On April 18, the Australian Government released its proposals for the future regulation of the Over-the-Counter derivative markets in Australia.
The proposals contemplate an extensive new regime. In fact, the new regulatory framework proposed could be described as Australia's equivalent to the regulation of derivatives under the United States' Dodd-Frank legislation. However, the impact could be far more manageable. The flexibility of the new regime, and the sophistication of the analysis on which its implementation seems likely to be based, might just avoid much of the market disruption that a more heavy-handed response could have brought.
In this article, we set out key parts of what is proposed and provide some insights as to what it might mean. It is clear that these proposals are not the final word, and there is much consultation and discussion to follow.
The Government has released two papers: the final report of the Australian Council of Financial Regulators (the Treasury APRA, the RBA and ASIC) on "OTC Derivative Market Reform Considerations" and the Consultation Paper of the Australian Federal Treasury on "Implementation of a framework for Australia's G20 over-the-counter derivative commitments". A link to each is here. The Council's paper contains the Australian regulators' conclusions following the extensive consultation in which they engaged last year. The Treasury paper sets out proposals for a legislative response. It is worth reading them together as the Council's paper contains both the reasoning for the proposals set out in the Treasury paper, as well as indicating how the regulators may use the flexibility provided to them through those proposals. However, it is the proposals set out in the Treasury paper which set the playing field for the next stage in the regulation of derivatives in Australia.
The proposals cover three primary issues: central clearing, trade reporting and trading platforms. All three of these were included in the undertakings given by the leaders of the G20 nations in September 2009 following the Global Financial Crisis and the latest paper represents the next step in the Australian Government fulfilling its commitments (a connection which is made abundantly clear).
The proposals at a glance
In brief summary, the proposals of the Australian Government are:
- Trade reporting may be mandated in regulation later this year to apply to a broad range of derivative classes, with most parties and transactions to be captured by trade reporting obligations.
- Central clearing will be the subject of ongoing assessment by Australian regulators to determine its suitability for derivative classes in Australia although one option is to move more expeditiously to mandate the clearing of some classes identified as “priorities”. In particular, systemically important derivative classes (such as Australian dollar denominated interest rate swaps) are to be subject to further assessment and monitoring to determine if capital incentives and other initiatives will ensure that central clearing becomes standard industry practice in Australia.
- Trading platforms are to be subject to further analysis in the context of the volume and liquidity characteristics of markets for particular derivative classes and the emergence of suitable trading platforms.
In some cases these proposals are firmer than the final conclusions of the Council. However, the legislative framework which is to be introduced does provide the regulators with the flexibility to provide a more tailored response if particular participants or products are thought to require it.
The new derivative law framework
The framework for implementing the new proposals involves amendments to Australia's Corporations Act.
These amendments are to allow the Minister for Financial Services and Superannuation, through a legislative instrument, to prescribe that mandatory obligations relating to trade reporting, central clearing and/or trade execution apply to a class of derivatives.
The amended legislation will give ASIC power to make derivative transaction rules (DTRs) which determine (within defined limits) which parties and transactions will be subject to trade reporting, clearing or execution requirements in respect of prescribed derivatives, how they comply and the timing of any requirements. All DTRs will require the Minister’s consent.
Also, there will be a regulation-making power to narrow the scope of the mandatory obligations (and therefore the parties who will be required to comply with the obligations under the DTRs). These regulations will provide a means of limiting the classes of persons and transactions to which the rules can be applied. Under the rule-making power, ASIC will also be able to specify cases in which certain persons or certain transactions would not be required to report, clear or execute trades in accordance with the DTRs.
Decisions to prescribe or make rules for a class of derivatives will require public consultation, and will include opportunities for other agencies to provide advice.
As noted in the Government's paper:
"The establishment of the framework (through amendments to the Corporations Act) does not in itself introduce any trade reporting, central clearing or trade execution obligations for OTC derivatives transactions. Rather, the framework creates a mechanism by which such obligations may be implemented by supporting regulations and rules. Trade reporting, clearing and execution obligations will be created only after further market analysis and subsequent additional consultation is undertaken by ASIC and other Council agencies."
The framework appears designed to address a twin goal - to allow Australia to comply with its G20 obligations whilst also providing flexibility for the mandatory obligations to be tailored to local market requirements and international regulatory developments. Accordingly, neither the framework, nor the Government's paper seeks to provide definitive answers on detailed questions such as the geographical scope of any Australian mandatory requirements or the interaction with foreign regulatory requirements. These are to be: "discussed in future consultations and will be developed following further assessment of international developments."
However, there is some detail in the Government's paper which will be of interest to a number of market participants, and potential providers of new financial market infrastructure. These are summarised below.
Reporting the trade
The Council's paper stops short of recommending the implementation of mandatory trade reporting. It notes that market forces may cause market participants to take up trade reporting without the need for a mandate, although it does note that an obligation to do so might need to be imposed. However, the Treasury's paper seems to provide a clearer direction for the proposal of trade reporting obligations (albeit subject to further consultation). It sets out a number of possible options for the scope of mandatory trade reporting. The first is to prescribe a broad range of derivative classes and for the obligation to apply to a broad range of entities and transactions, but to phase-in the implementation of them. Another option is to hold back prescription of derivative classes until a later date or restrict the entities and transactions to which it applies. However, the paper points out that this could deprive regulators of information and also make the future mandating of derivative classes for central clearing less accurate. The jurisdictional reach could be broad. The Treasury paper canvasses the option of the reporting obligation applying to all contracts booked in Australia, denominated in Australian dollars or where the underlying reference entity is resident or has a presence in Australia, as well as contracts traded by market participants resident or having a presence in Australia. This could be further restricted by ASIC when developing the DTRs.
