Report on the Australian OTC Derivatives Market 6. Assessment and Recommendations

6.1 Introduction

Chapters 4 and 5 have set out the OTC derivatives landscape in Australia, and the current state-of-play of risk management practices and centralised infrastructure usage. This chapter considers further the merits of regulatory intervention to drive a greater uptake of centralised infrastructure, given the in-principle benefits of this that were discussed in Chapter 2. Recommendations around bilateral risk management are also discussed.

The regulators will also take into account whether imposing mandatory central clearing, trade reporting or trade execution requirements would enable Australia's regulatory regime to be recognised as comparable or equivalent to those of key overseas jurisdictions. This may enable Australian participants and financial market infrastructure to avoid a duplicated regulatory burden, with Australian entities being primarily regulated in Australia where sufficient equivalence or substituted compliance tests are met.

6.2 Trade Reporting

As discussed in Section 5.4.1, trade reporting is not well entrenched in the Australian OTC derivatives market. There is some evidence of an increased uptake in trade reporting by larger market participants, which the regulators welcome. In the near term some of the domestic and foreign participants in the Australian OTC derivatives market are expected to be required to report transactions executed in US and EU markets (or undertaken with US and EU counterparties) in compliance with regulatory regimes being developed in those jurisdictions. Outside of these requirements, however, an industry-led transition to trade reporting in the Australian market would not seem likely in the near term.

6.2.1 Benefits of increased trade reporting in Australia

As discussed in Section 2.3.1, the regulators consider that there would be substantial benefits to the efficiency, integrity and stability of the financial system if market participants were to use centralised trade repositories, including:

• increased capacity for market oversight and monitoring of risk concentration and other systemic risk indicators
• improved risk management for market participants
• enhanced market transparency
• greater operational standardisation.

Comprehensive trade reporting would also provide the regulators with detailed information to inform recommendations around potential future product class prescriptions and DTR design.

In principle, all product classes and participants might directly or indirectly benefit from these enhancements. However, it is likely that the most immediate benefit would be in higher turnover markets and for larger participants. As discussed in Chapter 4, markets in interest rate derivatives and FX derivatives are the most actively used in Australia; the credit derivatives market is also widely used. Within these, the bulk of turnover involves financial institutions, of which the vast majority of activity is facilitated by a relatively small number of dealers.

6.2.2 The domestic regulatory environment for trade repositories

The Derivative Transactions Bill currently before the Australian Parliament proposes the creation of an Australian licensing regime for trade repositories. The licensing regime will be supplemented with further detail to be prescribed via regulations, derivative trade repository rules (DTRRs) to be made by ASIC and, potentially, licence conditions (as is the case with the AML and CS facility licensing regimes).

The licensing regime for trade repositories envisages a single licence type for both domestic and offshore trade repositories (the legislation also provides for mandatory reporting obligations to require the reporting of OTC derivatives transactions to specified public authorities in the absence of a licensed trade repository). The trade repository licensing regime enables rules to be made which will provide legal safeguards around a trade repository's use of the data it is holding, and who may access these data.

Subject to the Parliament passing the Derivative Transactions Bill, ASIC would consult on rules for trade repositories and guidance for applicants for trade repository licences. Assuming these steps are taken in a timely fashion, details of the regime would likely be largely in place in 2013. It is anticipated that obligations on trade repositories would come into effect alongside guidance as to the licensing of trade repositories.

6.2.3 Considerations around mandatory trade reporting obligations

Currently there are no trade repositories licensed in Australia. As noted above, work is underway to develop a regulatory regime for these entities. Until it is clear that an Australian trade repository licensing regime and a trade reporting mandate will be established, it is unlikely that many Australian market participants will be willing to closely engage with trade repositories, or voluntarily commit to the operational changes needed to undertake trade reporting.

The provision of data to a trade repository requires that a market participant either has some direct connectivity to the trade repository, or can use an agent or other intermediary arrangement to transmit and access necessary information. Once a connection is made, it is likely that the ongoing marginal cost of utilising this connection will be low. However, there may be some costs associated with establishing systems that can efficiently capture the necessary information and transmit this to and from trade repositories. A market participant's unit cost of reporting trades will, therefore, in part be a function of its overall scale and level of activity.

Globally, trade repositories exist for interest rate, FX, credit, equity and commodity derivatives, with eight trade repositories currently in operation across a number of jurisdictions including Brazil, the EU, Hong Kong, India, Korea and the US. The preferred business model of many of these trade repositories would appear to be to broaden the product classes for reporting and the markets in which they operate, while remaining physically located in just one jurisdiction. It is considered likely that at least one existing offshore trade repository would wish to apply for an Australian trade repository licence once the licensing regime is settled.

For most OTC derivatives product classes, the vast bulk of transactions will typically involve at least one counterparty from the group of larger market participants. These larger firms may therefore be well positioned, operationally, to act as agents for counterparties in using trade repositories.

