
fund's counterparty  would  lose at least some of  that liberty, and hence some of the 
associated  returns,  because  at  least  some  of  the  collateral  would  need  to  be  posted 
with  the  CCP.127  The  fund's  counterparty  may  then  try  to  compensate  this  shortfall 
by, for example, increasing the (implicit of explicit) fees it charges to the fund. 

Another  potential  source  of  costs  for  the  fund  is  related  to  the  type  of  collateral  it 
posts with the dealer. Compared to a CCP, a dealer usually accepts a wider variety of 
collateral to secure OTC derivatives deals.128 Assuming that a fund would not have 
sufficient collateral of the type accepted by a CCP, it would have two choices. On the 
one hand it could try and find the necessary collateral on its own (e.g. by using the 
repo market). On the other hand it may give to the collateral to the dealer. Since the 
dealer  would  not  be  able  to  reuse  the  collateral  with  the  CCP,  it  would  need  to 
provide  the  suitable  type  of  collateral  itself.  The  cost  of  this  "collateral 
transformation" would be charged to the fund(e.g. by applying a higher haircut to the 
collateral it provides). In both cases, CCP-clearing would entail higher costs for the 
fund.  129  This  problem  could  potentially  be  solved  by  allowing  CCPs  to  accept  a 
broader variety of collateral (with appropriate haircuts). 

The implications for non-financial institutions (NFIs) may be much more significant. 
NFIs usually do not provide any collateral to secure the OTC derivatives transactions 
that they have entered into. This would change in a CCP environment, where an NFI 
would be asked to provide both initial and variation margin. The former can be seen 
as an upfront cost of CCP clearing; the latter introduces a certain level of cash flow 
volatility. Both need to be funded, which entails costs. That is not to say that bilateral 
clearing is cost-free for NFIs. By not requiring any collateral from an NFI the dealer 
basically  provides  it  with  an  implicit  credit  line.  The  implicit  credit  line  involves 
certain  costs  for  the  dealer,130  so  the  latter  will  try  to  pass  them  on  to  the  NFI  by 
including  it  in  the  transaction  fee.  The  cost  of  moving  to  CCP  clearing  would 
therefore need to be compared to the implicit cost that is currently paid by the NFIs, 
to see what the net impact would be. 

The  impact  on  the  cash  flows  of  NFIs  also  needs  to  be  taken  into  account.  As 
mentioned  earlier,  the  posting  of  variation  margin  may,  in  times  of  heightened 
market  volatility,  could  provide  a  substantial  drain  on  the  liquidity  of  NFIs.  This 
could be addressed by ensuring that an NFI has a credit line it can draw upon in case 

127  The exact amount would depend on the extent to which the positions of the clients using the same dealer to 
access a CCP would offset one another (the dealer post the collateral based on his or her net position with 
the  CCP).  The  higher  the  amount  of  offsetting  contracts,  the  lower  the  net  position  and  the  lower  the 
amount of collateral that would need to be posted with the CCP. 

128  CCPs usually accept only the most liquid types of collateral, i.e. cash and government bonds. 
129   According  to  the  reply  to  the  second  public  consultation  submitted  by  the  Investment  Management 
Association, a pension fund’s return could be lowered by between 1.1 to 1.9 percentage points if it had to 
use the repo market to obtain the necessary cash to post as collateral with a CCP. 

130  The dealer has two basic choices: it can either hedge the credit risk associated with the credit line, e.g. by 
purchasing  a  CDS,  or  it  can  decide  not  hedge  in  which  case  it  will  have  to  set  aside  regulatory  capital. 
Either option involves costs for the dealer. 

EN 

48 

   EN 

 
                                                 
of need. This would, however, require the NFI to make the previously implicit credit 
line  (which  does  not  appear  as  debt  on  its  balance  sheet)  explicit.  This  could  have 
negative implications for the credit rating of the company. Furthermore, large swings 
in the market value of the derivative may lead to margin calls that would exceed the 
limit  of  an  NFI's  existing  credit  line.  This  would  force  the  NFI  to  either  seek  an 
extension  of  the  existing  credit  line  or  to  obtain  a  new  one  altogether.  Within  the 
short time limits of a collateral call, this may not be feasible or might prove costly, 
especially if the market itself is in turmoil. 

Last,  but  not  least,  CCP  clearing  requires  market  participants  to  have  in  place 
systems  that  allow  them  to  cope  with  daily  (or  even  intraday)  margining.  Many 
market participants currently do not have such systems and would therefore need to 
make investments in order to set them up. 

To the extent that the dealers would be willing to extend their commitments to OTC 
derivatives  that  are  currently  not  covered  and  to  the  extent  that  there  are  market 
participants  out  there  that  would  be  willing  to  adhere  to  the  (old  and/or  new) 
commitments (they would only adhere if the net benefits would not be negative), the 
benefits of this option would be larger than those of option 2.1.  One  benefit  of  the 
broadening of the personal scope would be that dealers would be able to clear more 
of  their  contracts  and  thus  potentially  benefit  from  larger  netting  efficiencies.  The 
associated total costs would also be higher then under option 2.1. This option would 
do nothing to solve shortcoming 2 (non-binding nature of the commitment) of option 
2.1. 

6.1.2.3.  Option 2.3. (provide additional regulatory incentives) 

Within the scope of the measures that can be examined in this report, one additional 
incentive  to  encourage  a  wider  adoption  of  CCP  clearing  could  be  making  CCPs 
safer  by  introducing  strict  safety  requirements  for  them.  Another  incentive, 
especially  for  those  market  participants  that  would  not  meet  the  criteria  to  become 
members of a CCP and would therefore need to access one only indirectly, through a 
general clearing member, would be to provide additional safeguards for the collateral 
they provide. 

In  a  voluntary  setting,  it  is  however  unclear  whether  such  incentives  would  be 
sufficiently  large  to  sway  market  participants  into  using  CCP  clearing.131  Indeed, 
both  solutions  provide  additional  safeguards,  but  these  safeguards  come  at  a  cost. 
Making  a  CCP  safer  might  result  in  the  CCP  requiring  higher  margins  from  its 
members.  Similarly,  segregating  client  accounts  may  result  in  general  clearing 
members charging higher fees to offset the loss of revenue that such solution would 
entail.132 

Overall, introducing such incentives may increase the number of market participants 
using CCP clearing, and thus bring about higher benefits than option 2.1. However, it 
is  difficult  to  gauge  how  many  more  would  start  using  CCP  clearing  due  to  the 
incentives. 

131   Existing incentives have had only a partial success in this regard. 
132  The analysis of the fund example under option 2.2. is applicable in this case as well. 

EN 

49 

   EN 

 
                                                 
6.1.2.4.  Option 2.4. (require the use of a CCP for eligible contracts) 

The selective approach of this option can be seen as recognition of the fact that not 
all  OTC  derivatives  may  be  suitable  for  CCP  clearing.  Of  course,  the  requirement 
would only be applicable in case there would be a CCP offering the service. 

This  option  would  apply  to  all  OTC  derivatives  that  meet  the  pre-defined  criteria 
and, in principle, to all market participants that trade them (eliminating shortcoming 
2  (non-binding  nature  of  commitment)  of  option  2.1.).  This  means  that  the  likely 
coverage  of  this  option  would  be  greater  than  the  one  of  option  2.1.  The  higher 
coverage  would  entail  both  higher  benefits  in  terms  of  overall  reduction  of 
counterparty  credit  risk,  but  also  higher  costs  than  option  2.1.  While  it  is  quite 
probable that the net benefit for G14 members would be positive (the additional costs 
would probably be lower than the benefits due to netting effects),133 the outcome for 
other  market  participants,  especially  the  NFIs  is  less  certain  (the  benefits  would  be 
the  ones  typically  associated  with  CCP  clearing,  the  costs  would  be  the  ones 
described in the analysis of option 2.3.). Provided that CCPs would manage to attract 
a large enough volume of business, the net benefits would probably be positive also 
for them. 

Given  the  limited  market  share  of  NFIs,  it  is  quite  likely  that  the  overall  benefits 
would outweigh the costs of this option. 

6.1.2.5.  Option 2.5. (require the use of CCP clearing for all contracts) 

This  option  would  require  all  market  participants  to  clear  all  OTC  derivatives 
through a CCP. In order for this option to be materially different from option 2.4., the 
trading of an OTC derivative that could not be cleared through a CCP would need to 
be banned. This would result, on the one hand, in a situation where, all traded OTC 
derivatives would be cleared by a CCP and therefore the counterparty credit risk of 
the  market  participants  would  be  substantially  reduced  (both  by  virtue  of  the  CCP 
and  by  virtue  of  there  being  less  contracts  traded).  On  the  other  hand,  it  would, 
however, result in the reduction of hedging possibilities for those market participants 
that have specific needs and may even lead to less hedging overall. From the overall 
perspective  of  counterparty  credit  risk  reduction,  this  option  could  be  considered 
superior to option 2.1. However, this superiority would need to be weighed against 
the lower hedging possibilities for market participants. 

It  could  happen  that  in  the  scenario  described  above  a  CCP  would  be  tempted  to 
accept  any  OTC  derivative  for  clearing  in  order  to  earn  additional  revenue.  In 
principle,  the  CCP  could  protect  itself  against  the  higher  risk  inherent  in  the  more 
its 
complex  OTC  derivatives  by  asking  markedly  higher  margins 
participants.134  This  could  make  these  derivatives  so  expensive  that  market 

from 

133  Depending on the particular situation, the migration to a CCP may also entail savings in regulatory capital. 
134  The  analysis  of  the  scenario  where  the  CCP  would  actually  ask  for  margins  that  would  not  adequately 
cover the exposures of the CCP is not provided here, as it is assumed that regulators would prevent such 
scenario from materialising. However, should such a scenario actually occur, then it is quite possible that 
the overall amount of risk in the system would actually increase, as the CCP would be less safe due to its 
behaviour.  

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participants  would  be  discouraged  from  using  them.  The  end  result  would  be  the 
same as the one described in the previous paragraph. 

Table 5: Summary of the impact analysis for operational objective 2 (use of CCPs) 

Impact on stakeholders 

Effectiveness 

n.a. 
(≈/?) possibility of expanded 
scope of clearing, though 
probably limited 

Efficiency 

n.a. 
(≈/+) costs at least 
offset by benefits 

Option 2.1. (baseline) 
Option 2.2. 
(obtain additional 
commitments) 

Option 2.3. 
(provide additional 
regulatory 
incentives) 

Option 2.4. 
(require CCP 
clearing of eligible 
derivatives) 

Option 2.5 
(require clearing for 
all derivatives) 

n.a. 
(+) regulators gain comfort that more 
contracts/ participants moved to CCP 
clearing. 
(-)higher costs in the form of initial 
margin, variation margin and 
contributions to default funds or any 
combination of the above (depending 
on the market participant) 
(+) capital relief for those market 
participants subject to capital 
requirements 

(+) market participants more 
comfortable using CCPs 
(+) smaller participants more 
comfortable accessing CCP indirectly 
(-) CCPs may require higher margins, 
which makes them more costly for 
participants 
(-) direct CCP participants may charge 
higher fees to fund segregation 

(+) regulators gain comfort that 
eligible contracts cleared on CCPs. 
(-) somewhat higher costs for dealers, 
but likely netting offsets 
(-) higher costs for non-financial 
institutions and potentially funds 

(++) all traded contracts are cleared 
by a CCP 
(-/--)market participants lose ability to 
use contracts that cannot be cleared by 
a CCP 

(≈/?) More participants use 
CCPs but overall effect 
uncertain due to cost and 
voluntary use of CCP 

(≈/+) costs at least 
offset by benefits 

(+/++) significant increase in 
use of CCP due to mandate, 
hence significant reduction in 
counterparty risk 

(-) increased cost  

(++) significant  reduction in 
counterparty risk 

(-/--) increased cost,  
reduced ability to 
hedge risks by using 
customised contracts 

6.1.3.  Options for operational objective 3 (bilateral clearing) 

6.1.3.1.  Option 3.1. (rely on existing initiatives) 

Existing initiatives have already led to significant improvements in the way bilateral 
clearing is done. Still, they suffer from the same shortcomings as the other initiatives: 

(1)  Limited  personal  scope.  While  the  parties  that  have  currently  committed  to 
improve  their  internal  collateral  management  processes  have  made  progress, 
further improvements at market level will depend on other market participants 
doing the same. 

(2)  Non-binding  nature  of 

the  commitments.  Not  honouring  a  voluntary 
commitment does not carry any particular sanction with it. Therefore, there is 
nothing that compels a market participant to honour the commitment in full or 
to prevent him or her from walking away from it at any point in time. 

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6.1.3.2.  Option 3.2. (obtain additional commitments) 

This option would entail mostly broadening the personal scope of the commitments. 
If other market participants signed up to the initiatives, this would improve both their 
processes and it would allow market participants already bound by the commitments 
to  improve  their  own  performance.  So  if  the  personal  scope  of  the  commitments 
could be broadened, the benefits of this option would be larger than those of option 
3.1. 

Improving bilateral clearing would entail a potentially large upfront investment, with 
benefits  of  such  investment  only  materialising  over  time.  In  the  case  of  smaller 
market  participants  that  do  not  have  sufficiently  high  transaction  volumes,  the 
benefits may not be sufficiently high to justify the adoption of sophisticated systems 
for  collateral  management.  This  would  discourage  them  from  adhering  to  the 
commitment.  To  a  certain  extent,  the  smaller  market  participants  could  resort  to 
using  third-party  service  providers  instead  of  developing  their  own  systems,  thus 
potentially  saving  on  the  costs.  Still,  it  is  highly  unlikely  that  this  option  would 
completely  eliminate  shortcomings  1  (limited  personal  scope)  and  2  (non-binding 
nature of the commitment). 

To the extent  that some more stringent commitments would be required, this could 
potentially introduce some additional benefits, but also costs, compared to option 3.1. 
In any case, for any additional market participants to adhere to the commitment, the 
benefits would need to at least offset the costs. 

6.1.3.3.  Option 3.3. (introduce specific targets) 

This option would eliminate shortcoming 2 (non-binding nature of the commitment) 
of option 3.1. and, depending on the scope of the legislation, potentially shortcoming 
2 (limited personal scope) as well. 

This option would probably lead to increased costs for those market participants that 
would not already be compliant with the requirements set in the legislation. Since the 
legislation would just set out the targets that would need to be achieved, but not the 
ways in which to achieve them, market participants would be free to choose the most 
cost effective solution to meet the targets (e.g. in-house IT system, third-party service 
provider etc.). Compared to option 3.1., this option would lead to larger benefits as it 
would  potentially  cover  all  market  participants  that  are  involved  in  the  collateral 
management process. 

6.1.3.4.  Option 3.4. (prescribe the methods) 

This option would lead to the same benefits as option 3.3. However, it is quite likely 
that  these  benefits  would  come  at  a  higher  cost  as  prescribing  how  the  processes 
should be organised would rob market participants of the flexibility that they would 
enjoy  under  option  3.3.  For  those  market  participants  that  use  processes  that  are 
significantly different from the prescribed ones, adaptation costs could be substantial. 

Table  6:  Summary  of  the  impact  analysis  for  operational  objective  3  (bilateral 
clearing) 

Impact on stakeholders 

Effectiveness 

Efficiency 

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Option 3.1. (baseline) 
Option 3.2. 
(obtain additional 
commitments) 

Option 3.3. 
(set specific targets) 

Option 3.4. 
(prescribe the methods 
to be used) 

n.a. 
(+) regulators gain comfort 
that risk management of 
non-CCP cleared contracts 
improved. 
(-) large upfront investment 
cost setting up procedures, 
particularly heavy for 
smaller market participants 

(+/++) regulators gain 
comfort that risk 
management of non-CCP 
cleared contracts 
significantly improved. 
(-) large upfront investment 
cost setting up procedures, 
particularly heavy for 
smaller market participants 

(+) regulators gain comfort 
that risk management of 
non-CCP cleared contracts 
significantly improved. 
(-) large upfront investment 
cost setting up procedures, 
particularly heavy for 
smaller market participants 

n.a. 
(≈/+) potentially broader 
personal scope and hence 
better risk management by a 
larger number of market 
participants 

n.a. 
(≈/+)  only market participants 
with positive net benefits would 
join 

(+/++) better risk 
management, broader scope,  
compulsory 

(≈/-) investment costs mitigated 
by freedom to choose way of 
meeting the targets 

(+/++) better risk 
management, broader scope, 
compulsory 

(-/--) no flexibility on how to 
implement, potentially large 
costs for market participants 
with processes that differ 
significantly from prescribed 
ones 

6.1.4.  Options for operational objective 4 (standardisation) 

Standardisation is a prerequisite for achieving most, if not even all, of the operational 
objectives  discussed  in  this  report.135  The  extent  to  which  the  other  solutions 
examined  in  this  report  will  be  successful  will  therefore  depend  on  the  level  of 
standardisation that will be achieved. 

6.1.4.1.  Option 4.1. (rely on existing initiatives) 

Existing  initiatives  have  already  led  to  significant  improvements  in  the  levels  of 
standardisation and therefore the mitigation of operational risk. Still, they suffer from 
the same shortcomings as the other initiatives: 

(1)  Limited  personal  scope.  While  the  parties  that  have  currently  committed  to 
adopt  more  standard  legal  contracts  and  more  standard  processes  have  made 
progress,  further  improvements  at  market  level  will  depend  on  other  market 
participants doing the same. 

(2)  Non-binding  nature  of 

the  commitments.  Not  honouring  a  voluntary 
commitment does not carry any particular sanction with it. Therefore, there is 
nothing that compels a market participant to honour the commitment in full or 
to prevent him or her from walking away from it at any point in time. 

135 

Standardisation  is  usually  the  driving  force  behind  the  adoption  of  central  market  infrastructure.  As  the 
case of CDS has shown the process of standardisation can be accelerated in order to facilitate the adoption 
of central market infrastructure. 

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6.1.4.2.  Option 4.2. (obtain additional commitments) 

This  option  would  entail  mostly  broadening  the  personal  scope  of  the  existing 
industry  commitments.  If  other  market  participants  signed  up  to  the  initiatives,  this 
would improve the overall adoption of more standard legal contracts and of standard 
processes. This would also  increase the use of such contracts and processes (e.g. if 
two parties want to enter into a standard legal contract, both need to have adopted it 
first). So if the personal scope of the commitments could be broadened, the benefits 
of this option would be larger than those of option 4.1. 

Switching  to  more  standardised  processes  could  entail  a  potentially  large  upfront 
investment, with benefits of such investment only materialising over time. In the case 
of smaller market participants that do not have sufficiently high transaction volumes, 
the benefits may not be sufficiently high to justify this switch. This would discourage 
them  from  adhering  to  the  commitment.  To  a  certain  extent,  the  smaller  market 
participants could resort to using third-party service providers instead of developing 
their own systems, thus potentially saving on the costs. Still, it is highly unlikely that 
this option would completely eliminate shortcomings 1 (limited personal scope) and 
2 (non-binding nature of commitment). 

To the extent  that some more stringent commitments would be required, this could 
potentially introduce some additional benefits, but also costs compared to option 4.1. 

6.1.4.3.  Option 4.3. (set specific targets for standardisation) 

This option would eliminate shortcoming 2 (non-binding nature of commitment) of 
option 4.1. and, depending on the scope of the legislation, potentially shortcoming 1 
(limited personal scope) as well. In the context of process standardisation, this would 
probably lead to increased costs for those market participants that would not already 
be compliant with the requirements set in the legislation. Since the legislation would 
just set out the targets that would need to be achieved, but not the ways in which to 
achieve  them,  market  participants  would  be  free  to  choose  the  most  cost  effective 
solution to meet the targets. 

As concerns contract standardisation, it could lead to the loss of some flexibility for 
certain market participants (those that require the flexibility of legal terms), however 
this  would  likely  be  at  least  mitigated,  if  not  even  offset  by  the  benefits  from  such 
standardisation (e.g. easier adoption of automated processes). 

Overall, compared to option 4.1., this option would lead to larger benefits as it would 
cover a larger group of market participants. Overall, the costs would also be larger, 
but not to such an extent that they would exceed the benefits. 

6.1.4.4.  Option 4.4. (require the use of standard legal contracts and processes) 

As concerns process standardisation, this option would lead to the same benefits as 
option 4.3. However, it is quite likely that these benefits would come at a higher cost 
as the more detailed requirements on how the processes should be organised would 
rob market participants of the flexibility that they would enjoy under option 4.3. For 
those market participants that use processes that are significantly different from the 
prescribed ones, adaptation costs could be substantial. 

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The  full  harmonisation  of  contracts  could  potentially  lead  to  higher  benefits  than 
option 4.3. To the extent that the resulting contracts would differ substantially from 
existing ones, this would also entail an increase in costs compared to option 4.3. 

Table 7: Summary of the impact analysis for operational objective 4 (standardisation) 

Option 4.1. 
(baseline) 
Option 4.2. 
(obtain additional 
commitments) 

Option 4.3. 
(set specific targets 
for standardisation) 

Option 4.4. 
(require use of 
standard 
contracts/processes) 

Impact on stakeholders 

Effectiveness 

Efficiency 

n.a. 

n.a. 

n.a. 

(≈/+) regulators gain comfort that 
standard contracts more widely 
used. 
(≈/+) easier use of automated 
processes 
(+) additional benefits for market 
participants already subject to the 
commitment 
(-) potentially large upfront 
investment cost, particularly heavy 
for smaller market participants 

(+/++) regulators gain comfort that 
standard contracts more widely 
used. 
(+) easier use of automated 
processes 
(-) potentially large upfront 
investment cost, particularly heavy 
for smaller market participants 
(-) loss of some flexibility for market 
participants  

(+/++) regulators gain comfort that 
standard contracts more widely 
used. 
(+) easier use of automated 
processes 
(-) potentially large upfront 
investment cost, particularly heavy 
for smaller market participants 
(-) loss of some flexibility 

(≈/+) potentially broader 
personal scope and hence 
broader use of standard 
contracts and processes 

(≈/+) only market 
participants with positive net 
benefits would join 

(+/++) better risk 
management, broader 
scope,  compulsory 

(≈/-) investment costs 
mitigated by freedom to 
choose way of meeting the 
targets 

(+/++) better risk 
management, broader 
scope, compulsory 

(-/--) no flexibility on how to 
implement, potentially large 
costs for market participants 
with processes that differ 
significantly from prescribed 
ones 

6.2. 

The preferred policy options and instruments 

6.2.1.  The preferred policy options 

The  preferred  policy  options  are  clearly  marked  in  the  tables  summarising  the 
impacts of the examined policy options. 

6.2.2.  The cumulative impacts of the preferred policy options 

The policy options that have been chosen require that i) all the requested information 
on outstanding OTC derivatives contracts be reported to trade repositories (or if that 
is  not  possible,  directly  to  supervisors),  ii)  aggregated  data  on  OTC  derivatives  be 
published for the benefit of the general public, iii) all contracts that meet pre-defined 
eligibility criteria be cleared by a CCP; iv) that the collateral management procedures 
for  all  OTC  derivatives  that  remain  cleared  bilaterally  be  improved,  and  v)  more 
standard contracts and processes be adopted by market participants. 

Taken  together,  the  above  measures  should  facilitate  the  early  detection  of  risks 
building  up  in  the  financial  system,  reduce  the  counterparty  credit  risk  related  to 

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OTC  derivatives,  and  improve  the  functioning  of  the  OTC  derivatives  market 
through the adoption of more efficient processes. Ultimately, the combined effect of 
the selected options should at least reduce the severity of any future financial crisis, 
thus reducing its impact on the real economy. 

