OTC Derivatives Market Reform Considerations 5. Analysis and Further Considerations

5.1. Introduction

Since undertaking the consultation process, the Council has been able to reflect on and further analyse many of the factors that need to be considered in trying to drive more uptake of centralised arrangements. Any policy proposals must take into account the nature of the OTC derivatives market, and also how FMIs might interact with this market. It has also become apparent that the interaction of the OTC derivatives market with other financial markets significantly complicates any decision-making in this area. This section sets out some of these considerations.

5.2. The Nature of the Australian OTC Derivatives Market

Through the consultation process, the Council was able to develop a deeper understanding of Australian OTC derivatives market practices and participants. The volumes and types of transactions undertaken in Australia are small by global standards, comprising only around 2 per cent of global notional turnover. But as is the case in most countries, Australian-located OTC derivatives market participants undertake a large amount of cross-border activity. The technology supporting financial markets means that a participant located in Australia can very easily transact with a participant located offshore. It is common for foreign-owned market participants active in the Australian market to centralise the booking of their global OTC derivatives transactions in an offshore entity. This cross-border activity permits greater economies of scale and scope than might otherwise obtain in the domestic market alone. For instance, the ability of locally based market participants to interact with offshore counterparties increases the range of available counterparties and products, in turn enhancing the depth and breadth of the Australian market.

The largest dealers in the Australian OTC derivatives market are perhaps a more heterogeneous group than in major offshore financial centres. While the local market is served by a range of foreign banks with significant operations around the world, the larger Australian-owned banks – with generally more domestically focused operations – also play an important market-making role. Australia has a very large managed funds industry, but within this more derivatives-intensive managers (such as hedge funds) comprise a very small share of activity. Financial institutions vary widely in the type of derivatives they use. Some participants only use simple single-currency interest rate derivatives to hedge interest rate risks. Others use a range of single- and cross-currency derivatives, FX derivatives and credit derivatives to manage and synthesise exposures. Derivatives usage by corporates is widespread, covering single- and cross-currency interest rate, FX and commodity derivatives.

Among users of derivatives, it is very common for positions to be collateralised or otherwise secured against the net mark-to-market valuation of all outstanding exposures, rather than collateralised by individual derivatives class.

5.3. Capital Charges and Incentives for Central Clearing

In late 2011 APRA collected counterparty exposure data from several Australian banks active in OTC derivatives, in order to understand the nature of the exposures and the potential impact of the Basel III rules. When comparing the bilateral and the CCP frameworks, there are two opposing effects that need to be considered. On the one hand, the central clearing of certain standardised OTC derivatives is likely to lead to reduced netting within current bilateral portfolios. Counterparty exposures may increase, depending on the proportion of existing bilateral portfolios that are moved to central clearing or that remain bilateral. In addition, clearing through CCPs can increase the demand for collateral, since initial margin will need to be posted. On the other hand, multilateral netting can reduce the net counterparty exposure of cleared products and thereby reduce capital requirements.

The data suggest the following tentative conclusions:

• The notional exposures are dominated by single-currency interest rate products. However, these tend to generate lower counterparty risk than other products not currently able to be centrally cleared, such as cross-currency interest rate swaps and FX derivatives.
• Central clearing of single-currency interest rate derivatives is likely to result in a requirement to post additional collateral to meet initial margin requirements.
• Assuming the final Basel III rules are such that clearing members are not dis-incentivised to clear client trades, the data suggest that the capital rules will provide sufficient incentive for Australian banks to centrally clear transactions.

However, it is difficult to be definitive in drawing conclusions from the data provided, as any analysis of capital incentives and liquidity impacts for central clearing is complicated by several factors:

• It is not possible to know how banks will adjust their current bilateral and centrally cleared portfolios given potential variations in the scope of mandatory clearing across jurisdictions, Basel III capital requirements for bilateral trades, the CCP rules, and possible future changes in margin requirements. However, it is expected that banks' activities will change as they consider the need to minimise collateral requirements and capital costs.
• Separately, international regulatory work on margin requirements for bilateral trades (discussed in section 4.4.5) is currently under way, and will not be finalised until mid 2012 at the earliest.
• The analysis has been done at a particular point in time of a sample of the banks' largest counterparty credit exposures, and the estimated effects will be heavily dependent on market levels at that point in time.

Any conclusions must be preliminary, given that a number of assumptions had to be made in the analysis. While the intention of the Basel III rules is that there will be sufficient incentives for central clearing, the Council acknowledges that there is some uncertainty around how this will play out in the Australian market. If capital incentives did not prove sufficient to move the market in the intended direction within a satisfactory timeframe, other regulatory measures may be necessary.

