A U.K. government minister has warned that over-the-counter derivatives and fixed income markets should not be treated as “pantomime villains”, while also suggesting that upcoming European financial regulations may foster a greater degree of protectionism.

Mark Hoban, the financial secretary to the U.K. Treasury, came to the defense of OTC markets, much of which are likely to be pushed on to regulated venues and through clearing houses by the start of next year, thereby meaning all deals are recorded, following a diktat from the G20 group of nations to introduce far-reaching reforms to protect against the potentially catastrophic effects of a big default.

The previously unregulated $700 trillion OTC derivatives sector, which accounts for roughly 95% of all derivatives trades, has been blamed, in some quarters, for the global financial crisis and the collapse of Lehman Brothers in 2008.

“OTC is not a dirty word,” Hoban told the annual convention of the Federation of European Securities Exchanges, a lobby group, in Istanbul today. “I firmly believe that exchanges represent the beating heart of the European market structure [with] their importance in price discovery, efficient allocation of capital and liquidity generation.

“But what sometimes commands less attention in regulatory debates is the complementary role played by bilateral dealer markets in serving modern end users’ needs. This is particularly the case in bond and derivative markets.

“It is inherent in the nature of many of these markets that there are a huge variety of instruments available—in OTC derivatives, the number of instruments is virtually infinite. And, as a result of this specialism, the number of potential buyers and sellers of a given instrument may be small compared to that in equities at any given time.

“And so it is in these markets where intermediaries can play a particularly useful role. Stepping in to bridge the gap between buyers and sellers. Helping users to hedge their risks and meet their investment objectives. My point is that exchanges and banks—each performing their role where needed—are both critical in meeting end users’ needs. And both sides need to recognize this if we are to have a sensible debate.

“It is not that we should shy away from regulating OTC markets—far from it. We have strongly supported compulsory clearing for derivatives, and we similarly support the move to increase organized trading using the new OTF category. But policymakers and regulators cannot simply wish away the fact that for the most part bonds and derivatives are not liquid enough for traditional equity style limited order book trading.

“So to portray OTC as the pantomime villain—without acknowledging the function it can perform in the real economy—is a temptation that must be resisted.”

The revised Markets in Financial Instruments Directive (MiFID II), with final adoption expected by 2014, is looking to impose the original MiFID rules surrounding pre- and post-trade transparency that equity markets have had to adopt since 2007 into fixed income and derivatives markets in the second coming of the directive. Another Brussels regulation, the European Market Infrastructure Regulation (Emir), meanwhile, aims to carry out the G20’s wishes to get most of the OTC derivatives markets on to regulated exchanges and through central clearing to reduce systemic risk. While in the U.S., the Dodd-Frank Act is imposing similar financial regulations on to American markets.

However, the new regulations across different jurisdictions, some of which have yet to be fully defined, differ in some crucial aspects—and may lead to greater fragmentation and regulatory arbitrage.

Some market participants believe that the world’s regulators should be working together more closely in order to establish a framework of regulatory recognition to address growing concerns over extraterritoriality and protectionism.

“We must also recognize the importance of Europe as a bloc globally,” said Hoban. “This means being vigilant against protectionism in financial services and playing our part in an integrated world economy.

“It is our job to resist any proposals that seek to raise barriers to European investment in the rest of the world, and promote a world of unrestricted global trade. Europe must take the lead in ensuring that, as we strengthen the global regulatory framework, we do so in a way that balances stability with the maintenance of global markets, sustaining economic growth.”

Earlier this week, a group of trade bodies from both sides of the Atlantic, called the EU-US Coalition on Financial Regulation, which has been in operation since 2005, warned in a report that the current regulatory stances of Europe and the U.S. were encouraging legal risk, compliance complexity, regulatory uncertainty and added transactional costs in an increasingly fragmented approach.

“It is important that domestic and international regulators assess the impact of proposed regulation by analyzing the overall impact that measures will have on markets globally,” said Simon Lewis, chief executive of the Association for Financial Markets in Europe and the Global Financial Markets Association.

“In addition, the G20 should address the need for common regulatory standards to be developed and the Financial Stability Board [the G20’s regulatory arm] is ideally placed to provide guidance on where it is most critical to have consistent implementation of new rules.”

Other trade bodies in the group want to see a return to the pre-2007 dialogue, before the global financial crisis took hold, of establishing a framework of transatlantic inter-jurisdictional regulatory accreditation and recognition.

“It is apparent that not only the regulators, but the investment industry as a whole should re-engage in the pre-crisis discussions to establish effective and credible framework of inter-jurisdictional transatlantic regulatory accreditation and recognition,” said Michelle Alexander, director of policy with the Investment Industry Association of Canada.

“This is critical not only for facilitating global recovery, but to improving the efficiency and effectiveness of the regulation of cross-border business.”