Given that the actions complement each other there is a concrete possibility that their 
combined  benefits  will  actually  exceed  the  sum  of  the  benefits  of  each  separate 
measure.  Similar  synergies  are  likely  to  happen  on  the  cost  side  of  the  measures. 
While it is true that most of the investments to support these measures will need to be 
borne  in  the  short  term,  at  least  some  of  those  investments  may  cover  several 
measures at the same time, thus reducing their overall cost impact. 

To  the  extent  that  the  policy  choices  will  help  correct  the  mispricing  of  risk  that 
occurred prior to the crisis (the price of risk was too low in relation to the level of 
risk in the system), they may (and probably will) lead to an increase in the price of 
hedging  and  ultimately  the  cost  of  capital.  The  exact  magnitude  of  this  increase  is 
unknown  (in  part,  it  depends  on  the  level  of  competitive  pressure),  but  is  not 
expected to be excessive. 

6.2.3.  The impact on retail investors and SMEs 

As  a  norm,  retail  investors  do  not  have  access  to  the  OTC  derivatives  market.  The 
policy  choices  made  above  will,  therefore,  not  have  a  direct  impact  on  them. 
Similarly,  the  use  of  OTC  derivatives  among  SMEs  is  relatively  limited.  To  the 
extent  that  they  use  OTC  derivatives,  the  expected  exclusion  of  non-financial 
institutions  from  the  scope  of  the  proposals  (see  section  6.2.8.2.  for  more  details) 
means  that  they  will  be  spared  the  direct  impacts.  Both  categories  will,  however, 
likely be subject to the indirect impact of the proposals (i.e. the increase in the cost of 
hedging and of capital). 

6.2.4. 

Social impact 

To  the  extent  that  the  proposed  policies  will  help  contain  the  effects  of  future 
financial  crises  on  the  real  economy,  they  will  also  help  reduce  the  social  costs  of 
those crises (e.g. unemployment). 

6.2.5.  Environmental impact 

Nothing  would  suggest  that  the  proposed  policy  will  have  any  direct  impacts  on 
environmental  issues.  There  may,  however,  be  at  least  some  indirect  impacts.  For 
example,  since  OTC  commodity  derivatives  will  be  included  in  the  scope  of  the 
proposals,  there  may  be  an  impact  on  the  prices  of  commodities  (e.g.  oil,  carbon 
emission  allowances)  and  hence  the  environment.  This  impact  is  likely  to  be  quite 
small, though. 

6.2.6. 

Impact on third countries / impact on EU competitiveness 

As  described  in  section  3.3.4.  several  countries  outside  the  EU  are  pursuing 
legislative initiatives in the area of OTC derivatives, most importantly the US. With 
the caveat that EU legislation still needs to be adopted by the EU legislators and that 
detailed  technical  rules  still  need  to  be  defined  both  in  the  US  and  in  the  EU,  a 
comparison of the main elements of the Dodd-Frank Act with the preferred options 

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chosen  above  shows  that  they  are  broadly  consistent.  At  this  stage  it  is  therefore 
possible  to  claim  that  there  are  no  significant  risks  of  regulatory  arbitrage  between 
the EU and the US. Whether this will remain the case after all the abovementioned 
processes will have been concluded, it is very difficult to predict. There is certainly a 
need  to  maintain  a  close  dialogue  with  the  US  to  prevent  that  major  divergences 
develop in the next phase of rulemaking. 

Since the OTC derivatives market is a global market, it is important to monitor not 
only the actions of the US, but also those of other G20 members. Particular attention 
will also need to be given to countries that are not part of the G20, as they are not 
bound  by  the  Group's  commitments  and  may  therefore  be  tempted  to  attract  OTC 
derivatives  business  to  their  jurisdiction.  This  could  have  a  negative  impact  on  the 
competitiveness of the EU (market participants may simply move their business to a 
jurisdiction that has either weaker rules or none at all), although it is hard to judge 
what the magnitude of this impact could be. Furthermore, without having a clear idea 
of what third-country actions will entail exactly, the means by which the EU could 
address this potential disadvantages are unknown. 

However,  any  potential  loss  of  competitiveness  or  opportunities  for  regulatory 
arbitrage  will  have  to  be  taken  into  account  when  deciding  on  the  best  way  to 
implement  the  desired  policy  initiatives.  In  addition,  international  commitments 
taken  by  the  EU  at  the  WTO  will  have  to  be  considered  to  ensure  that  the 
implementation  of  the  proposed  policies  is  not  incompatible  with  the  EU's  trade 
obligations. 

An important issue that still needs to be addressed by all sides are OTC derivatives 
that have a cross-jurisdictional component. If no agreement at international level is 
found on how to treat these contracts, there is a concrete risk that they would be able 
to  avoid  regulation,  at  least  partially  (e.g.  the  CCP-clearing  requirement).  Another 
point  where  close  cooperation  will  be  needed  concerns  the  recognition  of  market 
infrastructures (CCPs and trade repositories). This is due to the fact that EU market 
participants  may  want  to  use  them  for  the  purpose  of  complying  with  the  clearing 
and reporting obligations. 

The  Commission  will  therefore  need  to  develop  procedures  for  recognising  third-
country market infrastructures that will wish to offer their services to entities located 
in  the  EU.  In  view  of  the  recognition  process,  the  location  of  a  particular  CCP  or 
trade repository in a third country should not pose any particular issues: EU entities 
should  be  able  to  use  third-country  market  infrastructures  for  the  purpose  of 
complying  with  the  clearing  or  reporting  obligation  only  if  those  market 
infrastructures have been recognised to be subject to equivalent rules and supervision 
in their home country. 

6.2.7.  The preferred policy instrument 

Before  starting  the  analysis  of  the  various  policy  instruments,  it  is  worth  recalling 
that  in  its  October  2009  Communication  on  derivatives  markets  the  Commission 
stated that a paradigm shift in the approach towards derivatives markets was needed, 
to  a  more  ambitious  and 
namely  moving  from  "light-handed  regulation" 

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comprehensive regulatory policy. This paradigm shift has been broadly welcomed by 
the Council136 and strongly supported by the European Parliament.137 

In view of the above, the Communication can be immediately discarded from further 
analysis of the preferred policy option (it can also be discarded due to the fact that it 
has  already  been  used  in  the  initial  steps  of  the  Commission's  policy  development 
process). 

The same can be said about the self-regulatory approach. As it was shown in section 
3  of  this  report,  there  are  several  industry  initiatives  currently  under  way,  many  of 
which have already delivered improvements in the way the OTC derivatives market 
works.  However,  the  approach  cannot  be  used  as  the  basic  one  for  the  reasons 
outlined  in  the  analysis  in  section  6.1.  Rather,  the  existing  initiatives  can  be  used 
either as a starting point for legislative action (they provide useful information on the 
detailed measures that may be targeted) or as a useful complement to it. 

An  advantage  of  choosing  a  Recommendation  is  certainly  the  high  flexibility  that 
this instrument gives to Member States (the latter may decide whether or not to do 
something,  and  in  case  of  the  former  also  what  exactly  to  do).  In  other  words,  a 
Recommendation would simply provide the national policy makers with a suggestion 
by the Commission to the policy preference with no effect on the situation that needs 
to be addressed. Member States' legislators would then be left to decide whether to 
accept  or  not  the  policy  suggestion.  In  case  they  would  choose  to  accept  it,  they 
would  then  need  to  translate  it  into  concrete  mandatory  rules  within  their 
jurisdictions. 

In  the  context  of  the  problems  and  objectives  that  were  defined,  this  flexibility  is 
actually a severe drawback. Indeed, as 

(1) 

(2) 

(3) 

the  identified  problems  concern  areas  that  are  of  critical  importance  for  the 
smooth  functioning  of  financial  markets  and  therefore  the  economy  as  a 
whole, 

the  cross-border  effects  of  diverging  national  rules  addressing  the  OTC 
derivatives market constitute a severe drawback for the efforts to create a safe 
and efficient financial market, and 

solving the identified problems requires a high level of harmonisation of rules 
(and thus legal certainty), 

a  legally  non-binding  instrument,  such  as  a  Recommendation,  turns  out  to  be 
inadequate.  It  may  lead  to  a  situation  in  which  i)  no  action  is  taken  by  Member 
States, ii) action is undertaken only by some of them (potentially on different subsets 
of the issues), or iii) action is undertaken, but the Recommendation is not followed 
by  all  Member  States  that  decided  to  act,  leading  to  potentially  contradicting 
solutions  that  could  actually  worsen  the  situation.  Due  to  the  seriousness  of  the 
identified problems, neither outcome is acceptable. 

136   See point 5 of Council Conclusions of 2 December 2009. 
137   See Langen report. 

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This  means  that  the  basic  policy  choice  -  should  action  be  considered  necessary  at 
EU level - for introducing these changes is through a harmonising legal instrument at 
the  EU  level.  For  this  there  are  two  options,  namely  to  use  a  Directive  or  a 
Regulation. 

While it is correct to say that the main type of legislative instruments introducing EU 
financial services legislation has traditionally been Directives, this was the result of 
the  contents  and  the  objectives  of  those  instruments.  They  mainly  approximated 
national  rules  on  the  taking  up  of  business  and  the  provision  of  services  and  on  a 
gradual  manner.  They  also  allowed  the  seamless  integration  of  those  rules  in  the 
legal systems of the Member States while giving the opportunity to them to extend 
the EU rules to areas uncovered by the EU legislation. Admittedly, a Directive is the 
most appropriate form of instrument to achieve this result. 

However, in view of the objectives of the current proposal, a Directive does not seem 
to  be  the  right  choice  of  instrument.  The  proposal  requires  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. In fact, the 
three  objectives,  namely  information  on  positions,  the  use  of  a  CCP  and 
standardisation would require absolute clarity and uniformity as to the personal and 
material  scope  of  application,  the  conditions  of  its  application  throughout  the  EU 
without  exceptions  or  diverging  implementations  by  national  authorities  and 
jurisdictions.  

It  is  these  characteristics  of  this  legislative  instrument  that  in  a  sense  dictate  the 
choice of Regulation as the most appropriate form, since:  

(1) 

(2) 

(3) 

(4) 

directly applicable Regulations are the only way to have effectively uniform 
rules throughout the EU, to the recognised benefit of industry and the users of 
these  rules.  They  eliminate  divergences  in  applicable  law  between  Member 
States. At the same time, uniform rules do not mean "one size fits all" and are 
not incompatible with a certain degree of flexibility for national supervisors 
in the application of those rules. 

Regulations  reduce  legal  uncertainty:  in  case  of  directives  national  law 
provisions  have  to  be  interpreted  in  the  light  of  the  underlying  directives, 
which  themselves  may  require  interpretation,  whereas  regulations  are 
applicable without a second layer of national legislation. 

Regulations ensure that European law is applicable immediately and to its full 
extent in the whole Union after its adoption by the legislator. They avoid the 
resource-intensive and time-consuming transposition of directives by Member 
States  and  the  monitoring  of  timely  and  correct  transposition  by  the 
Commission.  

The  numerous  infringement  cases  against  Member  States  for  late,  non-  or 
incorrect transposition of directives are evidence that the transposition of EU 
law  is  ineffective  in  many  instances.  Depending  on  the  content  of  the 
regulations, adaptations of national legislation may continue to be necessary 
in  some  cases.  But  this  is  much  more  limited  than  the  transposition  of  a 

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directive, and [in most cases$ application of a Regulation in the markets will 
not depend upon it.  

The  transposition  process  has  proven  particularly  inappropriate  for  quick 
responses  needed  in  times  of  crisis  and  to  implement  G20  commitments 
within the timeframes committed to at the international level.  

Regulations can be directly invoked by the parties concerned before national 
administrations  and  courts,  whereas  this  applies  only  in  very  limited 
circumstances for Directives.  

(5) 

(6) 

For  all  these  reasons,  the  Commission  services  consider  that  a  Regulation  is  the 
preferred option.  

6.2.8.  The scope of legislation 

Various market participants have advanced arguments for excluding them or certain 
types  of  OTC  derivatives  they  use  from  the  scope  of  any  potential  legislation 
regulating the OTC derivatives market. The following two  sections provide  a more 
detailed  analysis  of  the  issues  that  were  raised  in  this  context  and  of  the  possible 
ways to tackle them. 

6.2.8.1.  Material scope 

In terms of the types of OTC derivatives that should not fall under the scope of the 
Commission's policy proposals, many market participants felt that the main problems 
were  caused  by  CDS,  so  any  future  legislation  should  only  be  focused  on  them. 
Especially  for  two  market  segments,  namely  foreign  exchange  and  commodity 
derivatives,  a  large  number  of  market  participants  felt  that  no  regulatory  action 
should be taken, because they played no role in the financial crisis. This argument is 
"problematic" in three ways. Firstly, it is not entirely true: as argued in various parts 
of this report, the web of connections among the biggest market players created by 
all  OTC  derivatives  played  an  important  role  in  the  crisis.  Secondly,  the  argument 
ignores the fact that many of the issues related to the functioning of the CDS market 
are  equally  valid  in  other  segments  of  the  OTC  derivatives  market.  Finally,  the 
argument is backward-looking: the proposed legislation should not just aim at fixing 
the  most  immediate  problems  that  arose  during  this  crisis.  It  should  also  provide 
regulators  with  a  comprehensive  set  of  tools  to  detect  the  build-up  of  risks  in  the 
system and thus prevent, or at least limit, the severity of future crises. 

The Commission already acknowledged, in its second Communication on derivatives 
markets,  that  the  various  market  segments  differed  in  their  characteristics  and 
indicated  that,  where  justified,  its  policy  proposals  would  duly  take  into  account 
these  specificities.138  However,  the  Commission  also  expressed  its  belief  that  a 
comprehensive  policy  on  derivatives  was  necessary  in  order  to  avoid  market 
participants exploiting differences in rules, i.e. regulatory arbitrage.  

138  The  Commission  indicated  that  particular  attention  would  be  given  to  the  specificities  of  certain 
commodity  markets,  e.g.  electricity  and  gas  markets,  due  to  their  particular  underlying  physical  market 
structure. 

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Given  that  the  main  focus  of  the  concerns  revolves  around  the  applicability  of  the 
reporting and CCP clearing requirements it is worth to look at the two in more detail. 
As clearly stated in this report, the main objective of the reporting requirement is to 
increase the transparency of the OTC derivatives market, in particular by providing 
comprehensive information on the positions held by the various market participants. 
Leaving  entire  segments  of  the  OTC  derivatives  market  out  of  this  requirement 
would  mean  that  regulators  could  not  gain  a  comprehensive  view  of  the  entire 
market. This would defeat the purpose of the whole exercise. 

As  concerns  the  CCP-clearing  requirement,  the  Commission  has  repeatedly  stated 
that it is aware of the fact that not all OTC derivatives could be cleared by a CCP and 
that  it  has  no  intention  of  forcing  market  participants  to  clear  all  their  trades  on  a 
CCP. The preferred policy option fully reflects this view: it requires that only those 
OTC derivatives that fulfil certain criteria be cleared by a CCP. 

6.2.8.2.  Personal scope 

In  terms  of  the  market  participants  that  should  not  fall  under  the  scope  of  the 
Commission's  policy  proposals,  there  was  a  unanimous  plea  from  non-financial 
institutions to be excluded from any kind of future legislation on OTC derivatives.139 
The  main  argument  that  they  advanced  in  defence  of  this  position  was  that  their 
dealings in OTC derivatives do not represent a systemic risk. They also warned that 
if  they  would  be  subject  to  the  legislation,  the  resulting  costs  could  force  them  to 
reduce, or in the extreme even abandon, their hedging practices. 

Similarly  to  its  statement  on  the  various  market  segments,  the  Commission  also 
indicated  that,  where  justified,  the  policy  proposals  would  strike  the  right  balance 
between financial and non-financial institutions. In particular, the Commission stated 
that  in  order  to  promote  competitiveness  and  growth  of  the  European  industry,  it 
would  strive  to  ensure  that  any  future  policy  option  would  allow  non-financial 
institutions to manage the risks inherent to their business. 

The  impact  analysis  shows  that  including  non-financial  institutions  in  the  scope  of 
the policy proposals, especially the CCP-clearing requirement, may expose them to a 
significant  increase  in  their  costs.  In  light  of  this,  two  possible  solutions  can  be 
contemplated. 

One is to leave non-financial institutions entirely outside the scope of the proposals. 
This approach has two important drawbacks. The first one is that it creates a loophole 
that other market participants may try to take advantage of. The second one is that it 
ignores the possibility that one or more non-financial institutions may already play, 
or  will  do  so  in  the  future,  a  significant  (even  systemically)  role  in  a  particular 
market segment. 

The other one is to leave non-financial institutions outside the scope of the proposals, 
including,  at  the  same  time,  a  safeguard  that  would  allow  the  inclusion  of  a  non-
financial institution in the scope of the legislation, should its positions exceed a pre-
defined threshold. The possibility of setting multiple thresholds that would allow for 

139 

Similar  calls  for  exclusion  have  also  come  from  supranational  institutions  (e.g.  development  banks)  and 
governments. 

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the  progressive  inclusion  could  also  be  considered.  The  thresholds  should  be  re-
calibrated  periodically  in  order  to  reflect  correctly  the  evolution  of  the  market.140 
This solution is better as it would address both drawbacks of the first one. 

6.2.9. 

Impacts of the detailed technical rules 

As  already  stated,  the  preferred  policy  options  represent  only  general  principles,  In 
order to make them operational, detailed technical rules will need to be adopted by 
the  Commission.  In  accordance  to  existing  practice,  the  costs  and  benefits  of  those 
rules will be assessed at that time. 

*   *   * 

The policy choices made above put financial market infrastructure at the very heart 
of the efforts to reform the OTC derivatives market. 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  outstanding  issues  that  have  been  identified  in 
relation to the functioning of CCPs and trade repositories need to be addressed. The 
issues  and  the  ways  of  addressing  them  are  discussed  in  the  next  section  of  this 
report. 

140  The  information  stored  in  trade  repositories  will  play  a  crucial  role  in  the  initial  definition  and  periodic 

calibration of the thresholds. 

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7. 

POST-TRADING MARKET INFRASTRUCTURE 

7.1. 

Central counterparties 

CCPs  can  clear  both  securities  and  derivatives,  irrespective  of  whether  they  are 
traded on an exchange or an OTC market. In many cases the same CCP clears many 
different financial instruments and markets and while there are certain nuances and 
specificities  that  are  related  to  each  one  of  them,  the  basic  principles  applicable  to 
CCP clearing are universal. The analysis presented in this section in respect of this 
fact. 

7.1.1.  Background141 

Today,  CCPs  are  used  to  clear  both  securities  and  derivatives  trades.  However, 
whereas some form of CCP has been present in the European derivatives space since 
the late 19th century, it took CCPs far longer, until late in the second half of the 20th 
century, to gain a firm foothold in the European securities space. The reason behind 
this  gap  lies  in  the  more  prominent  role  that  counterparty  credit  risk  plays  in 
derivatives  transactions  compared  to  securities  transactions.  Indeed,  derivatives 
transactions  take  much  longer  to  complete  (they  can  take  decades  to  complete, 
whereas  securities  transactions  typically  take  three  days)  and  involve  greater 
uncertainty as to the value (and even direction) of the ultimate transfer obligations. 
Hence, CCPs play a more prominent role for them. 

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.142 Thus the “many-to-many” chain of credit is replaced 
by “one-to-many” arrangement, with the CCP at the centre of the arrangement (see 
Figure 12 below). 

Figure 12: Bilateral vs central (CCP) clearing 

B
B

A
A

C
C

F
F

D
D

E
E

B
B

A
A

C
C

CCP
CCP

F
F

D
D

E
E

141  This  section  is  based  on  Bliss,  Robert  and  Robert  Steigerwald,  Derivatives  Clearing  and  Settlement:  A 
Comparison  of  Central  Counterparties  and  Alternative  Structures,"  Economic  Perspectives,  2006,  30  (4, 
Fourth 
at 
http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2006/ep_4qtr2006_part2_bli
ss_steigerwald.pdf. 

Chicago), 

Available 

p.22-29. 

Quarter, 

Reserve 

Federal 

Bank 

of 

142   Bank  for  International  Settlements,  Committee  on  Payment  and  Settlement  Systems,  and  Technical 
Committee  of  the  International  Organization  of  Securities  Commissions,  2004,  Recommendations  for 
Central Counterparties, Basel, Switzerland, November. http://www.bis.org/publ/cpss64.pdf. 

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The legal process whereby the CCP is interposed between buyer and seller is known 
as  novation.143  To  put  it  simply,  novation  is  the  replacement  of  one  contract  with 
another. In fact, when a CCP steps in between the original parties to the trade, two 
novations  takes  place,  leading  to  the  creation  of  two  new,  perfectly  offsetting 
contracts.  Because  the  two  contracts  offset  one  another,  the  CCP  normally144  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. 

CCPs  mitigate  their  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 (default) waterfall” of the CCP. 

•  Access  restrictions  (such  as  membership  requirements)  are  a  CCP’s  first  line  of 
defence.  CCPs  only  deal  with  parties 
for 
creditworthiness and operational capability and may revoke access privileges for 
those who fail to maintain these standards and meet other obligations to the CCPs. 
This permits the CCPs to limit their risk exposure to those parties they are able to 
monitor. 

their  standards 

that  meet 

•  The second line of defence is represented by the CCP’s counterparty credit-risk-
management  techniques.  A  CCP  usually  uses  several  of  them.  For  example, 
positions and payment requirements are multilaterally netted. CCPs also typically 
impose  collateral  requirements  (i.e.  initial  margin)  on  market  participants  that 
have direct access to the CCP. In addition, gains and losses due to mark-to-market 
fluctuations  in  the  open  positions  are  posted  to  a  clearing  member’s  margin 
account on a regular (usually daily) basis and result in calls for variation margin. 

•  If  the  posted  initial  margin  is  not  sufficient  to  offset  a  loss  resulting  from  the 
failure  of  a  clearing  member,  the  third  line  of  defence  is  activated.  After 
exhausting the failed clearing member’s initial margin, a CCP will use the latter’s 
contribution to the default fund to cover any residual losses. If this were to prove 
insufficient, the CCP can then proceed to share any remaining loss among all (or 
certain classes of) clearing members by using their default fund contributions. 

•  The fourth, and last, line of a CCP’s defence is its own capital.145 

143  

144  

In some European countries, an alternative approach, known as open offer, is used. In this case, the CCP 
makes  an  offer  to  enter  into pairs  of  contracts  on  terms  agreed  upon  by  two  markets  participants,  under 
certain rules. The market participants agree upon the terms but never formally enter into a contract vis-à-
vis each other. Instead, they report their agreement to the CCP, which then enters into the two contracts. 
In case of a counterparty’s default, the CCP’s position would become unbalanced and the CCP would be 
exposed to market risk until the defaulting counterparty’s position would be reversed. 

145   Depending on each individual CCP’s arrangements, the use of at least part of the CCP’s own capital can 
come before the other defences have been depleted, for example before the default fund contributions of 
the non-defaulting clearing members are tapped. This serves as an incentive for the CCP to perform its risk 
management  tasks  properly.  Some  CCPs  may  also  have  additional  defences  in  place,  such  as  additional 
calls for contributions from non-defaulted clearing members, which may be used before the CCP’s capital 
is tapped. 

