08 Nov 2012

Regulators support industry-led move to OTC central clearing for now, and broad mandatory reporting

by Louise McCoach

The recommendations in the Report on the OTC derivatives market provide some useful guidance on the policy position that is likely to inform the views of the regulators as they engage in the statutory consultation process.

On 30 October 2012, the Australian Prudential Regulation Authority (APRA), the Australian Securities and Investments Commission (ASIC) and the Reserve Bank of Australia released a Report on the Australian OTC Derivatives Market – October 2012.

The Report develops the issues explored in an earlier May 2009 survey of the OTC Derivatives Market in Australia in the broader context of the Corporations Legislation Amendment (Derivative Transactions) Bill 2012.

Industry-led move to central clearing

The Report considers a number of issues, including whether a move to central clearing of OTC derivatives would lead to strong in-principle benefits to the Australian OTC derivatives market.

After canvassing the merits of central clearing for various OTC asset classes, the Report concludes that central clearing of A$ interest rate derivatives is likely to yield the most immediate and substantial benefits to the Australian financial system. However, the Report stops short of recommending the introduction of a mandatory clearing obligation for this asset class.

Instead, the Report recommends that the Australian Government adopt a "wait and see" approach to allow market participants to voluntarily migrate to central clearing, with a view to reconsidering the need for mandating central clearing, at least for A$ interest rate derivatives, if the migration does not happen soon enough.

Whether or not Australia adopts mandatory clearing will depend on how quickly market and commercial considerations guide banks’ decisions to choose central clearing when dealing with counterparties. Lower capital charges on cleared derivatives under Basel III will certainly steer banks towards this result – the question is, will this be fast enough.

In order to facilitate the market's migration to central clearing, the Report acknowledges the responsibility of ASIC and the RBA to deal expeditiously with any licence applications to provide central clearing services in Australia.

A broad-based mandatory trade reporting obligation for OTC derivatives

In contrast to its support for an industry-led solution to central clearing, the Report recommends that the Australian Government consider the introduction of a mandatory trade reporting obligation for a broad range of OTC derivatives and market participants.

The implementation of the mandatory reporting recommendation hinges upon the progress of the Derivative Transactions Bill which is currently before the Senate and likely to be debated in early 2013. If mandatory reporting is introduced after the bill is passed, ASIC will have the role of developing the related licensing and reporting requirements in consultation with industry stakeholders.

Risk management for non-centrally cleared trades

The Report identifies shortcomings in the counterparty credit risk management practices among participants in the OTC electricity derivatives market and notes that further work should be undertaken to explore these issues. The Report also identified the following areas of concern in relation to current market practices generally, which it singled out for ongoing regulatory and market attention:

Credit support arrangements

The Report recommends the maintenance of adequate credit support arrangements for non-centrally cleared OTC derivatives transactions. It also recommends, as a matter of best practice, the daily collateralisation of exposures by larger and more active market participants, recognising the need to balance this against the operational and liquidity impact of doing so.

In considering the adequacy of current OTC collateralisation practices, the Report takes into account draft principles recently issued by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions which call for the mandatory posting of collateral to support the obligations of parties to non-centrally cleared derivatives transactions. The Report states that the regulators will continue to monitor these international developments and provide advice to the Australian Government as appropriate.

Trade compression and portfolio reconciliation services

The Report notes that the use of trade compression services in Australia is sporadic and urges a more co-ordinated market-wide approach to the use of these services. The Report also advocates greater utilisation of portfolio reconciliation services to reduce the likelihood of valuation disputes between parties.

Trade execution

While the Report recognises that greater use of trade execution platforms would be beneficial in principle, it concluded that further analysis was necessary to more precisely identify how the benefits can be appropriately harnessed.

The Report notes that the above recommendations are largely able to be adopted by the market without the need for specific regulatory action. However, the regulators have indicated that they will continue to monitor progress in this area in consultation with relevant industry stakeholders.

What is the significance of the Report?

Post-financial crisis, domestic derivatives reforms have largely focused on the migration of OTC derivatives to central clearing and how this will be regulated and licensed. Interestingly, the Report indicates that collateralisation practices in relation to non-centrally cleared OTC derivatives could potentially be on the regulatory reform agenda as well.

The Report is also significant in the context of the role that Australian regulators will have under Australia's new OTC derivatives framework once the Derivative Transactions Bill comes into force. In particular, the Minister for Finance and Superannuation will be required to consult with the regulators before determining that one or more classes of OTC derivatives should be subject to mandatory central clearing, reporting or trade execution requirements.

The recommendations in the Report provide some useful guidance on the policy position that is likely to inform the position of the regulators in the course of their involvement in any statutory consultation process in relation to central clearing, trade execution and reporting under the new framework. The policy position of the regulators is also likely to inform ASIC's approach to its rule development role under the new framework.

Next steps

The regulators propose to engage further with stakeholders about the findings in the Report with a view to exploring a number of issues, including:

  • stakeholder concerns around impediments to central clearing, such as operational and design elements;
  • the development of mutually acceptable client clearing agreements;
  • how best to manage systemic risks in other markets that are not currently amenable to central clearing, such as cross-currency and FX derivatives; and
  • if and how any further regulatory intervention may be warranted to further enhance the efficiency, integrity and stability of the Australian OTC derivatives market and the broader Australian financial system.

The Report expects that additional market reports will be undertaken in the period ahead.

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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.