16 Aug 2011

Should we have central clearing for OTC derivatives in Australia?

by Louise McCoach

Regulators are considering whether there should be central clearing for Australian OTC derivatives.

Following the G20 summit in April 2009, the G20 group of countries committed to several measures to strengthen the OTC derivatives markets, including the establishment of central clearing counterparties (CCP) for standardised OTC derivatives transactions. Many offshore jurisdictions have since undergone substantial reforms in this area, with the aim of having all standardised OTC derivatives cleared through CCPs by the end of 2012.

Now Australia (also a member of G20) is looking to do same, with the release of a discussion paper in June 2011 by the Council of Financial Regulators (Council), which is the co-ordinating body for Australia's main financial regulatory agencies (being the Australian Prudential Regulation Authority, the Australian Securities and Investments Commission, the Reserve Bank of Australia and the Treasury).

The purpose of the discussion paper is to seek feedback from the derivatives industry on a proposal by the Council for a domestic CCP for the Australian OTC derivatives markets.

International vs domestic CCP – what underlies the Council’s approach?

The Council has set out four main considerations informing its approach to the question of how to best achieve central clearing for the Australian OTC derivatives markets:

  • Availability of central clearing services to Australian-based market participants: There is currently no central clearing of OTC derivatives in Australia, and offshore clearing solutions, where they exist, are not really tailored for our markets (which are of much smaller scale compared to the European and US markets where most clearing systems are currently located). Moreover, the regulatory landscape across the globe is changing rapidly, making it hard to foresee how the clearing of Australian OTC derivatives will develop.
  • Cross-border linkages: Cross-border linkages are recognised as a significant part of the Australian OTC derivatives markets, and play an important role (along with overseas market and regulatory activities) in shaping it.
  • Implications for financial stability: While central clearing can enhance market resilience through reducing some interdependencies between market participants and assisting in the resolution of participant defaults, it can also have systemic risk implications, especially if it results in greater concentration of exposures or interdependencies. Moreover, given the central role of a CCP, any CCP failure would have serious consequences for financial markets.
  • The configuration of CCPS: How CCPs are configured will in itself affect market efficiency and market functioning. For instance, fragmentation of clearing could reduce netting opportunities and collateral efficiencies.

The Council’s main proposals

Currently, interest rate and foreign exchange derivatives are the most common OTC derivatives traded by domestic market participants. Consistent with this, the Council has concluded that "the market for Australian dollar-denominated interest rate derivatives (such as overnight indexed swaps, forward rate agreements, and interest rate swaps) is systemically important within Australia, given the wide range of domestic participants that use these instruments, and the interdependencies between these derivatives markets and other domestic capital and credit markets."

The Council is therefore considering whether to require all A$ interest rate derivatives to be centrally cleared and whether the clearing should take place domestically. The requirement would generally apply to ADIs and AFS licensees, although there is scope for exemptions.

In canvassing the case for a domestic CCP, the Council observed that if no Australian regulatory action is taken, the domestic CCP solution may not emerge and Australian-based market participants may be limited to using offshore CCPs for a significant part of their business to fulfil any clearing requirements in Australia. The Council expressed concerns that the clearing of systemically important domestic markets through offshore CCPs may introduce new risks into the Australian financial system, given that the Australian regulatory agencies are likely to have little scope to oversee offshore CCPs and to respond as needed in stressed conditions.

What are the next steps?

Obviously much of the devil will be in the detail, such as how an "Australian" derivative or market should be defined, determining the assets classes that are amenable to clearing, and the extent to which the centrally cleared requirement will apply to cross-border trades (taking into account the harmonisation issues associated with cross-border trading) and how the varying risks associated with different products and classes should be managed.

Ahead of making recommendations to the Government, the Council is seeking submissions from industry on the paper by 1 September 2011. Once the submission period has closed, the Council will continue to consult with industry though a number of round table discussions and meetings. This consultation process will be a very valuable opportunity for the derivatives industry to shape the future of the OTC derivatives market in Australia.

If you are interested in commenting on the discussion paper, and would like our assistance, please contact Louise McCoach or Graeme Dennis.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.