5.4. The Design and Nature of Centralised Infrastructure

In developing a policy response to the question of how to increase the use of multilateral FMIs, the design and economics of these arrangements are important considerations.

Given the network externalities of an FMI, it is likely that once a sufficiently large proportion of the market uses this arrangement a tipping point will be reached and other market participants will choose to join. As discussed in section 2.6, this means that once a particular FMI is established, it can be difficult for the market to move to an alternative arrangement. While this can be an advantage to an incumbent provider, the longer-run viability of an FMI is still generally contingent on its having continued support from market participants. An FMI's systems will need to be compatible with participants' in-house systems, and therefore require cooperation both in establishing itself and in making changes over time. Similarly, the risk management arrangements of an FMI will typically depend on participant cooperation – it is usual practice for staff from market participants to sit on risk committees and review boards of FMIs to provide necessary market expertise. Feedback from market participants can also help shape an FMI's ongoing product innovation.

It would be preferable, therefore, if any regulatory intervention could be designed so that problems of market coordination were overcome, but the symbiotic nature of the relationship between FMIs and participants was not disrupted. It would also be important that regulation was flexible enough to adapt to, and accommodate, an evolving market structure. The organisation and design of FMIs, the activity of market participants, technological developments, and the wider regulatory environment are all somewhat endogenous. It would be desirable if regulation could be implemented in a way that did not overly restrict market evolution and innovation.

The strong economies of scale and scope of FMI services, as well as network effects, are likely to mean that – absent regulatory constraints – market participants will coalesce around a relatively small number of infrastructure providers. Given the global nature of the markets for many OTC derivatives, it is likely to be the case that many of the transactions undertaken in Australia could be supported by infrastructure located either in Australia or in offshore jurisdictions. It is also possible that, given the relatively small size of the Australian market, local participants could be more likely to use FMIs located in offshore jurisdictions than might be the case in jurisdictions that are home to larger markets. The time zone differences with the largest global markets in North America and Europe could, however, pose operational challenges.

Cross-border activity of FMIs also poses significant jurisdictional and oversight challenges, which need to be given careful consideration in developing reform proposals. Questions such as legal compatibility, protections for clients, and supervisory requirements have been major issues for many other jurisdictions, including large markets such as the US. While various proposals have been considered in individual jurisdictions and international fora, there is very little practical experience to guide regulators in the best way to accommodate the cross-border activity of FMIs.

5.5. Non-centrally Cleared Transactions

It is clear that not all OTC derivatives will be able to be centrally cleared. However, it remains important that these transactions are robustly risk managed.

The bilateral nature of these non-centrally cleared transactions provides significant flexibility in tailoring agreed terms to individual circumstances, which can be of benefit for many counterparties. However, a consequence of this flexibility is that parties' relative negotiating power can be a factor in determining the strength of risk management arrangements. For instance, high volume clients may be able to negotiate more favourable terms regarding collateral agreements. Over the lifetime of a contract, commercial considerations can also be a factor in determining how strongly contractual provisions are enforced. The potential for an inadequate application of risk management standards is therefore a key disadvantage of bilateral arrangements. This is an area where it could be appropriate for regulators to mandate minimum requirements.

Collateralisation agreements are widely used across the financial sector in Australia; non-financial usage is much lower. For most classes of market participants, collateralisation agreements generally only cover mark-to-market changes in exposures; in contrast, centrally cleared arrangements require initial margin to also be posted. An important role of initial margin is to serve as a protection against replacement cost risk, should a counterparty default on a position and prices move significantly before a non-defaulting counterparty is able to re-establish a position in the market. Highly leveraged and active derivatives end users, such as hedge funds, will often post an ‘independent amount’ to their brokers that serves much the same purpose as initial margin in a centrally cleared market, though this is an exception to wider market practice. However, since initial margin would tend to net out for positions between banks and other large counterparties, collateralisation agreements between these types of counterparties often do not require initial margin payments at all. While in these cases it would be possible for initial margin to be held at a third party, this has not been a widespread practice.

The traditionally diffuse nature of the OTC derivatives market has also hindered the development of standardised arrangements that might facilitate risk management enhancements. In-house and third-party vendor systems have been developed to streamline the management of some transaction lifecycle events such as trade confirmations, mark-to-market valuations, collateral management, portfolio reconciliation and settlement of cash flows. But often the effectiveness of these depends on how widespread they are used, and the degree of standardisation in other systems.

