It is in London where 40% of the world derivatives trade is conducted, however France and Germany have called for tougher regulation of the over-the-counter (OTC) derivatives market as well as to credit default swap.
According to the European Commission derivatives played a “central role” in the financial crisis. Hence, it has recently proposed a regulation on OTC derivatives, central counterparties and trade repositories aiming at introducing more transparency to the OTC derivatives market. Last May, Germany put into effect a total ban on naked short selling. Then, Angela Merkel together with Nicolas Sarkozy called upon the Commission to consider a total ban on naked short selling and credit default swaps. The European Commission has also put forward a proposal for a regulation on short selling and certain aspects of Credit Default Swaps (CDS). Both proposals, if adopted, would entail further transfer of powers from national regulators to the new European Securities and Markets Authority (ESMA). It is important to recall that all decision-making in the ESMA’s Board of Supervisors would be done through a system of “one member, one vote.” All member states would have the same voting power. The Board of Supervisors will adopt most of its decisions by qualified majority voting. This would entail a reduced influence to the UK as the member state with the biggest financial sector.

The European Commission draft regulation on derivatives provides for uniform requirements for derivative contracts that are traded over-the-counter as well as for the performance of activities of central counterparties and trade repositories. In fact, the Commission proposal will harmonise the work of clearing houses across the EU. Unsurprisingly, the European Securities and Markets Authority (ESMA), expected to be in operation next year, will have “a central role in the authorisation and monitoring of central counterparties and trade repositories.”

Under the European Commission’s proposal, in order to increase safety in the sector, derivatives will be processed by clearing houses or central counterparties (CCPs), instead of being exchanged bilaterally. The draft proposal will, therefore, create European central clearing houses. Such CCPs would be subject to harmonised organisational and prudential requirements.

The draft regulation provides the criteria for determining the eligibility to the clearing obligation. In fact, it would be up to ESMA to decide whether derivatives meet the eligibility criteria. There would be, therefore, a clearing obligation for OTC derivative contracts. Such clearing obligation applies to financial counterparties and to the non-financial counterparties which enter into eligible OTC derivative contracts with third country entities.

In order to ensure that as many OTC contracts will be cleared, the Commission has proposed two approaches to determine which contracts must be cleared. The so called
'bottom-up' approach, under which a member state's competent authority authorises a CCP to clear certain contracts. The Member States' competent authorities would be required to “immediately notify ESMA” when they authorised a CCP to clear a class of derivatives and request a decision on the eligibility for the clearing obligation. Consequently, ESMA, after receiving such notification will have six months to address a decision to the requesting competent authority stating whether that class of derivatives is eligible for the clearing obligation. Moreover, ESMA shall publish any decision in a register which must also contain the eligible classes of derivatives as well as the CCPs authorised to clear them. Under the so called 'top-down' approach ESMA, in consultation with the European Systemic Risk Board, will decide which classes of derivatives contracts would be subject to the clearing obligation.

The Commission will be empowered to adopt regulatory technical standards specifying the details to be included in the abovementioned notification, in the register as well as the criteria for the decision of ESMA on the eligibility for the clearing obligation. ESMA would be required to present drafts for those regulatory standards to the Commission by June 2012.

The draft regulation will not apply, in principle, to non-financial (corporate) counterparties, except where their OTC derivatives positions reach a given threshold. Hence, the OTC contracts of non-financial counterparties would be subject to the clearing obligation if they are particularly active in the OTC derivatives market and if this is not a direct consequence of their commercial activity. The Commission has proposed a process aiming at identifying the non-financial institutions with important positions in OTC derivatives and consequently subjecting them to certain obligations provided in the draft Regulation.

The European Commission will specify, through delegated acts, an information threshold and a clearing threshold on the basis of draft regulatory standards proposed by ESMA. According to the draft proposal, through the information threshold financial authorities would be able to identify non-financial counterparties that have accumulated significant positions in OTC derivatives whereas the clearing threshold would identify whether a non-financial counterparty will become subject to the clearing obligation. If they are above a given threshold they will be required to report the details of any derivative contract they have entered into as well as any modification to a registered trade repository.

Under the draft proposal, financial counterparties will only be able to use CCPs which comply with the requirements provided in the Regulation. The draft proposal provides, therefore, for authorisation and supervision rules of CCPs. According to the draft regulation “the authorisation of a CCP will be subject to that CCP having access to adequate liquidity” and “Such liquidity could result from access to central bank or to creditworthy and reliable commercial bank liquidity, or a combination of both.”

The member states' competent authorities would be responsible for all aspects of the authorisation and the supervision of CCPs, as well as verifying whether the applicant CCP is compliant with the present Regulation. Nevertheless, ESMA will play a “central role” in the authorisation process and making sure that the Regulation is complying with.