An impediment to the larger firms doing so, voluntarily or under the reporting mandate of another jurisdiction, could be the duty of confidentiality that banks and other larger market participants owe to clients under Australian law and under contract. Without the express consent of clients, banks may be unable to report the details of client trades to trade repositories in the absence of a regulatory provision that would allow the banks or market participants to report data without breaching such duties. This ‘opt in’ requirement could substantially slow the uptake in trade reporting in Australia, delaying the system-wide benefits discussed previously.

The issue of confidentiality is also relevant with respect to the reporting obligations that are being implemented in other jurisdictions. Many Australian and foreign participants active in the domestic market are also active in major overseas markets. There is a strong likelihood that, depending on the counterparties involved, some transactions undertaken in the Australian OTC derivatives market will have to be reported to trade repositories in accordance with offshore reporting obligations. In this regard, the Derivative Transactions Bill provides legal protections to entities that report to trade repositories in accordance with a mandatory obligation imposed under Australian law.

6.2.4 Recommendation

In the view of the regulators, having as high a proportion of OTC derivatives transactions as possible reported to trade repositories would enhance the efficiency, integrity and stability of the Australian financial system, for the reasons discussed earlier.

While there is some prospect of the largest Australian-based market participants voluntarily taking up trade reporting should a trade repository be licensed in Australia, it is unlikely that there would be a rapid uptake in reporting by smaller market participants. As noted above, there may be limits to voluntary uptake in trade reporting by Australian OTC derivatives market participants, especially where voluntary trade reporting involving smaller counterparties or clients is constrained for operational or legal reasons. If the legal constraints under Australia's legal framework limit domestic banks and other institutions from participating in offshore markets, this could potentially reduce the liquidity and efficiency of domestic OTC derivatives markets.

Given these various considerations, the regulators recommend that the government consider a broad-based mandatory trade reporting obligation for OTC derivatives should the Derivative Transactions Bill be passed.

Should mandatory reporting obligations be implemented, due regard should be given to the operational impact that this may have for different market participants. Implementation of trade reporting obligations could be phased in across products and participants.

In particular, many larger participants may already be well advanced in implementing operational changes in response to reporting obligations in offshore markets. It may therefore be appropriate to consider whether the initial scope of any reporting obligation might usefully be limited to this group of larger market participants, either by requiring only these participants to report, or providing for them to have the capacity to act as reporting agents on behalf of smaller entities. This could be set out in regulations when making an initial prescription of derivatives under the proposed Derivative Transactions Bill, or through DTRs. Over time, it may be appropriate to require trade reporting from a larger group of entities (including ADIs, insurers, AFSL holders and market participants that are exempt from the requirement to hold an AFSL), so as to ensure the benefits discussed above are more fully realised.

Subject to further consultation around larger market participants' readiness to connect to trade repositories, the regulators consider it desirable for reporting obligations to be implemented as soon as practicable for the markets in which such larger participants predominantly transact. The timing for any mandatory obligations to take effect, and decisions around what is practicable for reporting, would also need to take into account the availability of licensed trade repositories for product classes that may be prescribed. In parallel with the uptake of trade reporting by industry participants, the regulators will need to ensure they have sufficient analytical resources in place to effectively utilise data available from trade repositories.

6.2.5 Further considerations

Should the government prescribe one or more classes of derivatives as subject to a mandatory reporting obligation, ASIC would then need to develop DTRs in consultation with stakeholders and the other regulators. The following sets out some of the considerations regarding the parameters of reporting obligations.

Scope and phasing of trade reporting – products and participants

The scope of any mandatory obligation could be shaped through regulations at the time following the Minister's determination that a class of derivatives should be subject to mandatory trade reporting requirements, or subsequently through DTRs developed by ASIC.

As noted above, the regulators consider it appropriate for trade reporting mandates to apply to a broad scope of instruments. In implementing a reporting obligation, however, it may be appropriate to consider a phased-in obligation across product classes. A first phase could include interest rate, FX and credit derivatives, with other products in subsequent phases, reflecting the relative importance of these various product classes within the Australian financial system.

As far as scope of entities is concerned, the regulators also see merit in broad coverage of institutions licensed by the regulators: ADIs, insurers and AFSL holders, as well as some exempt entities. Again, some phasing-in of reporting obligations might be appropriate, according to metrics around participant size or activity. Beyond these classes of entities, it may also be appropriate to consider reporting obligations for other entities, subject to there being appropriate materiality thresholds so as to ensure that benefits continue to outweigh costs.

In determining phasing and thresholds for reporting obligations, the relative costs of data submission across different participants and products would also need to be considered. For some participants and products, data submission to trade repositories might be possible through existing automated processes, while for others it may involve costlier manual processes. If reporting thresholds were in place, these might take into account whether a participant transacts with dealers or through market infrastructure.

In general, the regulators would look to harmonise reporting obligations across participants and products with those in place in other jurisdictions.

Subject to passage of the Derivative Transactions Bill and if any subsequent Ministerial determination is made relatively soon thereafter, it is possible that DTRs could be consulted on and finalised in the first half of 2013. A first phase of reporting obligations could commence after a relatively short transitional period, with longer lead times for other products and participants.

Range of data reported

The range of data that must be reported would be specified in DTRs or regulations. As discussed in Section 3.2.3, CPSS and IOSCO have provided guidance about the data fields that may be reported for each class of product, and such international guidance will be considered by the regulators.

