OTC Derivatives Market Reform Considerations 6. Proposed Policy Approach

6.1. Introduction

Drawing on the foregoing discussion, the Council recommends the proposed policy approach set out below.

Broadly the Council considers that it is preferable for an increased uptake in centralised arrangements for OTC derivatives to be an industry-led initiative, with additional impetus coming from some changes to incentives. However, to ensure that desired outcomes are reached in acceptable timeframes, a capacity to mandate certain obligations should also be available, though any such decision should only be made after thorough consultation. It is acknowledged that both the relatively small size and the cross-border nature of the Australian market might pose a challenge to the success of any domestic regulatory initiative. However, since this is also the case for most other countries, it is in all jurisdictions' mutual interests that regulatory reform proposals for OTC derivatives markets are as harmonised and coordinated as possible. Global harmonisation would also reduce the risk of disruptions to cross-border activity which contributes to the efficiency and liquidity of domestic markets.

The following sets out the proposed approach for the three elements under discussion.

6.2. Trade Repositories

Trade repositories are a relatively new class of financial market infrastructure, and many market participants will be unfamiliar with their capacity. For individual market participants, centralisation of trade data may assist them in understanding their own risks and exposures. Given the use of standardised reporting formats, the use of trade repositories is also likely to encourage operational efficiencies in post-trade processing, either by the trade repository or by other service providers that use the data maintained by the trade repository. If trade information is submitted by both counterparties to a trade, data from the trade repository can be used to facilitate electronic trade matching and confirmation, settlement of payment obligations, trade novation and affirmation, portfolio compression and reconciliation, and collateral management. With the shift to automated post-trade services in the Australian market having been slower than in some overseas markets, there is significant scope for participants in the Australian market to benefit through improved risk reduction, operational efficiency, automation and legal certainty.

Reporting to trade repositories should facilitate the maintenance of a reliable and comprehensive source of information on participant trading activity, which would be useful to many regulators in performing their respective functions. It is expected that this increased transparency will assist authorities in identifying vulnerabilities in the financial system and, more broadly, to develop well-informed policies to promote financial stability. Information from trade repositories will be particularly useful in times of financial distress, where rapid and reliable access to accurate data may assist prudential and systemic regulators in their functions. From a market supervision perspective, transaction information stored in trade repositories in some product classes in particular, such as equity derivatives and credit derivatives, has the potential to assist investigations into market misconduct.

Notwithstanding the substantial benefits that could accrue to Australian market participants in using trade repositories, other considerations might slow the uptake of these services. For instance, participants may need to make some investment in systems in order to pass data to a trade repository. Other participants may be concerned about commercially sensitive information being held by a third party. These impediments might be overcome should a sufficiently large share of the market move to use trade repositories, given the strong network effects at work in financial market arrangements and conventions. But should this not occur, and since the effectiveness of trade repository services is maximised when all transactions of all counterparties are recorded, there may be a case for regulatory action to promote universal uptake of trade repositories for the collective benefit of market participants. For regulators, as complete an information set as possible enhances their understanding of the OTC derivatives market. In addition, as reporting to trade repositories will give regulators a more accurate understanding of market activity and participation, these data will underpin regulators' consideration of the merits of other regulatory reform proposals for OTC derivatives.

To that end, the Council recommends that a legislative framework be introduced to enable the imposition of a mandatory reporting requirement in respect of certain products and participants. However, thorough public consultation should be undertaken prior to the implementation of any such obligations. Given the reliance of both market participants and regulators on the transaction information collected and retained by trade repositories, and the commercially sensitive nature of this information, it is important that operators of these types of FMIs meet high standards of operational risk management and integrity. Therefore, it is important for these entities to be licensed and for regulators to be able to effectively supervise and hold accountable trade repository operators. The revised CPSS-IOSCO principles will be important in this regard.

International encouragement of trade repositories has seen the emergence of trade repositories for each class of OTC derivatives – credit, interest rates, equity, commodity and foreign exchange. To date the dominant trade repository operator in each of these classes has been DTCC, which levies fees on a cost-recovery basis. However, other providers are either actively or prospectively developing similar services, for which their commercial terms are not yet known. It may be that multiple trade repositories in a given asset class can co-exist. The Council would prefer to leave questions of industry structure to the market to decide, and the intention of any mandatory reporting obligations would be that they could accommodate a wide range of industry outcomes. Nonetheless, the appropriateness of an available trade repository's terms and conditions would likely be a factor in any decision to mandate trade reporting, which in turn may have an effect on industry structure.