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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. 
Indeed,  should  a  CCP  fail,  the  most  immediate  consequence  would  be  at  least  a 
temporary breakdown of the market as the whole structure through which positions 
are established, maintained, and closed-out would be disrupted. The effects of such a 
CCP failure, were it to occur, might be extremely serious. 

In view of their systemically important role, CCPs are subject to strict regulation. In 
the  EU,  CCPs  are  regulated  at  the  national  level.  Since  the  rules  in  each  Member 
State  have  been  shaped  by  the  specific  economic  and  institutional  circumstances, 
different  Member  States  have  adopted  different  solutions  when  regulating  CCPs. 
This  has  led  to  a  very  diverse  and  fragmented  CCP  landscape  in  the  EU.146  The 
diversity is reflected in the different forms (e.g. a bank, a commercial entity) and in 
the  different  business  models  (vertically  integrated  with  exchanges  or  stand-alone) 
that CCPs have adopted. The fragmentation is a function of the number of CCPs that 
exist in the EU. 

The above differences make cross-border provision of CCP services more costly and 
potentially less safe than would be desirable and represent a barrier to the integration 
of  the  EU  financial  market.  The  Commission  highlighted  this  issue  in  two 
in  2002  and  2004.147  The  2004 
Communications,  published 
Communication concluded that legislation was necessary to ensure efficient and safe 
pan-European clearing and settlement. 

respectively 

In  July  2006,  after  having  considered  the  advantages  and  disadvantages  of  a 
legislative  solution,  the  Commission  decided  not  to  propose  any  new  legislation  in 
the area of post trading in general and CCPs in particular. Instead, it opted for a two 
pronged  approach.  In  order  to  increase  efficiency  and  integration  in  the  market  for 
post-trading services, it called on the industry to provide a self regulatory solution. In 
November 2006 the industry responded by adopting a Code of Conduct on Clearing 
and  Settlement148  that  addressed  three  main  issues:  transparency  of  prices  and 
services,  access  and  interoperability,  and  unbundling  of  services  and  accounting 
separation. Its scope is limited to cash equities. To monitor the implementation of the 
commitment, the Commission created the Monitoring Group of the Code of Conduct 
(MOG).149  The  Commission  services  also  prepared  regular  reports  to  inform  the 
Council about the progress made in implementing the Code of Conduct.150 

In order to ensure more consistent regulation across the EU the Commission called 
upon  CESR  and  ESCB  to  complete  their  work  on  recommendations  for  securities 
settlement systems (SSSs) and CCPs. In June 2009 the ESCB and CESR published 
their  recommendations  for  SSSs  and  CCPs,151  an  adaptation  of  the  global  CPSS-

146   See Annex 4 for an overview of existing CCPs. 
147   Clearing and Settlement in the European Union: Main policy issues and future challenges - COM(2002) 
257 and Clearing and Settlement in the European Union - The way forward - COM(2004) 312. Available 
at http://ec.europa.eu/internal_market/financial-markets/clearing/communication_en.htm#com. 

148   A  copy  of  the  text  of  the  Code  of  Conduct  and  of  other  related  documents  is  available  at 

http://ec.europa.eu/internal_market/financial-markets/clearing/communication_en.htm#code. 
149   See MOG website at http://ec.europa.eu/internal_market/financial-markets/clearing/mog_en.htm. 
150   Available at http://ec.europa.eu/internal_market/financial-markets/clearing/communication_en.htm#ecofin. 
151   Available at http://www.ecb.europa.eu/pub/pdf/other/pr090623_escb-cesr_recommendationsen.pdf 

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IOSCO  recommendations,  with  the  aim  to  increase  the  safety,  soundness  and 
efficiency of CCPs in the EU. The recommendations are addressed to regulators and 
overseers,  who  have  committed  to  using  them  as  a  regulatory  tool  and  to  strive  to 
achieve their consistent implementation and a level playing field for SSSs and CCPs 
in  the  European  Union.  The  CCP  recommendations  cover  all  aspects  of  a  CCP’s 
activities,  including  risk  management,  governance  and  links.  They  also  take  into 
account the specific risks related to central clearing of OTC derivatives. 

7.1.2.  The political mandate 

As  concerns  OTC  derivatives,  in  the  October  2009  Communication  on  derivatives 
markets the Commission announced that it intended to propose legislation governing 
their activities so as to eliminate any discrepancies among national legislations and 
ensure safety, soundness and proper governance. 

In  the  area  of  securities,  the  November  2009  Commission  services  report  to  the 
Council concludes that the Code of Conduct has reached its objective of enhancing 
efficiency  by  increasing  competition.  It  furthermore  points  out  that  the  Code  of 
Conduct helped reveal additional problems - especially regulatory ones - that need to 
be properly addressed. Finally, it concludes that in order to resolve issues related to 
risk and differences in regulation can only be addressed by legislation. 

In its Conclusions of 2 December 2009, the Council agreed with the need to promote 
CCP clearing of eligible derivatives, welcomed the Commission's intention to work 
on  legislative  proposals  for  CCPs  and  agreed  that  further  steps  need  to  be  taken  to 
address  issues  related  to  risk  and  regulatory  barriers  to  CCP  clearing  of  cash 
equities.152 

In its Resolution, the European Parliament welcomed the Commission’s intention to 
submit legislative proposals on clearing houses CCPs.153 

7.1.3.  The problems 

7.1.3.1.  Problem 1: Lack of level playing field for CCPs 

Given the lack of common rules, a CCP wishing to offer its services outside its home 
market  may  need  to  obtain  multiple  authorisations  and  may  have  to  comply  with 
multiple  sets  of  rules.  For  example,  in  some  Member  States  a  CCP  is  required  to 
have  a  banking  license  in  order  to  be  authorised.  A  CCP  coming  from  a  Member 
State  not  having  this  requirement,  would  therefore  risk  being  subject  to  double 
regulation. In the best of cases, this leads to an increase in the operational costs for 
CCPs providing their services in several Member States and consequently increases 
the costs for market participants using them. In the worst of cases, it discourages a 
CCP from even attempting to enter another market, as the associated costs would be 
simply too high. In short, the lack of common rules can act as an additional barrier to 
entry in a market, providing an additional layer of protection to the incumbent CCP. 
More in general, it prevents the integration of the post-trading sector in the EU. 

152   See Annex 3. 
153   See Langen report, paragraph 44. 

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The  practical  difficulties  stemming  from  the  lack  of  common  rules  for  CCPs  have 
been  highlighted  both  in  the  area  of  cash  equities  (more  specifically  in  connection 
with  the  establishment  of  links  between  CCPs)  and  in  the  area  of  OTC  derivatives 
(more specifically the CDS market). 

7.1.3.2.  Problem 2: Lack of common rules for the establishment and treatment of links 

The establishment of links is considered to be a way to increase competition among 
CCPs. It is therefore no surprise that when the Code of Conduct, and in particular the 
Guideline  on  access  and  interoperability,  was  established,  there  was  a  flurry  of 
interoperability requests between CCPs. The CCPs wanted to take advantage of the 
opportunity  presented  to  them  by  links  and  enter  new  markets.  However  of  all  the 
interoperability request that had been made, only one came to fruition so far. The rest 
of  the  requests  have  been  either  abandoned  or  are  still  in  the  process  of  being 
completed.  Setting  aside  those  requests  that  may  have  been  more  the  result  of 
strategic  positioning  than  anything  else,  the  slow  progress  of  the  majority  of  the 
requests  can  be  mainly  attributed  to  three  groups  of  obstacles:  regulatory, 
commercial and technical/operational. 

The  regulatory  obstacles  are  mainly  linked  with  the  differences  in  national  rules 
highlighted in problem 1 above. Indeed, a mapping exercise concluded by CESR154 
highlights  that  national  regulatory  arrangements  differ  in  how  link  requests  are 
regulated, what the conditions are for cross-border service provision, the authorities 
involved, the supervisory powers and how cross-border coordination is ensured. As 
requests between CCPs started taking off, regulators have started to grapple with the 
impact  that  interoperability  involving  multiple  CCPs  may  have  on  liquidity,  credit 
and systemic risk.155 In particular, regulators raised concerns on the way CCPs chose 
to collateralise the exposures they would have with one another. In this context the 
lack of common rules does not help, as it makes it more difficult to reach a common 
position on how to address the risk concerns. While the concerns that regulators have 
in relation to interoperability in cash equities markets are significant, they are not as 
strong  as  those  related  to  the  concerns  they  have  on  interoperability  in  the  OTC 
derivatives market. 

The  commercial  obstacles  are  the  direct  consequence  of  the  lack  of  incentives  for 
incumbent  CCPs  to  accept  interoperability  requests.  By  definition,  an  incumbent 
CCP  that  enjoys  a  dominant  position  can  only  lose  by  opening  up  its  market  to 
competition. Consequently, the incumbent will have no interest in agreeing to enter 
in  an  interoperability  agreement.  This  is  why  the  Code  of  Conduct  explicitly  states 
that  loss  of  market  share  cannot  be  used  as  an  argument  to  turn  down  a  request. 
However, an incumbent can always find away of slowing down the process without 
being  in  breach  of  the  letter  of  the  Code  of  Conduct.  In  this  situation,  the  trading 
venues have proved to play a crucial role as facilitators of interoperability. Indeed, in 
instances  where 
themselves  showed  a  clear  will  for 
interoperability,  the  process  tended  to  be  much  faster  then  in  those  where  this  was 
not the case. 

trading  venues 

the 

154   CESR  (2009).  Preliminary  technical  advice  on  access  &  interoperability  arrangements  in  the  EU, 

CESR/08-870. 

155   See  Joint  Regulatory  Authorities  of  LCH.Clearnet  Group,  Investigation  of  risks  arising  from  the 

emergence of multi-cleared trading platforms, July 2008. 

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The technical/operational obstacles are due to differences in business models, market 
standards,  practices  and  technical  communication  languages  between  CCPs.  For 
example,  a  very  important  question  in  an  interoperability  agreement  concerns  the 
treatment  of  exposures  between  the  two  interoperating  CCPs.  Given  that  CCPs 
usually adopt different risk management models, finding an agreement on how these 
exposures will be handled can be difficult, as each CCP will have a clear preference 
for an approach that mimics its existing solutions.  

The lower number of links due to the existence of these obstacles means that there is 
less competition, less choice for investors, and also less chances for integration and 
consolidation in the sector. 

7.1.3.3.  Problem 3: Danger of competition on risk 

The Code of Conduct is not the only source of competition in the CCP space: there is 
also the MiFID. The competition between multilateral trading facilities (MTFs) and 
regulated  markets  (i.e.  exchanges)  that  was  spurred  by  the  MiFID  has  had  a 
somewhat  surprising  side  effect:  indirect  competition  between  CCPs.  To  put  it 
simply, in order to compete against established exchanges, MTFs chose to use newly 
established CCPs that offered much lower fees than the incumbent CCPs. This made 
the  overall  price  proposition  of  the  MTFs  much  more  attractive  than  those  of  the 
exchanges  and  allowed  them  to  capture  an  important  market  share.  In  response  to 
this  new  competition,  exchanges  started  cutting  their  fees  and  started  demanding 
their post-trading infrastructure (therefore also CCPs) to do the same. This has led to 
an unprecedented drop in clearing fees on the market. 

This has prompted questions as to whether the fees charged by CCPs will soon reach 
the physiological floor dictated by the economies of scale. This in turn gave rise to 
concerns  about  the  possibility  of  CCPs  starting  to  compete  on  risk  (this  is  to  be 
understood  as  competition  through  lowering  the  quality  of  risk  management,  more 
specifically by cutting the margins required from the clearing members). A number 
of  market  participants  seem  to  fear  that  this  is  already  happening.  They  have 
privately  told  the  Commission  services  on  various  occasions  that  CCPs  had  started 
lowering  their  risk  standards  in  order  to  lower  their  costs  and  attract  more  clients. 
Recently,  a  CCP  voiced  the  same  concern  in  public.156  These  claims  were  never 
backed  with  concrete  evidence,  so  the  Commission  services  cannot  judge  whether 
they  are  true  or  not.  Irrespective  of  whether  they  are  true  or  not,  however,  they 
highlight a potentially dangerous side effect of competition between CCPs. 

Unlike competition between CCPs based on, for example, technological innovation, 
the  race-to-the-bottom  kind  of  competition  that  is  competition  on  risk  is  highly 
undesirable,  as  it  can  have  devastating  consequences  given  the  systemic  role  of 
CCPs. 

156   LCH.Clearnet warns of loose standards, Financial Times, 16 April 2010. 

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7.1.3.4.  Problem  4:  Impaired  portability  of  positions  and  associated  margins  (collateral)  in 

the CCP environment 

One of the consequences of introducing a clearing requirement is that those market 
participants that would not meet the criteria to become clearing members of a CCP 
would have to access it indirectly, through a general clearing member (GCM). This 
raises the question of what these indirect participants could do in case of the GCM’s 
default. In principle, they would have two basic choices in such a situation. The first 
one  would  be  to  close  their  positions  with  the  defaulting  clearing  member  and 
seeking to replace the closed contract with a new one. In this case, they would bear 
the market risk. The second one would be to move their positions and the associated 
collateral to another GCM within the same CCP (assuming that they had found one 
that would be willing to accept this). In this case, no market risk would be involved. 
Irrespective of the choice they would make, the question of whether they would be 
able  to  get  back  the  collateral  (more  precisely  the  initial  margin)  they  have  posted 
with the failed GCM would arise.157 In the first case, the answer would depend on the 
manner in which the initial margin had been provided and held, and particularly, the 
extent to which margin had been segregated from the GCM’s assets and recoverable 
by  the  clients.  In  the  second  case  the  answer  would  additionally  depend  on  the 
effectiveness of the CCP’s procedures for the transfer of client positions and related 
initial margin. In both cases the  answer would depend on the law applicable to the 
defaulting GCM. 

The  question  is  not  just  theoretical,  as  clients  of  Lehman  Brothers  International 
Europe (LBIE) found out after the latter defaulted. When these clients attempted at 
transferring  their  positions  and  related  initial  margin  from  LBIE  to  another  GCM 
within  the  same  CCP,  they  discovered  they  could  do  the  former,  but  not  the  latter 
(because  the  margin  of  LBIE’s  clients  was  frozen).  To  make  matters  worse,  the 
clients  were  required  to  deposit  margin  with  their  new  GCM  to  meet  margin 
requirements associated with the transferred positions, resulting in “double margin”. 
The origin of the problem was two-fold: first, in some cases the assets of LBIE and 
those of its clients were co-mingled in the same account. In other words, it was not 
immediately evident which assets belonged to whom. Second, the margin was often 
transferred to LBIE with hypothecation rights, i.e. LBIE was allowed to lend out the 
assets it received from its clients to a third party. 

7.1.3.5.  Problem tree 

Figure  13  below  provides  an  overview  of  the  various  problems,  their  drivers  and 
their consequences. 

157  

In fact there are two questions: the first one concerns the ability to get the initial margin back, while the 
second one concerns the timing of this happening. In times of market turmoil the second question may be 
considered as important as the first one. 

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Drivers
Drivers

Problems
Problems

Consequences
Consequences

Different rules on 
Different rules on 
risk management 
risk management 
for CCPs
for CCPs

Obstacles to cross-
Obstacles to cross-
border provision of 
border provision of 
CCP services
CCP services

Obstacles to the 
Obstacles to the 
establishment of 
establishment of 
links between CCPs
links between CCPs

Inadequate 
Inadequate 
segregation of 
segregation of 
margins at CCP 
margins at CCP 
level
level

Lack of level playing 
Lack of level playing 
field for CCPs
field for CCPs

Lack of common 
Lack of common 
rules for the 
rules for the 
establishment and 
establishment and 
treatment of links
treatment of links

Danger of 
Danger of 
competition on risk
competition on risk

Impaired portability 
Impaired portability 
of client positions 
of client positions 
and associated 
and associated 
margins
margins

Inefficient and 
Inefficient and 
potentially unsafe 
potentially unsafe 
post-trading 
post-trading 
infrastructure
infrastructure

Compromised 
Compromised 
investor protection
investor protection

7.1.3.6.  How would problems evolve without EU action? 

Problem 1 

In  the  absence  of  any  EU  action,  the  only  available  framework  for  facilitating  the 
cross-border  provision  of  CCP  services  would  be  the  one  provided  by  the  ESCB-
CESR recommendations. It is still unclear to what extent these recommendations can 
contribute to resolving this problem, as too little time has passed since their adoption. 
Nevertheless, there are at least some elements that may lead one to believe that they 
will  not  be  able  to  eliminate  the  problem  in  its  entirety.  First,  the  ESCB-CESR 
recommendations  are  based  on  CPSS-IOSCO  recommendations  which  were 
published already in November 2004. Although the latter were adopted by regulators 
in  the  EU,  they  failed  to  make  any  significant  contributions  towards  solving  this 
problem.  Second,  they are  a  set  of high-level principles that can be interpreted and 
implemented in different ways. Last, and most important, they are non-binding and 
are thus automatically superseded by any binding rules set at national level. 

Problem 2 

Similarly to problem 1, in the absence of EU action, the establishment of links will 
depend on existing national rules, and any existing standards and recommendations, 
as well  as on cooperation between competent national authorities. At EU level, the 
common 
the  ESCB-CESR 
recommendations  (in  particular  recommendation  11).  However,  as  in  the  case  of 
problem 1, there are limits to what the recommendations can achieve. 

framework  could  yet  again  be  provided  by 

On the industry side, the Code  of Conduct would  continue to provide the blueprint 
for  the  process  of  establishing  links  between  CCPs  in  the  cash  equity  space. 
Furthermore, the industry is also trying to deal with the issue of risk management of 
links. For example, the European Association of CCP Clearing Houses (EACH) has 
produced  a  set  of  standards  for  the  risk  management  of  links  in  July  2008.158 

158   http://www.eachorg.eu/each/code-of-conduct-risk-mgmt-0807.pdf. 

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However,  similar  to  the  ESCB-CESR  recommendations,  these  standards  too  have 
their limits. While CCPs agree on the substance of the standards, they currently do 
not agree on how they should be implemented in practice, as each CCP believes its 
approach  to  risk  management  to  be  the  best  one.  Another  weakness  of  these 
standards is that, in principle, they deal only with interoperability between two CCPs. 
A  more  recent  initiative,  led  by  EuroCCP,159  is  focused  on  interoperability  among 
multiple CCPs. For the time being it is difficult to judge whether this initiative will 
bear any fruit. 

Problem 3 

The same analysis as the  one provided  for problem  1 applies.  One  additional point 
that  needs  to  be  made  on  this  problem  concerns  recent  developments  in  the  post-
trading  market.  In  recent  months,  NYSE.Euronext  has  announced  that  it  intends  to 
move its clearing in-house and the London Stock Exchange has launched a review of 
its clearing arrangements that could lead to the same outcome. While the main driver 
behind  these  decisions  appears  to  be  dissatisfaction  with  existing  clearing 
arrangements  used  by  the  two,  the  practical  consequence  is  a  rather  strong  shift 
towards  the  vertical  silo  model  in  the  EU.  This  shift  is  likely  to  further  reduce  the 
effectiveness of the Code of Conduct. 

Problem 4 

The  industry  initiatives  mentioned  in  section  3  include  also  commitments  on  buy-
side  access  to  CCP  clearing  with  segregation  of  initial  margin  and  portability.  For 
CDS, the OSC has committed to work together with CCPs in order to deliver these 
results  by  mid-December  2009.  A  commitment  to  resolve  impediments  to  broader 
buy-side access has also been provided for interest rate derivatives. The commitment 
have  already  led  to  concrete  results:  CCPs  actively  clearing  CDS  and  interest  rate 
derivatives  are  already  offering  buy-side  institutions  the  possibility  of  direct  access 
and  of  initial  margin  segregation.  The  industry  has  also  prepared  a  report  on 
segregation and portability of customer CDS positions and related margin.160 

At  least  one  Member  State  (the  UK)  is  also  looking  at  the  issues  related  to 
segregation and portability. 

7.1.4.  The policy objectives 

The  general  objectives  are  to  increase  the  safety  and  efficiency  of  the  EU  post-
trading  infrastructure  and  to  increase  investor  protection.  Reaching  this  general 
objective requires the realisation of the following more specific policy objectives: 

(1) establish a level playing field for the provision of CCP services; 

(2) facilitate the establishment of links between CCPs; 

(3) increase the safety of CCPs; and 

159   http://www.euroccp.co.uk/docs/leadership/EuroCCP_InteroperatingCCPs.pdf 
160   http://www.newyorkfed.org/newsevents/news/markets/2009/an090713.html 

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(4) provide  additional  safeguards  for  market  participants  accessing  CCPs 

indirectly. 

In  turn,  the  specific  objectives  listed  above  require  the  attainment  of  the  following 
operational objectives: 

(1) remove obstacles to cross-border provision of CCP services; 

(2) remove obstacles to the establishment of links between CCPs;161 

(3) prevent CCPs from competing on risk; 

(4) facilitate the portability of client positions and associated margins. 

An overview of the various objectives and their interrelations is depicted in Figure 14 
below. 

Figure 14: The objectives and their interrelation 

General 
General 
General 
General 
objectives
objectives
objectives
objectives

Specific 
Specific 
Specific 
Specific 
objectives
objectives
objectives
objectives

Operational
Operational
Operational
Operational
objectives
objectives
objectives
objectives

Increase the safety 
Increase the safety 
Increase the safety 
Increase the safety 
and efficiency of 
and efficiency of 
and efficiency of 
and efficiency of 
post-trading 
post-trading 
post-trading 
post-trading 
infrastructure
infrastructure
infrastructure
infrastructure

Increase investor 
Increase investor 
Increase investor 
Increase investor 
protection
protection
protection
protection

Establish a level 
Establish a level 
Establish a level 
Establish a level 
playing field for the 
playing field for the 
playing field for the 
playing field for the 
provision of CCP 
provision of CCP 
provision of CCP 
provision of CCP 
services
services
services
services

Facilitate the 
Facilitate the 
Facilitate the 
Facilitate the 
establishment of 
establishment of 
establishment of 
establishment of 
links between CCPs
links between CCPs
links between CCPs
links between CCPs

Remove obstacles 
Remove obstacles 
Remove obstacles 
Remove obstacles 
to cross-border 
to cross-border 
to cross-border 
to cross-border 
provision of CCP 
provision of CCP 
provision of CCP 
provision of CCP 
services
services
services
services

Remove obstacles 
Remove obstacles 
to establishment of 
to establishment of 
links between CCPs
links between CCPs

Increase the safety 
Increase the safety 
Increase the safety 
Increase the safety 
of CCPs
of CCPs
of CCPs
of CCPs

Prevent CCPs from 
Prevent CCPs from 
Prevent CCPs from 
Prevent CCPs from 
competing on risk
competing on risk
competing on risk
competing on risk

Provide additional 
Provide additional 
Provide additional 
Provide additional 
safeguards for 
safeguards for 
safeguards for 
safeguards for 
market participants 
market participants 
market participants 
market participants 
accessing CCPs
accessing CCPs
accessing CCPs
accessing CCPs
indirectly
indirectly
indirectly
indirectly

Facilitate the 
Facilitate the 
Facilitate the 
Facilitate the 
portability of client 
portability of client 
portability of client 
portability of client 
positions and 
positions and 
positions and 
positions and 
associated margins
associated margins
associated margins
associated margins

7.1.5.  The policy options and policy instruments 

Before defining the policy options, it is important to point out that these will set out 
broad principles rather than detailed measures. The more detailed measures will need 
to  be  defined  at  a  later  stage,  most  likely  through  Commission  delegated  and/or 
implementing acts. Their impacts will be analysed in accordance to established rules. 