For dealers and larger market participants, or for transactions that pass through FMIs, it may be relatively straightforward to record and report a comprehensive set of data fields for each transaction as contemplated under this international guidance.

However, for other classes of participants or transactions, establishing the requisite systems to provide more detailed reporting may be more costly. In such cases, it may be appropriate for the regulators to consider alternative interim reporting arrangements that still generate some of the regulatory benefits of reporting (such as facilitating the monitoring of any build-up of risks in the relevant OTC derivatives markets). In some circumstances, it may be sufficient to only require reporting that enabled position and counterparty risks to be understood. Should this approach be taken, the regulators would consult with relevant stakeholders on the parameters of proposed reporting requirements and the implementation of such requirements.

Data transparency – statistics and post-trade transparency

The regulators are of the view that should a mandatory reporting obligation be prescribed by the Minister, it could be useful for the wider market if aggregate market statistics were published on a relatively frequent basis. This would be consistent with public reporting proposals in other jurisdictions. In the EU, for example, technical standards proposed by ESMA will require aggregate open position data per product class to be published and updated at least weekly.

In developing DTRRs – that is, the rules that specifically apply to trade repositories – another consideration will be the extent (if any) to which post-trade transparency obligations imposed on Australian-licensed trade repositories should be harmonised with those of other jurisdictions. For instance, in the US the CFTC will require swap data to be published by the trade repository as soon as technologically possible, unless a time delay applies to the data (which may vary from 15 minutes to 48 hours depending on the nature of the transaction and the counterparties). As noted above, some Australian banks and dealers will likely be required to register as swap dealers with the CFTC, and may be obliged by US requirements to report to trade repositories that comply with US post-trade transparency requirements. On the other hand, under proposed requirements in the EU, post-trade transparency obligations are imposed on market participants and particular kinds of execution venue, rather than on trade repositories (though trade repositories may be able to fulfil transparency obligations on behalf of clients in certain conditions).

Differences in trade reporting requirements, and the potential consequences of these differences for the mutual recognition of trade repositories based in Australia or offshore, may also be a consideration for ASIC in developing the Australian licensing regime for trade repositories.

Timing of trade reporting

A trade reporting obligation will have to specify an acceptable timeframe within which trades must be reported. One consideration here is a possible requirement on trade repositories to publish aggregate (or potentially trade-level) data, and the frequency of this publication. Another consideration is the need, in stressed circumstances, to ensure access by regulators to fresh data held by trade repositories; this may require more timely reporting to trade repositories than would be required simply to facilitate aggregate-level data.

On this basis, for example, it could be that transactions must be reported by the close of business on the business day following the execution, modification or termination of transactions (that is, on a T+1 basis), even if aggregate-level data are only required to be published less frequently.

Data aggregation and standardisation

Data aggregation is necessary for regulators to analyse and assess the risk of OTC derivatives markets, particularly counterparty exposures among market participants, and for public post-trade transparency. There are legal and operational factors that make the aggregation of data challenging and which reflect the limited capacity of existing trade repositories to aggregate data. The lack of a standardised industry-wide format for trade reporting creates operational complexity and additional technology costs due to the multiple reporting formats across and among product classes for those reporting, and for trade repositories and regulators. These costs could prove to be a significant burden for smaller market participants, though the regulators consider there is scope to mitigate such costs through industry- or regulator-led initiatives. For example, reporting costs may be reduced by the outsourcing of reporting to third parties (including FMIs such as trading platforms and CCPs) given the functional synergies between trading, clearing and trade reporting. Industry work around data standardisation may also reduce costs and complexity; some of the main initiatives were discussed in Section 3.5.1.

Use of data by regulators

International standard-setters have been developing guidance around regulatory authorities' access and utilisation of data held in trade repositories (as discussed in Section 3.2.3). It will be necessary for the Australian regulators to consider and define their own needs for data reported to trade repositories, and where necessary review their arrangements for sharing data among themselves (the Derivative Transactions Bill proposes amendments to facilitate this). A related consideration is how the regulators individually or collectively will use data reported to trade repositories to ensure adequate monitoring of risks in market participants and across the markets. This is expected to be an increasing focus of regulators' work in 2013.

Regulators will also have to consider issues including: data fragmentation arising from multiple trade repositories and the reporting of trades to different jurisdictions; the potential future demands for system architecture to use, house and store data for trade repository supervision and enforcement purposes; and adequate analytical resourcing.

6.3 Central Clearing

For markets in financial products that are sufficiently liquid and standardised, central clearing can promote greater market resilience and thereby contribute to the stability and integrity of the wider financial system. The transition to central clearing from a bilaterally organised market does, however, pose a number of challenges.

The regulators have previously suggested that the market for Australian dollar-denominated interest rate derivatives is of systemic importance to the Australian financial system and is amenable to central clearing. For other classes of OTC derivatives transacted by Australian market participants, the availability of appropriate CCPs and the systemic benefits of central clearing are less clear at this time.

