16 Aug 2012

Australia's CFD industry subject to tougher regulatory financial requirements

by Louise McCoach, Matthew Daley

The new measures will bring Australia in line with the minimum financial requirements imposed on issuers of retail OTC derivatives products operating in other jurisdictions.

On 31 July 2012, the Australian Securities and Investments Commission (ASIC) announced new financial requirements for issuers of contracts for differences (CFDs) and other over-the counter (OTC) retail derivatives. The new requirements will apply from 31 January 2013 and will be implemented through ASIC Class Order [CO 12/752] – Adequate financial resources for financial services licensees that issue OTC derivatives to retail clients.

What is the purpose of the new requirements?

The introduction of the new requirements is the latest step in a series of regulatory developments affecting the OTC retail derivatives industry, commencing with ASIC's indepth review of the Australian CFD market in 2009. The results of that review, published in July 2010, highlighted ASIC's concerns that the financial requirements imposed on retail OTC derivatives issuers (as described in ASIC's Regulatory Guide 166 (RG 166) did not adequately address the risk of issuer failure.

Those concerns were bought into sharp relief by the subsequent collapse of a number of CFD issuers operating in the Australian OTC retail derivatives industry, including the high-profile collapse last year of MF Global.

The new financial requirements under ASIC Class Order [CO 12/752] have been introduced to address ASIC's concerns. In broad terms, they are aimed at ensuring that issuers of retail OTC derivatives products have sufficient financial resources to conduct their financial services businesses in compliance with the Corporations Act. However, they are not intended to prevent issuer failure or to provide compensation to retail clients who suffer loss as a result.

The new measures will bring Australia in line with the minimum financial requirements imposed on issuers of retail OTC derivatives products operating in other jurisdictions such as the United Kingdom (which imposes a minimum financial requirement of €750,000) and Singapore (which imposes a minimum financial requirement of S$1,000,000). ASIC believes that addressing this inconsistency should reduce the risk of regulatory arbitrage that may have attracted some undercapitalised issuers to Australia previously.

The new requirements are consistent with a tightening of ASIC's financial requirements in respect of a number of participants in the financial services sector, including responsible entities of managed investment schemes, electricity derivative market participants and platform operators.

Who do the new requirements apply to?

The new requirements will apply to any holder of an Australian financial services licence (AFSL) that is actually operating a retail OTC derivatives business (as opposed to merely being authorised to do so under its AFSL).

However, bodies regulated by the Australian Prudential Regulation Authority will be excluded, as will retail OTC derivative issuers that are market or clearing participants.

Further, ASIC may grant relief from the new requirements to foreign retail OTC derivatives issuers that it considers are adequately prudentially regulated in their home jurisdiction.

What are the new financial requirements?

The new requirements will supplement the existing minimum financial requirements imposed on retail OTC derivatives issuers under their AFSLs (and as described in RG 166).

There will be three key changes.

Net Tangible Asset requirement

The most significant change is the introduction of a new net tangible assets (NTA) test, which will be phased in for issuers over two years. During the initial phase-in period commencing on 31 January 2013, an issuer's NTA must be the higher of A$500,000 and 5% of its average revenue. During the second phase-in period commencing on 1 February 2014, an issuer's NTA must be the higher of A$1,000,000 and 10% of its average revenue.

The NTA test will replace the current AFSL condition which requires issuers of retail OTC derivatives to hold a certain level of adjusted surplus funds (ASLF) based on a percentage of adjusted liabilities. However, unlike the cash outflow-based ASLF requirement, the NTA requirement will be calculated based on revenue (ie. cash inflows) which ASIC believes is a better indicator of an issuer's overall operating risk. This approach is consistent with the approach adopted under Basel III, which uses revenue to determine a bank's capital requirement for operating risks associated with its trading business.

Average revenue will be calculated based on the issuer's total average revenues over three years (ie. the current year plus the two previous years). The calculations do not distinguish between revenue sources and so appear to take into account the whole of the issuer's revenue including from non-retail OTC derivatives sources. This may encourage players with significant revenues from non-retail OTC derivatives sources to create SPV entities to run their retail issuing business.