161   Operational  objectives  1  and  2  are  not  substitutes,  but  rather  complements.  The  first  objective  simply 
means that a CCP wishing to offer its services to market participants in another Member States should be 
able  to  do  so  without  the  need  to  seek  additional  authorisations.  However,  for  that  CCP  to  be  able  to 
effectively  offer  its  services  in  that  Member  State,  it  will  also  need  access  to  local  infrastructure  (the 
trading venue, the central securities depository and potentially the incumbent CCP). 

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7.1.5.1.  Policy options for operational objective 1 (cross-border provision of CCP services) 

The basic policy options for this objective are the following: 

•  Option  1.1.:  Rely  on  ESCB-CESR  recommendations  for  CCPs  and 

cooperation among regulators (baseline scenario) 

•  Option 1.2.: Introduce a passport for CCP services 

An important question that needs to be addressed in the context of a passport is the 
distribution  of  supervisory  responsibilities  between  the  various  national  (and 
potentially European) authorities that have a direct interest in the safe and efficient 
operations of a CCP. The basic policy options addressing this topic are the following: 

•  Option 1.3.: National authorisation and supervision (baseline scenario). 

•  Option 1.4.: National authorisation and supervision, with a strengthened role 

for the college of supervisors. 

•  Option  1.5.:  EU  authorisation  performed  by  ESMA  combined  with  national 

supervision 

•  Option 1.6.: EU authorisation and supervision performed by ESMA. 

In  all  four  scenarios  oversight  of  CCPs  would  continue  to  be  performed  by  the 
relevant central banks. 

7.1.5.2.  Policy options for operational objective 2 (links) 

The basic policy options for this objective are the following: 

•  Option  2.1.:  Rely  on  Code  of  Conduct,  ESCB-CESR  recommendations  and 

cooperation between authorities (baseline scenario) 

•  Option 2.2.: Introduce a right for CCPs to establish links provided that certain 
conditions  are  met.  This  option  would  set  up  detailed  rules  that  links 
established between CCPs would need to respect in order to be approved and 
set  the  supervisory  approval  procedures  that  would  need  to  be  followed. 
Apart  from  risk  considerations,  the  right  of  CCPs  to  become  interoperable 
would be subject to additional conditions (e.g. proof of demand for the link 
from  users,  prior  assessment  by  competent  authority  that  level  of  existing 
competition insufficient). 

•  Option  2.3.:  Introduce  a  right  for  CCPs  to  establish  links  provided  that  all 

relevant risks are addressed and competent authorities approve the link. 

7.1.5.3.  Policy options for operational objective 3 (preventing competition on risk) 

The basic policy options for this objective are the following: 

•  Option  3.1.:  Rely  on  ESCB-CESR  recommendations  for  CCPs  (baseline 

scenario) 

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•  Option  3.2.:  Introduce  common  risk  standards  for  CCPs.  This  option  would 
spell out the principles that CCPs would need to follow when setting up their 
risk  management  processes.  In  addition  it  would  include  specific  targets 
concerning  the  overall  financial  resources  that  CCPs  should  hold,  without 
specifying  in  what  form  they  should  be  held  (default  fund,  capital  or 
something else). 

•  Option  3.3.:  Harmonise  the  risk  models  of  CCPs.  This  option  would  entail 

prescribing in detail how a CCP’s defences should be structured. 

7.1.5.4.  Policy options for operational objective 4 (portability) 

The basic policy options for this objective are the following: 

•  Option 4.1.: Rely on existing national rules and industry initiatives (baseline 

scenario). 

•  Option  4.2.:  Require  CCPs  to  offer  indirect  participants  the  possibility  of 
having  their  margins  placed  in  segregated  (omnibus  or  nominee)  accounts; 
leave indirect participants the choice of whether or not to take advantage of 
the offer. 

•  Option  4.3.:  Require  CCPs  to  provide  segregated  nominee  accounts  to 
indirect  participants  and  require  the  latter  to  instruct  their  general  clearing 
members to place their margins in those accounts. 

7.1.5.5.  Policy instruments 

The same analysis applies as the one provided for in sections 5.2. 

7.1.6.  Analysis of impacts and choice of preferred policy option(s) 

7.1.6.1.  Options for operational objective 1 (cross-border provision of CCP services) 

Option 1.1. (rely on ESCB-CESR recommendations) 

The analysis for this option is already provided in section 7.1.3.6. 

Option 1.2. (introduce a passport) 

Under this option, a CCP that would be compliant with the regulatory requirements 
in its home market could gain access to the market in other Member States without 
the  need  to  undergo  additional  authorisations  or  having  to  comply  with  additional 
requirements. In other words, the passport would give CCPs the freedom to provide 
their  services  across  the  EU.162  This  is  because  the  passport  regime  is  based  on  a 
harmonisation of the regulatory rules in the Member States. 

162   The  passport  only  refers  to  the  free  provision  of  services  because  there  is  no  apparent  need  to  provide 
CCPs  with  the  possibility  to  establish  branches  in  Member  States  other  than  the  one  where  they  are 
established. A CCP can already serve markets and market participants located in different Member States 
without the need for them to establish a physical presence in every one of those Member States. 

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Compared to option 1.1., this option would significantly lower the costs of entering a 
market in another Member State and would therefore probably lead to an increase in 
competition in the CCP space. This would in turn increase the choice for investors, 

Table  8:  Summary  of  the  impact  analysis  for  operational  objective  1  (cross-border 
provision of CCP services) 

Option 1.1. (baseline) 

n.a. 

n.a. 

n.a. 

Impact on stakeholders 

Effectiveness 

Efficiency 

Option 1.2. 
(common authorisation 
process) 

(+) increased ability of 
CCPs to provide services 
across border 
(+) increased choice for 
investors 

(+) increased competition 

(+) lower costs of CCP-
clearing 

Option 1.3. (national authorisation and supervision) 

This approach to authorisation and supervision is common in financial services. The 
passport  would  allow  CCPs  to  offer  services  in  each  Member  State  without  prior 
scrutiny  of  competent  authorities  other  than  those  in  the  Member  State  of 
establishment. National competent authorities would establish colleges, which would 
include  the  competent  supervisors  of  the  CCP  and,  depending  on  whether  the  CCP 
served  and  exchange  or  the  OTC  market,  the  supervisors  of  the  exchange  or  the 
supervisors  of  the  CCP’s  users.  Disputes  between  national  authorities  could  be 
resolved within the structures of the EU supervisory authorities. 

This option is a direct embodiment of the argument that since fiscal responsibility in 
case of the failure of a CCP lies within that CCP’s home Member State, supervision 
should also be located there. This argument is certainly true in the national context. 
However, in a cross-border context, where a CCP may have members coming from 
multiple  Member  States,  this  argument  may  no  longer  hold.  Indeed,  in  such  a 
situation other Member States may need to use their fiscal resources were a CCP to 
fail, for example to provide support to their own banks that are members of the failed 
CCP.  This  problem  will  be  particularly  acute  in  the  context  of  the  CCP-clearing 
requirement  for  OTC  derivatives:  given  that  there  are  only  a  handful  of  CCPs 
clearing  these  instruments,  most  market  participants  will  have  to  access  a  CCP  not 
located in their jurisdiction. 

Option 1.4. (national authorisation and supervision, with a strengthened role for the 
college) 

This  option  leaves  the  responsibility  of  supervision  and  authorisation  of  CCPs  to 
national  competent  authorities.  However,  it  recognises  the  need  for  other  Member 
States' authorities and ESMA to take a stronger role in the authorisation process. In 
particular,  this  solution  foresees  that  the  national  competent  authority  would 
ultimately  decide  on  granting  the  authorisation,  but  would  need  to  obtain  a 
favourable opinion of the college before the authorisation could take effect. 

This  solution  recognises  that,  on  the  one  hand,  the  activities  of  a  CCP  are  by 
definition cross-border and that competent authorities other than the home authority 
may have an interest in a CCP's proper functioning. On the other hand, it recognises 
the need to align supervisory and fiscal responsibility. 

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Option 1.5. (EU authorisation, national supervision) 

In view of the issues highlighted under option 1.3., this option contemplates a split 
between authorisation and day-to-day supervision. In particular, it gives the former to 
ESMA while leaving the latter with the national competent authority. In practice, this 
option would ensure a uniform implementation and application of the  authorisation 
requirements across the EU. 

From  a  legal  perspective,  however,  it  is  clear  that  if  ESMA  is  awarded  formal 
competence  to  authorise  CCPs,  it  must  also  have  the  competence  to  withdraw  the 
authorisation, if need arises. This raises issues of fiscal responsibility for the Member 
State where the CCP is located. 

Option 1.6. (EU authorisation and supervision) 

This option is diametrically opposite to option 1.3. It foresees that authorisation and 
supervision of CCPs would be given to ESMA. Central authorisation and supervision 
would  immediately  ensure  a  coherent  application  of  rules  and  would  therefore  also 
address  the  cross-border  issue.  ESMA  would  ensure  that  Member  States'  interests 
and concerns are balanced. Since ESMA has legal personality, any authorisation and 
supervision decisions would be attributed to the EU. 

This  solution  would  address  the  issue  of  the  free  provision  of  services  and  foster 
confidence  among  national  competent  authorities.  However,  it  has  a  fundamental 
flaw: it does not align fiscal and supervisory responsibility. Indeed, in the absence of 
an EU-wide resolution fund (or burden sharing agreement), the fiscal responsibility 
would be left with the Member States. 

Table  9:  Summary  of  the  impact  analysis  for  operational  objective  1  (cross-border 
provision of CCP services – supervision and authorisation) 

Impact on stakeholders 

Effectiveness 

Efficiency 

Option 1.3. 
(national authorisation 
and supervision - baseline) 

n.a. 

n.a. 

Option 1.4. 
(national authorisation 
and supervision + 
stronger college) 

(+) country with fiscal 
responsibility maintains 
authorisation and 
supervision power 
(+) increased role for 
authorities in the college 

Option 1.5. 
(EU authorisation, 
national supervision) 

(-) country with fiscal 
responsibilityloses power to 
authorise 

Option 1.6. 
(EU authorisation and 
supervision) 

(-) country with fiscal 
responsibility looses 
supervisory control over 
CCP 

(+) involvement of other concerned 
authorities by means of college opinion 
strengthens passport effect, as barriers 
related to lack of trust dismantled 
(+) supervisory and fiscal 
responsibilities aligned 
(?/-)  potential divergences in 
application of authorisation 
requirements across EU 

(+) uniform implementation and 
application of authorisation 
requirements across EU 
(?/-) potential differences in national 
supervision 
(-) misalignment of supervisory and 
fiscal responsibilities 
(+) coherent application of rules and 
supervision, no uncertainty about cross-
border service provision 
(-) misalignment of supervisory and 
fiscal responsibilities 

n.a. 

n.a. 

n.a. 

n.a. 

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7.1.6.2.  Options for operational objective 2 (links) 

Option 2.1. (rely on Code of Conduct, ESCB-CESR recommendations) 

The analysis for this option is already provided in section 7.1.3.6. 

Option  2.2.  (introduce  a  conditional  right  to  establish  links  with  additional 
conditions) 

Compared  to  option  2.1.,  this  option  should  result  in  more  links  being  established, 
with a higher level of choice for investors and more competition in the CCP space. 
This  is  due  to  the  fact  that  this  option  addresses  the  regulatory  barriers  and  issues 
related to risk highlighted by the Code of Conduct. The benefits of this option should 
therefore be greater than the ones of option 2.1. At the same time, the costs should 
not  be  greater,  and  may  even  decrease  compared  to  option  2.1.  due  to  faster  and 
clearer procedures to establish links. 

The only potential issue with this option are the additional conditions. In practice it 
may be very difficult to define the appropriate threshold for the conditions. Indeed, 
questions  concerning  a  prior  competition  analysis  (e.g.  determining  the  relevant 
market and making a judgement on the optimal number of CCPs serving a market) or 
user demand (e.g. the minimum necessary level of user support for approving a link 
request, who are relevant users…) are inherently difficult to answer. 

Option 2.3. (introduce a right to establish links conditional upon regulatory approval 
and adequate risk mitigation) 

This option goes further than option 2.2. in that it only considers risk-related aspects 
of  links.  This  option  should  lead  to  the  establishment  of  more  links,  more 
competition  and  therefore  to  higher  benefits  than  option  2.2.  By  eschewing  the 
additional conditions of Option 2.2, it also reduces administrative costs and increases 
legal certainty. This option also limits the potential for an excessive proliferation of 
links  by  requesting  prior  supervisory  approval  and  requiring  CCPs  to  identify, 
monitor and mitigate the risks that may arise from those links. 

Table 10: Summary of the impact analysis for operational objective 2 (links) 

Option 2.1. (baseline) 

n.a. 

n.a. 

n.a. 

Impact on stakeholders 

Effectiveness 

Efficiency 

Option 2.2. 

(right to establish links 
subject to conditions 
related to 
demand/competition, 
risk controls and prior 
approval) 

(+) If conditions met, 
increased user choice 

(+) If conditions met, new 
entrant CCPs able to become 
interoperable and hence grab 
market share 

(-) If conditions met,  
incumbent CCP subject to 
increased competition 

(+) Market opening if 
conditions are fulfilled and put 
a limit to excessive 
proliferation of links due to 
need for prior approval and 
risk controls 

(≈/-)Inherent difficulty of 
making conditions related to 
user demand and prior 
competition analysis legally 
operational, hence lingering 
legal uncertainty of extent of 
right. 

(≈/-) Administrative cost of 
determining whether user 
demand/ competition 
conditions met 

Option 2.3. 

(right to establish links 
subject to conditions 

(+) If conditions met, 
increased user choice 

(+) If conditions met, new 

(+/++) Ensure market opening 
if conditions fulfilled and put 
limit to excessive proliferation 

(≈) 

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related to risk controls 
and prior approval) 

entrant CCPs able to become 
interoperable and hence grab 
market share 

of links due to need for prior 
approval and risk controls 

(-) If conditions met,  
incumbent CCP subject to 
increased competition 

7.1.6.3.  Options for operational objective 3 (prevent competition on risk) 

Option 3.1. (rely on ESCB-CESR recommendations) 

The analysis for this option is already provided in section 7.1.3.6. 

Option 3.2. (introduce common risk standards) 

Prescribing the common risk standards should avoid a situation where CCPs would 
start  cutting  corners  on  their  risk  management.  To  the  extent  that  the  existing  risk 
standards of some CCPs are below the level at which the common would be set, the 
introduction of common standards could actually increase the overall quality of risk 
management (the converse is, however, also true). For both these reasons, this option 
is better than option 3.1. Of course, the crucial question in this case is at what level 
the common standards should be set. 

The  impact  on  CCPs  and  market  participants  will  depend  on  where  a  CCP's  risk 
management would be positioned with respect to the common standards. For a CCP 
with  risk  standards  below  the  required  level  it  would  mean  a  tightening  of  risk 
management, which would in all likelihood result in an increase in the costs for its 
users. Conversely, a CCP with standards above the level set in the common standards 
could potentially decide to lower them and therefore decrease the costs for its users. 
The  lowering  of  standards  is  not  a  foregone  conclusion,  though.  If  the  CCP  with 
higher  risk  management  standards  was  under  competitive  pressure  from  the  CCP 
with  the  lower  standards,  the  introduction  of  the  common  standards  may  actually 
dampen  this  competitive  pressure.  Obviously,  the  size  of  the  impact  would  be 
directly proportional to the difference between the CCP's existing risk standards and 
the level set in the common standards. The costs of this option would be higher than 
those of option 3.1. (especially if option 3.1. would result in a race to the bottom). 
However, provided that the level of the common standards would not be set too high, 
these  costs  should  not  outweigh  the  benefits  of  this  option.  Furthermore,  since  this 
option would only prescribe the targets, but not how to achieve them, it would leave 
CCPs some flexibility in choosing the most cost-effective way of doing it. 

Option 3.3. (harmonise risk models) 

This  option  would  go  a  step  further  than  option  3.2.  and  would  actually  prescribe 
how  a  CCP's  defences  should  be  structured  and  how  risk  management  should  be 
done.  Compared  to  option  3.2.,  this  option  would  bring  few  additional  benefits 
(assuming  that  the  targets  of  the  harmonised  model  coincide  with  those  of  the 
minimum risk standards). The most significant one of them would potentially be the 
lowering of administrative and IT costs for the users of CCPs. Indeed, if all CCPs ran 
the same risk model, then their users would not need multiple IT systems to manage 
their relationships with multiple CCPs. 

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This option would, however, entail significantly higher costs than option 3.2. This is 
because CCPs have adopted different solutions. Harmonising their risk management 
would mean that at least some of them may need to radically change their processes, 
which would entail considerable investment costs. This type of harmonisation would 
also have a negative effect on innovation. 

Table  11:  Summary  of  the  impact  analysis  for  operational  objective  3  (preventing 
competition on risk) 

Option 3.1. (baseline) 

n.a. 

n.a. 

n.a. 

Impact on stakeholders 

Effectiveness 

Efficiency 

Option 3.2. (minimum 
risk standards) 

(+) no race to the bottom 
(competition on risk) 

(+) regulators gain comfort 
that CCPs manage risk in 
stringent manner 

(-) cost for members of CCP 
whose risk management is 
currently below minimum level 

Option 3.3. (harmonise 
risk models) 

(+) regulators gain comfort 
that all CCPs have same model 

(+) lower administrative and IT 
costs for CCP users 

(-/--) significant adaptation for 
CCPs to harmonised risk model 

(+) no race to the bottom 

 (-) impact on innovative 
approaches to manage 
risk; risk models set by 
legislation 

(+) While potentially increased 
cost as stringency of risk 
management increase these 
costs mitigated by freedom to 
choose most cost-effective 
solution 

(-) significant investment costs 
by CCPs 

7.1.6.4.  Options for operational objective 4 (portability) 

Option 4.1. (rely on existing national rules and industry initiatives) 

The analysis for this option is already provided in section 7.1.3.6. 

Option  4.2.  (require  CCPs  to  provide  segregation  and  leave  participants  to  choose 
whether or not to use it) 

This option differs from option 4.1. in that it introduces a requirement for CCPs to 
provide  for  segregation  (MiFID  currently  deals  mainly  with  the  segregation  at  the 
GCM level). The fact that they are currently not required to do so does not mean that 
CCPs do not offer this possibility. In fact, they usually do. From the point of view of 
market  participants  accessing  a  CCP  indirectly  (indirect  participants)  not  much 
would therefore change. They would keep the option that in many cases they already 
have.  

The  problem  with  the  status  quo,  and  therefore  with  this  option,  is  that  indirect 
participants  often  choose  not  to  have  separation  at  CCP  level  for  purely  economic 
reasons: segregation is more expensive due to the effects described in section 6.1.2.2. 
(in short, with segregation at CCP level GCMs would lose some of the revenues and 
would  therefore  try  to  recuperate  them  by  charging  higher  clearing  fees  to  their 
clients). 

To  the  extent  that  market  participants  accessing  a  CCP  indirectly  did  not  have  the 
possibility  to  have  their  margin  segregated  at  CCP  level  because  the  CCP  did  not 
offer  them  this  possibility,  this  option  would  bring  some  additional  benefits 
compared to option 4.1. The costs for market participants would depend on the level 

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of  segregation  chosen,  but  would  almost  certainly  be  higher  than  under  option  4.1. 
However,  given  that  the  choice  of  whether to  segregate  or  not  would  be  left  to  the 
market participants, only those that would have a positive net benefit would decide in 
its  favour.  Any  opportunity  cost  that  GCMs  may  incur  due  to  segregation  would 
probably be recuperated through higher clearing fees. One additional cost would be 
the loss of some netting efficiency at the aggregate level. 

For those market participants that would not choose full segregation, the problem of 
timely  access  to  their  margin  in  case  of  the  default  of  their  GCM,  and  thus  of 
portability of these margins, would not be solved. 

Option 4.3. (require CCPs to provide segregation and participants to use it) 

Given  that  this  option  obliges  indirect  participants  in  a  CCP  to  use  segregation 
through  nominee  accounts,  it  eliminates  the  issue  of  portability  (to  the  extent  that 
there are no legal obstacles to it). From this perspective, the benefits of this option 
are higher than those for option 4.2. However, this also imposes higher costs on those 
indirect participants that would not have chosen full segregation were they given the 
choice. 

Table 12: Summary of the impact analysis for operational objective 4 (segregation) 

Option 4.1. (baseline) 

n.a. 

n.a. 

n.a. 

Impact on stakeholders 

Effectiveness 

Efficiency 

Option 4.2. (possibility 
segregation) 

Option 43. 
(segregation 
obligation) 

(+) Increased protection for clients that 
choose to segregate 
(-) no increased protection for clients that 
choose not to segregate. 

(-) High costs for clients that would have 
chosen not to exercise right under option 
4.2. 

(+) Portability largely 
delivered. 

(+) Clients would 
chose solution with 
highest net benefits 

(++) Portability ensured 

(-) high costs of 
implementation 

7.1.6.5.  The preferred options 

The  preferred  policy  options  are  clearly  marked  in  the  tables  summarising  the 
impacts of the examined policy options. 

7.1.6.6.  The social impacts 

The analysis of option 6.2.4. applies. 

7.1.6.7.  The environmental impacts 

The analysis of option 6.2.5. applies. 

7.1.6.8.  The impacts on third countries 

The rules resulting from the preferred policy options would have an impact on third-
country  CCPs.  In  particular,  they  would  have  to  comply  with  those  rules  (or  prove 
that the rules to which they are subject to in their come jurisdictions are equivalent to 
the EU rules) in case they wanted to offer their services to EU market participants. 
At the same time, the Commission will need to continue monitoring that EU CCPs 
wishing to offer their services in third countries will not be discriminated against. 

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7.1.7.  The preferred policy instrument 

The  analysis  of  section  6.2.7.  is  true  even  in  relation  to  the  part  of  the  future 
instrument  that  would  deal  with  the  authorisation  and  operation  of  CCPs,  which 
could be considered as a typical, traditional taking-up of business type of measure. In 
fact, there is a major difference with this "traditional" approach; the instrument will 
oblige market participants to use CCPs. This departs from the traditional facilitation 
and  optionality  aspects  of  financial  services  legislation,  i.e.,  that  we  create  a 
framework  for  the  cross-border  operation  of  entities  and  then  leave  to  the  markets 
and to the market participants the choice of using them or not. Here on the contrary, 
we  will  be  obliging  market  participants  to  use  these  infrastructures,  wherever  they 
are located and without an option. In that respect, the existence of precise common 
rules is paramount and this is best achieved through a regulation. 

7.2. 

Trade repositories 

7.2.1.  Background 

A trade repository is an entity that has its origins in the OTC derivatives market.163 It 
is a centralised registry that maintains an electronic database of open OTC derivative 
transaction records (contracts). A trade repository may also engage in other services, 
such  as  contract  events  management  and  trade  processing  services.  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. 

As already mentioned in this report, only two trade repositories currently exist, one 
for  credit  derivatives  (the  DTCC's  Warehouse  Trust)  and  one  for  interest  rate 
derivatives  (TriOptima's  IR  TRR).164  The  second  one  was  launched  only  at  the 
beginning of this year. 

7.2.2.  The political mandate 

In  its  October  2009  Communication,  the  Commission  stated  that  trade  repositories 
should  be  regulated  in  order  to  ensure  that  they  are  operated  in  a  safe,  sound  and 
efficient  manner.  It  also  expressed  its  belief  that  ESMA  should  be  responsible  for 
authorising and supervising trade repositories. 