As discussed in Section 5.4.2, some larger Australian financial institutions have commenced indirect central clearing of some of their OTC derivatives, reflecting:

• the likelihood of overseas mandatory central clearing requirements
• proposed changes to APRA's counterparty credit risk standards, in line with Basel III
• observed differentials in dealer-quoted pricing of centrally cleared versus non-centrally cleared contracts.

In addition, as discussed in Section 3.2.5, derivatives that remain outside of central clearing may be subject to minimum margining requirements under international standards being developed by the BCBS and IOSCO. These requirements, if implemented in Australia, have the potential to impose larger collateral demands on participants than margin requirements for centrally cleared positions, providing a further incentive to migrate towards central clearing.

At the moment smaller ADIs have not moved to central clearing due to the operational challenges and associated costs. Both large and small Australian-based market participants still have many concerns around migrating OTC derivatives to central clearing.

6.3.1 Benefits of increased central clearing in Australia

As discussed in Section 2.3.2, the Australian regulators consider there to be strong in-principle benefits to the Australian OTC derivatives market from adopting central clearing. A key benefit is the enhanced market resilience that a CCP brings. CCPs are able to apply risk controls – such as collateralisation of exposures in the form of margining – consistently and transparently to participants, and are not subject to the information asymmetry involved in bilateral counterparty risk assessments. The robustness of a CCP's risk framework is ensured through strict regulation and oversight.

A particular benefit in times of market stress is that, in comparison to a market comprising only bilateral exposures, counterparty default management can typically be handled in a more orderly manner by a CCP. This default management capacity is supported by pooled financial resources maintained by the CCP to cover default losses in an extreme scenario, and transparent, documented and legally enforceable procedures for the closing out or transfer of a defaulter's outstanding portfolio.

Central clearing could also strengthen other aspects of risk management practices in the Australian OTC derivatives market. For example, the regular use of trade compression services to restrict the build-up of large, bilateral exposures over time is not currently universal, and many bilateral exposures remain uncollateralised. Central clearing can also contribute to increased operational efficiencies in financial markets.

6.3.2 Developments in the availability of CCPs

The central clearing landscape for OTC derivatives continues to evolve. Offshore, CCPs now operate for most broad classes of OTC derivatives, while domestically an OTC interest rate derivatives clearing service is under development (Annex 3 provides a list of CCPs offering OTC derivatives clearing).

CME Group (CME) and LCH.Clearnet Ltd (LCH) operate two of the largest and most well-established CCPs for OTC interest rate derivatives. They each clear a range of product classes, including fixed-to-floating interest rate swaps in a number of currency denominations, including Australian dollars. Direct participants in CME's OTC derivatives clearing services are mainly global investment banks and securities dealers. A similar range of globally active institutions participate in LCH's interest rate derivatives clearing service, SwapClear; participants in this service also include a number of domestically focused European banks. Many of the non-Australian direct clearing participants in both CME and LCH are also active participants in the Australian interbank OTC derivatives market, in some cases through affiliated legal entities.

Other OTC derivatives CCPs tend to be more narrowly targeted in either their product or participant scopes. For example, LCH.Clearnet SA, ICE Clear Europe and ICE Clear Credit attract cross-border participation by the global banks, but clear predominantly credit default swaps relevant to their respective jurisdictions. No CCPs currently clear Australian CDS products, such as those referencing the iTraxx Australia index. A number of other CCPs – particularly those in (or under development in) the major Asian financial centres – offer a broader range of product classes, but are designed for local financial institutions. Many of these CCPs are being developed specifically in response to the implementation of OTC derivatives reform in the local jurisdiction.

In Australia, the ASX Group is investigating the development of a clearing service for Australian dollar-denominated interest rate derivatives.^[1] ASX has suggested that the service would leverage its existing CCP for exchange-traded derivatives, ASX Clear (Futures), and, in doing so, offer cross-product margin offsets with interest rate futures. ASX has engaged in a design study in collaboration with interested market participants, that it intends to complete by the end of 2012. Should ASX proceed with this, it has indicated it would aim to deliver the new service in mid 2013. ASX has also developed a clearing service for OTC equity options written on ASX-listed entities.

For other classes and some specific contract types, lack of standardisation and liquidity or other practical issues have hampered the development of central clearing solutions. For example, the expansion of central clearing of FX derivatives with a deliverable component is currently problematic, largely because of difficulty in integrating central clearing with the existing CLS settlement mechanism. The international FX dealer community and CCPs continue to investigate the development of a solution which could appropriately manage both pre-settlement and settlement risks.

Given no CCP offers clearing of all contract types, an institution that deals in a broad range of products is likely to require access to multiple CCPs to clear its portfolio of contracts that are capable of being centrally cleared. While interoperability allows for the central clearing of trades between participants of different CCPs, there are no existing interoperability arrangements between CCPs for OTC derivatives products, reflecting the challenges in establishing risk controls appropriate to such arrangements.^[2]

6.3.3 Direct and indirect participation in central clearing

In making a transition to central clearing, Australian market participants would need to decide whether to join relevant CCPs as direct clearing participants (where this was possible) or seek to appoint one or more direct clearing participants to provide indirect clearing services for them.