To allow for competition and to facilitate the exploitation of potential economies of scale in trade repository operations, it would be appropriate to allow trade repositories to operate across borders. Indeed, the Council agencies understand that some Australian ADIs, other AFSLs and end users are already reporting some OTC derivatives transactions to overseas trade repositories. Consequently, it would be expected that reporting entities would have the ability to select from appropriately licensed trade repositories, including trade repositories located in offshore jurisdictions subject to certain conditions. These would include regulators' ongoing access to data, and the data protections available to participants.

6.3. Clearing Arrangements

The Council has been of the view for some time that central clearing is a more robust arrangement for OTC derivatives markets than bilateral arrangements, and that therefore a transition to CCPs where possible should be encouraged. However, the Council also acknowledges that many OTC derivatives cannot (currently at least) be centrally cleared, and that central clearing may not be appropriate in all situations.

In the first instance, rather than regulators implementing a mandatory regime to force the move of transactions to CCPs, the Council would prefer to rely on economic factors to drive this transition. Australian regulators will be applying internationally agreed standards for prudential capital charges, which are being increased for banks' exposures that relate to non-centrally cleared contracts. International regulators are also working on proposals to strengthen risk management practices for non-centrally cleared OTC derivatives by introducing global minimum standards on margin requirements. As well as reinforcing the incentive to centrally clear, this would also serve to mitigate the risks involved in bilateral clearing of OTC derivatives. Australian regulators would intend to adopt these standards as appropriate once they are finalised – the agencies will consult on this as these proposals become more concrete.

The Council expects that these measures will prove effective in sending a price signal to all market participants that increases the relative cost of non-centrally cleared transactions over that of central clearing. In the short run this should be particularly effective in encouraging larger market participants to move to central clearing arrangements, which should in turn make a significant contribution to systemic risk reduction. Given the network externalities of clearing arrangements, once a sufficient number of large market participants begin centrally clearing it is likely that other market participants will also choose to centrally clear. A sustained differential in the relative prices of centrally and non-centrally cleared arrangements should also provide an incentive for market participants to continue searching for central clearing solutions for products where this is not currently available.

While the Council is looking to encourage central clearing in general, it accepts that it is appropriate for some market participants to retain bilateral clearing arrangements. For instance, smaller participants may find that managing the liquidity risks associated with central clearing (e.g. in relation to the posting of variation margin) outweighs the counterparty risk management benefits of central clearing. For other participants, the need to retain bilateral arrangements for transactions that are not currently eligible for central clearing may mean that central clearing of related transactions could in fact reduce netting opportunities. Over time, though, this preference for bilateral arrangements should become weaker as a result of the changed relative price signals noted above. The international standards currently being developed around minimum margin requirements for non-centrally cleared transactions will be implemented in Australia as appropriate. This should help mitigate some of the risks that would remain if these transactions remained outside of CCPs.

A transition to greater central clearing of OTC derivatives is a significant change to market practices and organisation. For example, it will require a host of changes to legal and operational arrangements, and it will be likely to result in changes to many market participants' balance sheets since larger amounts of collateral will be required to be posted and received. The highly cross-border nature of the OTC derivatives market makes this adaptation an even more complex process. Allowing time for the work-through of changed price signals will permit the financial system to reconfigure itself in an organic way, with scope for regulatory guidance or intervention as necessary.

However, the magnitude of the changes necessary may result in some participants making the transition at a slower-than-desirable pace. A significant difference in the pace of change among market participants, particularly larger intermediaries, could increase coordination problems and result in a transition to central clearing that was less orderly than desirable. It is also important that the take-up of central clearing occurs on a timeline that is satisfactory to the Government and regulators. To that end, it is appropriate that there be a capacity to mandate central clearing if necessary.