In  its  Conclusions  of  2  December  2009,  the  Council  stated  that  the  Commission 
should work towards proposing a common legal framework for trade repositories and 
consider the role and functions ESMA should have in this context.165 

In its Resolution, the European parliament welcomed the Commission’s intention to 
submit legislative proposals on trade repositories.166 

163  

In  essence  it  performs,  for  bilaterally  cleared  contracts,  the  same  record-keeping  functions  that  a  CCP 
performs in case of centrally-cleared derivatives contracts. 
Interest Rate Trade Reporting Repository. 

164  
165   See Annex 3. 
166   See Langen report, paragraph 44. 

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7.2.3.  The problems 

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).  This  situation  was 
mainly  due  to  the  fact  that,  up  until  very  recently,  the  trade  repository  was  not  a 
regulated entity,  so  to  the  extent that information  needed  to be asked  through legal 
means (e.g. a court order) or required the consent of the clients of the trade repository 
it took time for regulators to obtain it. 

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.  These  include 
authorisation/registration of trade repositories, access to and participation in a trade 
repository,  disclosure  of  data,  data  quality  and  timeliness,  access  to  data, 
safeguarding of data, governance and operational reliability, bundling of services etc. 

7.2.3.1.  Problem tree 

Figure  14  below  provides  an  overview  of  the  various  problems,  their  drivers  and 
their consequences. 

Figure 14: Problem tree 

Drivers
Drivers

Problems
Problems

Consequences
Consequences

Lack of common 
Lack of common 
legal framework 
legal framework 
governing the 
governing the 
activities of trade 
activities of trade 
repositories
repositories

Limited access by 
Limited access by 
regulators to 
regulators to 
information stored 
information stored 
in trade repositories
in trade repositories

Un-level playing 
Un-level playing 
field for the 
field for the 
provision of trade 
provision of trade 
repository services
repository services

Lack of 
Lack of 
transparency for 
transparency for 
regulators
regulators

Inefficient and 
Inefficient and 
potentially unsafe 
potentially unsafe 
provision of trade 
provision of trade 
repositories services  
repositories services

7.2.3.2.  How would problems evolve without EU action? 

At present, the two trade repositories are regulated under national rules: TriOptima's 
IR TRR is regulated by the Swedish Financial Supervisory Authority while DTCC's 
Warehouse  Trust  is  regulated  by  the  Federal  Reserve  Bank  of  New  York  and  the 
New York State Banking Department. In both cases, access to data would require a 
Memorandum  of  Understanding  (MoU)  between  the  direct  regulators  and  any 
competent  authority  requiring  the  data.  The  already  mentioned  OTC  Derivatives 
Regulators'  Forum  has  as  one  of  its  objectives  the  development  of  international 
cooperative oversight arrangements that may be applied to trade repositories. 

Since  there  are  currently  no  internationally  agreed  regulatory  standards  for  trade 
to  develop  a  set  of 
repositories,  CPSS  and  IOSCO  have  been 

tasked 

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recommendations to fill this gap. The recommendations are expected by the end of 
this year.167 

7.2.4.  The objectives 

The main policy objectives are 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. 
Reaching  this  general  objective  requires  the  realisation  of  the  following  more 
specific policy objectives: 

(1) ensure the safety and integrity of data stored in a trade repository; 

(2) establish a level playing field for the provision of trade repository services; 

(3) ensure  that  competent  authorities  have  unfettered  access  to  the  information 

stored in trade repositories. 

The  specific  objectives  listed  above  require  the  attainment  of  a  single  operational 
objective, namely the introduction of common rules governing the activities of trade 
repositories. 

An overview of the various objectives and their interrelations is depicted in Figure 15 
below. 

Figure 15: Overview of objectives and their interrelations 

General 
General 
objectives
objectives

Specific 
Specific 
objectives
objectives

Operational
Operational
objectives
objectives

Ensure the safety 
Ensure the safety 
and integrity of data 
and integrity of data 
stored in a trade 
stored in a trade 
repository 
repository 

Ensure the safety, 
Ensure the safety, 
soundness and 
soundness and 
efficiency of trade 
efficiency of trade 
repositories
repositories

Ensure a level 
Ensure a level 
playing field for the 
playing field for the 
provision of trade 
provision of trade 
repository services
repository services

Introduce common 
Introduce common 
rules governing the 
rules governing the 
activities of trade 
activities of trade 
repositories
repositories

Ensure that 
Ensure that 
regulators have 
regulators have 
unfettered access to 
unfettered access to 
information stored 
information stored 
in a trade repository
in a trade repository

7.2.5.  The policy options 

The basic policy options for the only operational objective are the following: 

167  CPSS and IOSCO have recently launched a consultation on a set of considerations for trade repositories in 
the OTC derivatives market and for relevant authorities. See http://www.bis.org/press/p100512.htm. 

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•  Option  1.1.:  Rely  on  CPSS-IOSCO  recommendations  for  trade  repositories 

and cooperation among regulators (baseline scenario) 

•  Option 1.2.: Introduce legislation governing the activities of trade repositories 

An  important  question  that  needs  to  be  addressed  is  the  distribution  of  regulatory 
responsibilities  between  the  various  national  (and  potentially  European)  authorities 
that  have  a  direct  interest  in  the  safe  and  efficient  operations  of  a  trade  repository. 
Since  activities  of  trade  repositories  do  not  raise  issues  of  prudential  concern  to 
regulators  compared  to,  for  instance,  the  risk  management  of  a  CCP,  instead  of  a 
system  of  authorisation  and  supervision,  a  less  intrusive  system  of  registration  and 
surveillance  (to  be  distinguished  from  'supervision'  or  'oversight')  over  trade 
repositories should therefore be sufficient to achieve the objectives sought. The basic 
policy options addressing this topic are the following: 

•  Option 1.3.: National registration and surveillance (baseline scenario). 

•  Option 1.4.: EU registration and surveillance performed by ESMA. 

In both scenarios oversight of trade repositories would be performed by the relevant 
central banks. 

7.2.6.  Analysis of impacts and choice of preferred policy option(s) 

7.2.6.1.  Option 1.1. (rely on CPSS-IOSCO recommendations) 

Currently, there is no set of common rules applicable to trade repositories, neither at 
EU  nor  at  international  level.  As  already  indicated,  recommendations  are  currently 
being  developed  by  CPSS-IOSCO.  Once  they  will  be  ready,  they  will  provide 
guidance  to  national  regulators.  However,  they  would  suffer  from  the  same 
shortcoming  as  the  other  recommendations,  i.e.  they  would  provide  only  broad 
principles. This means that they could result in widely differing regulatory solutions 
in the various Member States. This could introduce a multiplicity of different rules 
applicable  to  the  activities  of  trade  repositories.  Since  the  latter  are  by  definition 
entities  which  provide  their  services  cross-border,  this  would  result  in  the  need  for 
multiple authorisations and compliance with multiple rules, increasing unnecessarily 
their costs. 

7.2.6.2.  Option 1.2. (introduce legislation) 

This option would eliminate the shortcomings of option 1.1. by providing a single set 
of  rules  applicable  to  any  trade  repository  operating  in  the  EU.  In  view  of  the 
importance  of  these  entities  for  ensuring  transparency  about  the  OTC  derivatives 
market and effective supervision of this market, it is paramount that they are subject 
to  a  common  set  of  binding  rules.  Furthermore,  the  reporting  requirement  calls  for 
safeguards to be put in place to prevent that trade repositories will abuse their role at 
the expense of the entities that will be subject to this requirement. Again, this is best 
achieved through binding rules applicable throughout the EU. This option will also 
mean  that  the  cross-border  provision  of  services  would  not  entail  any  additional 
costs, as the same rules would apply in any EU Member State. 

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7.2.6.3.  Option 1.3 (national registration and surveillance) 

*   *   * 

This  approach  mimics  the  usual  authorisation  and  supervision  regime  common  in 
financial  services.  Under  this  approach,  a  trade  repository  would  register  with  its 
national competent authority, which would also be responsible for ensuring the trade 
repository's proper functioning. However, the reporting obligation on all EU market 
participants  and  the  need  to  ensure  unfettered  access  for  EU  regulators  is  likely  to 
result in cumbersome and possibly not frictionless procedures, if the organisation of 
data  access  would  fall  under  the  responsibility  of  the  national  competent  authority 
where the trade repository would be established. While dispute resolution procedures 
within ESMA would apply, this approach would not be most direct and efficient way 
to organise regulatory governance of trade repositories across the EU. It would also 
complicate  cooperation  with  regulators  of  trade  repositories  located  outside  of  the 
EU. 

7.2.6.4.  Option 1.4. (EU registration and surveillance) 

As  the  main  purpose  of  trade  repositories  is  to  provide  services  to  the  regulatory 
community,  centralised  registration  and  surveillance  seems  the  most  efficient 
approach.  In  this  way,  ESMA  could  act  as  the  gateway  for  information  requests 
aimed  at  a  trade  repository.  This  would  facilitate  a  standardisation  of  access 
procedures to trade repositories located in different Member States. In addition, data 
confidentiality  issues  could  be  handled  in  a  transparent  and  non-discriminatory 
manner  and  conflicts  between  requesting  national  authorities  directly  resolved. 
Moreover,  ESMA  could  act  as  a  central  point  channelling  information  requests  to 
trade repositories located outside the EU. This centralisation would reduce costs for 
both trade repositories and regulators. 

This  option  is  superior  to  option  1.3.  both  from  the  point  of  view  of  costs  and 
benefits. 

7.2.6.5.  The preferred options 

Based on the above impact analysis, the preferred policy options are options 1.2 and 
1.4. 

7.2.6.6.  The social impacts 

The analysis of option 6.2.4. applies. 

7.2.6.7.  The environmental impacts 

The analysis of option 6.2.5. applies. 

7.2.6.8.  The impacts on third countries 

Similarly to the case of CCPs, the rules resulting from the preferred  policy options 
would  have  an  impact  on  third-country  trade  repositories.  In  particular,  they  would 
have to comply with those rules (or prove that the rules to which they are subject to 
in  their  come  jurisdictions  are  equivalent  to  the  EU  rules)  in  case  they  wanted  to 

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offer  their  services  in  the  EU.  Given  that  authorities  based  in  the  EU  would  need 
unfettered access to information stored in trade repositories located in third countries, 
the  recognition  process  would  need  to  specifically  establish  that  such  access  is 
actually possible. If not, the direct consequence would be that no third-country trade 
repository  would  be  able  to  offer  its  services  in  the  EU  for  the  purpose  of  the 
reporting requirement. 

As in the case of CCPs, the Commission will need to continue monitoring that EU 
CCPs  wishing  to  offer  their  services  in  third  countries  will  not  be  discriminated 
against. 

7.2.7.  The preferred policy instrument 

The  analysis  of  section  6.2.7.  is  true  even  in  relation  to  the  part  of  the  future 
instrument that would deal with the authorisation and operation of trade repositories. 

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8. 

MONITORING AND EVALUATION 

Ex-post  evaluation  of  all  new  legislative  measures  is  a  top  priority  for  the 
Commission.  Evaluations  are  planned  about  5  years  after  the  implementation 
deadline  of  each  measure.  The  forthcoming  Regulation  will  also  be  subject  to  a 
complete  evaluation  in  order  to  assess,  among  other  things,  how  effective  and 
efficient it has been in terms of achieving the objectives presented in this report and 
to decide whether new measures or amendments are needed. 

In  terms  of  indicators  and  sources  of  information  that  could  be  used  during  the 
evaluation,  a  distinction  needs  to  be  made  between  the  evaluation  of  the  measures 
aimed at addressing transparency, counterparty credit risk and operational risk, and 
the  measures  aimed  at  establishing  a  common  regulatory  framework  for  CCPs  and 
trade repositories. 

For  the  first  group  of  measures,  especially  for  monitoring  the  reporting  and  the 
clearing  requirement,  the  most  convenient  source  of  information  will  be  the  trade 
repositories.  The  information  they  store  will  allow  for  the  monitoring  of  indicators 
such as the size of the various market segments, the proportion of contracts subject to 
CCP clearing, the relative importance of different groups of market participants and 
so  forth.  For  monitoring 
terms  of  contract  and  process 
standardisation,  existing  sources  could  be  used,  such  as  the  various  ISDA  surveys 
and  the  indicators  published  by  MarkIt.  The  indicators  that  could  be  used  are,  for 
example, the proportion of contracts that are electronically affirmed and confirmed, 
the  average  age  of  unconfirmed  contracts,  the  proportion  of  trades  covered  by 
collateral  agreements, the number of collateral disputes and so on. For the clearing 
requirement a potential indicator could also be the types of contracts that are subject 
to the requirement and the number of CCPs that are being used in relation to it. 

the  progress 

in 

For the second group of measures, finding meaningful indicators would seem to be 
more  difficult.  A  potentially  better  approach  could  be  a  questionnaire  directed  at 
market  participants  and  the  operators  of  the  market  infrastructure  on  whether  the 
changes made reduced the risks they face in their daily business. 

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ANNEX 1: Glossary168 

Affirmation (of a trade confirmation)  A  procedure  in  a  confirmation  process,  whereby  a 
single  record  of  the  trade  is  created  by  one  party 
evidencing  the  full  terms  of  the  trade  and  the 
counterparty  verifies  and  agrees  to  that  record. 
Affirmation  of  trade  confirmations  is  different  from 
trade  verification 
(also  known  as  economic 
affirmation),  which  is  limited  to  principal  economic 
terms 

Arbitrage 

Bilateral collateral agreement 

Central counterparty (CCP) 

Clearing 

Collateral 

Confirmation 

Confirmation process 

The  exploitation  of  price  differences  in  connected 
markets. 

An  agreement  that  defines  the  terms  or  rules  under 
which  collateral  is  posted  or  transferred  between 
counterparties to an OTC derivative contract. 

that 

interposes 

An  entity 
the 
counterparties to the contracts traded in one or more 
financial markets, becoming the buyer to every seller 
and the seller to every buyer. 

itself  between 

The  process  of  establishing  settlement  positions, 
including  the  calculation  of  net  positions,  and  the 
process  of  checking  that  securities,  cash  or  both  are 
available  for  the  settlement  of  obligations.  In  other 
words it is the process used for managing the risk of 
(cid:214) open positions.  

An  asset  or  third-party  commitment  that  is  used  by 
the  collateral  provider  to  secure  an  obligation  to  the 
collateral  taker.  Collateral  arrangements  may  take 
different  legal  forms;  collateral  may  be  obtained 
using the method of title transfer or pledge. See also 
margin. 

A document identifying the details of a trade and any 
governing  legal  documentation,  as  agreed  upon  by 
both parties. This document serves as the final record 
of the transaction 

The process by which trade details are verified with a 
counterparty, with a view to obtaining a final record 
of the trade. This is generally done by exchanging a 

168  This glossary draws partly on glossaries contained in various reports published by Committee on Payment 

and Settlement Systems of the Bank for International Settlements. 

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Counterparty credit risk 

Coupon 

Credit event 

Default fund 

Exposure 

General clearing member (GCM) 

Hedge 

Leverage 

Margin 

Marking to market 

confirmation  proposal  via  fax,  mail  or  an  electronic 
confirmation service. Either one party provides trade 
details and the other then verifies the information, or 
both  parties  submit  records  of  the  trade  and  verify 
each other’s records. 

The  risk  that  a  counterparty  will  not  settle  an 
obligation  for  full  value,  either  when  due  or  at  any 
time  thereafter.  Credit  risk  includes  pre-settlement 
risk  (replacement  cost  risk)  and  settlement  risk 
(principal risk). 

The regular payment on a contract, often also referred 
to as premium or (cid:214) spread. The coupon can be fixed 
or floating. 

An  event  that  may  trigger  the  exercise  of  a  CDS 
contract.  Credit  events  include,  for  example,  failure 
to pay (interest or principal when due), bankruptcy or 
(cid:214) restructuring. 

A  fund  composed  of  assets  contributed  by  a  CCP’s 
participants  that  may  be  used  by  the  (cid:214)  CCP  in 
certain  circumstances  to  cover  losses  and  liquidity 
pressures  resulting  from  defaults  by  the  CCP’s 
participants. Also known as clearing fund. 

The amount of funds at risk, i.e. the amount that one 
may lose in an investment. 

A member of a (cid:214) CCP that clears on its own behalf, 
on  behalf  of  its  customers  and  on  behalf  of  other 
market participants. 

A (cid:214) position established in one market in an attempt 
to  offset  (cid:214)  exposure  to  the  risk  of  an  equal  but 
opposite obligation or position in another market. 

A financial ratio that compares some form of owner's 
equity (or capital) to borrowed funds. The higher are 
the  borrowed  funds  with  respect  to  own  capital,  the 
higher is the leverage. 

An asset (or third-party commitment) that is accepted 
by a counterparty to ensure performance on potential 
obligations  to  it  or  cover  market  movements  on 
unsettled transactions. 

The  practice  of  revaluating  open  positions 
in 
financial instruments at current market prices and the 
calculation of any gains or losses that have occurred 

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Master Agreement 

Multilateral netting 

Multilateral trading facility (MTF) 

since the last valuation. 

An  agreement  that  sets  forth  the  standard  terms  and 
conditions  applicable  to  all  or  a  defined  subset  of 
transactions that the parties may enter into from time 
to  time,  including  the  terms  and  conditions  for 
closeout netting. 

Netting  on  a  multilateral  basis  by  summing  each 
participant’s  bilateral  net  positions  with  the  other 
participants  to  arrive  at  a  multilateral  net  position. 
Such  netting  is  often  conducted  through  a  central 
counterparty  (but  it  can  also  be  done  by  other 
entities).  In  such  cases  the  multilateral  net  position 
represents  the  bilateral  net  position  between  each 
participant and the central counterparty. 

A  multilateral  system,  operated  by  an  investment 
firm  or  a  market  operator,  which  brings  together 
multiple  third-party  buying  and  selling  interests  in 
financial 
in 
accordance  with  non-discretionary  rules  -  in  a  way 
that results in a contract. 

the  system  and 

instruments  - 

in 

Netting 

Notional amount 

Novation 

Open interest 

Plain vanilla transactions 

Portfolio reconciliation 

The  offsetting  of  positions  or  obligations  by 
counterparties. 

The reference amount on which a derivative contract 
is written. 

The  replacement  of  a  contract  between  two  initial 
counterparties to a contract (the transferor, who steps 
out of the deal, and the remaining party) with a new 
contract  between  the  remaining  party  and  a  third 
party (the transferee). 

The  total  number  of  open  derivative  contracts  on  a 
specific underlying. 

Generally  used  to  refer  to  a  type  of  derivatives 
transaction  with  simple,  common  terms  that  can  be 
that  have 
processed  electronically.  Transactions 
unusual or less common features are often referred to 
as exotic, structured or bespoke. 

the  existence  of  all 
The  process  of  verifying 
outstanding trades with a particular counterparty and 
comparison of their principal economic terms. 

Portfolio compression  

(cid:214) Multilateral netting. 

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Position 

Reference entity 

Restructuring 

Segregated account 

Segregation 

Settlement 

Speculation 

Straight through processing (STP) 

Trade matching 

Trade repository 

The stance an investor takes vis-à-vis the market. An 
investor's position is said to be long (short) when she 
buys (sells) a financial instrument. 

A  corporate,  a  sovereign  or  any  other  form  of  legal 
entity  which  has  incurred  debt,  on  which  a  CDS  is 
written. 

One  of  the  (cid:214)  credit  events  that  may  trigger  the 
exercise  of  a  CDS  contract.  The  term  denotes  a 
change in the legal terms of an issuer's ((cid:214) reference 
entity)  obligation,  such  as  the  reduction  in  the 
obligation principal, the reduction in the contractually 
agreed  interest  payments  and  the  deferral  of  interest 
or principal payments. 

An  account  used  for  the  (cid:214)  segregation  of  a  client's 
assets 

A  method  of  protecting  a  client’s  assets  by  holding 
them separately from those of the custodian (or other 
clients, as the case may be). 

The  completion  of  a  transaction,  wherein  the  seller 
transfers  securities  or  financial  instruments  to  the 
buyer and the buyer transfers money to the seller. 

The  act  of  making  an  investment,  i.e.  taking  a  (cid:214) 
position in the market, without certainty of being able 
to  recover  the  initial  investment  or  earning  a  return 
on the investment. 

The  automated  end-to-end  processing  of 
trades 
including,  where  relevant,  the  automated  completion 
of  confirmation,  matching,  generation,  and  clearing 
and settlement of orders. 

The  process  by  which  both  counterparties  to  a  trade 
create  a  written  or  electronic  record  evidencing  the 
full  terms  of  the  trade.  These  two  records  are  then 
compared  and  considered  matched 
they  are 
identical. 

if 

A  centralised  registry  that  maintains  an  electronic 
database of open OTC derivative transaction records 
(contracts). 

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ANNEX 2: Future policy actions for ensuring efficient, safe and sound derivatives 
markets 

Objective 

Proposed actions 

Time line 

Reduce counterparty credit 
risk - strengthen clearing 

Propose legislation on CCP requirements, governing:  

Mid 2010 

(a) 

(b) 

(c) 

safety requirements (e.g. conduct of 
business, governance, risk 
management, legal protection of 
collateral and positions) 

authorisation/withdrawal of 
authorisation and supervision of CCP 

mandating of CCP clearing of 
standardised derivatives 

Amend CRD in order to: 

(d) 

(e) 

Mandate financial firms supplying 
initial and variation margin; 

Substantially differentiate capital 
charges between CCP-cleared and 
non-CCP cleared contracts in CRD;  

Reduce operational risks - 
standardisation  

Assess whether to re-shape the operational risk 
approach in the CRD to prompt standardisation of 
contracts and electronic processing. 

Work with industry to increase standardisation of legal 
regimes and processes; 

Increase transparency - trade 
repositories  

Propose legislation on trade repositories: 

(f) 

(g) 

Regulate trade repositories 

Mandate reporting of OTC 
derivatives transactions to trade 
repositories;  

End-2010 

End 2010 

On-going 

Mid-2010 

Increase transparency – 
trading 

Amend MiFID to require transaction and position 
reporting to be developed in conjunction with CCPs 
and trade repositories;  

End-2010 

Ensure trading of standardised contracts on organised 
trading venues under MiFID; 

Enhanced trade and price transparency across venues 
and OTC markets, as appropriate, in MiFID; 

Conclude review of exemptions from MiFID for 
commodity firms. 

Improve market integrity 

Extend MAD to OTC derivatives; 

End-2010 

Give regulators the power to set position limits in 
MiFID. 

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ANNEX 3: 2 December 2009 Council conclusions on derivatives markets and clearing 
and settlement169 

The Council adopted the following conclusions: 

"1.  The  Council  RECALLS  the  Conclusions  of  the  European  Council  of  18/19  June  2009, 
where the European Council called for "further progress to be made in the regulation of 
financial markets, notably on transparency and stability of derivatives markets." 

2.  The Council RECOGNISES the global dimension of derivatives markets and the need for 
a level playing field, as agreed by G-20 leaders at their meeting on 25 September 2009, 
where  they  called  i.a.  for:  "Improving  over-the-counter  derivatives  markets:  All 
standardized  OTC  derivative  contracts  should  be  traded  on  exchanges  or  electronic 
trading platforms, where appropriate, and cleared through central counterparties by end-
2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-
centrally cleared contracts should be subject to higher capital requirements." 