Direct participation

An immediate hurdle to direct participation in OTC derivatives clearing for Australian participants is the need for a relevant licensed CCP to offer these services in Australia. A CCP that offers OTC derivatives clearing services to Australian entities must have an Australian CS facility licence, or receive an exemption from this requirement. The regulation of these facilities is jointly overseen by ASIC and the RBA, with the granting and revocation of a licence at the discretion of a Minister of the Australian Government. Apart from ASX's OTC equity options clearing service, there are currently no licensed CCPs offering OTC derivatives clearing services in Australia. The time taken for a licence applicant to prepare and submit a formal licence application; for that application to be assessed by ASIC and the RBA; for ASIC and the RBA to prepare advice for the Minister; and for the Minister to make a decision on granting a licence can take, at a minimum, several months.

Direct membership of CCPs may confer a number of benefits in a market landscape where standardised contracts have largely moved to central clearing, both from a commercial and a risk management perspective. The commercial benefits include:

• direct access to more liquid markets vis-à-vis those that remain outside of CCPs
• the ability to offer client clearing services (where facilitated by the CCP), which may become an important competitive advantage for banks in servicing their customers
• avoiding the need to direct business as a client through an institution which may otherwise be a competitor in the wholesale or retail banking market
• avoiding onerous and undesirable contractual terms under a client clearing agreement
• capital advantages in circumstances where indirect clearing does not qualify for a lower risk weighting under the Basel III capital framework.

The risk management benefits include:

• having exposure to (i.e. collateral posted with) the CCP, which is likely to be of greater credit standing than a bank owing to its risk-management focus and close oversight under regulatory standards such as the PFMIs
• ongoing participation in a CCP's decision-making around risk management and operational design.

Indirect participation

For many participants in the OTC derivatives market, direct membership of a CCP will likely be too onerous, and therefore access to CCPs would need to be arranged through clearing participants. However, at present, the global market for these indirect clearing services is highly concentrated among a small group of global institutions. It appears these clearing participants may only provide clearing services to a small number of (more active) Australian counterparties, for a number of reasons including operational capacity, risk appetite and cost.

Where client clearing arrangements are available, the terms of these agreements generally differ from the greater flexibility offered by current bilateral arrangements. Typically these agreements have been initially modelled on clearing agreements for exchange-traded futures and options, and contain terms that reflect the fact that the clearing participant is responsible to the CCP should its client default. Discussions with market participants have highlighted some terms in particular. For example, client clearing agreements typically give the clearing participant the right to call additional margin from clients, including amounts that are a multiple of what is required by the CCP, to reflect the clearing participant's assessment of the client's creditworthiness.

In part, the uncertainties articulated to the regulators in consultations would appear to reflect the fact that indirect OTC derivatives clearing agreements are a relatively new arrangement, and there is not yet a market-wide consensus in Australia as to what is a standardised arrangement, notwithstanding developments in the EU and US (see Section 3.5.3). As noted in Section 5.2, the bulk of smaller Australian counterparties' bilateral derivatives documentation is Australian law-governed. Where indirect clearing agreements are established to access offshore CCPs, the relevant governing law may be that of other jurisdictions. This may be an additional challenge for some market participants.

Australian regulators continue to examine matters such as client monies rules, so as to ensure adequate protections for Australian institutions that engage in client clearing. Client monies also remain an important area of focus for regulators around the world, and various international groups are exploring the scope for further coordinated work in this area.

6.3.4 Australian dollar-denominated interest rate derivatives

Of the various product classes traded in the Australian OTC derivatives market, an increase in the central clearing of Australian dollar-denominated interest rate derivatives is likely to yield the most immediate and substantial benefit to the Australian financial system. As discussed in Chapter 4, this product class forms the largest component of Australian financial institutions' derivatives exposures (in terms of gross notional outstanding amounts), and is of systemic importance given the prevalence of its use by a large number of domestic financial institutions in managing interest rate risk. The existence (and prospective entry) of a number of CCPs clearing this market indicates that the preconditions for safe, effective and economically viable clearing for many contract types in this product class have been met. Given the core role of the Australian dollardenominated interest rate derivatives market, its resilience is a key consideration for the stability and integrity of the Australian financial system. Central clearing would enhance this resilience.

There may be collateral efficiencies to be gained from the central clearing of this market. Relative to other product classes, the build-up of notional exposures between counterparties from activity in interest rate derivatives has been particularly rapid owing to the long maturity of many contracts.

Market participants

As described in Chapter 4, dealing activity in the Australian dollar-denominated interest rate derivatives market is quite concentrated. AFMA data suggest that around 75 per cent of turnover and outstandings in this market is interbank, of which close to half is interdealer.

This would indicate that large benefits to financial system efficiency, integrity and stability could be realised even if only a relatively small number of large market participants were to centrally clear interbank trades. Not only would this result in a large amount of notional exposure moving to clearing, but – owing to economies of scale and product scope – large financial institutions would stand to benefit most from the netting and the standardised operational and collateral practices afforded by central clearing.

