OTC Derivatives Market Reform Considerations 3. Consultation

In June 2011 the Council issued a discussion paper that sought to better understand how greater use of CCPs might be promoted in the Australian OTC derivatives market. The paper set out some of the advantages and disadvantages of central clearing, and raised the question of whether Australian regulators should prefer central clearing of markets that were systemically important within Australia (such as Australian dollar-denominated interest rate derivatives) to take place through an Australian-located CCP. Around 30 written submissions were received in response to the paper and numerous meetings were held, including roundtable discussions in Sydney, Melbourne and Brisbane. Participants in these meetings included both Australian and foreign-owned banks, credit unions and building societies, operators of financial market infrastructure, fund managers and institutional investors, legal and advisory firms, large non-financial corporations, government borrowing authorities and industry associations. A list of consultation parties is provided at the end of this paper.

The discussion paper set out a number of propositions, namely:

• that in the absence of Australian regulatory action, domestic CCP solutions may not emerge
• that where a market is of systemic importance to Australia, a move to offshore central clearing might introduce risks to the Australian financial system that do not currently exist
• that the Council agencies considered the market for Australian dollar interest rate swaps to be systemically important within Australia
• that in light of this, the Council agencies were considering the case for a requirement that those instruments be centrally cleared, and as part of that were considering whether such clearing should take place domestically.

Although the primary focus of the discussion paper was on central clearing, some similar issues arise in considering how best to promote a move to other centralised arrangements such as trade repositories or trading venues. Accordingly, the consultations held to date have also provided the Council with information relevant for considering other elements of the international reform agenda for OTC derivatives markets.

3.2. Issues Raised During Consultation

3.2.1. General comments on the international regulatory push toward central clearing

There were many broad statements of support for the intent of the G-20 commitments. However, there were also concerns about the manner in which central clearing is to be implemented. In particular, there were concerns about fragmentation of global markets, and regulatory inconsistencies and complexities that may arise in a world where jurisdictions have potentially conflicting central clearing mandates.

3.2.2. Products to be included in a mandatory central clearing requirement

Almost all stakeholders agreed on the broad features of an OTC derivatives product that would make it centrally clearable and therefore eligible for inclusion in a mandatory central clearing requirement. These features are those that would allow for the risks of the product to be managed by a CCP, such as: standardisation and a lack of complexity in the terms of the contract; liquidity and broad usage; and readily available pricing information. It was also suggested that any mandatory central clearing requirement define its product scope carefully rather than use a broad definition of ‘derivative’ such as that used in the Corporations Act 2001.

There was broad agreement that Australian dollar-denominated interest rate derivatives were one class of derivatives for which a mandatory clearing requirement could be viably imposed. It was also generally agreed that FX swaps and forwards could be exempted (in line with the proposed exemption from the requirements of the Dodd-Frank Act announced by the US Treasury). A number of stakeholders also called for intra-group transactions to be exempted.

Attention was drawn to some specific derivatives markets, where it was argued that mandatory central clearing could substantially improve risk management practices.

3.2.3. Participants to be included in a mandatory central clearing requirement

Most stakeholders argued that any mandatory clearing requirement should apply only to participants which pose systemic risk, and that exemptions should apply for smaller users of derivatives and institutions using derivatives for hedging purposes only.

A number of stakeholders expressed concerns about the implications of central clearing for corporate and other non-financial users of derivatives. It was argued that the collateral requirements of central clearing are likely to significantly increase costs for these users and possibly discourage them from hedging.

3.2.4. Costs of moving to central clearing

There was consensus that a move to central clearing could increase the cost of dealing in OTC derivatives. Large international banks noted the costs that might be incurred if swap portfolios were cleared across multiple CCPs; such costs might arise from legal complexity, un-netting of portfolios and an increase in collateral requirements. Some stakeholders also questioned whether there would be sufficient securities available to meet the substantial increase in collateral requirements.

3.2.5. Clearing through an Australian CCP

The arguments in favour of a domestic CCP came mainly from Australian stakeholders, with the benefit of Australian regulators having direct oversight of the CCP commonly cited. Other benefits identified included that the design of a domestic CCP (e.g. acceptable collateral, operational timelines, participation requirements) would be tailored to Australian institutions. The scope for margin offsets between OTC and exchange-traded products was also identified. However, some respondents' support for a domestic CCP was conditional on this not reducing their capacity to engage with international counterparties.