These disadvantages in part explain why central clearing arrangements can be preferable. However, recognising that some participants will continue clearing some transactions on a bilateral basis, regulatory steps to impose minimum requirements and drive additional standardisation in some aspects could be appropriate for some non-centrally cleared transactions. Imposing margin requirements may also reduce incentives to avoid any central clearing requirements.

5.6. Implications for Other Financial Markets

Changes in clearing arrangements for OTC derivatives are likely to result in a significant volume of collateral being posted to central counterparties as initial and variation margin. With many counterparties clearing derivatives transactions through members of CCPs, these reforms will see clearing members handle (and hold) larger volumes of client collateral. For non-centrally cleared transactions, any increase in collateralisation (whether initial or variation margin) will similarly see many market participants posting and holding larger amounts of collateral.

The relative shortage of high-quality liquid assets in Australia could pose a challenge for domestic market participants. Central counterparties generally only accept the highest quality collateral, which means that a pick-up in the extent of central clearing is likely to increase demand for such assets in Australia. Any increase in the use of initial margin for non-centrally cleared OTC derivatives would add to this. The introduction of the Liquidity Coverage Ratio (LCR) as a part of Basel III will also increase demand for high-quality liquid assets.

The increased demand for relatively scarce assets that can serve as collateral for initial margin will inevitably increase the demand for collateral management and collateral transformation services. Tri-party collateral management services aim to use the pool of available collateral more efficiently and are usually provided by private financial institutions and central security depositories. Collateral transformation is usually achieved in the interbank market through repurchase transactions. Banks providing collateral transformation services manage their risks through haircuts that increase as the quality of the collateral decreases. They have also traditionally generated income by on-lending the securities that they have taken as collateral. Banks are also increasingly entering into collateral swaps with other institutions, such as pension funds, to obtain high-quality liquid assets.

The financial crisis has highlighted the risks inherent in these activities, which form an important part of what is known as the shadow banking system. Regulators and supervisors have responded in a variety of ways. Domestic regulators and the international regulatory community have made a number of proposals to improve the resilience of repo markets. For example, the Federal Reserve Bank of New York has proposed reforms to tri-party repo arrangements in the United States to mitigate the intraday liquidity risks that are concentrated in two large financial institutions. Other central banks have taken steps to encourage greater use of CCPs for repo transactions in their markets. At the international level, many of the Basel III roposals are designed to ensure that the provision of lines of credit, which are a common feature of prime-brokerage relationships, appropriately incorporate a price for liquidity risk. The FSB has workstreams looking at ways of reducing the risks inherent in securities lending and repo markets; and the subject of protecting client collateral is being considered in a number of fora, including the working group on non-centrally cleared derivatives (see section 4.4.5). Where these reforms restrict the extent to which financial institutions reuse collateral, the shortage of collateral discussed above will be even more acute.

5.7. Clearing Participants and Client Money Considerations

As larger numbers of market participants post margin to support OTC derivatives positions, it will be important to ensure that segregation and portability arrangements allow these participants to maintain their hedges and/or regain posted collateral in the event their bilateral counterparty or clearing member defaults. Ensuring the effectiveness of these arrangements is particularly important where a counterparty's collateral is commingled with that of other counterparties (whether clients, or a dealer or clearing participant). Otherwise, a counterparty default might mean these market participants are exposed to market, credit and liquidity risks which, depending on the circumstances, could have systemic implications. At the same time, protections available to a counterparty posting collateral should not interfere with the other counterparty's capacity to secure and exercise claims over this collateral in the event of the other party's default.

In Australia, these arrangements are set out in the ‘client money rules’ of the Corporations Act (Division 2 of Part 7.8). All money paid by clients to Australian Financial Services Licence (AFSL) holders, including licensees operating in OTC and exchange-traded markets, are subject to these rules. Most clearing participants of Australian-licensed CCPs would be required to hold an AFSL (though some are exempt). This means that, in the case of centrally cleared transactions, the operating rules of the CCP and the client money rules will both apply to clearing participants and determine how clearing participants should handle client collateral. For non-centrally cleared transactions, it is the client money rules alone that regulate arrangements for initial margin posted to an AFSL holder. As part of a review of the effectiveness of these provisions, a discussion paper was issued by the Treasury in November 2011, with consultation closing in February 2012.^[1] Although the paper was most focused on retail OTC transactions, many of the issues and questions raised are also relevant to wholesale OTC derivatives transactions and therefore will inform the Council's thinking in this area.