While smaller financial institutions (including smaller ADIs) are counterparties to a material share of turnover and outstanding positions in this market, the benefits of these entities moving to central clearing are less clear. Participation in central clearing, particularly direct participation, requires considerable financial, operational and legal sophistication; such requirements are more easily met by larger financial institutions. Alternative forms of indirect access would also likely require substantial business changes and possibly introduce new risks, the cost of which may outweigh the in-principle benefits of central clearing. These considerations would also hold for non-financial counterparties, who make up a relatively small share of market activity.

Central clearing options

As noted above, two CCPs – LCH and CME – currently offer clearing of Australian dollar-denominated OTC interest rate derivatives, although neither is a licensed CS facility in Australia (Annex 4 gives more detail of these offerings). These CCPs could permit direct participation by Australian-domiciled entities if licensed. Many of the larger foreign-owned banks active in the Australian OTC derivatives market are already participants of these CCPs. ASX has also indicated its plans to develop a clearing service for Australian dollar-denominated OTC interest rate derivatives.

Whether particular offerings are more attractive to Australian participants will depend on a number of factors. In addition to the requirement that a CCP be licensed in Australia, elements of the CCP's design and functioning are also likely to influence the decision of Australian participants (particularly larger banks) on joining the CCP:

• Product scope: As discussed in Section 4.6.1, fixed-to-floating rate swaps comprise well over half of Australian participants' notional outstandings in single-currency interest rate derivatives (excluding options). Overnight index swaps also make up a significant share, followed by forward rate agreements and floating-to-floating rate swaps.
• Acceptable collateral: Section 5.2.2 highlighted that most Australian participants' existing collateralisation arrangements are strongly shaped around Australian dollar-denominated securities and cash. Many participants are therefore looking for central clearing arrangements that are harmonised with existing arrangements.
• Operational time lines: Many CCPs are not open during the Australian business day, and therefore conduct margin calculations and calls outside the regular business hours of many domestic market participants.
• Payment and settlement arrangements: A CCP may require clearing members to have bank or securities accounts in another jurisdiction or jurisdictions, and require these accounts be denominated in currencies other than Australian dollars, for the purposes of posting cash or other securities to meet collateral obligations. Other CCPs could allow clearing members to have accounts in Australia denominated in Australian dollars.
• Client clearing models: For participants of some CCPs, only the ‘principal’ model of membership is available. Other CCPs offer the ‘agency’ model of membership. Under the ‘principal’ model, any collateral posted by a clearing member to the CCP on behalf of a client generally remains in the name of the clearing member – that is, the CCP has no direct relationship with, or any ‘see through’ to, the client. Should a clearing member default in this case, its clients' only recourse to their collateral is through the clearing member. Work is underway, however, to develop individually segregated accounts for clients, that would afford more protections to clients in the event of a clearing member default. Under the ‘agency’ model, arrangements executed between clients and the CCP seek to ensure that should a clearing member default, a contractual relationship between the client and CCP will come into being, giving rights over the collateral to the client.
• Legal jurisdiction: In clearing through an offshore CCP, Australian institutions could be submitting to a foreign legal jurisdiction. In particular, they would likely be subjecting themselves to the insolvency regimes in place in that jurisdiction.

Discussions with a wide range of market participants have indicated a diversity of views as to the importance of these various considerations, and how concerns should be best addressed. As existing offshore OTC derivatives CCPs have developed outside of Australia, it is unsurprising that some aspects of their design have not been shaped primarily around the requirements of domestically focused market participants. For example, operational time lines may be based on overseas time zones, rather than activity in the Australian business day. Similarly, some Australian market participants may be accustomed to market pricing or valuation conventions, or a range of acceptable collateral, that are different to those used by offshore CCPs.

As discussed in Section 3.3, there have been a number of regulatory developments in Australia over recent months intended to support the uptake of central clearing by the Australian market. In particular, an exacting framework for the regulation of any CCP (whether domestic or offshore) offering OTC derivatives clearing services is being put in place via the RBA's revised FSSs (this is discussed further in Section 3.3.3). This includes requiring the CCP to consider how its operations promote stability in the Australian financial system. Such requirements, particularly where they relate to operational matters, could address some of the issues listed above. In parallel, ASIC has developed complementary regulatory guidance (discussed in Section 3.3.4), in part to ensure that adequate regulatory influence over offshore CCPs is in place.

The regulators remain interested in understanding Australian participants' concerns regarding existing and prospective CCPs that may look to be licensed in Australia, where these relate to the fairness and effectiveness of a CCP, or how the CCP promotes the stability of the Australian financial system. However, where concerns are more related to commercial considerations, the regulators would not wish to interfere with the competitive responses of CCPs or market participants in developing clearing solutions that best serve the market as a whole.

6.3.5 Cross-currency and FX derivatives

The benefits of central clearing identified in Section 6.3.1 would appear to also apply to the cross-currency interest rate and FX derivatives markets.^[3] These are important classes of derivatives in the Australian market, as evidenced by the value and volume of transactions (discussed in Sections 4.6.2 and 4.6.3) and the economic role played by these contracts – for example, the management of FX risk involved in offshore funding activities. However, there is less immediate scope for the benefits of central clearing to be realised in these markets, as a central clearing solution for derivatives with a deliverable FX component is yet to be developed (see Section 6.3.3). Possible risk mitigants for these product classes are discussed further in Section 6.4.3.