The Council does not propose that exemptions for any particular class of derivatives or participants be embedded in legislation. Rather, any decision to introduce a mandatory obligation for a particular class of derivatives would be accompanied by thorough consultation, with wide scope to make exemptions as appropriate. The Council considers it important that a high degree of flexibility be adopted in developing mandatory obligations, to enable Australia to develop a regime which is responsive to ongoing developments in clearing arrangements and in international regulation. A flexible approach would also allow regulators maximum scope to tailor any mandatory requirements to the particulars of a given market. There would be benefit in having scope to implement both ‘bottom-up’ and ‘top-down’ approaches, such as those adopted in the EU and US. A mandatory obligation could be imposed that required central clearing of a prescribed class of products (even in the absence of a CCP licensed in Australia as being able to offer this service). As and when such a CCP did become licensed, it would then be mandatory to clear through this entity. If no CCP emerged through a ‘bottom-up’ process, regulators could take a ‘top-down’ approach and call for expressions of interest from CCPs to offer such a service.

It would be the intention of Australian regulators that local clearing obligations be consistent, as appropriate, with international requirements. While the Council is looking to provide as much flexibility as possible to entities to establish central clearing arrangements, it is the intention of the Council that the Australian regime has an equivalent effect to that of offshore regimes. Depending on how quickly the domestic market moves towards central clearing of its own accord, regulators might look to implement a mandatory clearing regime that applied to the largest institutions in Australia within a short time horizon, since it is here that central clearing will have the greatest impact on systemic risk reduction.

If a mandatory clearing obligation were to be imposed, regulators would need to be conscious of the effect this might have on the relationships between dealers, clearing participants, end users and CCPs. Although the ultimate aim is for more transactions to be centrally cleared, ideally this transition would take place with maximum choice available to participants on issues such as the commercial terms of agreements, the choice of counterparties, and operational changes that might be needed. The Council would prefer that central clearing arrangements evolve in response to the commercial considerations of market participants and infrastructure providers.

An important question raised in the Council's June 2011 discussion paper was whether central clearing of markets systemically important within Australia should be cleared by a CCP located within Australia. The Council has come to the view that this need not be the case, based on current information and expectations. Domestic and international regulatory developments discussed elsewhere in this paper have increased agencies’ comfort around the prospect of increased clearing by offshore CCPs, as discussed in section 7.3. As well, given the rapidly changing global landscape for central clearing, the Council would prefer not to unduly constrain market participants' choices as to clearing arrangements.

The Council would also prefer to have come to concluded views on client clearing arrangements before moving to mandate any clearing requirements. A related question is what quality and quantity of collateral might be needed to support a shift to central clearing (and margining for non-centrally cleared transactions) in Australia, and the consequences of this for the financial system more broadly. Depending on the degree of un-netting of positions (such as discussed in section 5.3), and the level of individual client account segregation, there could be a significant uplift in the amount of collateral required to be posted to clearing participants and CCPs. Australia is facing a challenging situation on this front, with restricted supply of, and high demand for, good quality local currency collateral.

6.4. Trade Execution

The third limb of the G-20 commitment to reform the OTC derivatives market is for transactions to take place, where appropriate, on exchanges or electronic trading platforms. It is important to have in place a legislative framework which would enable this commitment to be implemented expeditiously. Accordingly, it is intended that a legislative framework be introduced which will enable the development of detailed subsidiary legislation and the imposition of a mandatory trading requirement in respect of appropriate products.

However, at this stage the Council considers that it is premature to impose a mandatory trading obligation in respect of any products or participants. It is anticipated that transaction data from trade repositories will be required to effectively evaluate whether there are products for which it would be appropriate to mandate trading on an exchange or electronic platform. It is also anticipated that the move towards central clearing, which necessarily involves a degree of product standardisation, will organically give rise to an increase in electronic trading in products which are sufficiently liquid.

It is also important to recognise that there are likely to be costs associated with any mandatory requirement. These are likely to include costs to buy-side derivatives users and OTC derivatives market participants (such as trading technology and operational costs to connect with electronic trading platforms). It is also acknowledged that a decision to mandate trading in a product in which there is insufficient liquidity could result in an increase in bid/ask spreads, and even result in some users or market participants withdrawing from the market.

Given the size of the Australian OTC derivatives market and the presence of many international participants that are likely to be subject to trading requirements in other major jurisdictions, it is also expected that regulatory initiatives to mandate electronic trading in other jurisdictions will provide a significant impetus towards electronic trading by Australian participants in some products.