In addition, the central clearing of OTC derivatives transactions raises questions that were not specifically posed in the Treasury discussion paper – for instance, how clearing members and CCPs are required to handle and protect client collateral, treatment of client collateral in the bankruptcy of a clearing member or CCP, and account portability.

Protection for collateral posted as margin, especially initial margin, may need to be reviewed in light of other jurisdictions' collateral rules and insolvency rules, whether clearing participants for Australian entities are subject to overseas regulation, and how margin posted by Australian entities may be affected by these arrangements. A recent instance of the importance of these questions is the default of MF Global.

Where clearing is taking place through an offshore CCP, it is quite likely that some Australian end users will be posting collateral to a clearing participant that is a foreign entity. The Council notes that ASIC class orders currently exempt some of these overseas entities from the requirement to hold an AFSL, and that it may be appropriate for this exemption to be revisited – particularly if a clearing participant is clearing a significant proportion of an Australian market. While the Council would not be looking to duplicate regulation, it would be important to understand how a foreign-based entity's home regulation would apply to transactions involving Australian market participants.

Any changes to the client money rules would need to be considered in light of other initiatives affecting CCP regulation under consideration by the Council. These include the Council's review of FMI regulation in Australia and the revised CPSS-IOSCO principles due for release in coming months. Since the regulatory initiatives under consideration will likely require CCPs and industry participants to undertake potentially significant operational and systems changes, this may be an opportune time to implement enhanced protections for clients. In particular, there could be scope for changes to CCP and clearing participant account structures to be reworked.

Currently, there are three types of account structures in general use for the handling of collateral posted by members of CCPs and their clients: the ‘complete’ or full physical segregation model, legal segregation with operational commingling (LSOC), and the ‘futures model’. At least some CCPs that clear OTC derivatives will likely offer more than one account structure to their clearing members and the clients of clearing members, and as the market develops, CCPs may offer variations of these account structures.

• Full physical segregation

  Under the full physical segregation model, collateral posted by clients is held in individual accounts, fully segregated from the accounts of clearing members and other clients. The use of individual accounts is expected to provide the most robust protection against what is described as ‘fellow-customer risk’. This model is also expected to facilitate account portability and timely distribution of collateral that has not been ported, as the account structure is expected to give the CCP visibility of clients' positions and attached collateral and ensure the CCP has access to client collateral.

  However, the full physical segregation model may entail the highest operating costs, and clearing members may be expected to pass these costs on to their clients.

  In Europe, EMIR requires CCPs and clearing members to offer full physical segregation as an optional account structure to clearing clients, for a reasonable commercial cost.

• Legal segregation with operational commingling

  Under the LSOC model (a gross omnibus approach), client margin is passed directly from a clearing member to the CCP without netting across client positions. The clearing member, as well as the CCP, is required to maintain legally segregated records of client positions and collateral. However, client collateral is held by the CCP in an omnibus account. The CCP will have limited or no recourse to client collateral in the event of a clearing participant default. This segregation arrangement is intended to provide some protection against ‘fellow-customer risk’ and facilitate account portability, though the protections for clients may be less robust than under the full physical segregation model.

  The LSOC model may entail higher costs than the futures model, but the costs may be lower than the full physical segregation model.

  The CFTC issued final rules under the Dodd-Frank Act requiring Futures Commission Merchants (FCM, or clearing members) and Derivatives Clearing Organizations (DCO, or CCPs) to offer the LSOC account structure to clearing clients.

• Futures model

  Under the futures model (a net omnibus approach), all client collateral is pooled by the clearing member, which posts to the CCP a net margin requirement calculated across its entire client portfolio. There is no requirement for the CCP to maintain legally segregated records of client positions and collateral. This model is expected to provide the lowest level of protection against ‘fellow-customer risk’, and may reduce the likelihood of account portability compared with the other two models.

  The futures model is expected to entail lower margin costs for the clearing members, which may lead to lower costs for their clearing clients.

Clearly each of these models involves trade-offs between client protections and operational and financial efficiencies. Any proposed reforms to the client money rules would need to ensure they have the capacity to accommodate different business models across OTC and exchange-traded markets, and the range of account structures that may be used by FMIs. While the Council is particularly interested in client protection considerations, it would like to understand further the wider implications of any shift in clearing arrangements before taking a position on this issue.

Footnote

Treasury (2011), Handling and Use of Client Money in Relation to Over-the-counter Derivatives Transactions, November. Available at <http://www.treasury.gov.au/contentitem.asp?NavId=&ContentID=2231>. [1]