Almost all of the stakeholders that addressed the domestic CCP issue put forward at least one argument against a domestic CCP. The most common of these arguments related to the possible fragmentation of the global market for Australian dollar-denominated interest rate derivatives. Large international banks argued that fragmentation would increase their costs, and possibly lead them to not participate in an Australian CCP. A number of these banks suggested that they would transact wherever the netting and liquidity benefits were greatest. They also noted the legal and regulatory complexity that could arise for them should they face conflicting clearing requirements in different jurisdictions. It was argued by a number of stakeholders that Australian institutions might be put at a competitive disadvantage if they were forced to clear through a domestic CCP serving a smaller, less-liquid fragment of the global market.

Some stakeholders argued that the set-up costs of a domestic CCP would be significant, and possibly not warranted given the Australian market could be served by existing offshore CCPs. However, other respondents suggested that the set-up costs may not be as high as might be expected.

Rather than simply putting forward arguments for or against a domestic CCP, many stakeholders discussed the circumstances in which requiring domestic clearing or setting up a domestic CCP would be acceptable. These were mainly centred on ensuring or facilitating international participation in a domestic CCP. A number of stakeholders called for any domestic CCP to meet the requirements for recognition that are being set down by US and European Union (EU) regulators, such that foreign banks could meet their home-regulator clearing requirements by clearing in Australia. Related to this, it was argued that before proceeding with a domestic clearing requirement, Australian regulators should ensure they have a full understanding of the requirements that offshore regulations would impose on foreign institutions that participate in the Australian market. Some stakeholders also called for clearing of OTC products to be kept separate from a CCP's other businesses.

3.2.6. Risks of clearing through an offshore CCP

Most stakeholders were sympathetic to the Council's concerns about the clearing of markets systemically important to Australia through CCPs located offshore. Submissions noted the importance of local regulators being able to manage systemic risk. Respondents differed in what this might entail: some argued that the location of collateral was the most important issue, while others argued that full domestic operational capacity was required. Others suggested that Australian regulators could never assert full control over the businesses of Australian institutions or systemically important markets, because many transactions currently occur (and will continue to occur) offshore.

Some Australian financial institutions noted concerns about counterparty credit risk to their clearing member should they participate in a CCP indirectly. There were also concerns about legal protections for posted collateral, particularly when that collateral is posted with an offshore-based entity.

A number of stakeholders called for a (possibly international) regulatory plan for handling a serious default in a CCP.

3.2.7. Segregation and portability, and other legal issues

Submissions from industry bodies argued against prescribing minimum standards (via law or regulation) for segregation and portability, suggesting instead that clearing members and CCPs should be free to contract on these matters. Other submissions suggested that legal protections around a CCP's ability to port client positions require clarification. A number of stakeholders called for the extension of protections under Australian netting and insolvency legislation to all of a CCP's default management processes (e.g. position close-out and transfer). It was also suggested that the operation of offshore CCPs be given recognition under Australian law.

Some stakeholders called for examination of other issues related to clearing through an offshore CCP, including tax consequences and the scope for conflict between Australian and foreign legal requirements.

3.2.8. Interoperability

Almost all of the stakeholders that addressed interoperability argued that, while it could provide market efficiency benefits, it was unlikely to occur in the short term. One submission argued that interoperability was unlikely to be practicable for interest rate derivatives, while another raised concerns about the consequences of interoperability for risk in the financial system.

3.2.9. Extraterritoriality

Most stakeholders recognised the possible extraterritorial effects of the regulatory regimes being developed offshore, and called for the Australian response to be consistent with, and recognised by, those regimes.

3.2.10. Basel III capital framework

Most stakeholders argued that the Basel III capital rules will create an incentive to move to central clearing because exposures to a CCP will generally attract a lower capital charge than other bilateral exposures. However, some submissions expressed uncertainty as to whether the new capital charges will result in a significant move to central clearing before the end of 2012.

Some Australian financial institutions noted that bespoke OTC derivatives used to hedge specific risks might become too costly to deal in from a capital charge perspective. This may lead to some end users (most likely corporates) becoming either unwilling or unable to hedge risks appropriately.

3.2.11. Suggested ways forward

A number of stakeholders made specific recommendations for the way forward for the Australian market. Some stakeholders suggested that regulators impose mandatory trade reporting requirements first, and then use these data to inform a decision on whether mandatory central clearing was desirable (and whether it should or could occur through an Australian CCP). Another stakeholder suggested a comprehensive scenario modelling exercise involving the industry. Some Australian stakeholders suggested forming an industry and regulatory working group to design a domestic CCP solution (should the regulators require domestic clearing).