This month, the European Commission introduced rules to regulate the over-the-counter derivatives. Firstly, it is important to understand what derivatives are and then examine the proposed rules and some of the issues that will need to be addressed.
A derivative is a financial instrument that derives its value from another financial asset. It is a financial contract with a value linked to the expected future price movements of the asset it is linked to " such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. .
Derivatives can be classified into two types:.
1. Over-the-counter (OTC) derivatives: These derivatives are custom made and are not traded on any futures exchange, but rather they are traded on over-the-counter markets, also known as the OTC market. .
2. Exchange-traded derivative contracts (ETD): These are derivative instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals' trade standardized contracts that have been defined by the exchange. .
The financial crisis highlighted the significant role played by derivatives, particularly, OTC derivatives in the failures of Bear Stearns, Lehman Brothers and AIG. Over-the-counter derivatives have been heavily criticized for its complexity, lack of transparency and an absence of regulatory oversight. Therefore, the European Commission has announced rules with the aim of bringing more transparency to the OTC market.
The proposed rules stem from agreement by G20 leaders last year to standardize derivatives trading and move them on to exchanges or electronic trading platforms. The proposed rules would closely mirror with the new regulatory regime that is coming into force in the United States.
The rules will require standard OTC derivatives to be processed through clearing houses in order to reduce systemic risk arising from a default of one party in an OTC deal.