6.3.6 Other product classes

Turnover in Australian credit derivatives – particularly credit indices – suggest that there is some prospect of the preconditions for central clearing being met, though the regulators are not aware of any proposals by CCPs to clear these products.

For the remaining product classes, there may be less immediate market efficiency, integrity or stability benefits to be gained from increased central clearing. Largely, this reflects the lower level of larger Australian market participants' activity in these derivatives. It also reflects that there is generally less standardisation and liquidity among these contracts and, consequently, there are fewer clearing solutions available. Although promotion of standardisation through central clearing can benefit the integrity and stability of a market, it must also be recognised that bespoke contracts in many cases are designed for specific and idiosyncratic purposes. Should standardisation be imposed on such contracts, there may be other unintended and adverse consequences for these markets and sectors of the broader economy.

6.3.7 Recommendations and further considerations

The regulators recommend that a mandatory clearing obligation for Australian dollar-denominated interest rate derivatives is not necessary at this time. However, should substantial industry progress towards central clearing in this class of derivatives not be evident in the near future, the regulators would revisit this recommendation.

This recommendation is based on the following considerations:

• There would be a substantial benefit to the efficiency, integrity and stability of the Australian financial system from increased central clearing of OTC Australian dollar-denominated interest rate derivatives. The practical scope for this exists since established clearing solutions are already available (subject to licensing in Australia).
• Given the bulk of activity is interbank, and the fact that large international participants in the Australian market already have access to central clearing, only the large Australian banks would need to migrate to central clearing for much of this benefit to be achieved. Moreover, this migration would appear to be well underway.
• In part, a more wholesale migration to central clearing of larger market participants' Australian dollar-denominated interest rate derivatives activity is pending the availability of a licensed CCP that clears these products. Larger participants are also considering the benefits and costs of direct participation, as well as how best to address the issues outlined in Section 6.3.4. The regulators understand that the local dealer community has been discussing with relevant CCPs ways in which these concerns might be allayed. It would seem beneficial to allow the competitive responses of CCPs and market participants to play out further, so as to facilitate the development of clearing solutions that best serve the market as a whole.
• The systemic benefits of increased central clearing of Australian dollar-denominated interest rate derivatives by smaller market participants are not immediately apparent. Furthermore, the availability of acceptable client clearing services for these market participants would appear to be quite restricted at present.
• There would be some systemic benefit from the central clearing of FX and cross-currency derivatives with a deliverable component, but no such central clearing solutions currently exist. It follows that there is no immediate scope for an uptake of central clearing of these derivatives by the Australian market, although Australian regulators will continue to monitor relevant industry developments.
• For credit derivatives, there would also be some benefits from central clearing. There are CCPs for certain European and North American CDS products, but not yet for Australian products. As above, Australian regulators will continue to monitor relevant industry developments.
• Australian entities' use of derivatives in the remaining product classes is highly heterogeneous, and the prospects for appropriate central clearing services are not clear. In addition, many of the contracts traded within these product classes – particularly electricity – are bespoke and not currently suitable for central clearing. Regardless, based on the evidence available, the aggregate exposures associated with these product classes would not appear to present immediate concerns for the financial system.

The regulators consider that it remains appropriate for industry-led migration to central clearing of Australian dollar-denominated interest rate derivatives to continue for the time being. There is clear evidence that large Australian banks are establishing central clearing arrangements for this product class. Further, the regulators are of the view that there are good prospects for adequate arrangements to be put in place for Australian participation in the relevant CCPs. However, should the migration of single-currency interest rate derivatives to central clearing not make sufficient progress in the near future, the regulators would consider recommending that a mandatory central clearing obligation be instituted as a priority.

The regulators also note the points set out in Section 2.6.3, that mandatory obligations may be warranted for regulatory equivalence purposes, or to ensure that opportunities for regulatory arbitrage were not being exploited. Should evidence suggest that there would be some benefit from mandatory clearing obligations in these regards, the regulators would respond accordingly.

For smaller market participants, the availability of acceptable client clearing agreements may be a constraint in migrating to central clearing. This availability in part depends on there being a sufficient number of institutions active in the Australian market with the requisite operational and financial capacity to offer client clearing. An expansion in the number of such institutions, as well as the development of mutually acceptable client clearing arrangements, will take time.

The regulators will continue to assess market developments, with a view to considering where central clearing for other products might be warranted.

6.4 Risk Management for Non-centrally Cleared Transactions

The migration to central clearing of single-currency interest rate derivatives can be expected to address many of the risk management concerns discussed in Chapter 5, given many of the key advantages of central clearing relate to enhancements to the management of counterparty credit risk and trade life-cycle processes.

However, as discussed above, central clearing is not likely to be available for a number of important product classes, nor may it be desirable that it be adopted by all market participants. It is therefore important that rigorous bilateral risk management processes are in place. This section discusses these further, and makes a number of recommendations.

