On 15 September 2010, exactly two years after the bankruptcy of Lehman Brothers, the European Commission (EC) published its Proposal for a Regulation of the European Parliament and of the Council on Over-The-Counter (OTC) Derivatives, central counterparties and trade repositories. It is aimed at enhancing transparency, withstanding shocks of the credit default swaps and reducing the overall vulnerability of the counterparty credit risk. It will enter into force on 1 July 2012.

The main goal of the proposal is the establishment of central counterparties (CCPs) for OTC derivatives clearance and the creation of trade repositories (TRs) responsible for gathering data to identify, early on, where imbalances may be building up. The scope of the regulation is wide, laying down uniform requirements covering financial counterparties, non-financial counterparties (exceeding certain thresholds) and all categories of OTC derivatives.

Regarding CCPs, the main distinction to be made is between non-standardised and standardised contracts (the latter being the only ones eligible for clearing by CCPs). The role attributed to TRs is based on the idea that more disclosure and better quality of publicly-available data should enable a better assessment of counterparty risk and of contagion via direct and indirect channels. To ensure the risks are adequately captured, the EC also envisages reviewing the Markets in Financial Instruments Directive and the Market Abuse Directive, introducing reporting obligations for OTC transactions and extending the market manipulation prohibition to all OTC financial instruments.

If the opacity around the OTC derivatives may be a potential element of instability in crisis environments, the truth is that the envisaged measures regarding reporting duties, the wide use of CCPs and the creation of specific provisions applicable to bilateral clearing must always account for their impact in the derivatives market (the first of which will be on the respective price).

The EC has underscored that the main purpose of the regulation is to reduce the systemic risk by increasing the safety and the efficiency of the OTC market. However, it should be noted that the envisaged transparency cannot be misrepresented as zero-risk. After all, the counterparties will each have different risk expectations. The key factor must always be the accurate evaluation of such risk.

Although in some respects the measures may seem heavy-handed, once enacted they will be subject to serious scrutiny in order to guarantee that they meet their aim and are not too restrictive by over-regulating. Additionally, it will be necessary to ensure that the measures adopted in the European Union are in line with those in place† in other jurisdictions.

The critical point will be to ensure that the CCPs do not themselves become a source of systemic risk. For that purpose it will be necessary to set forth prudential and behavioural provisions, notably regarding the adoption of real contingency and recovery plans with a clear segregation of assets guaranteeing the continuity of the clearing activities even in situations of financial instability of the CCP.

Regarding OTC transactions not eligible for clearing by CCPs, it will be necessary to adopt procedures allowing the efficient measurement, monitoring and mitigation of the operational and the credit risk of these transactions, the reconciliation of portfolios, the evaluation of positions and the resolution of inter-party conflicts.

Ana Sofia Silva is an associate at Cuatrecasas Goncalves Pereira.