A related point that the Treasury paper proposes is that a new licensing regime would need to be introduced for trade repositories in Australia, as none currently exists under the Corporations Act (unlike for clearing and market services). The principles for this new licence are also proposed for comment in the Treasury paper.
Clearing a path
In relation to clearing, the extent of the Treasury proposals seem more closely aligned to the Council's recommendations. The Treasury paper (like the Council's paper) recognises that economic incentives and other initiatives should encourage the transition to central clearing without the need for a mandatory requirement to initially apply. This includes the implementation of capital charges on banks and minimum standards for margin requirements for non-centrally cleared transactions. It is noted that these measures are expected to provide a price signal that the cost of non-cleared trades will be greater than cleared trades - which should encourage market participants to clear. However, it is recognised that central clearing does require significant change and the ability to mandate central clearing is needed if market participants make the transition "at-a-slower-than-desirable-pace". In particular, it is noted that systemically important derivative classes, such as AUD denominated interest rates swaps (IRS), may be identified as priorities for mandating, subject to further assessment of the market and consideration of the effect of capital incentives and other initiatives. Although AUD IRS were singled out in last year's paper issued by the Council, the final recommendations of the Council do not appear to make any similarly-focussed statement.
A further important proposal in relation to clearing is that of jurisdictional reach. It is recognised that a defined application of the new regime may be appropriate. One option which is proposed is that central clearing be required (if it is mandated) where at least one side of the contract is booked in Australia and either:
- both parties to the contract are resident or have a presence in Australia and are entities that are subject to the clearing mandate; or
- one party to the contract is resident or has a presence in Australia and is subject to the clearing mandate, and the other party is an entity that would have been subject to the clearing mandate if it had been resident or had a presence in Australia.
These parameters may be prescribed in the regulations or the DTRs. It is also noted that ASIC may further restrict the obligation and provide exemptions in some instances where these transactions would also be subject to a clearing obligation in another jurisdiction.
The Council's final report does address a few further important aspects with clearing. It clarifies that the regulators are more comfortable with their initial concern that clearing would need to be conducted in Australia. This is on the basis of international developments such as the weight given to the interests of smaller jurisdictions like Australia in the work of the Financial Stability Board around safeguards in a global central clearing framework. It is also on the basis of domestic developments around "location" requirements for systemically important financial market infrastructure (see below). Accordingly, the Council did not see the need to expressly require that clearing takes place domestically. However, in the case of systemically important central counterparties, those location requirements may cause a similar result. Also, in its paper, the Council indicated that there were two elements on which it would need to become more comfortable before it mandated clearing - these are client clearing, and the liquidity requirements imposed by clearing, particularly given the shortage of high quality liquid assets (eg government bonds) to provide as collateral in Australia.
Executing the trade
The Government's paper is less clear on the basis for implementing any requirement for the use of trade execution facilities then it is on trade reporting and clearing. It notes that:
“It may be premature to impose a mandatory trade execution obligation in respect of any derivatives or participants. It is anticipated that transaction data from trade repositories will be useful to effectively evaluate whether there are derivatives for which it would be appropriate to mandate execution on an exchange or electronic platform. It is also anticipated that the move toward central clearing, which necessarily involves a degree of product standardisation, will organically give rise to an increase in electronic trading in derivatives that are sufficiently liquid.”
This reluctance to mandate trade execution requirements in the absence of the other requirements being established appears consistent with the Council’s final report.
Locating the infrastructure
The Treasury's proposals are that only licensed entities can be eligible as trade repositories, CCPs or trading platforms. This could include Australian, or foreign entities (subject to certain conditions being met). The intention is to ensure that regulators can supervise facilities which they mandate.
The Government's paper also makes reference to the separate review process in which it has been engaged in relation to additional requirements and obligations on systemically important financial market infrastructure (a link to the recently published final report of the Council on this can be found here). The result of this is a recommendation that each of the RBA and ASIC can impose additional licence conditions relating to location requirements and compatibility of rules with Australian law - although it is noted that these would be imposed in a proportional and graduated manner. However, it is possible that an overseas clearing facility could be required to incorporate in Australian if it became integral to the smooth functioning of the Australian financial system. It is important for market participants to recognise this. Effectively, one of the most complex issues, being the need to locate clearing house infrastructure in Australia may have moved to a different stream of review.
What to do now
Whatever participants think of the impact on their business, it can be said that the Australian Government’s papers represent a sophisticated and reasoned response to the complexity of seeking major change in the manner in which an extremely complicated and very interconnected and globalised market operates. The consideration of the detailed issues in the Council paper, and the flexibility of the legislative proposals in the Treasury paper, should go some way to giving market participants comfort that the regulatory approach in Australia to the OTC market should remain well-informed and inclusive. This approach has been evident since the Council's first survey of the OTC derivatives market in Australia following the financial crisis. The Australian Government's proposals clearly give the market the opportunity for discussing, developing and implementing its own solutions before mandated requirements will need to be implemented. If we in the market don’t take that opportunity, then at least we should have clear-sight of what might happen next.