3.  The Council also STRESSES the importance of the two related workstrands set out in the 
ECOFIN  roadmap  adopted  by  the  Council  (ECOFIN)  on  20  October  as  an  annex  to  its 
conclusions on strengthening EU financial stability arrangements, namely: 

–  "Increasing the safety for "over the counter" derivatives markets, by : the clearing of 
standardized  OTC  derivative  contracts  through  central  counterparties  and,  if  not, 
higher capital requirements; the reporting of non-standardized derivative contracts to 
trade repositories"; 

–  "Improve transparency in use of derivatives". 

4.  The Council broadly WELCOMES the future actions announced by the Commission in 
its  Communication  on  "Ensuring  efficient,  safe  and  sound  derivatives  markets  -  Future 
policy action". On that basis, the Council, bearing in mind the aforementioned declaration 
of G-20 leaders in Pittsburgh: 

5.  Broadly  WELCOMES  the  paradigm  shift  in  the  approach  towards  derivatives  markets 
suggested by the Commission, namely moving from so-called "light-handed regulation" 
to  a  more  ambitious  and  comprehensive  regulatory  policy,  that  is  aimed  at  reducing 
counterparty and operational risks, increasing transparency of the derivatives market and 
strengthening  market  integrity  and  oversight  and,  operationally,  is  expected  to  shift 
derivatives trading and clearing from predominantly OTC bilateral  transactions  towards 
centralised trading and clearing infrastructures; 

6.  STRESSES  in  that  respect,  as  noted  by  the  Commission,  the  need  to  have  a 
comprehensive policy on OTC derivatives in order to avoid regulatory arbitrage and, at 
the  same  time,  to  take  into  account  differences  across  classes  of  instruments  and 
contracts, as well as those of specific market participants, incl. non-financial firms, and 

169   Available  at  http://www.consilium.europa.eu/ueDocs/cms_Data/docs/pressdata/en/ecofin/111706.pdf.  See 
p. 26-30. The relevant passage is reported in its entirety, although not all of the points are relevant to this 
report. 

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commodity markets, e.g. for gas and electricity. Any future policy option should ensure 
that non-financial institutions can continue managing the risks inherent to their business, 
without  incurring  disproportionate  costs;  and  where  appropriate  should  allow  them  to 
tailor risks to individual needs, subject to proper risk mitigation techniques and internal 
controls, but without underpricing risks nor opening regulatory loopholes. 

7.  AGREES  with  the  need  to  improve  substantially  the  mitigation  of  counterparty  credit 

risk, and focusing in particular on: 

b.  Promoting  clearing  of  clearing  eligible  derivatives  by  means  of  one  or  more  central 
counterparties (CCPs) which should be subject to adequately harmonised regulation and 
supervision and oversight to ensure improved safety and soundness. 

The  Council  WELCOMES  the  joint  CESR-ESCB  Recommendations  for  Central 
Counterparties in Europe and broadly WELCOMES the Commission's intention to work 
on appropriate legislative proposals addressing in particular 5 issues, namely: conduct of 
business  and  governance,  risk  standards,  legal  protection  to  collateral  and  positions, 
authorisation and recognition of third-country CCPs. 

Taking into account i/ the pan-European reach and systemic importance of CCPs and ii/ 
the  fact  that  CCPs  may  ultimately  be  supported  by  fiscal  authorities,  the  Commission 
should propose appropriate institutional responsibilities; 

c.  Recommending the use of CCPs located in Europe. The Council recognises that there are 
strong reasons for some CCPs being located in Europe, relating to regulatory, supervisory 
and monetary policy concerns. 

d.  Accordingly,  mandating  CCP  clearing  for  clearing-eligible  derivatives.  The  Council 
however RECOGNISES that there are limits to the scope of potential standardisation, and 
that non-standardised OTC derivative contracts will therefore remain necessary and that 
proper  arrangements  need  to  be  in  place  to  fulfil  the  aforementioned  objectives  of 
transparency and safety for the OTC derivatives markets; 

e.  Consequently,  requiring  proper  collateralisation  for  bilateral  clearing,  and  making  it 
subject higher capital charges than centrally cleared trades, taking into account the risk-
mitigating effect of collateral arrangements and other measures, as well as the impact on 
the corporate sector. The Council  INVITES the Commission to conduct comprehensive 
impact  assessments  and  reflect  the  principle  of  higher  capital  requirements  for  bilateral 
OTC contracts, as agreed at G-20 level in Pittsburgh, in future amendments to the Capital 
Requirements Directive (CRD). The Commission should take into account the technical 
solutions being developed under the aegis of the Basel Committee. 

8.  Also  AGREES  with  the  importance  of  improving  transparency,  efficiency  and  integrity 

for derivative transactions, focusing in particular on four issues: 

a.  Mandating  reporting  of  transactions  to  trade  repositories,  to  be  then  provided  to 
regulators. The Commission should work towards proposing a Common legal framework 
for  the  regulation,  supervision  and  oversight  of  trade  repositories,  incl.  the  roles  and 
functions that may be given i.a. to ESMA within the overall supervisory framework; 

b.  European regulators' and Central banks' access to information stored in trade repositories. 
The  Council  CONSIDERS  that  European  regulators  and  Central  banks  must  have 

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unfettered  access  to  complete  global  information.  In  the  absence  of  such  access  to 
the  Council  WOULD 
information 
ENCOURAGE the creation and operation of European-based trade repositories; 

third  countries, 

repositories 

located 

in 

in 

c.  Ensuring  that  all  relevant  trades  eligible  for  exchange-trading  take  place  on  organised 

markets; 

d.  Enhancing pre-and post-trade transparency requirements as appropriate. 

The  Commission  should  include  these  issues  in  its  review  of  the  Directive  on  Markets  in 
Financial Instruments (MiFID). 

9.  Broadly WELCOMES the Commission's intention to work also on mitigating operational 
risk and, within the context of the forthcoming review of the MiFID and of the Market 
Abuse  Directive  (MAD),  to  revise  relevant  legislative  provisions  underpinning  market 
integrity and oversight. 

10.  Overall,  broadly  WELCOMES  the  Commission's  intention  to  put  forward,  or  revise  as 
appropriate, several legislative proposals (i.e. a possible Proposal on CCPs, amendments 
to the CRD; the reviews of MiFID and MAD). The Council RECALLS in that respect the 
common  /  inter-institutional  commitment  to  better  regulation  and  INVITES  the 
Commission to carry out a thorough impact assessment for the legislation to be proposed, 
working  towards  addressing  the  needs  of  all  concerned  stakeholders,  and  seeking 
consistency  with  existing  or  emerging  international  standards,  whilst  respecting  the 
aforementioned overarching principles of market transparency and financial stability. 

Clearing and Settlement 

11.  In the field of clearing and settlement for cash equities, as clarified by the Commission 
report  on  the  Code  of  Conduct,  the  Council  NOTES  the  progress  made  in  terms  of 
increased efficiency and reduced costs for investors, in particular as regards cash-equity 
CCP-clearing.  The  Council  AGREES  with  the  conclusion  that  further  steps  need  to  be 
taken  to  address  the  issues  related  to  risk  and  regulatory  barriers  that  have  been 
highlighted  by  the  Code  of  Conduct.  The  Council  TAKES  NOTE  of  the  ongoing  work 
aiming  at  increasing  legal  certainty  of  securities  holding  and  transaction  and  INVITES 
the Commission to present its draft legislation on securities law as soon as possible. 

12.  The Council INVITES the new Commission to continue work with the industry to resolve 
remaining  challenges  as  regards  price  transparency  and  comparability,  commercial  and 
operational barriers to links and access and service unbundling in the post-trade sector. 

13.  The  Council  RECALLS  in  that  respect  its  conclusions  of  December  2008  where  it 
stressed the need for further progress on access and interoperability requests, bearing in 
mind financial stability concerns that these arrangements should be compatible with the 
safety and soundness of the post-trading infrastructure, and emphasised in particular that 
links  between  CCPs  should  comply  with  high  prudential  standards  in  respect  of  credit, 
liquidity and operational risks." 

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ANNEX 4: Summary of first public consultation 

1. 

INTRODUCTION 

This document presents a broad non-exhaustive summary of the responses to the consultation 
on  OTC  Derivatives  market.  The  summary  follows  the  same  sections  outlined  in  the 
consultation  document  and  for  each  section  provides  both  an  overview  of  the  general 
comments received and of the detailed responses to the single questions. 

2. 

PROMOTING FURTHER STANDARDISATION 

General comments 

The Commission Consultation paper had distinguished two types of standardisation, namely 
that of the contract (the legal frame) and the contractual parameters (the economic content). 
Several respondents refined standardisation into the following three subcategories: 

1.  Contract  uniformity 

(standard 

legal 

relationships,  confirmation  agreements, 

documentation, market conventions on event handling) 

2.  Product uniformity (standard valuations, payment structures, dates) 
3.  Process  uniformity  and  automation  (Straight-through  processing  (STP),  matching, 

confirmation and settlement) 

Many  respondents  found  using  standardised  legal  terms  beneficial.  Market  practice  has 
generated model legal frameworks (Master  Agreements), while a few may co-exist (e.g. for 
UK  and  US  legal  regime).  This  might  happen  naturally  in  a  maturing,  more  liquid  market. 
Commodity  derivatives,  however,  would  by  nature  be  highly  specific  but  there  was  no 
evidence  that  they  posed  a  risk  to  the  financial  system.  However,  corporations  often 
responded that they would not use some of those model contracts because they would entail 
market  practices  not  suitable  for  them  (e.g.  the  provision  of  collateral,  which  would  expose 
them to liquidity risk). One respondent argued that the recent market agreement on the auction 
settlement for CDS would have exposed CDS sellers to higher risk. On the other hand, one 
respondent  argued  that  the  standard  practice  of  "cash  settlement"  in  CDS  cause  speculation 
and  might  have  hinder  access  to  credit  for  the  companies  on  whose  name  the  CDS  was 
written. Other respondents argued that the regulation of investment/mutual funds (subject to 
UCITS)  required  some  specific  clauses  in  otherwise  standard  CDS  contracts  to  avoid  loan 
delivery. 

Product  uniformity,  as  far  as  standardising  the  economic  parameters  of  the  contract  is 
concerned (provided they are consistently defined), was widely rejected, since it would limit 
hedging  possibilities  and  might  result  in  a  conflict  with  accounting  rule  IAS  39.  Uniform 
event  handling  was  seen  in  some  cases  as  problematic,  as  there  was  diversity  in  national 
legislation  (e.g.  corporate  action).  However,  one  public  authority  regarded  further 
standardisation of contract and economic terms as beneficial, which should be determined in 
an industry/regulator working group. 

The  technical  standardisation,  i.e.  automation  of  processes  was  widely  seen  as  beneficial; 
however  many  respondents  emphasised  the  set-up  costs.  To  achieve  this,  for  example  the 
fields  to  be  completed  in  every  transaction  could  be  standardised.  Process  automation  to 
reduce  operational  risk  was  often  seen  as  the  driver,  rather  than  the  consequence,  of 
standardisation.  Some  argued  that,  especially  for  rather  specific  needs,  the  first  steps  in 

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concluding  a  trade  (the  brokering)  need  not  be  automated.  One  respondent  also  argued  that 
electronic confirmation on the trade date may risk resulting in cash flows from the swap not 
matching those of the underlying bond. 

A  large  number  of  respondents  (with  exceptions,  though)  did  not  consider  it  necessary  to 
incentivise  standardisation  through  regulatory  capital  charges,  as  markets  would  have  an 
inherent incentive to reduce operational risks anyway. 

Several respondents report that the standardisation needed to allow for central clearing (and 
hence  reduction  of  counterparty  risk)  should  be  strictly  separated  from  the  kind  of 
standardisation/automation  that  would  reduce  operational  risk.  Moreover,  considering  only 
centrally-cleared trades as standardised would transfer a regulatory responsibility to clearing 
houses, which pursue the business objective of attracting order flow. 

 (1)  What  would  be  a  valid  reason  not  to  use  electronic  means  as  a  tool  for  contract 
standardisation? 

It  was  pointed  out  that  there  was  still  scope  to  wider  use  electronic  affirmation  and 
confirmation to reduce settlement risk. Broker dealers should be required to receive positive 
affirmation  from  their  clients  on  all  OTC  derivative  trades.  Market  participants  should  be 
invited  to  explain  why  the  use  of  electronic  means  would  not  be  possible  in  some  cases. 
However, it was warned that dominant market players might impose their electronic systems 
onto the rest of the market, thus cementing their market power. 

Clearinghouses stated that "electronic means" would work on a general level, but the level of 
standardisation would not be suitable to determine if a contract was eligible for CCP clearing. 

A market infrastructure provider argued that capturing the complete information of an OTC 
derivative trade in an electronic format early during its life cycle (Execution – confirmation – 
clearing  –  data  repository  –  life  cycle  events)  should  be  regarded  as  a  pre-requisite  to 
increasing the resilience and the transparency of the market. The respondent added that, whilst 
the  degree  of  standardisation  of  legal  terms  is  relevant  for  the  eligibility  of  a  product  for 
electronic processing during all stages of its life cycle, its eligibility for electronic execution 
and clearing would in addition depend on its actual liquidity and reliability of pricing. 

One  respondent  offered  a  functional  breakdown  of  "electronic  means"  during  the  trading 
cycle:  

"Electronic execution: should be encouraged wherever possible, but with the realisation that 
only  liquid  segments  of  certain  markets  may  meaningfully  benefit  from  that  type  of  high 
transparency  environment.  Certain  types  of  trade  may  only  occur  very  infrequently,  and 
where price uncertainty exists there is little motivation to risk creating price deviation by the 
mere disclosure of the price. 

Electronic  reconciliation  and  confirmation:  potentially  a  very  valuable  tool  to  ensure  that 
details  of  trades  are  agreed  early  and  accurately,  and  can  be  used  in  both  high  and  low 
velocity markets. 

Straight-Through  Processing  (STP):  trade-capture  via  electronic  systems  (even  if  it  occurs 
posttrade) allows STP to market participants’ internal risk and settlement systems. 

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Auto routing to depositories and/or CCPs: once trade information is accurately captured it can 
be submitted automatically to clearing and settlement systems and/or to data depositories. 

Clean data for analysis by regulators: as with trade information submitted to infrastructure, 
accurate, reconciled and ideally netted data can be made available to regulators for analysis." 

It was pointed out that brokering the contract may not necessarily be electronic; however once 
a trade was agreed the remaining back office work can be done electronically. 

(2)  Should  contracts  standardisation  be  measured  by  the  level  of  process  automation? 
What other indicators can be used? 

Many respondents argued that a certain level of process automation was possible even without 
standardisation,  hence  the  level  of  process  automation  was  not  an  exclusive  measure  of 
standardisation. So-called "copper" electronic trade records would retain only some key terms 
of a trade. In the same vein, it was argued that the vast amount of (operational) risk reduction 
would  already  be  achieved  by  confirming  the  key  financial  terms  of  a  transaction,  which 
would correct the incorrectly booked trades.  

Also, for example, equity derivatives may have bespoke contracts to deal with specific legal 
and business risks, but can still be eligible for electronic confirmation. However, it was also 
argued that such "short form" automation would be a strong impediment to central clearing. 

A focus on execution and confirmation automation levels would provide the best measure for 
standardisation because these processes will use a fully valid legal record of the contract. 

It  was  suggested  to  look  at  the  time  needed  for  two  parties  from  agreeing  on  a  trade  to 
reaching  a  legally  binding  contract  (or  between  transaction  initiation  and  execution,  or,  if 
applicable,  novation).  Furthermore,  the  number  of  failed  trades  (or  erroneous  or  incomplete 
confirmations) could be taken as an indicator. 

Higher  trading  volumes  and  the  absence  of  significant  (economic  and  in  legal  form) 
differences in contract terms could be viewed as indicators. One respondent answered that the 
ratio  of  traded  turnover  over  outstanding  nominal  of  underlying  instrument,  the  more 
standardised a contract. 

One  bank  pointed  out  that  the  NY  Federal  Reserve  considered  20  trades  per  month  in  a 
product  range,  such  as  interest  rates,  as  the  threshold  for  an  electronic  process.  Similarly, 
another bank suggested setting the use of electronic trade processing as an industry standard 
depending on the transaction volume, for example for entities with at least 10 transactions in 
one asset class or 20 cumulatively per month. 

(3) Should non-standardised contracts face higher capital charges for operational risk? 

This question proved quite controversial, since the use of the term "standardisation" was not 
uniform among respondents (see general remarks and preceding questions). 

Some  public  authorities  argued  that  priority  should  be  given  to  counterparty  risk  mitigation 
tools. The Capital Requirements Directive (CRD) already takes operational risks into account 
in general terms; it would be difficult to technically introduce a strengthened recognition for 
non-standardised  contracts.  To  include  possible  losses  from  manual  processes  would  face 
conceptual  problems.  This  was  supported  by  some  industry  answers;  neither  the  Advanced 

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Measurement Approach nor the Standard Approach in the CRD would be able to capture each 
and every transaction. 

However, one regulator argued that in practice, novel or increased operational risk is likely to 
arise  more  commonly  for  non-standard  contracts.  Therefore,  compared  to  standardised 
contracts, higher capital charges may be appropriate more frequently. 

In  contrast,  others  pointed  out  that,  to  the  extent  that  non-standardised  contracts  were  not 
centrally cleared, they already face higher capital charges (for counterparty risk). It was even 
argued that an extensive standardisation would conflict with the risk mitigation function that 
the CRD would attribute to derivatives. One respondent would like to see proof of correlation 
between non-standard contracts and higher operational risk.  

Others  pointed  out  that  non-standardised  contracts  did  not  only  face  higher  operational  and 
counterparty  risk,  but  also  higher  liquidity  risk.  While  flexible  when  written,  they  become 
inflexible  in  terms  of  maintenance  and  closure.  Operational  risk  was  not  the  main  driver  of 
risk for non-standard products. 

In  the  same  vein,  a  bank  suggested  to  define  regulatory  targets  directly  for  post-trade 
automation  and  performance,  rather  than  addressing  standardisation.  Calibrating  a  possible 
level of regulatory capital charges and ensuring that the system is robust to market changes 
would be a lengthy exercise.  

Further  respondents  argued  that,  if  it  was  decided  to  impose  higher  charges,  those  should 
relate  to  the  level  of  process  automation  and  straight-through  processing  rather  than 
standardisation on its own. 

Some public authorities thought however that higher capital charges linked to operational risk 
could serve as an incentive to promote standardisation. Some private-sector respondents also 
thought  that  increasing  capital  charges  would  help  to  reduce  appetite  for  complex  and  less 
transparent  structures.  In  contrast,  banks  argued  that  internal  operational  risk  models  were 
already  taking  into  account  the  increased  risk  associated  with  non-standardised  contracts.  It 
was also thought that moves in the direction of standardisation were already in the interest of 
market participants, if justified by volumes, and did not need further incentives. For example, 
standardised products would be better priced. It was pointed out that the industry has already 
committed to more standardisation (ISDA letter to NY Fed, 2 June 2009). 

Corporations were very firm in pointing out that their use of derivatives was determined by 
the  structure  (maturity  etc.)  of  their  liabilities,  so  that  standardisation  of  the  economic 
parameters  of  the  contracts  would  undermine  their  hedging  and  conflict  with  accounting 
standards. While some companies acknowledged that a common understanding of legal terms 
was useful, they would like to retain the freedom not to use standard collateral agreements. 

It  was  suggested  that  regulators  carry  out  a  quick,  determined  review  of  existing  industry 
associations' framework agreements (both for derivatives as well as their underlying assets). 
Indeed,  one  regulator  suggested  establishing  a  working  group  to  determine  1)  a  mutually 
acceptable definition of "standardised", and 2) a roadmap for increasing such standardisation. 

(4)  What  other  incentives  toward  standardisation  could  be  used,  especially  for  non-
credit institutions? 

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It  was  pointed  out  that  non-credit  institutions  would  receive  more  favourable  prices  on 
standardised products. In addition, if capital charges were applied to credit institutions, these 
might be passed on to non-credit institutions as spread or price. 

One  credit  institution  suggested  using  the  audit  process  to  monitor  the  implementation  of 
policy objectives by corporations. 

One regulator suggested better education of OTC derivatives users. 

3. 

STRENGTHENING  BILATERAL  COLLATERAL  MANAGEMENT  FOR  NON-CCP  ELIGIBLE 
OTC DERIVATIVES 

General comments 

Most  respondents  highlight  concern  with  existing  statistics  (e.g.  ISDA)  on  collateral  levels. 
These  may  under  represent  the  level  of  collateral,  as  they  focus  on  collateral  covered  by 
Credit Support Annexes (CSAs) and hence do not focus on collateral provided outside such 
relations.  Many  respondents  therefore  argue  that  it  is  necessary  to  improve  transparency  of 
how exposures are calculated and the level of collateral.  

As regards the currently less than full level of collateralisation (one third of exposures remain 
uncollateralized),  many  respondents  argue  that  this  is  natural,  as  many  end-users  of  OTC 
derivatives  do  not  supply  collateral  (e.g.  smaller  financial  firms,  corporates,  sovereigns  and 
supranational lending institutions).  

The views on the merits of strengthening bilateral collateral management differ considerably 
depending  on  the  type  of  respondent.  Generally,  among  financial  firms  there  is  a  broad 
support  for  strengthening  bilateral  collateral  management  by  (i)  increasing  collateral  levels 
(subject  to  the  comments  above)  and  (ii)  improving  the  frequency  by  which  exposures  are 
marked-to-market and collateral is exchanged.  

Broadly, most financial firms believe that daily valuation, exchange of collateral and portfolio 
reconciliation  should  be  the  long-term  goal.  Most  respondents  do  not  see  any  particular 
market  as  beyond  that  ambition,  even  though  specific  attention  has  to  be  paid  to  –  and 
exceptions made – for (i) certain counterparties (small), (ii) certain contracts (complex), and 
(iii)  certain  types  of  collateral  (non  cash),  where  the  costs  of  setting  up  daily  valuation, 
exchange of collateral and reconciliation would be disproportionate to the benefits in terms of 
risk reduction. 

Two groups of respondents have considerable concern with strengthening bilateral collateral 
management: corporates and supranational lending institutions. Both groups are active mainly 
in FX derivatives, interest rate swaps and commodity derivatives. While both groups support 
the  objective  of  making  OTC  derivatives  safer,  they  argue  that  they  adequately  address  the 
risks  associated  with  their  current  use  of  OTC  derivatives  and  that  obliging  them  to  submit 
collateral would create significant risks, in terms of unpredictable margin calls, and costs, in 
terms of administering their collateral obligations. This would effectively reduce their ability 
to take recourse to OTC derivatives to hedge their business related risks. 

Moreover, some corporates express particular concern related to the CDS market, which they 
judge opaque and volatile and where impredictable CDS spreads may affect corporates' access 
to credit.  

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As regards the need for legislation, views differ significantly. Most financial firms argue that, 
as current collateral levels are adequate, existing rules and incentives are sufficient. Others – 
infrastructures, many Member States – on the contrary argue that legislation is necessary to 
complement  industry  action.  Most  of  them,  however,  argue  in  favour  of  regulatory  capital 
incentives rather than mandating either supply of collateral or certain collateral management 
techniques per se. 

(5)  How could the coverage of collateralised credit exposures be improved?  

