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EU takes a crucial step toward market regulation

European Commissioner for Internal Markets and Services Michel Barnier

Used under creative commons license from Security & Defence Agenda

After the disastrous financial collapse in 2008, the commodity  and  financial market regulatory reform process on both sides of the Atlantic has been a series of promising but halting steps, all too often two steps forward and one step back. This week the EU Parliament decided not to take that one step back, when it withdrew a resolution to object to standards for the centralized clearing of over-the-counter (OTC) financial and commodity derivatives contracts. Such a centralized system is essential for effective market regulation. Joost Mulder, of the Brussels-based NGO Finance Watch, said, “the decision to withdraw the resolution is a victory for the real economy.”

The new standards will make transparent pricing and other information previously hidden in the privately negotiated, but market-dominant, OTC contracts and will prevent a repeat of the 2008-09 cascades of counterparty defaults. According to the standards, Centralized Clearing Platforms (CCP) authorized by the European Market Infrastructure Regulation (EMIR), would ensure that the counterparties to an OTC contract are credit worthy and able to cover their losses. Lack of centralized clearing of OTC trades (called swaps) was a major factor in the financial industry crisis of 2008-09, which triggered taxpayer bailouts of the industry and a real economy crisis on both sides of the Atlantic, wreaking price havoc in agriculture and energy markets.

In September 2009, the Group of 20 (G-20) major economy leaders issued a diplomatically qualified commitment: “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.” (Paragraph 13: “A Framework for Strong, Sustainable and Balanced Growth”) (IATP has criticized the standardization criteria loophole but further criticism can be saved for another time.) On January 30, European Commissioner for Internal Markets and Services Michel Barnier reminded the Members of Parliament that if the clearing standards were not implemented, the European Union would default on G-20 derivatives clearing commitments.

Commissioner Barnier persuaded the European Parliament Committee on Economic and Monetary Affairs (ECON) and other Members of Parliament to withdraw the resolution to undermine the clearing standards, the public justification for which was a procedural failure by the Commission on transmitting the EMIR standards for Parliamentary review. On February 7, Commissioner Barnier welcomed the decision to withdraw the resolution, stating that the EMIR standards would continue progress on complying with G-20 commitments. He agreed to work with the Parliament to ensure adequate time for consultation on EMIR and other market reform rules.

Behind the five pages of recitals (“whereas”) in the six-page ECON resolution were substantive demands by Non-Financial Corporations (NFCs) and the banks that usually are the counterparties to the OTC trades. NFCs include major companies, such as Cargill, John Deere and Archer Daniels Midland, which both hedge the commodities that they trade or use, and speculate in financial derivatives. These NFCs, which like the banks are members of the International Swaps and Derivatives Association (ISDA), are demanding that the exemption from clearing for bona fide commodity hedging be extended to cover OTC trades on all their financial risks, e.g., Special Purpose Vehicles to hide the extent of a corporation’s debt. The agreement between the European Commission and Parliament rejects the demand for a broad NFC exemption from clearing OTC contracts, but allows phased-in, rather than immediate, NFC compliance with the EMIR clearing standards.

Retaining the narrow commercial hedging exemption for clearing is consistent with the “comparable comprehensive oversight” requirement of Dodd-Frank reform legislation authorized rules, which allow a clearing exemption for bona fide commodity hedging (price-risk management for those who trade or consume physical commodities, as opposed to speculating to achieve long-term investment goals or for short-term portfolio diversification). One reason for this exemption is that commodity derivatives contracts make up a minute fraction of all derivatives trades. For example, in the first reporting quarter of 2012, commodity derivatives contracts comprised slightly more than one half  of one percent of the total value of all U.S. derivatives trades in 2012, according to the Office of the Comptroller of Currency. Furthermore, clearing imposes margin collateral and working capital costs that make small commercial commodity hedgers uncompetitive with larger ones.  

The Parliament’s decision to withdraw its resolution will enable the EMIR standards to enter into force by mid-March. After adequately resourced CCPs are set up and recognized by the European Securities Market Authority, compliance with EMIR central clearing standards should begin this summer. Commissioner Barnier further announced that he would be traveling to the United States during the week of February 10 to meet with, among others, Commodity Futures Trading Commission (CFTC) Chair Gary Gensler. They will have a lot to talk about.

As noted in a January 28 IATP blog, on December 21, the CFTC voted to postpone for six months the beginning of compliance for non-U.S. OTC traders with the Dodd-Frank market reform requirement of “comparable comprehensive oversight.”  If the Parliament had delayed and carved broad exemptions into EMIR clearing standards, it would have been impossible for Commissioner Barnier and Chairman Gensler to claim progress towards Dodd-Frank mandated “comparable comprehensive oversight” of OTC trading in other jurisdictions.

Unfortunately, the CFTC may weaken the terms for complying with the Dodd Frank mandated “comparable comprehensive oversight” of OTC traded contracts. Under pressure from many of the same financial and NFC firms lobbying the European Parliament , the agency is considering “further proposed guidance” on the definition of who is required to report OTC trades for CFTC data surveillance and possible enforcement actions. One contentious issue is whether the foreign affiliates of U.S. OTC swap dealers must report their trades through their U.S. headquarters to the CFTC.

It is not possible to summarize all the U.S. OTC dealer and foreign bank comments against reporting foreign affiliates OTC trades to the CFTC.  However, the International Swaps and Derivatives Association (ISDA) comment may be indicative of the opposition. No matter how adverse the consequences for the U.S. economy of the swaps of J.P. Morgan, Bear Stearns, AIG run through their London, Cayman Island etc. offices, all noted in Chairman Gensler’s statement about the proposed guidance, ISDA accuses the CFTC proposed guidance of an “anti-swap dealer bias” and of using an inappropriate reporting requirement.

U.S. and European markets trade the vast majority of OTC derivatives contracts in all asset classes. Substantive regulatory harmonization and effective regulatory cooperation—not mutual recognition of high-level principles of regulation—is necessary to prevent regulatory evasion in these markets. If the CFTC adopts the ISDA (et al) arguments and creates more exemptions for who must report to the CFTC and when, it will undo the small but critical progress made on February 7, when European institutions agreed to begin to make OTC trade data public, to protect the public from default cascades of private deals, and to end the dark market reign of terror over the real economy.