By Huw Jones
LONDON (Reuters) - Banks and companies will have to set aside billions of euros to back derivatives trades from September under new European Union rules designed to make the $550 trillion market safer.
The tougher rules apply to derivatives like interest rate or credit default swaps that are traded privately or over-the-counter (OTC), and not passed through a clearing house.
"Compared to the existing OTC market, it's a monumental change," said Emma Dwyer, a partner at Allen & Overy law firm.
A clearing house stands between two sides of a trade, ensuring its completion even if one side goes bust by automatically requiring margin to be posted.
Regulators now want all trades to be backed by margin in the form of cash or top quality bonds to cover any losses.
This follows the crash of Lehman Brothers bank nearly eight years ago, leaving regulators unsure who was on the other side of its derivatives trades and if there was enough margin to cover losses.
For the first time in the OTC market, initial and variation margins to cover a trade and subsequent changes in market prices will be mandatory.
"The exchange of variation margins seems to be common practice among financial institutions, but the exchange of initial margins is rare," the new rules state.
Initial margins currently total less than 40 billion euros ($44 billion) in the EU, and the regulators estimate this will rise to about 200 billion euros under the new requirements.
"The challenge now will be for the industry to implement the rules in time for the September 2016 start date – just six months away," said Scott O'Malia, chief executive of the International Swaps and Derivatives Association, an industry body.
"Firms will need to revise thousands of their legal documents so they comply with the final rules," O'Malia said.
The Group of 20 economies (G20) agreed during the financial crisis that margins on uncleared trades should be much higher than for cleared transactions to promote clearing.
"I think it's too early to tell if that is the case," Dwyer said.
From June, plain varieties of interest rates swaps traded in the EU must be cleared, with some credit default swaps following suit, probably in January 2017.
This still leaves swathes uncleared and subject to the new rules, including commodity derivatives and equity options.
Dwyer said the regulators have given equity options a longer phase in period so that EU and U.S. regulators have more time to iron out differences in their rules.
Banks will welcome news they can use cash for initial margins, an option effectively ruled out in earlier drafts, Dwyer added.