How to optimize the derivatives market structure in Europe

Key Takeaways

• Market participants caution against regulatory overkill in Capital Markets Union (CMU)
• Trading infrastructure must be updated and harmonized
• The EU will need a single CCP and a single CSD for all securities trades

The European Union (EU) must unite its capital markets or risk undermining its very existence.

This is the ominous warning from Mario Draghi, the Italian economist and former European Central Bank (ECB) President, in his paper on the future of competitiveness in the region.

Referring to prosperity, equity equality, freedom, peace and democracy, Draghi said: “The EU exists to ensure that Europeans can always benefit from these fundamental rights.” If it cannot, “it will have lost its reason for being.”

Increasing growth and productivity are the only options for Europe. Compared to the US economy, the 20-country bloc of the eurozone is sluggish, weighed down by structural and political challenges. Between the fourth quarter of 2019 and the second quarter of 2024, labor productivity per hour worked increased by 0.9% in the euro area, whereas it increased by 6.7% in the US, ECB data shows.

A myriad of national rules and reporting regimes is a hallmark of cross-border finance in the EU, and the European Commission (EC) has long sought to create a CMU. Policymakers see this as critical to meeting net zero goals and achieving the zero-carbon transition, keeping pace with technological advances and reducing dependence on external states for essential resources.

Capital markets, including derivatives, are vital in facilitating wealth creation, financing investment and mitigating risk. The policies and decisions that the EC takes to stimulate growth and establish a CMU will have a significant impact on derivatives, where billions of euros are traded daily.

Stricter rules for derivatives?

Among Draghi’s recommendations for advancing the CMU are calls for more stringent rules for the derivatives markets, particularly those focused on commodities.

He notes that “the financial and behavioral aspects of gas derivative markets can exacerbate this volatility and amplify the impact of shocks,” citing action during COVID-19 and the Russian invasion of Ukraine as examples.

To remedy this, Draghi recommends that the EU establish a common trading rulebook for spot and derivatives markets, and ensure the integrated supervision of energy and energy derivatives markets.

Further, the EU should review the “ancillary activities exemption” so that all trading entities are subject to the same supervision and requirements.

Finally, the paper proposes giving EU authorities powers to set financial position limits and price limits for normal trading, and dynamic price caps during crises, particularly when the bloc’s prices diverge significantly from global prices.

Derivatives industry urges caution

Such recommendations have been met with consternation from derivatives market proponents, who argue that these instruments should be regulated with care.

The Futures Industry Association (FIA) argues that as the EU advances on the CMU, “it should work towards and promote an open, competitive, pragmatic, predictable, safe, well-regulated and fair marketplace for domestic and international financial institutions alike”.

The association believes that any measure that “falls significantly out of step with other major relevant non-EU markets will risk causing a fragmentation of liquidity, which hampers the ability of end users to manage the risks associated with their exposures as part of their legitimate hedging strategies.”

Simplifying better than over-regulating

The FIA also opposes using price-cap controls, saying that “if improperly implemented and calibrated, these tools can be damaging to the market and the wider financial system.”

Instead of greater regulation—which a recent survey identifies as the biggest challenge for 53% of derivatives market participants in trying to grow their businesses over the next five years—the EU should simplify the regime.

“Financial markets have experienced significant regulatory change in the past two decades,” the FIA states. “Pausing to allow time to implement the rule framework and allow supervisors sufficient time to fulfil their supervisory goals will help identify areas of excessive red tape and overlapping requirements that may pose barriers to further enhancements of the CMU.”

Rather than overhauling the regulations governing derivatives markets, the FIA wants the regime to be fine-tuned. This means creating an international dialogue with peer regulators and global standard setters “to avoid a patchwork of regulations that increases costs for all involved and disincentives investment.”

Trade infrastructure is also important

Revisiting regulations is only part of the roadmap to a successful CMU.

The EU is unique in boasting more exchanges, central counterparties (CCPs) and central securities depositories (CSDs) than anywhere else in the world, according to the Association of Financial Markets in Europe (AFME).

This is not to the EU’s advantage, and reform of the settlement market infrastructure is “essential to improving the competitiveness and attractiveness of EU capital markets to both issuers and investors.”

Draghi agrees and says the CMU will need a single CCP and a single CSD for all securities trades.

This will require the EU to embrace technological innovation, including smart contracts and asset tokenization, and an expansion of distributed ledger technology.

AFME notes: “Although current systems and processes have adapted to this changing landscape, there is scope to remove structural barriers in the post-trade environment to support the broader development of EU securities markets and reduce costs for the end users.”

If the CMU is to succeed, the new EC is likely to use regulation to protect market participants and encourage innovation. Commentators are keen that policymakers avoid reinventing the regulatory wheel and instead rely on the expertise of industry professionals to help guide the market structure.

To thrive in the evolving landscape of derivative markets, firms must prioritize investment in their post-trade technology. The current underinvestment has left the industry lagging, and it’s crucial for firms to collaborate with regulators and politicians to develop robust clearing infrastructure. This collaboration is essential to achieve the productivity and scalability needed to meet future demands.