Plenary Session 14-17 June

A famous investor once likened derivatives to financial weapons of mass destruction. These complex financial instruments have been blamed for exacerbating the financial crisis and putting many an indebted government in a tight spot. However, as German MEP Werner Langen (EPP) says, derivatives also help reduce a plethora of risks faced by financial and non-financial companies. In his report on the issue, he emphasises that transparency is the key to making the derivatives market safer.

How derivatives work in real life

A derivative is a contract that allows one to reduce risk. For example, if you are an airline executive worrying that because of the instability in the Middle East the price of oil and thus of jet fuel will rise steeply in the next six months, that would significantly dent profits or even push the airline into loss-making territory.

Now take a look at the derivatives market. There is something called an oil future, a contract allowing you to buy today, at a specified price, a certain amount of oil for delivery in six months. Let's say that you buy today 10,000 barrels of oil for €50  a barrel, to be delivered in six months. If in six months time the price of oil is  €75 a barrel, you save €250,000 on your 10,000 barrels.

Of course, you paid for the privilege of being able to hedge risk in such a way. An oil future contract costs money. But if you're right about the oil price, your contract will be worth much more in six months time - who would not want to buy a contract, i.e. a derivative, that gives one the right to buy oil at €50  when the price is €75?

Shedding more light on the market

"Derivatives play a largely useful role in the economy as they help to disperse risk. To allow companies to continue to use derivatives, one must make a distinction between derivatives that are used to hedge risk and those that are of a purely speculative nature," says Mr Langen, explaining the thrust of his report.

"What is problematic is that these financial instruments have not been sufficiently transparent and regulated," explains the MEP. Most derivatives involve two parties, a seller and a buyer of a contract, with other market participants and regulators usually kept out of the loop.

"In the future, derivatives transactions will have to be reported to trade repositories (i.e. data warehouses) by both financial and non-financial firms, so that regulators can access the information. This will help us differentiate between different types of derivatives," says Mr Langen.

Greece - victim of speculators?

Having as much data as possible on whether derivatives are used for speculation rather than hedging is especially important in the case of credit default swaps (CDS), a derivative that allows one to buy protection against the default of a bond. They have been blamed for exacerbating the crisis on European bond markets, especially in Greece. 

"It has been claimed that speculators using naked CDS have massively raised the cost of borrowing for the Greek government, but I have yet to see a proof for these claims," says Mr Langen. Still, in the opinion of many experts, naked CDS, i.e. CDS whose owner doesn't own the underlying bond, but would still collect money in the event of default, are a clear case of speculation.

Clear the decks

"The report explicitly demands that CDS be centrally cleared by an independent clearing house. In addition, the report says that some types of highly risky derivatives should only be allowed under certain conditions or, on a case-by-case basis, forbidden," says Mr Langen, outlining another central plank of his report.

This means that sellers and buyers of CDS and other derivatives would not be able to deal just between themselves, over-the-counter, but would have to go through a clearing house. The latter would stand at the centre of all trades, making sure that all parties live up to their obligations and that money changes hands.

No exodus of financial services

Mr Langen says stricter regulation of the derivatives market will not lead to financial services providers leaving the EU. "After all, the US and the G20 governments have all unequivocally expressed their support for better regulation of this market and are already drafting legislation to this effect." The rules that the Commission will eventually propose, should be such as not to isolate the EU internationally when it comes to derivatives trading, warns Mr Langen. Developments in the US and other G20 markets should therefore be followed.

The own-initiative report will be presented to the plenary on Monday, 14 June.