OTC Derivatives Market Reform Considerations 1. Introduction

Rapid growth in over-the-counter (OTC) derivatives markets over the past decade and longer has been accompanied by an increasing awareness of the systemic importance of these markets, and of the potential risks inherent in market practices. These risks were most starkly demonstrated during the peak of the recent financial crisis in 2008. As a result, authorities have been developing a global regulatory agenda to drive substantial reforms in the functioning of OTC derivatives markets.

The agencies of the Council of Financial Regulators have been considering reforms in the Australian OTC derivatives market for a number of years. In 2009 a survey of the domestic OTC derivatives market was published,^[1] and in June 2011 a discussion paper on central clearing was released as a basis for detailed consultation with interested stakeholders.^[2] At an international level, various standard-setting bodies have been developing proposals to strengthen OTC derivatives market practices and improve regulation in this area. The Financial Stability Board (FSB) has played an important role in coordinating much of this activity. In October 2010 the FSB issued a set of recommendations to guide jurisdictions in developing regulatory reform proposals in this area.^[3]

Government leaders have endorsed this agenda, most notably through commitments made at successive summits of the Group of Twenty (G-20) economies, of which Australia is a member. The most recent G-20 statement on this issue was at the Cannes summit in November 2011:

‘Reforming the over the counter derivatives markets is crucial to build a more resilient financial system. All standardized over-the-counter derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and centrally cleared, by the end of 2012; OTC derivatives contracts should be reported to trade repositories, and non-centrally cleared contracts should be subject to higher capital requirements … We call on the Basel Committee on Banking Supervision (BCBS), the International Organization for Securities Commissions (IOSCO) together with other relevant organizations to develop for consultation standards on margining for non-centrally cleared OTC derivatives by June 2012 …’^[4]

This reform agenda is setting in train changes to the global OTC derivatives market that are already having an impact on market participants in Australia. In response to this, and to consider how Australia's G-20 commitments might best be implemented, the Council agencies have been considering regulatory reform policy options for OTC derivatives market practices in Australia. In particular, the Council agencies have been considering how to promote an increased use of centralised infrastructure in the Australian market.

This paper sets out some conclusions of the Council on this matter, indicating where further work may be required. The Council's view is that, in the first instance, industry-led solutions should be the preferred route to increasing the use of centralised infrastructure within the Australian OTC derivatives market. Importantly, various regulatory and commercial incentives are playing out which should have the effect of driving the market towards centralised arrangements.

However, there is a risk that progress might be slow, particularly given the heterogeneous nature of the domestic market and the absence of an existing strong coordination mechanism. Given the systemic risks inherent in existing bilateral arrangements, slow progress on this front is undesirable. As well, it is important that the Australian market keeps pace with international developments. It may therefore be appropriate for regulators to have a capacity to mandate outcomes in this area.

An important consideration in the Australian market is its highly international nature, both in terms of the role played by foreign banks and the importance of cross-border capital flows. Given this, the Council has been considering whether infrastructure supporting the domestic market should be located in Australia, or whether offshore facilities should be accommodated. The Council has concluded that market participants' choices on this question should not be unduly constrained. In part, domestic and international regulatory developments have given the Council increased comfort that satisfactory arrangements around the use of offshore facilities can be developed. The paper sets out some considerations on this issue, as well as discussing where changes to the existing Australian regulatory regime might be warranted.

Footnotes

APRA, ASIC and RBA (2009), Survey of the OTC Derivatives Market in Australia, May. Available at <https://www.rba.gov.au/payments-system/ clearingsettlement/survey-otc-deriv-mkts/sotcdma-052009.pdf>. [1]

Council of Financial Regulators (2011), Central Clearing of OTC Derivatives in Australia, June. Available at <https://www.rba.gov.au/publications/consultations/201106-otc-derivatives/>. [2]

Financial Stability Board (2010), Implementing OTC Derivatives Market Reforms, October. Available at <http://www.financialstabilityboard.org/publications/r_101025.pdf>. [3]

G-20 Summit, Cannes, 4 November 2011, Final Declaration (article 24). Available at <http://www.g20-g8.com/g8-g20/g20/english/for-the-press/news-releases/ cannes-summit-final-declaration.1557.html>. [4]