On July 3, 3009, the Commission of the European Communities (the “Commission”) adopted a communication (the “Communication”) on the subject of Ensuring efficient, safe and sound derivatives markets. LINK.

In the Communication, the Commission acknowledged that derivatives are an integral part of the global economy in that “[t]hey share or redistribute risks and they can be used as protection against a particular risk” enabling “commercial entities, such as airline companies, manufacturers, etc. . . . to cover the risk of price increase in the basic materials they use to run their business and to better plan their future needs.” However, the Commission went on to note that, as highlighted by the current financial crisis, the opaqueness of the privately negotiated over-the-counter (“OTC”) derivatives market prevented market participants, supervisors and regulators from assessing and appreciating the risks associated with derivatives, particularly counterparty risk. The Commission pointed out that counterparty risk is particularly acute in connection with credit default swaps (“CDS”) because (i) the credit risk that these contracts cover is difficult to assess, and may come on quite suddenly and (ii) the potential settlement of these contracts is “extreme,” in that a seller of protection must pay the full principal amount of the contract minus the value of the defaulted obligation.

The Communication outlines four tools intended to increase transparency, strengthen operational efficiency, mitigate counterparty risk and, generally, improve financial stability in the derivatives markets. The first of these is to encourage the further standardization of OTC derivatives contracts to enable increased volumes of such contracts to be efficiently executed, confirmed and processed. As the Communication notes, standardization requires investments by market participants in operational and other infrastructure but is a necessary “prerequisite” for other tools. The second of these is to study the usefulness of a central data repository in the European Union to track, among other things, the number of derivatives transactions and size of outstanding positions. The third tool outlined in the Communication is to continue to promote the use of central counterparty (“CCP”) clearing in Europe. In connection with CDS, the Communication noted that the major derivatives dealers had signed a commitment with the European Commission to clear European CDS through European CCPs by July 31, 2009 and that two European CCPs are expected to be operational by such date. The Commission also noted that, in the future, it could strengthen the incentives for market participants to use CCP clearing by, among other things, amending the rules on regulatory capital to make it more beneficial to use a European CCP. Finally, the Communication addressed the possibility of trading standardized derivatives cleared through a CCP on an organized, regulated exchange or trading facility. However, the Commission declined to make any recommendations regarding regulated exchanges or trading facilities, noting that it would further examine the channeling of trade flow through such trading venues, as well as the appropriate level of price, transaction and position transparency for such venues.

The Commission welcomed comments to the Communication by August 31, 2009 and announced that it will hold a public hearing relating to the Communication on September 25, 2009.