Many stakeholders stress that available ISDA statistics on the level of exposures covered by 
collateral  are  unreliable.  Between  financial  dealers,  some  argue  that  collateral  levels  are 
sufficiently  high,  due  to  the  'natural  incentives'  to  supply  collateral  (e.g.  regulatory  capital 
treatment). Moreover, the less than full coverage is explained by end-users who either cannot 
(e.g. corporates) or will not (e.g. supranational lending institutions) supply collateral.  

Corporates  argue  that  being  forced  to  conclude  collateral  agreements  (CSAs)  would  lead  to 
excessive  and  unpredictable  margin  calls,  which  would  expose  them  to  significant  liquidity 
risk.  Currently  they  are  exposed  to  counterparty  risk,  as  no  CSAs.  However,  this  risk  is 
manageable provided you choose your counterparty carefully and use several counterparties. 
Liquidity risk is not, as nobody can predict how prices will evolve. An obligation to submit 
collateral  would  put  a  significant  strain  on  corporate  liquidity  and  would  be  operationally 
costly.  

Similarly,  supranational  lending  institutions  argue  that  obliging  them  to  submit  collateral 
(either by means of CCP membership or in bilateral collateral relations) would significantly 
increase their cost and submit them to liquidity risk. 

In  order  to  strengthen  the  level  of  collateral,  some  respondents  argue  that  it  is  necessary  to 
explore the possibility of non-cash collateral. 

(6) 

Are  there  markets  where  daily  valuation,  exchange  of  collateral  and  portfolio 
reconciliation cannot be the goal? Please justify. 

A majority of stakeholders argues that there are no markets that per se cannot support daily 
valuation, exchange of collateral and portfolio reconciliation and that it should accordingly be 
a long-term goal. However, most respondents stress the costs of daily procedures, which for 
smaller  financial  firms  and  most  end-users  would  be  prohibitive.  Therefore,  while  broad 
support for strengthening bilateral collateral management, it is necessary to make exceptions 
for (i) certain counterparties (small), (ii) certain contracts (complex), and (iii) certain types of 
collateral (non cash), where the costs of setting up daily valuation, exchange of collateral and 
reconciliation would be disproportionate to the benefits in terms of reducing risk. 

(7)  How frequently should multilateral netting be used? 

There is a broad support for trade compression, the kind of multilateral netting referred to in 
this question. However, the frequency of compression depends on the liquidity of underlying 
instrument; if liquid, compression could occur more frequently; if not, less. 

(8) 

Should  bilateral  collateral  management  be  left  to  self-regulatory  initiatives  or 
does it need to be incentivised by appropriate legislative instruments? 

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Views  on  the  relative  merits  of  self-regulation  vs.  legislative  instruments  differ.  Financial 
firms  broadly  express  little  support  for  legislation,  arguing  that  natural  incentives  push 
towards  high  level  of  collateralisation  and  that  existing  legislation  (CRD)  already  provide 
regulatory capital incentives. Others – corporates, infrastructures, public authorities – on the 
contrary  argue  that  legislation  is  a  useful  and  necessary  complement  to  industry  action.  As 
regards the form of such legislation, with the exception of many infrastructure providers, there 
is  limited  support  for  mandating  either  collateral  provisioning  or  certain  collateral 
management techniques.  

Instead, legislation should focus on incentives (regulatory capital requirements differentiated 
according  to  clearing  method).  Regulatory  capital  regime  should  favour  CCP  clearing.  For 
example,  it  is  argued  that  regulatory  capital  rules  on  bilateral  collateral  should  take  into 
account  whether  collateralisation  includes  future  replacement  cost  (initial  margin)  and  not 
only  variation  margin,  as  is  currently  the  norm.  Moreover,  some  argue  that  the  charge  on 
bilateral  collateral  should  be  reduced  in  steps  depending  on  the  contract  being  sufficiently 
standardised,  variation  margin  being  supplied  and  initial  margin  being  supplied.  The  best 
treatment should be accorded to CCPs.  

Furthermore, those supporting mandating argue that risk taking (trading) should be separated 
from  risk  management  (collateral  collection).  Accordingly,  collateral  management  should 
preferably be handled by a third party bilateral collateral manager. A commonly held position 
is  that  irrespective  of  what  is  done,  it  is  essential  that  institutions  remain  responsible  for 
properly  managing  their  risk.  Therefore,  when  adapting  rules,  it  is  necessary  to  keep 
incentives to assess and hedge risks at institutional level. 

4. 

CENTRAL DATA REPOSITORIES 

General comments 

The idea of central data repositories or trade repositories (TR) is generally well accepted by 
all kind of respondents. Some divergences appear on the scope of products to be covered and 
on  the  need  of  a  unique  TR  or  several  ones  exclusively  covering  a  segment  of  the  market. 
Confidentiality  and  transparency  are  the  two  main  concerns  to  be  addressed  when  creating 
such  TR  according  to  an  overwhelming  majority  of  respondents.  The  disclosure  of 
information  to  the  public  is  positively  considered  by  most  of  the  respondents.  However 
unanimously, respondents propose not to disclose to the public any information which could 
be detrimental to the market or one of its participants. Disclosure of aggregate data according 
to the respondents is the way to avoid this happening. Respondents  also  unanimously agree 
that  regulatory  authorities  should  have  an  extended  access  to  all  data  with  the  sufficient 
granularity to allow them to exercise their market supervisory duties. 

(9)   Are there market segments for which a central data repository is not  necessary or 
desirable? 

An  overwhelming  majority  of  the  answers  recognise  the  need  to  put  in  place  central  data 
repositories  for  all  class  of  assets  and  markets.  However  among  the  answers  received  from 
entities falling under the business category "infrastructures", there seems to be an unanimity 
in favour of having markets and  transactions  done "through  CCP" not being reported to the 
TR in view of avoiding duplication of work. 

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There  are  also  an  important  number  of  answers  requiring  the  settlement  of  a  unique  central 
data repository in order to avoid competition and unnecessary duplication. 

(10)   Which regulatory requirements should central data repositories be subject   to? 

Regarding  the  kind  and  the  level  of  regulatory  constraints  to  put  in  place,  in  general  it  is 
suggested to have an equal treatment between TR and other financial market players. Some 
referred  explicitly  to  the  MIFID  provisions  (article  32)  whereas  others  referred  to  the  legal 
framework surrounding Central Securities Depositories (CSD) activities. 

One of the major concerns raised is the need for high level of transparency and adequate rules 
on system controls and confidentiality.  

There  are  an  equal  number  of  answers  in  favour  of  TR  being  public  entities  or  privately 
owned  ones.  Work  undertaken  by  IOSCO  and  CESR  on  this  matter  can  serve  as  a  base 
according to one public authorities. 

(11)   What information should be disclosed to the public? 

Regarding information disclosure a distinction is made by all respondents: the direct and full 
access  to  be  given  to  regulatory  Authorities  on  the  one  hand  and  on  the  other  hand  a 
disclosure to the public of high level statistics based on aggregated figures.  

Regarding  the  scope  of  the  data  to  be  published,  most  of  the  answers  propose  to  cover  all 
markets  segments  on  three  elements:  average  prices  (intraday),  volumes  and  open  interest. 
Many respondents asked also that the disclosure to the public take place on a delayed basis. 

One respondent explicitly quoted the work of the OTC Derivatives Regulators Forum on this 
topic  which  proposes  to  disclose  to  the  public  5  kind  of  data  (all  live  positions  as  of  a 
specified  date;  weekly  activity  for  aggregate  positions;  weekly  transaction  activities; 
aggregate open interest by currency and aggregate settlement data by currency). 

Disclosure to the public of information on individual transaction is unanimously rejected. As 
written  by  a  respondent  the  commonly  accepted  goal  to  be  achieved  is  that:  "The  public 
should be able to analyse the evolution of the market structure over time on the basis of the 
information made available". 

Also many respondents have concerns about the additional reporting obligation it will convey: 
all  "corporate"  respondents  have  indicated  that  these  new  constraints  should  be  born 
exclusively by their financial counterpart and that in any case these new reporting obligations 
could not lead to an increase of the costs of these financial entities. 

5. 

MOVE CLEARING OF STANDARDISED OTC DERIVATIVES TO CCPS 

General comments 

Respondents  highlight  a  general  aversion  to  mandatory  clearing  (even  exchanges  and 
infrastructures  are  not  supportive)  and  suggest  to  follow  the  way  of  incentivising  clearing 
through  adequate  capital  incentive.  Some  indicate  the  work  of  the  Basel  Committee  in  this 
respect  and  the  higher  capital  charges  that  should  apply  to  bilateral  transactions  as  an 
incentive to CCP clearing. 

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Many  call  for  regulation  to  define  minimum  standards  for  CCPs,  in  particular  on  risk 
management to avoid competition to the detriment of risk, but also on CCPs governance and 
protection of client assets. 

Many respondents highlight the time needed to adapt their systems. 

Both banks are against multiple CCPs and some suggests a limited number or only one CCP 
per asset class. In their view, the competition problem would be better solved by appropriate 
governance arrangements or ownership. 

In general the corporate sector is against the idea of CCPs that would simply increase the cost 
for them. They believe that it is relevant only for CDS and for the financial sector. 

Many point out that the FX market is different and CCPs are not needed as the main source of 
risk is the settlement risk not replacement risk and the former is already adequately covered. 

(12)  Do  you  agree  that  the  eligibility  of  contracts  should  be  left  to  CCPs?  Which 
governance  arrangements  might  be  necessary  for  this  decision  to  be  left  to  the 
CCPs' risk committees? 

Almost all the respondents agree that the eligibility should be left to CCPs which are the one 
to  bear  the  risk.  Many  however  argue  that  the  decision  should  not  lead  to  an  obligation  to 
clear the product via a CCP.  

Many banks suggests that users should be appropriately consulted and some suggest that the 
decision of the risk committee should be binding. Some suggest also a role of the regulators in 
this  respect.  Many  highlight  the  risk  of  CCPs  that  are  for  profit  organisation.  Many  also 
request the respect of the ESCB/CESR recommendations on governance arrangements. 

For funds it is very important that CDS contracts that exclude loan delivery in case of a credit 
event are considered eligible. 

(13)  What  additional  benefit  should  the  CCP  provide  to  secure  a  broader  use  of  its 

services? 

Many agree with the suggestion of the consultation paper that one of the benefit can certainly 
be  for  the  CCP  to  act  as  reporting  entity  on  behalf  of  its  members.  However,  a  couple  of 
respondents  highlight  that  in  a  competitive  CCP  environment  the  information  held  by  the 
different CCPs would be incomplete and not up to date considering that clearing not always 
occur on the same day. Therefore other market infrastructures would be better placed in this 
respect. 

Among the other services and benefits suggested appear the following: 

–  Broad market participation; 
–  Straight Through Processing; 
–  Transparency on methodologies and prices; 
–  Cost reduction and adaptation of fee structure for less active customers; 
–  Cross-margins; 
–  Interoperability; 
–  Leveraging of existing infrastructure; 
–  Incorporate trade tear-up, termination or compression (even through account segregation); 

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–  Equal treatment of corporate actions; 
–  Tri-party repo arrangements for collateral posted; 
–  Account segregation and portability; 
–  Better tax treatment of CCP cleared transactions; 
–  Use of central bank money; 
–  Participation and guarantee of States or central banks. 

(14) 

Is the zero-risk weighting a sufficiently effective incentive for using CCPs across 
different market segments? 

In  general  most  of  the  respondents  believe  that  the  zero-risk  weighting  is  a  sufficient 
incentive. However, some point out that to be effective appropriate weights should be placed 
elsewhere,  i.e.  bilateral  transactions.  In  this  respect  many  call  for  global  consistency  on  the 
incentive applied and therefore suggest leaving this work to the Basel Committee.  

One interested party argues that since exchange traded contracts incur a minor liquidity risk, 
this should be reflected in a better capital treatment than CCP cleared contracts traded OTC. 

(15)   Should  additional  requirements,  such  as  appropriate  account  segregation,  be 

introduced to apply the zero-risk weighting to indirect participants? 

Almost  all  respondent  are  in  favour  of  account  segregation.  Some  believe  that  extending 
capital incentives to them is a positive tool, however to do that it should be ensured that the 
only counterparty risk that the client face is the CCP one and not that of the clearing member. 
Some  suggests  that  a  large  portion  of  indirect  participants  are  not  credit  institution  and 
therefore the zero-risk weighting does not apply. 

Some  argue  that  since  segregation  comes  at  a  cost  it  should  not  be  imposed,  in  particular 
segregation at CCP level. It should be for the customer to decide on the basis of a transparent 
assessment of costs and risks faced. 

Some,  in  particular  infrastructures,  buy-side  and  some  public  authority,  call  for  appropriate 
regulation  to  establish  harmonised  rules  on  protection  of  client  assets.  It  is  even  more 
important in considering that interoperability will not be immediately available and access via 
clearing members may represent an interim solution. 

(16)   Should  bilateral  clearing  of  CCP-eligible  CDS  be  penalised  and,  if  so,  to  what 
extent? Is there a need to extend regulatory incentives to clear through a CCP to 
other derivatives products? 

In general it is suggested that the same approach should apply to the different asset classes, 
but most of  the respondent are against punitive charges. Capital requirements should reflect 
the effective risk faced and not be improperly used. However, bilateral clearing implies higher 
risks  and  these  should  be  duly  taken  into  account  and  by  doing  so  an  incentive  to  CCP 
clearing  will  be  provided.  Some  market  participants  may  have  valid  reasons  not  to  clear 
through CCP and only the higher risk of that choice should be captured.  

Capital charges are generally preferred to mandatory use of a particular infrastructure. Some 
respondents from the buy-side, from infrastructures or from the public sector believe that it is 
not unreasonable to penalise bilateral clearing of CCP-eligible contracts. Buy-side firms are, 
however, against penalisation for decisions outside their control.  

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(17)  Under which conditions should exemptions be granted and by whom? 

The  majority  of  those  who  replied  to  this  question  indicated  that  CCP  use  should  not  be 
mandated  and  hence  no  exemptions  are  needed.  Corporates  unanimously  replied  that  they 
should  be  exempt  from  using  CCPs.  Some  of  the  respondents  indicated  that  CCP  clearing 
should be mandated only for entities with sufficiently large exposures and for entities that are 
systemically  important.  In  these  cases  the  exemptions  should  be  granted  by  the  relevant 
authorities (in some cases after discussions with the industry). 

(18)  What is the minimum acceptable ratio of CCP cleared/eligible contract? What is 

the maximum acceptable number of non-eligible contracts? 

Almost all of the respondents who replied to this question indicated that it is not advisable to 
set  arbitrary  thresholds.  Those  who  did  provide  some  indications  of  what  these  thresholds 
could  be,  pointed  out  that  they  would  differ  according  to  product  types;  in  such  cases  best-
practice benchmarks should be used. CCPs warned that setting the maximum number of non-
eligible  contracts  could  be  counterproductive,  as  CCPs  could  be  forced  to  clear  unsuitable 
contracts to keep their members below the threshold. 

(19)  What statistics need to be provided to regulators to make sure they have all the 

information necessary to perform their duties? 

In  general,  the  respondents  indicated  that  regulators  should  receive  all  the  information 
necessary to perform their duties. A number of respondents have stressed the important role 
that  trade  repositories  could  play  in  the  provision  of  information  to  regulators  (some  have 
even indicated that the repositories should be the default exit point for all information). Some 
have also pointed out to the current work being done within the OTC Derivatives Regulators 
Forum  for  determining  what  type  of  information  regulators  would  like  to  have.  One 
respondent highlighted the need for comparable statistics between data provided by CCPs and 
data  provided  by  repositories.  A  few  corporates  asked  to  be  exempt  from  any  reporting 
requirements to regulators. 

(20)  How  could  European  legislation  help  ensuring  safety,  soundness  and  a  level 

playing field between CCPs? 

The  great  majority  of  respondents  indicated  that  some  sort  of  legislation  is  necessary  to 
regulate the activity of CCPs (a few indicated that the ESCB-CESR recommendations should 
be used as the basis for such legislation). The main reasons for legislation mentioned included 
ensuring  safety  and  soundness  of  CCPs,  a  level  playing  field  and  preventing  competition 
between  CCPs  on  margin  (and  thus  a  race  to  the  bottom).  To  this  end,  the  respondents 
indicated  that  legislation  should  cover,  inter  alia,  open  and  fair  access,  business  continuity, 
effective  risk  management  (especially  concerning  default  management  process:  mandatory 
periodic fire drills and stress testing of the default fund), segregation of client assets, common 
authorisation regime (on this a few respondents indicated that this could be done by one of the 
new European authorities) and passporting. 

Some  respondents  indicated  either  that  the  recently  adopted  ESCB-CESR  recommendations 
for CCPs are sufficient or that one should wait and see if these recommendations will work 
before considering legislation. Some respondents also stressed the importance of developing 
international standards. 

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A  few  respondents  also  stressed  the  importance  of  granting  CCPs  access  to  central  bank 
liquidity  in  times  of  markets  stress.  In  this  context  some  have  argued  that  CCPs  should  be 
located in the area of the currency in which derivatives are denominated and should have the 
status of credit institutions. One respondent called for explicit public guarantees for CCPs. 

6. 

TRANSPARENCY OF TRADING 

General comments 

Extending MiFID style transparency on OTC derivatives market is facing opposition from a 
large  majority  of  the  stakeholders  that  have  responded  to  the  consultation.  The  professional 
nature  of  the  market  participants,  the  size  of  the  trades,  the  existing  arrangements  and 
presence  of  data  providers,  and  the  diversity  of  derivatives  markets  lead  the  majority  of 
stakeholders to reject uniform extension of MiFID style transparency rules, especially for pre-
trade  information  and  for  specific  markets  like  interest  rate,  foreign  exchange  and 
commodities markets, saying that it would damage liquidity. 

Transaction  and  position  reporting  finds  much  more  support  from  stakeholders,  especially 
position  reporting  towards  regulators.  They  consider  that  TRs  and  CCPs  are  the  best 
positioned to fulfil such requirements. They also underline the need to minimize as much as 
possible the cost and burden of the new reporting and to preserve confidentiality on individual 
transaction from public scrutiny, as well as the fragmentation of data that may result from it. 

 (21)  Should  MiFID-type  pre  and  post  trade  transparency  rules  be  extended  to  non-

equities products? Are there other means to ensure transparency? 

Even if a few of respondents agree in principle on increased transparency, a large majority of 
them consider that MiFID type transparency rules, especially pre-trade, are less relevant for 
derivatives because of the specificities of these markets. Market participants are professional 
investors,  transactions  large  in  size  and  data  providers  are  actively  operating.  Most  market 
participants  which  have  answered,  being  financials  or  corporates  consider  that  the  level  of 
transparency  on  these  markets  is  overall  satisfactory.    Most  corporates  estimate  that 
transparency on foreign exchange, interest rates and commodities markets is adequate. On the 
contrary, a couple of respondents mention the lack of transparency of the CDS market. Lastly, 
there  are  some  comments  on  the  fact  that  increased  transparency  without  further 
standardisation would create confusion. 

Several respondents across different categories underline that increased transparency could be 
detrimental  to  liquidity,  that  any  new  transparency  measure  should  go  through  a  thorough 
costs/benefits  analysis  and  adapted  to  each  segment  of  the  OTC  derivatives  markets  which 
encompass very different products and trading features. 

(22)  How  should transactions reporting of OTC derivatives to  competent authorities 
be  envisaged?  Should  it  be  extended  to  all  contracts  or  to  certain  categories?  If 
so, which ones? Are there other means to ensure that the competent authorities 
receive the relevant information on OTC derivatives transactions? 

A  majority  of  respondents  are  supportive  of  transaction  reporting  towards  competent 
authorities. They also consider that the reporting to competent authorities should come from 
CCPs or TRs and to a less extent, sell side institutions. 

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Several  respondents,  especially  from  the  corporate  side  and  more  particularly  in  the  energy 
markets,  stress  the  necessity  of  preserving  confidentiality  of  individual  transactions  towards 
the public in order to preserve sensitive commercial information and avoid damaging market 
liquidity. A few point out the fact that transaction reporting may not be the most suitable tool 
for regulators, especially for energy markets. 

There were also several comments on the needs to avoid duplication of existing data and too 
heavy administrative burden. 

(23)  How  should  position  reporting  of  derivatives  to  competent  authorities  be 
envisaged? Should it be extended to all contracts or to certain categories? If so, 
which  ones?  Are  there  other  means  to  ensure  that  the  competent  authorities 
receive the relevant information on the exposures to particular contracts? 

There is a large support for position reporting, on a post trade basis, with the same restriction 
than for transaction reporting regarding public release of individual positions. TR and CCPs 
are mentioned as the most suitable sources of data. 

There  were  also  individual  comments  on  the  needs  for  comparable  data  across  Europe,  for 
clear and unique identification of each transaction, and on the necessity to avoid complexity 
and  minimize  costs.  A  couple  of  respondents  mentioned  TREM  as  a  blue  print  for  this 
position reporting. 

7. 

MOVE TRADING TO MORE PUBLIC TRADING VENUES 

General comments 

Trading on public trading venues, it is seen as complementary to OTC trading because of the 
necessity  to  be  able  to  trade  customised  products,  to  use  voice  market  when  needed  and  
choose  between  competing  trading  venues.  A  majority  of  stakeholders  consider  that  forcing 
all derivatives trading to public venues would have limited added value if central depositary 
and  CCP  clearing  are  implemented  but  could  damage  liquidity  for  some  markets.  A  natural 
evolution should be favoured over a mandatory approach.   

(24) How can further trade flow be channelled through transparent and efficient trading 
venues?  What  would  be  the  appropriate  level  of  transparency  (price,  transaction, 
position) for the different derivatives markets? 

The majority of respondents do not support the transfer, especially mandatory of derivatives 
trading to public trading venues. For several respondents, trading on public venues would not 
add value if sufficient standardisation, TR and CCP clearing is achieved, but would create a 
number  of  issues  regarding  the  ability  to  trade  for  large  size,  confidentiality,  and  the 
possibility of using voice trading rather then electronic trading when needed. 

For  several  respondents,  OTC  and  public  trading  venues  are  said  to  be  complementary  and 
competition between trading venues is welcome and should be maintained. 

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ANNEX 5: Summary of second public consultation 

I. 

Clearing and risk mitigation of OTC derivatives 

Questions:  

What  are  stakeholders'  views  on  the  clearing  obligation,  the  process  to  determine  the 
eligibility  of  OTC  derivate  contracts  for  mandatory  clearing,  and  its  application?  Do 
stakeholders  agree  that  access  from  trading  venues  to  CCPs  clearing  eligible  contracts 
should be guaranteed?  

The spectrum of the answers ranged from general and strong support for the introduction of a 
clearing obligation (mostly voiced by market infrastructures) to an outright opposition to the 
concept  as  such  (expressed  by  some  banks  and  dealers).  It  also  included  responses  that 
approved the principle of mandatory clearing while raising concerns about the ability of some 
parts of the industry to adapt smoothly and timely to the consequences.  

Regarding  the  process,  views  were  expressed  both  on  the  bottom-up  and  the  top-down 
approach  to  determine  the  eligibility  of  OTC  derivative  contracts  for  mandatory  clearing. 
Some  respondents  raised  concerns  that  a  bottom-up  approach  might  incentivise  markets 
infrastructures to apply for mandatory clearing out of commercial interests. As concerns the 
top-down  approach,  some  respondents  expressed  concerns  if  this  included  the  possibility  of 
forcing CCPs to clear contracts they do not want to clear. The question of the enforceability of 
the clearing obligation was raised by some market infrastructures, i.e. if the non-respect of the 
obligation  to  clear  would  entail  the  invalidity  of  the  contract  and  if  there  were  appropriate 
sanctions in place. 

