Risky trading falls under the spotlight

There is growing momentum for reform of Europe’s derivatives market.

Excessive trading in risky derivatives was at the heart of the 2008 financial crisis. The insurance company AIG, which had to be rescued by the US government in September 2008, was on the verge of defaulting on obligations that it had built up through a €2 trillion derivatives portfolio. 

AIG built up its portfolio through trading in over-the-counter (ie, off-exchange) derivatives, which regulators and governments now see as inherently more risky than trading on-exchange. Globally, the over-the-counter market is estimated to be worth €449 trillion. Credit default swaps (CDS), a type of derivative that insures an underlying asset, played a particularly important role in AIG’s near-collapse.

Derivatives have also featured prominently in political debate about the Greek debt crisis. The Greek government, with support from several other member states, has claimed that unscrupulous traders pushed up the price of CDS on its sovereign debt to make a quick profit, with the side-effect of making it more expensive for Greece to borrow from the financial markets.

In March, Nicolas Sarkozy, France’s president, Angela Merkel, Germany’s chancellor, Jean-Claude Juncker, the president of the Eurogroup of eurozone finance ministers, and George Papandreou, Greece’s prime minister, sent a joint letter to José Manuel Barroso, the president of the European Commission, calling on him to consider banning or limiting the practice of ‘naked short-selling’ of CDS on government bonds (by which people trade in CDS without owning the underlying assets).

Improved transparency

The Greek crisis has strengthened the momentum that was already growing in Europe for reform of the derivatives market. Michel Barnier, the European commissioner for the internal market and services, told bankers last week that he would present proposals before the summer to improve transparency in over-the-counter derivatives trading.

The centrepiece of Barnier’s plans is to force traders to use central counterparty (CCP) clearing. Clearers act as middlemen and guarantors to market transactions, and their involvement would improve financial stability. He also wants better regulation and supervision of trade repositories.

Barnier has also set up a taskforce in the Commission to study the effect of CDS trading on sovereign debt and to propose possible follow-up actions. Barnier set up the task-force in response to a commitment by Barroso, in March, to examine the role that CDS may have played in Greece’s problems.

Barnier has also said that he plans to establish a “framework of rules and transparency” for general short-selling. He expects to make a legislative proposal on this in October, and may combine this with his work on CDS.

The EU’s momentum to regulate derivatives is matched on the other side of the Atlantic. Gary Gensler, the chairman of the US Commodity Futures Trading Commission, told MEPs last month that the US would seek a “comprehensive regulatory framework” for over-the-counter derivatives. “It is now time to bring regulation to this marketplace [that is] similar to what we have in the securities and on-exchange derivatives…markets,” he said. A financial reform bill, under discussion in the US Senate, contains similar reforms to those being prepared by the Commission.

Non-financial firms, which account for around 9% of derivatives trading, have raised strong concerns about this reform agenda. The European Association of Corporate Treasurers wrote to the Commission in January, saying that it was “deeply concerned” by the plans. It said that forcing traders to use CCP clearing would “increase liquidity risk and funding costs…and reduce flexibility to match underlying commercial exposures”.

The reform agenda is not immune from intra-EU rivalry. The Commission last year took a first step toward promoting CCP clearing by securing a voluntary commitment from banks to use clearers when trading CDS. But the bulk of this clearing activity is being made through IntercontinentalExchange in London, much to the chagrin of the French and German governments as well as the European Central Bank, which want euro-denominated CDS clearing to take place inside the eurozone. France was able to claim a significant step forward last month when LCH.Clearnet, another clearing house, launched a CDS clearing service in Paris.