08 Dec 2011
Proposed reforms to the handling and use of client money in OTC derivatives transactions
by Louise McCoach, Vittorio Casamento
While a counterparty might believe that "client moneys" are held on trust for it, there are a number of risks to which the counterparty is exposed.
In the wake of the collapse of MF Global in November 2011, the Australian Government published a discussion paper on "Handling and use of client money in relation to over-the-counter derivatives transactions".
As can be gleaned from the title of the discussion paper, its main purpose is to raise for discussion certain issues relating to the holding of client moneys in connection with OTC derivatives and to consider whether existing laws (including the Australian Corporations Act) are sufficient to protect those moneys.
It is interesting to note that the discussion paper specifically singles out OTC derivatives, rather than exchange traded derivatives. OTC derivatives have been the subject of much attention since the onset of the global financial crisis, as regulators around the world seek to mitigate the perceived negative impact of OTC derivatives on the global economy.
The discussion paper relating to client moneys follows a recent consultation paper published by the Australian Council of Financial Regulators (published in October 2011) relating to a review of financial markets infrastructure regulation and an earlier discussion paper published by the same council in June 2011 relating to the central clearing of OTC derivatives in Australia.
The current position under the Corporations Act
Counterparties that enter into derivatives transactions via a broker will often be required to provide cash collateral, or "margin", to the broker . The Corporations Act allows those client moneys to be pooled with money belonging to other clients of the broker in a "client segregated account".
While a counterparty might believe that "client moneys" are held on trust for it and, as a result, protected in the event of the insolvency of the broker, in actual fact, there are a number of risks to which the counterparty is exposed. These include:
- the Corporations Act allows a broker to use client monies received in connection with derivatives for the purpose of meeting the broker's obligations in relation to certain dealings in derivatives, whether on behalf of the client or third parties;
- the agreement between the broker and the client will often give the broker a broad authority to make withdrawals from the client segregated account for any purpose whatsoever;
- as a result, if the broker becomes insolvent, there may be insufficient funds in the client segregated account of the broker to meet the claims of all the broker's clients. Each client will then become an unsecured creditor of the broker for the amount of the deficiency. If the broker's personal assets are not sufficient to meet the unsecured claims of all its clients, its clients will share pro rata in the assets of the broker.
International proposals for reform of client money rules
In connection with reforms to the OTC derivatives markets agreed by the G20 in 2009, law reforms relating to the protection of client monies have been on the agenda for many countries, including in the US, UK and Europe.
In the majority of the jurisdictions considered by the government in the discussion paper, regulations require a strict segregation of client money. In other words, client money should be clearly held on trust for the relevant client and a broker should not be able to use those moneys to fund their own working capital requirements. These measures seek to minimise the risk that there will be any deficiency in the client segregated account of a broker at a time when it may be insolvent.
Proposals for reform in Australia
Any reform to Australia's laws is likely to follow a similar approach to the above. Whilst this will be a change of direction to the current legal framework, the government considers such reforms to be integral to maintaining the integrity of the financial markets, particularly given that the use of OTC derivatives among retail clients has been increasing in recent years. The discussion paper also envisaged that any increase in broker compliance costs under a stricter segregation regime will not be significant since brokers are likely to be subject to similar obligations if they operate in overseas jurisdictions.
If Australia does not follow the approaches being taken overseas, a number of alternative proposals are canvassed in the discussion paper. These include:
to shorten the timeframe within which licensees are required to top up the client segregated account after they have made a withdrawal;
requiring licensees to reconcile client segregated accounts to the individual client level (as opposed to a general reconciliation at a pooled level).
The specific reforms which the government has proposed in the discussion paper are:
to restrict or prohibit the use of client money as margin for hedging transactions entered into by the broker;
to require brokers to act as trustees of client money;
to impose a statutory trust in order to prevent brokers from using client money to hedge their own positions in derivatives;
to require that client moneys be individually segregated (ie. not pooled with funds belonging to other clients).
The Government is seeking industry feedback on the above reforms by 27 January 2012.