On 15 September, the second anniversary of Lehman Brothers' bankruptcy no less, the European Commission published draft legislation overhauling the regulation of Europe's over-the-counter (OTC) derivatives market.

The proposed legislation covers all OTC derivative contracts entered into by European Union-domiciled financial and non-financial institutions. It contains a framework for centrally clearing most standardised derivative contracts and scrutinising and controlling those which are not; beefy regulation of central counterparties (CCPs) and trade repositories; and strict reporting requirements to those newly-created trade repositories.

A new pan-European regulatory body, the European Securities and Markets Authority (ESMA), will oversee implementation and will write detailed rules to flesh out the regulation's broad principles by the middle of next year. It will have its work cut out – similar detailed rules in corresponding US legislation are likely to run to thousands of pages.

OTC derivatives central clearing is the poster child of derivatives regulation, both in Europe and the US. The regulation has two approaches to deciding which derivatives contracts must be centrally cleared. A top-down approach will give ESMA power to require central clearing of selected derivative categories. A bottom-up approach will allow it to demand mandatory central clearing of categories of derivatives already, to some extent, centrally cleared.

The regulation draws a distinction between those who use OTC derivatives, distinguishing between financial and non-financial counterparties. Financial institutions will have to centrally clear all OTC derivatives categories ESMA designates. Non-financial counterparties will be exempt from central clearing and notification to ESMA unless their non-hedging transaction volumes exceed yet-to-be-determined thresholds.

Regulators hope central clearing will guard the financial system against the woes it alleges derivatives have caused. But who will watch the central counterparties or institutions deemed too big to fail?

Individual member states will regulate their CCPs but must co-operate with a 'college' of national regulators. The CCPs will have rigorous internal systems and procedures, open themselves up to internal audits, call for and segregate margin from their members and be restrictive as to whom they admit as members.

The regulation also deals with what happens when a clearing member defaults. First it provides that posted margin will be applied to cover the CCPs' losses. If this is insufficient, the CCP will look to a default fund funded by other members. Finally, it will look to its own capital and resources.

The regulation promises that ESMA will develop strict risk management requirements for non-centrally cleared trades, in particular in relation to electronic trading, portfolio reconciliation, dispute resolution, collateral segregation and capital requirements. To keep regulators in the know, the regulation will establish trade repositories, which will also be ESMA-regulated.

Financial counterparties will then notify the relevant trade repository of new derivative transactions. ESMA will use the information to increase market transparency and to identify and quickly address any systemic risks.

The EU proposal is broadly similar to that introduced by the Dodd-Frank Act in the US, although certain of the more contentious areas are absent, such as pushing out financial institutions' derivative desks to new entities, restrictions on proprietary trading and the potential introduction of derivative position limits.

Edmund Parker is a partner at Mayer Brown International and co-head of the firm's derivatives & structured products practice.