04 Feb 2016
Mandatory central clearing on its way for issuers of OTC derivatives in Australia
by Sonia Goumenis, Mano Karthigeyan
You will need to work out if you are a clearing entity or a foreign internationally-active dealer, either in your personal capacity or in a representative capacity.
Issuers of certain over-the-counter (OTC) interest rate derivatives will soon be required to clear their swaps in compliance with the Australian Securities and Investments Commission's (ASIC) new mandatory clearing rules.
The rules were finalised and released in December 2015 following a period of industry consultation on the initial draft released by ASIC in May 2015. At the time, the Treasury also consulted on a draft Ministerial determination that prescribed the product scope of the proposed clearing rules and regulations that established the parameters of ASIC's rule-making powers. The Ministerial determination was made in August 2015 and the regulation was passed in September 2015.
Who is impacted?
The rules are likely only to affect major banks and foreign dealers as they are limited in application to derivative transactions entered into between two "clearing entities" (or transactions between a "clearing entity" and a "foreign internationally-active dealer").
Entities of the following types that have gross notional outstanding OTC derivatives positions that are equivalent to or in excess of AUD100 billion (the clearing threshold) and are acting in their personal capacity are "clearing entities":
- Australian or foreign Authorised Deposit-taking Institutions (ADIs);
- Australian or foreign Australian Financial Services (AFS) licensees; or
- exempt foreign AFS licensees.
The regime will also apply to entities that are acting in a representative capacity and hold gross notional outstanding OTC derivatives positions that are equivalent to or in excess of the clearing threshold on behalf of a registered trust or scheme that is established in Australia.
Background to the new mandatory clearing rules
The clearing requirements under the new regime will commence in April 2016 and are part of a broader reform agenda with respect to OTC derivatives reflecting Australia's G20 commitments. These commitments, most of which were agreed at the 2009 Pittsburgh Summit and later supplemented in November 2011 by G20 Leaders in Cannes, include the overarching objectives to substantially reform market practice for OTC derivatives and ensure more transparency and stability in derivatives markets.
Agreed reform measures include mandatory reporting requirements for OTC derivative transactions to trade repositories, which after a staggered implementation through July 2013 to December 2015 has now been implemented in Australia.
We also await rules in relation to margining requirements for non-centrally cleared OTC derivatives, jurisdiction for which (at least with respect to ADIs) sits with the Australian Prudential Regulatory Authority (APRA) rather than ASIC.
Classes of derivatives affected
In addition to its limited application to significant swap dealers, the scope of the rules is narrow in terms of the classes of derivatives affected. The rules are confined to transactions involving interest rate derivatives that are denominated in either Australian Dollars, US Dollars, British Pounds and Japanese Yen (collectively known as the G4 interest rate derivatives). Specifically, the rules will apply to basis swaps, fixed-to-floating swaps, forward rate agreements and overnight index swaps. The interest rate derivative market is the largest and systemically most important derivatives market in Australia.
ASIC's focus on G4 interest rate derivatives stems from the clearing mandates implemented in other relevant jurisdictions, namely by the U.S. Commodity Futures Trading Commission (CFTC) and by the European Securities and Markets Authority (ESMA), in an effort to streamline the mandatory clearing rules across different jurisdictions to maintain overall consistency for financial institutions involved in cross-border OTC derivative transactions.
ASIC's objective through implementing clearing rules that are broadly consistent with regimes in the U.S. and Europe is to enhance the likelihood of Australian financial institutions reducing or relieving themselves of compliance obligations relating to foreign clearing requirements through substitute compliance.
This more limited scope differs from the much wider scope of the mandatory trade reporting rules for OTC derivatives.
Key exceptions to the rules
There are some limited exceptions to mandatory clearing. For instance, clearing will not be required in the event that a relevant transaction is terminated prior to its deadline or a licensed or prescribed clearing and settlement facility is unavailable.
Other exceptions include intra-group trades or trades in connection with a multilateral portfolio compression cycle (a process whereby notional exposures in a portfolio are reduced by modifying, terminating or replacing derivatives in order to minimise operational risks or counterparty credit risks). An intra-group trade is defined as one where the counterparty to the clearing transaction is a related body corporate of the clearing entity.
What you need to do
As the rules have limited application you will need to work out if you are a clearing entity or a foreign internationally-active dealer either in your personal capacity or in a representative capacity. If you enter into a relevant OTC derivative transaction after April 2016 you will need to ensure compliance for trades entered into with other clearing entities and should seek advice in relation to the new rules.
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