ESMA would also be responsible for recognising CCPs established in third countries as well as allowing them to provide clearing services in the EU, provided that the European Commission has ascertained the legal and supervisory framework of that third country as equivalent to the EU one. A CCP of a third country will not be allowed to perform activities and services in the EU, if the ESMA has not established co-operation arrangements with the third country competent authorities.

Presently, the reporting of OTC derivatives is not obligatory. Hence, in order to increase transparency of the derivatives market, the draft regulation will introduce reporting requirements of OTC derivative transactions to trade repositories. Market participants would be, therefore, required to report all details regarding OTC derivative contracts they have entered into to trade repositories. The EU regulators will have access to the data kept by trade repositories.

However, according to the European Commission, “as there are no fiscal responsibilities implications connected to the surveillance of trade repositories, a national supervisory approach is not necessary”, hence ESMA will be in charge of supervising trade repositories as well as granting or withdrawing their registration. This would be another power taken away from national regulators.

The draft regulation provides for organisational and operational requirements that trade repositories would have to comply with. In fact, trade repositories must be established in the EU if they want to be registered. But, if a trade repository established in a third country meets several requirements provided in the regulation it might be recognised by ESMA, namely if it is subject to similar rules in that third country.

In order to ensure that trade repositories comply with the present Regulation, ESMA would be able to request the Commission to impose fines where provisions of the Regulation have been breached. Moreover, ESMA would be entitled to conduct investigations and on-site-inspections.

The European Commission has also recently adopted a proposal for a regulation on short selling and certain aspects of Credit Default Swaps (CDS). The main aim is to established a harmonised framework whilst increasing transparency and ensuring coordination for short selling and Credit Default Swaps. The draft regulation will harmonise requirements relating to short selling in the EU as well as the powers that regulators may use in exceptional situations, in case of serious threat to financial stability or market confidence.

The draft regulation transparency requirements will apply to all “natural or legal persons with significant net short positions relating to EU shares and EU sovereign debt” as well as “to natural or legal persons with significant credit default swap positions relating to EU sovereign debt issuers.” The draft regulation will cover all financial instruments, including derivatives and debt instruments.

The draft regulation proposed by the Commission would oblige traders that short-sell considerable amounts of shares or government bonds to disclose their positions to regulators and to the market. Private disclosure to regulators would be required as regards significant net short positions relating to sovereign debt issuers in the EU.

Any natural or legal person that has a net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue would be required to notify the national regulator whenever the position reaches or falls below a notification threshold which is 0.2% of the value of the issued share capital of the company. In case of a higher threshold positions must be disclosed to the market. Hence, any natural or legal person that has a net short position in relation to the issued share capital of a company that has shares admitted to trading on a trading venue would be required to disclose to the public details of the position every time the position reaches or falls below a publication threshold which is 0.5% of the value of the issued share capital of the company.

The abovementioned thresholds might be modified by the Commission through delegated acts (comitology procedure).

Moreover, a natural or legal person would be required to notify regulators of any significant net short positions in sovereign debt and credit default swaps every time such position reaches or falls below a notification threshold for the Member State concerned or the EU. The Commission would be empowered to introduce measures specifying the abovementioned notification thresholds.

Under the draft proposal, the member states' competent authorities would be required to provide information to ESMA on net short positions relating to shares or sovereign debt, as well as on uncovered positions relating to credit default swaps.

The draft regulation also provides requirements aimed at addressing the potential risk of settlement failure and market volatility associated to uncovered or naked short selling of shares and sovereign debt. Hence, any natural or legal person may only enter into a short sale of a share admitted to trading on a trading venue or a short sale of a sovereign debt instrument if, at the time of the sale, they have borrowed the share or sovereign debt instrument, they have entered into an agreement to borrow the share or sovereign debt instrument, or they have made arrangements with a third party in order to ensure that the security can be borrowed.

The draft proposal provides for several exemptions. For instances, the shares of a company admitted to trading on a trading venue in the EU where the principal venue for the trading of the shares is located in a country outside the EU will not be subject to the provisions requiring notification to competent authorities of significant net short positions in shares, public disclosure of significant net short positions in shares as well as on restrictions on uncovered short sales. An exemption is also provided for market making activities. Nevertheless, such exemptions would only apply where the natural or legal person has first notified, in writing, the competent authority of its home Member State that they intend to make use of the exemption. The use of exemptions might be prohibited by the member state competent authority if it deems that the natural or legal person does not satisfy the exemption conditions.

