09/12/10 - Financial Times - By Nikki Tait in Brussels and Jeremy Grant in London

The European Union will this week announce tough proposals to regulate the over-the-counter derivatives markets, aligning its rules closely with the new regulatory regime coming into force in the US.

The proposals, which have been in the making for 18 months, will be unveiled by the European Commission on Wednesday. They follow numerous rounds of consultation and ferocious lobbying from sectors of the financial services industry – from securities exchanges to investment banks and corporate treasurers at companies that use OTC derivatives.

Changes were still being made even at the end of last week, as commission officials debated the drafting internally.

The aim is to introduce more transparency to the huge OTC derivatives market, in the same way that the so-called Dodd-Frank act, signed into law in the US in June, stipulates more transparency and safety in the treatment of such previously opaque markets.

The impetus for the proposals stems from an agreement by G20 leaders last year that the OTC derivatives markets be made safer by requiring that many “standardised” contracts be traded on formal exchanges or other platforms, and that trades be processed through clearing houses, or central counterparties (CCPs).

A clearing house stands between two parties to a trade, intervening in case of default to ensure the transaction process.

Most OTC derivatives – like credit defaults swaps and interest rate swaps – are traded bilaterally between banks or sold by banks to users such as industrial companies. The 2008 collapse of Lehman Brothers left many counterparties exposed to the bank, exposing a weakness in the system.

The Commission’s legislation will set down rules for a system for deciding which contracts need to go through clearing houses, laying down tougher governance standards for CCPs and mandating reporting of deals to “trade repositories”, a type of electronic database.

Unlike the Dodd-Frank act, the Brussels proposals will not deal with how OTC derivatives should be traded. That will be tackled separately under a review of the Markets in Financial Instruments Directive (Mifid), which is under way.

Aspects of the Brussels proposals will be debated further as EU officials seek backing for the rules from the European parliament and EU member states.

One issue is the extent to which non-financial firms, which use OTC derivatives for business hedging purposes – such as managing exposure to interest rate and foreign exchange price fluctuations – should be caught by the new rules. A draft of the proposal largely exempts them from the clearing obligation, unless their business is has “systemic” implications – mirroring a similar exemption in the US legislation.

Another issue is whether clearing houses, which are set to become more systemically important as they handle a new wave of OTC derivatives, should be given access to central bank liquidity in times of crisis. A draft circulating last week stipulated that clearing houses “must have access” to central banks.