In addition, an issuer will be required to notify ASIC if it has 110% or less of the required NTA, which suggests that ASIC expects a 10% buffer above the required NTA to be observed.

If an issuer's NTA falls below 100% of the required NTA, the issuer will be required to top up its NTA to the required level. If it fails to do so within two months, it must notify the shortfall to each client and any person that it holds money on trust for.

Furthermore, the issuer will be prohibited from entering into any transactions with any person to whom it provides financial services that could give rise to any new liabilities or other financial obligations unless its board has certified that there is no reason to believe that the issuer could fail to meet any of its other AFSL conditions and there is no evidence of a shortfall in any client money account.

If an issuer's NTA falls to 75% (or below) of the required NTA, the prohibition against incurring new liabilities or other financial obligations cannot be cured by board certification.

Liquidity requirement

The changes include the introduction of a new liquidity standard which will require issuers to hold 50% of the required NTA in cash or cash equivalents and 50% in liquid assets (being either cash or certain cash equivalents or assets that the issuer can reasonably expect to realise for its market value within six months). Any cash or cash equivalents held in respect of client liabilities or obligations cannot be counted towards satisfying either of these liquidity requirements.

Cash flow projections requirement

The new rules will require all issuers to prepare quarterly cash flow projections over at least the next 12 months (instead of three months as currently provided under RG 166) based on a reasonable estimate of revenue and expenses over that term, taking into account the whole of the issuer's revenues and expenses (as opposed to just those that relate to its retail OTC derivatives business).

The projections must describe the assumptions upon which they are based, be approved by the relevant issuer's board and be made available to ASIC on request.

Impact of new requirements

ASIC's new rules seek to strike a balance between ensuring that issuers have sufficiently rigorous risk management frameworks and resources to support their business operations, and the need to avoid imposing an unreasonable cost burden through requiring issuers to maintain financial resources at levels which create unjustifiable barriers to market entry.

This is a difficult balance to strike.

There is no doubt that the new requirements will increase operational costs for many issuers in Australia. The question is – has ASIC set the operational cost base too high?

Based on recent media comments by the key players in this sector, the answer to this question appears to be no for the larger issuers. In fact the established issuers appear to have embraced the new requirements as a positive step towards protecting the market's reputation against issuers that are undercapitalised or poorly governed. They have even argued that the new requirements do not go far enough and would appear to support ASIC imposing even higher financial hurdles in order to maintain investor confidence in the market.

So, although there will be additional costs associated with compliance, it appears that the key players will either absorb the costs or seek to pass them onto retail investors. The smaller issuers that are not as well capitalised will obviously find compliance more challenging and are likely to bear the burden of the new requirements. This could lead to under-capitalised issuers exiting the market and new entrants being deterred from entering it.

Any resulting consolidation within the industry as a result of these developments could adversely impact on its competitiveness.

What work needs to be done in the lead up to 31 January 2013?

The main task in the lead up to 31 January 2013 will revolve around issuers assessing whether they can comply with the new NTA test. This assessment will require issuers to carefully review the definition of assets set out in Class Order 12/752 to determine which of their assets can be counted towards their NTA calculations.

For example, as the definition of "NTA" excludes intangible assets such as goodwill, issuers that have grown through multiple acquisitions might find themselves unable to meet the NTA requirements despite a healthy balance sheet.

Based on an issuer survey conducted by ASIC in August 2011, the four largest issuers are not expected to need to raise additional capital. However, smaller issuers will need to start planning now for any new capital that they will need to top up their existing position in order to satisfy the new NTA test.

It will also be necessary for entities to modify their sign-off procedures to build in the requirement that directors must approve each quarterly projection. This is particularly important in light of a number of recent decisions, including Centro and James Hardie which emphasised that those matters which require director sign off could not be delegated.

On the horizon

Bolstering the financial requirements for issuers of retail OTC derivatives is only the first of a number of other reforms that ASIC is potentially considering for the retail OTC derivatives industry, including the use of client money, advertising standards and client-appropriateness screening practices.

If you have any questions in relation to the new financial requirements for issuers of retail OTC derivatives, please contact  Matthew Daley.


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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.