Presently, the powers of national regulators to restrict or ban short selling vary between Member States. The Commission’s proposal aims to harmonise the national regulators’ powers as well as the conditions and procedures to prohibit or restrict short selling activities. Hence, under the draft proposal, in case of exceptional circumstances, when adverse developments constitute a serious threat to financial stability in a member State or the EU, national regulators would have powers to temporarily restrict or ban short selling in any financial instrument, credit default swaps and other transactions, subject to coordination by ESMA.

Unsurprisingly, the Commission will adopt measures, through delegated acts, specifying criteria and factors to be taken into account by competent authorities and ESMA while deciding when the adverse events or developments create a serious threat to financial stability or market confidence.

Under the draft proposal, in case of adverse events or developments which constitute a serious threat to financial stability or to market confidence in one or more Member States, natural or legal persons who have net short positions in relation to a specific financial instrument might be required by a member state competent authority to notify it or to disclose to the public details of the position every time the position reaches or falls below a notification threshold fixed by national regulators. Moreover, a member state competent authority may forbid or impose conditions relating to natural or legal persons entering into a short sale or from entering into transactions relating to financial instruments.

The Commission’s draft proposal would allow a member state’s competent authority to impose restrictions on credit default swap transactions in exceptional situations. Hence, it may limit natural or legal persons from entering into credit default swap transactions that relate to an obligation of a Member State or the EU, in case of adverse events or developments constituting serious threat to financial stability in one or more Member State and if the measure is necessary to address such threat.

The draft regulation provides for a list of conditions that must be fulfilled before a national regulator can ban short-selling of a financial instrument.
Under the draft proposal, member states’ competent authorities would be given the power to impose a temporary prohibition on short selling of a financial instrument, in case of a significant fall in the price of the instrument. Hence, where the price of a financial instrument on a trading venue has during a single trading day fallen by 10% or more, in the case of a share, from the closing price on that venue on the previous trading day, the home member state’s competent authority would have to consider whether it is suitable to ban or restrict natural or legal persons from engaging in short selling of the financial instrument on the trading venue.

The competent authority may therefore, in the case of a share or debt, prohibit or restrict persons from entering into a short sale on the trading venue or limit transactions in the case of another type of financial instrument. The Commission will specify, through a delegated act, the fall in value for financial instruments other than shares.

However, before imposing the measures abovementioned, the concerned member state’ competent authority would be required to notify the competent authorities of the other member states as well as ESMA of the proposed measures. Unsurprisingly, ESMA will “perform a facilitation and coordination role in relation to measures taken by competent authorities.” Moreover, under the draft regulation, ESMA would be required to issue an opinion, within one day, stating whether it considers that the adverse events constitute a serious threat to financial stability, whether the proposed measure is suitable to address the threat and whether the duration of the measures is justified. ESMA might also consider that such measures should be taken by other competent authorities. If a national regulator decides to take measures contrary to an ESMA’s opinion it would be required to fully justify its decision.

The Commission’s proposal will transfer the national regulators’ powers to deal with emergency situations to ESMA. Under the draft proposal ESMA may take the same measures as the national regulators. Hence, ESMA would be empowered to require natural or legal persons who have net short positions in relation to a specific financial instrument to notify a competent authority or to disclose such position details to the public. It may also forbid or impose conditions relating on natural or legal persons from entering into a short sale. It may also restrict natural or legal persons from entering into credit default swap transactions or limit the value of uncovered credit default swap positions that a natural or legal person may enter into relating to an obligation of a Member State or the EU.

Under the draft proposal, ESMA would be given the power to take such measures if they are necessary to address a threat to the functioning of financial markets or the stability of the EU financial system, if the situation has cross border implications and if the competent authorities have not taken measures or the measures taken were not adequate to address the threat.
ESMA would be required to notify competent authorities of the measure it proposes. But, the proposed measures will take effect when ESMA publishes on its website notice of any decision to impose.

ESMA would be, therefore, empowered to adopt measures with direct effect, limiting or forbidding short selling. Unsurprisingly, under the draft proposal any measure adopted by ESMA would prevail over any previous measure taken by a national regulator. Hence, in the abovementioned situations ESMA would be able to override measures taken by national regulators.

The Government should seek to amend the Commission’s proposals as they would confer even more powers on ESMA. However, the European Commission has based both proposals on Article 114 TFEU which is the general legal basis for internal market legislation. The Commission has been extensively using this legal base to expand EC competences to the detriment of the competences of the Member States. Measures proposed under this article would have to be adopted by the Council and the European Parliament (ordinary legislative procedure) with QMV required at the Council. It remains to be seen what will come out from the negotiations. However, it will be difficult for the UK to water down the proposals.