On  the  issue  of  application  of  the  obligation,  views  ranged  from  an  all  encompassing 
approach  in  terms  of  personal  and  material  scope  to  a  limited  applicability  of  the  clearing 
obligation.  Respondents  who  argued  in  the  latter  sense  cited  some  types  of  contracts  and 
institutions that should be regarded as being less of a source for systemic risks than others. 

As  regards  the  access  of  all  relevant  trading  venues  to  CCPs,  a  majority  of  respondents 
expressed  support  for  a  guaranteed  access.    Views  differed  among  market  infrastructures, 
where  some  argued  that  trading  platforms  should  comply  with  operational  and  risk 
requirements established by CCPs.  

Question:  

Do stakeholders share the general approach set out above on the application of the clearing 
obligation to non-financial counterparties that meet certain thresholds? 

Representative  from  buy-side  institutions  expressed  a  broad  support  for  the  thresholds  in 
principle, while voicing some concerns about possible loopholes.  

A large majority of banks, dealers and non-financial undertakings believed that non-financial 
counterparties  should  not  under  any  circumstances  be  covered  by  the  clearing  obligation. 
Instead of the concept of a "hard" clearing threshold, many non-financial undertakings would 
opt for a flexible approach which encompassed a number of qualitative criteria. 

While  largely  recognizing  the  usefulness  of  an  information  threshold,  some  respondents 
called for clear and appropriate definitions, esp. related to the base of the threshold.  

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Question:  

Do stakeholders share the principle and requirements set out above on the risk mitigation 
techniques for bilateral OTC derivative contracts? 

In  terms  of  the  provisions  related  to  risk  mitigation  of  non-cleared  contracts,  larger 
counterparties expressed in general broad support for such measures. There was less approval 
from  smaller  firms.  All  counterparties  did  not  consider  that  there  should  be  a  mandatory 
collateralisation of bilateral exposures.  

II. 

Requirements for Central Counterparties 

Questions:  

Do  stakeholders  share  the  general  approach  set  out  above  on  organisational  requirements 
for  CCPs?  In  particular  comments  are  sought  on  the  role  and  function  of  the  Risk 
Committee;  whether  the  governance  arrangements  and  the  specific  requirements  are 
sufficient  to  prevent  and  manage  potential  conflicts  of  interest;  stringent  outsourcing 
requirements; and participation and transparency requirements?  

Do  stakeholders  consider  that  possible  conflicts  of  interests  would  justify  specific  rules  on 
the ownership of CCPs? If so, which kind of rules? 

1. Organisational requirements 

There was general support for the requirements indicated in the consultation document. Some 
respondents argued for CCPs having dedicated CCP status, while others would favour a bank 
status.  

2. Risk committee 

There was wide agreement on the necessity to have a risk committee. Views diverged as to 
the  role  and  concrete  set  up  of  the  committee.  While  most  banks  and  dealers  argued  for  a 
decision  making  role  of  this  body,  some  Member  States  expressed  clear  preference  for  a 
strictly  advisory  role.  Some  respondents  questioned  the  usefulness  of  having  independent 
administrators  whose  incentives  were  not  clear.  Buy-side  institutions  stressed  the  need  for 
end-users  to  be  represented  on  the  risk  committee  and  called  for  a  mediation  mechanism  if 
there was a disagreement between the risk committee and the CCP management. Many banks 
and  dealers  believed  that  the  risk  committee  should  be  involved  in  providing  views  on 
interoperability arrangements. 

3. Conflicts of interest 

Respondents  expressed  general  support  for  clear  rules  on  conflicts  of  interest.  Some  market 
infrastructures  voiced  concern  over  an  extension  of  the  relevant  provisions  to  clients  of 
clearing members with whom CCPs have no direct relationship. 

4. Outsourcing 

This  point  was  addressed  in  particular  by  Member  States,  market  infrastructures,  banks  and 
dealers.  There  was  a  broad  agreement  to  limit  outsourcing,  esp.  regarding  risk  management 
functions. 

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5. Participation requirements 

Respondents  supported  the  need  for  stringent  participation  requirements.  Smaller  financial 
institutions stressed that access should be open and non-discriminatory and cautioned against 
putting  in  place  requirements  that  were  too  high  for  smaller  players  to  meet.  Non-financial 
undertakings  emphasized  the  need  to  be  able  to  become  clearing  members  should  they  fall 
under the clearing obligation. On the issue of informing CCPs about client relationships, most 
financial  institutions  were  critical  of  passing  information  on.  On  the  other  hand,  market 
infrastructures expressed the need for this information, while cautioning against a shift in the 
burden of measuring the risk emerging from indirect participation to CCPs. 

6. Transparency 

In general, there is broad support for strong transparency requirements. Market infrastructures 
recommended some modifications as to the exact formulation on disclosure requirements. 

Questions:  

Do stakeholders share the approach set out above on segregation and portability? 

7. Segregation and portability 

There was strong support for the general principle, with some respondents suggesting a more 
detailed  legislative  text  as  to  the  scope  of  segregation.  Some  expressed  concerns  about 
imposing a prescriptive structure, but rather to provide choice. Many responses called for an 
explicit override of national insolvency and bankruptcy laws.  

Questions:  

Do  stakeholders  share  the  general  approach  set  out  above  on  prudential  requirements  for 
CCPs? In particular: what should be the adequate level of initial capital? Are exposures of 
CCPs  appropriately  measured  and  managed?  Should  the  default  fund  be  mandatory  and 
what  risks  should  it  cover?  Should  the  rank  of  the  different  lines  of  defence  of  a  CCP  be 
specified? Will the collateral requirements and investment policy ensure that CCPs will not 
be exposed to external risks? Will the provisions ensure the correct management of a default 
situation?  Are  the  provisions  above  sufficient  to  ensure  access  to  central  bank  liquidity 
without compromising central banks' independence? 

8. Prudential requirements 

Apart  from  market  infrastructures,  most  respondents  limited  their  comments  to  general 
statements  on  the  desirability  of  prudential  requirements.  There  was  widespread  agreement 
among  respondents  on  sound  and  coherent  prudential  requirements  for  CCPs  which  should 
prevent CCPs from competing by lowering risk management standards.  

A. Initial capital 

Some  market  infrastructures  called  for  a  clearer  distinction  between  initial  and  ongoing 
capital, favouring the reference to "minimum" capital rather than "initial" capital. 

Some  respondents  saw  the  adequate  level  of  initial  capital  by  5  million  Euros,  while  others 
would prefer the capital to be a certain multiple of months of running costs. 

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B. Exposure management 

A number of Member States would opt for an increased focus on liquidity risk rather than on 
credit risk.  

C. Margin requirements 

Some  non-financial  counterparties  cautioned  against  a  requirement  to  post  margins  on  an 
intraday  basis  as  they  did  not  have  direct  access  to  central  bank  liquidity.  On  the  part  of 
market infrastructures, some voiced concerns on the protection of margins. 

D. Default fund 

There  was  widespread  support  for  a  mandatory  default  fund.  Some  respondents  called  for 
clearer definitions on the make-up, the functioning and the coverage of such a fund.  

E. Other risk controls 

Market infrastructures regarded some of the proposed requirements as being overly strict, e.g. 
the  requirement  to  withstand  the  default  of  the  three  largest  clearing  members  and  the 
limitation of credit lines per clearing member to 10 %. 

F. Default waterfall 

Market  infrastructures  expressed  diverging  views  on  the  set-up  and  operation  of  a  default 
waterfall. Some believed that capital should not be part of the default waterfall, but only the 
last line of defence.  

G. Collateral requirements 

Market  infrastructures  displayed  broad  agreement  with  the  suggested  solution.  Some 
suggested  to  better  specify  the  process  for  determining  adequate  haircuts.  Non-financial 
undertakings  called  for  the  inclusion  of  bank  guarantees  and  credit  lines  as  highly  liquid 
collateral. 

H. Investment policy 

A  number  of  market  infrastructures  raised  concerns  about  the  requirement  to  deposit 
securities with securities settlement systems and cash with central banks. Buy-side institutions 
expressed a general support for the requirement that investments of CCPs should be made in 
safe  and  highly  liquid  assets,  but  cautioned  against  penalising  funds  with  long-term 
investment strategies. 

I. Default procedures 

Banks and dealers generally pointed out that members' liability vis-à-vis a CCP should not be 
unlimited. Some market infrastructures pointed out that it should be made clear that the law of 
the CCP should govern any default procedure.  

J. Review of models, stress testing and back testing 

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Market infrastructures were supportive of the general thrust of the process while questioning 
the adequacy of some of the procedural steps proposed. 

K. Settlement risk 

There were no particular comments made by respondents. 

Questions:  

Do  stakeholders  share  the  general  approach  set  out  above  on  the  recognition  of  third 
country  CCPs?  Are  the  suggested  criteria  sufficient?  Do  stakeholders  consider  that 
additional criteria should be considered?  

Do stakeholders agree with the extension of the clearing obligation to contracts cleared by 
third country CCPs to ensure global consistency? 

9. Relations with third countries 

The majority of respondents favoured an equivalence based approach. A few Member States 
showed support for a location-based approach. A number of comments called for the respect 
of EU data protection and confidentiality standards. 

III. 

Interoperability 

Question:  

Stakeholders' views are welcomed on the general approach set out above on interoperability 
and the principles and requirements on managing risks and approval. 

1. Interoperability 

There were diverging views both on the desirability of interoperability in general and on the 
concrete  scope  and  operation  of  interoperability  in  particular.  While  some  respondents 
supported  the  principle  of  interoperability,  others  called  it  premature  or  overly  risky 
considering the current state of play of legal and operational harmonisation.  

Regarding  the  scope,  a  number  of  respondents  intended  to  limit  interoperability  to  cash 
securities or even cash equities.  

As  far  as  the  process  is  concerned,  some  suggested  a  validity  check  by  the  competent 
authorities of the denial of access. 

2. Managing risks arising from an interoperability arrangement 

There was a broad support for strict risk controls. Some respondents called for a harmonised 
regulatory framework to ensure proper risk management of a link and to ensure transparency 
to users.  

3. Approval of interoperability arrangements 

A  number  of  respondents  expressed  support  for  prior  approval  by  competent  authorities  of 
interoperability arrangements. 

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IV. Reporting obligation and requirements for trade repositories 

Questions:  

What are stakeholders' preferred options on the reporting obligation and on how to ensure 
regulators' access to information with trade repositories? Please explain. 

1. Reporting obligation 

Preference for the various options differed among stakeholders. A majority of Member States 
and  non-financial  undertakings  favoured  option  A,  while  a  majority  of  banks  and  dealers 
would  support  option  B.  Buy-side  institutions  expressed  preference  for  option  A,  provided 
that reporting obligations would be fulfilled by dealers. A number of respondents pointed out 
the need for a consistent approach with the reporting system that is to be set up for the trading 
of energy contracts. 

2. Requirement for Registration of a Trade Repository 

A majority of Member States as well as banks and dealers supported option 2. 

Questions:  

Do stakeholders share the general approach set out above on the requirements for trade 
repositories?  In  particular,  are  the  specific  requirements  on  operational  reliability, 
safeguarding and recording and transparency and data availability sufficient to ensure 
the  adequate  function  of  trade  repositories  and  the  adequate  protection  of  the  data 
recorded? 

Requirements for trade repositories 

A number of respondents expressed broad support for stringent and coherent requirements for 
trade repositories. It was often stressed that the confidentiality of data in trade repositories had 
to  be  ensured.  Reference  was  also  made  to  the  issue  of  confidentiality  clauses  of  reporting 
institutions and the need of future legislation to deal appropriately with them. 

V. Technical reference glossary of definitions 

Questions:  

Do stakeholders agree with the definitions set out above? 

Some  respondents  suggested  clearer  definitions  on  certain  terms,  e.g.  "end-user  corporates" 
and "financial counterparty". 

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ANNEX 6: An overview of derivatives 

Derivatives 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), a market variable (e.g. a stock index or an interest rate), the occurrence of an event 
(e.g. a default) or something else (e.g. weather conditions). 

Derivatives are used by a wide variety of companies. According to a survey conducted by the 
International  Swaps  and  Derivatives  Association  (ISDA),170  94%  of  the  world’s  500  largest 
companies  ranked  by  revenue  use  derivatives  to  manage  and  hedge  their  business  and 
financial  risks.  The  most  used  types  of  derivatives  are  foreign  exchange  derivatives  (88%), 
closely followed by interest rate derivatives (83%). 

An important characteristic of derivatives is their ability to provide leverage, i.e. they allow 
investors  to  take  a  large  position  in  the  market  while  committing  only  a  small  amount  of 
capital. This makes hedging, but also speculating, cheaper. In other words, leverage allows an 
investor to earn a higher rate of return on their capital if the underlying moves in the direction 
that,  for  example,  the  buyer  of  the  derivative  anticipated.171  Unfortunately,  the  converse  is 
also true: a party to the contract can suffer large losses in case the underlying moves in the 
wrong direction. 

The fact that derivatives are contracts provides them with a further important characteristic: 
flexibility. Indeed, 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  most  common  types  of  derivatives  traded  on  an  exchange  are  futures  and  options. 
Trading  on  exchanges  is,  in  principle,  accessible  to  everyone  (either  directly  or  indirectly), 
although  in  practice  only  a  very  small  portion  of  the  trading  volume  in  some  types  of 
derivatives  (most  notably  single  equity  options)  is  due  to  retail  investors.  This  wide 
accessibility is one of the main reasons why exchanges are tightly regulated. While there are 
numerous derivatives exchanges out there, trading in a particular type of derivative tends to be 
concentrated  on  one  venue.  Last,  but  certainly  not  least,  a  derivatives  exchange  is  usually 
served  by  a  central  counterparty,172  which  guarantees  the  trades  executed  on  the  exchange, 
nets  down  mutually  offsetting  contracts  and  ensures  that  exposures  are  sufficiently 
collateralised. 

The most common types of OTC derivatives are swaps, forwards and (exotic) options. Unlike 
exchange-traded  derivatives,  OTC  derivatives  are  reserved  to  professional  investors  and  are 
thus not accessible to the general public. This is why the OTC derivatives market is subject to 

170   2009 ISDA Derivatives Usage Survey. The document is available at 
http://www.isda.org/researchnotes/pdf/ISDA-Research-Notes2.pdf. 

171   The higher return does not, however, come for free: it is the direct consequence of the higher risk that the 

investor takes on. 
In the vast majority of cases the CCP is owned by the exchange that it serves. 

172  

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much lighter regulation.173 The bilateral nature of this market makes it rather opaque to parties 
outside  a  particular  transaction.  In  spite  of  its  bilateral  nature,  which  would  lead  one  to 
presume  a  wide  dispersion  of  trading,  many  segments  of  the  OTC  derivatives  market  are 
actually  highly  concentrated,  with  a  large  share  of  the  trading  being  done  by  a  handful  of 
major  dealers.  Unlike  in  the  case  of  derivatives  exchanges,  the  use  of  CCPs  is  far  less 
pervasive  in  the  OTC  derivatives  market.174  This  lack  of  a  CCP  is,  to  a  certain  extent, 
compensated  by alternative arrangements: the exposures related to the contracts are secured 
through  bilateral  collateral  arrangements175  and  mutually  offsetting  trades  are  terminated 
through a process called portfolio compression. The bilateral nature of the market and the fact 
that practically all major financial institutions are participants in this market has lead to a high 
level of interconnection between these institutions and hence a high level of interdependence 
amongst them. 

173   The basic premise behind this lighter treatment has always been that professional investors can take care of 

themselves. 

174   Prior  to  the  launch  of  CCPs  for  CDS,  the  only  market  segment  where  CCP-cleared  trades  represented  a 
significant  portion  of  the  market  was  the  interest  rate  swaps  segment.  CCPs  also  clear  OTC  equity  and 
commodity derivatives (e.g. oil), but to a far lesser extent. 

175   Whereas a CCP requires the posting of both initial and variation margin, OTC derivatives trades usually 
require only the posting of variation margin. This does not mean that there are no cases where initial and 
variation margin are required on a regular basis. For example, prime brokers require both to be posted by 
hedge  funds  they  serve.  The  practice  of  not  requiring  any  collateral  is,  however,  not  uncommon.  For 
example,  OTC  derivatives  where  one  of  the  counterparties  is  a  non-financial  company  or  a  government 
usually do not involve the exchange of collateral, mainly because they do not wish to provide the collateral 
(e.g.  because  they  have  a  high  credit  rating  and  therefore  consider  themselves  to  be  sufficiently 
creditworthy not to have to provide collateral). 

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ANNEX 7:  

One way to estimate the economic impact of OTC derivatives on the financial crisis is to look 
at the economic costs of the financial crisis first. The costs of a financial crisis are typically 
measured by evaluating the fiscal costs or the costs of lost output. Existing literature on the 
subject suggests that past crises resulted in large costs on both measures.176  

On  quantifying  the  fiscal  costs,  the  narrowest  measure  one  could  look  at  is  the  amount  of 
public funds (that is taxpayers' money) used to support the banking sector. As Table 1 shows, 
by the end of 2009 a total of €226 billion (1.9% of EU GDP) of public funds were disbursed 
in  the  form  of  capital  injections  used  to  either  prop-up  ailing  banks  or  to  bail  out  insolvent 
ones. Furthermore, over €1 trillion contingent liabilities have been created through measures 
such as guarantees on bank liabilities, impaired asset relief and liquidity support. 

Table 1: Total size of EU public interventions in the banking sector (as of 31 December 2009) 

Capital injections 

Guarantees on 
bank liabilities 

Relief of impaired 
asset 

Liquidity and bank 
funding support 

Total approved measures 
Effective capital injections  
Total approved measures 
Guarantees granted 
Total approved measures 
Effective asset relief  
Total approved measures 
Effective liquidity interventions  

Total for all approved measures 
Total effective for all measures 

Source: European Commission 

€ billion  % of GDP 

393.0 
226.5 
2895.1 
916.4 
329.3 
329.3 
123.2 
66.8 
3740.6 
1539.1 

3.3 
1.9 
24.5 
7.7 
2.8 
2.8 
1.0 
0.6 
31.6 
13.0 

While these direct fiscal costs are by no means trivial, they are but a fraction of the overall 
costs  of  the  crisis.  The  bulk  of  the  costs  are  those  related  to  the  economic  recession  that  is 
usually  triggered  by  the  crisis  and  that  manifest  themselves  in  the  form  of  loss  of  output, 
increase  of  unemployment  and  public  debt.  As  can  be  seen  from  Table  2,  the  current  crisis 
fully  complies  with  this  pattern.  Since  the  beginning  of  the  crisis,  all  the  major 
macroeconomic indicators registered a significant deterioration, most notably those on public 
finances.  The  table  reports  the  EU  average  and  as  all  averages,  this  one  too  masks  national 
realities which are substantially worse. 

Table 2: The effects of the financial crisis on the EU economy 

Real GDP 
growth 
(%) 

Cumulative 
output gap 
(€ billion)1,2 

Government 
debt 
(% of GDP) 

Government 
balance 
(% of GDP) 

2007 

2.9 

0 

58.8 

-0.8 

Unemployment 
rate 
(%, December 
average) 
6.9 

176   See Reinhart, C. M. and K. Rogoff (2009), "This Time is Different: Eight Centuries of Financial Folly", 

Princeton University Press, for a detailed historical overview. 

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2008 

2009 
20103 

0.7 

-4.2 

1.0 

-134 

-802 

-921 

61.6 

73.6 

79.6 

-2.3 

-6.8 

-7.2 

7.6 

9.4 
9.64 

Notes: 1 The gap is calculated assuming an annual potential growth rate of real GDP of 2% in the period 2008-2010. 

2  The values are expressed at constant, year 2000 prices. 
3 Commission Spring 2010 forecast,177 unless stated otherwise. 
4 Average rate of unemployment for February 2010. 

Source: Eurostat, European Commission, Commission services calculations 

Recent  studies  suggest  that  the  output  losses  associated  with  financial crises  were  generally 
not recovered.178 There is also a possibility that this latest financial crisis had an effect on the 
potential growth rate of the EU economy, namely that it reduced it. If that turns out to be the 
case, the losses associated with the crisis would be even higher than the ones estimated above. 

As indicated in this report, OTC derivative have played a role in the financial crisis. As such, 
at  least  part  of  the  costs  of  the  crisis  can  be  attributed  to  them.  Even  a  very  conservative 
assumption on the share of the costs (i.e. 1%) means that more than €10 billion of costs can be 
attributed to OTC derivatives. 

177   http://ec.europa.eu/economy_finance/publications/european_economy/2010/pdf/ee-2010-2_en.pdf. 
178   See  Cerra,  V.  and  S.C.  Saxena  (2008),  "Growth  dynamics:  the  myth  of  economic  recovery",  American 

Economic Review 98, 439-457. 

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ANNEX 8: An overview of CCPs in the EU 

Member State   CCP  

Instruments and products cleared  

Austria  

Central 
CounterpartyAustria 
GmbH (CCP.A) 

Equities,  bonds,  funds,  warrants,  on-exchange  derivatives 
(equity) 

Belgium  

LCH.Clearnet S.A.  

See France  

Denmark  

Finland  

NASDAQ OMX 
Stockholm AB 

EMCF 

NASDAQ OMX 
Stockholm AB 

See Sweden 

See Netherlands 

See Sweden  

EMCF 

See Netherlands 

France  

LCH.Clearnet S.A.  

Germany  

EUREX Clearing AG  

European Commodity 
Clearing AG 

Equities, bonds, repos, on-exchange (commodity, equity, FX) 
and OTC derivatives (commodity, credit, interest rate) 
Equities, bonds, repos, funds, on-exchange derivatives 
(commodity, equity) 
Commodities  (energy),  on-exchange  and  OTC  derivatives 
(commodity) 

Greece  

ATHEXClear 

On-exchange derivatives (equity, interest rate) 

Hungary  

KELER 

Equities,  bonds,  funds,  on-exchange  derivatives  (commodity, 
equity, FX, interest rate)  

Ireland 

Italy  

EUREX Clearing AG 

Equities, funds  

Cassa di Compensazione 
e Garanzia (CC&G)  

Equities, bonds, funds, repos, warrants, on-exchange derivatives 
(commodity, equity) 

Netherlands  

LCH.Clearnet S.A. 

See France  

Portugal  

Romania 

EMCF 

Equities 

LCH.Clearnet S.A. 

See France  

Casa de Compensare 
Bucuresti SA 

Casa Romana de 
Compensatie SA 

On-exchange derivatives (equity, FX) 

On-exchange derivatives (commodity, equity, FX) 

Spain  

MEFF 

Repos, on-exchange derivatives (equity) 

OMIClear 

On-exchange and OTC commodity  (energy) derivatives 

Sweden  

NASDAQ OMX 
Stockholm AB 

On-exchange  (commodity,  equity,  interest  rate)  and  OTC 
derivatives 

EMCF 

See Netherlands 

United 
Kingdom  

LCH.Clearnet Ltd 

Equities,  bonds,  repos,  on-exchange  (interest  rate,  commodity, 
equity, FX) and OTC derivatives (commodity, interest rate)  

EuroCCP 

Equities 

ICE Clear Europe 

On-exchange  derivatives  (commodity)  and  OTC  derivatives 
(commodity, credit) 

Norway 

Oslo Clearing 

Equities,  equity  derivatives  (on-exchange  and  OTC)  and 

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NOS Clearing ASA 

Commodities, on-exchange and OTC commodity derivatives 

securities lending products. 

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