6.4.1 Counterparty credit risk management

The extent of credit support for OTC derivatives transactions appears to have increased since the 2009 survey, though the survey responses suggest that only around 50 per cent of transactions are covered by CSAs.

Participants should ensure that adequate credit support arrangements are in place for all OTC derivatives transactions.

At present there appears to be limited use of initial margin. This is not unexpected, given this has not been a widespread component of counterparty credit risk management in OTC derivatives markets. In addition to industry-led changes to the use of credit support for non-centrally cleared transactions, international standard setters are considering international principles on margin requirements for such transactions. The regulators will continue to monitor these developments and provide advice to the government as appropriate.

A welcome development is the growing trend of Australian market participants to collateralise mark-to-market exposures. However, survey responses indicated some instances of quite high unsecured threshold and minimum transfer amounts. As a general principle, the regulators would expect that unsecured thresholds and minimum transfer amounts should be as low as possible, to ensure mark-to-market exposures are adequately collateralised at all times. Within this, the regulators recognise that the operational and balance sheet-related costs of this are likely to be non-trivial, and may be overly burdensome for smaller participants in particular. For exposures between systemically important participants, however, a more stringent approach should be in place.

The regulators consider that for large and more active market participants, daily collateralisation of exposures should be adopted as best practice in the market where possible. It is recognised that this needs to be balanced against the operational costs and liquidity risks that this may create for some types of counterparties.

Survey responses indicated that, where collateral is posted, in some cases the amounts over-collateralise mark-to-market positions. Some respondents are likely to have done so to minimise the operational burden of continuous collateral flows. Nevertheless:

Market participants should understand the increased counterparty exposure generated by posting collateral over and above mark-to-market (variation margin) requirements, and ensure that the resultant risks are adequately managed.

The regulators also note that further consideration should be given to the risks associated with practices around collateral rehypothecation, and the availability of additional collateral for margining of cleared and uncleared trades. While rehypothecation and reuse of collateral can lengthen the chains of interdependencies between market participants, it can also contribute to liquidity in securities markets.

In relation to the OTC electricity derivatives market, the regulators consider there is a case for industry and regulatory initiatives to strengthen counterparty credit risk management practices, particularly among larger participants (many of whom are significant participants in the National Electricity Market). One way to do so may be requiring participants to establish, over an appropriate period of time, CSAs or equivalent arrangements. The terms of these arrangements should require adequate collateralisation of exposures that exceed specified thresholds, taking into account the scale of participants' commercial activities. Further, these arrangements should be an integral component of the entity's overall risk management strategy and systems.

6.4.2 Post-trade practices

Trade compression services are now being more actively used by larger participants across the major product classes. However, the evidence also suggests that usage is still somewhat sporadic among these participants. Moreover, utilisation of trade compression services has been insufficiently coordinated to achieve the full multilateral netting benefits.

The regulators see increased benefits in there being a more coordinated market-wide approach to the usage of trade compression services. The regulators call on the industry to consider how this may be achieved.

Disputes around trade valuation and missed trades would not appear to be of major concern in the Australian market at present, and incidents that do occur appear to be appropriately managed. ISDA has developed best practice guidelines in this regard, and Australian market participants are encouraged to review these proposals. Continued work on trade automation and straight-through processing would help further reduce the incidence of missed trades, as well as provide other operational efficiencies.

A more widespread usage of portfolio reconciliation services would also reduce the prospects of trade disputes becoming an issue over time.

Although there has been some increase in the use of portfolio reconciliation services, the regulators consider that a greater utilisation of these services should be pursued by the industry.

In this regard, the regulators note that draft guidance from APRA (APG 113) outlines that ADIs with significant exposure to OTC derivatives counterparty credit risk should seek to mitigate operational risk by regularly reconciling trade populations, trade valuations and collateral valuations with counterparties and, where practical, take opportunities to participate in portfolio compression exercises.^[4] There may also be benefit for non-ADIs that have significant exposures to OTC derivatives markets to consider participating in some of these services.

6.4.3 Other considerations

As discussed in Chapter 4, the cross-currency and FX derivatives markets are important components of the Australian OTC derivatives landscape, along with Australian dollar-denominated single-currency interest rate derivatives. But while central clearing of the latter is in prospect, as discussed in Section 6.3.2 it currently appears unlikely that CCPs clearing cross-currency and FX derivatives markets will emerge in the near future (particularly for trades that require physical delivery of currencies at settlement, which are the main product types used in Australia). The regulators are therefore considering what other regulatory and market responses might be usefully applied to enhance the resilience of these markets.

In particular, the absence of a CCP for these markets reduces the capacity for a whole-of-market response to a counterparty default. Without a CCP's financial risk resources standing behind a defaulted participant's positions, and without binding rules on participants to control the response to a default, market participants may have a strong incentive to quickly close out positions, which could result in a disorderly market and see stresses emerge for other market participants.

To mitigate some of the impact of a large participant default in these markets, it is important that market participants with large exposures in these markets have highly robust approaches to risk management. These participants should ensure they adopt the recommendations discussed in Sections 6.4.1 and 6.4.2, in particular:

• widespread usage of collateralisation, portfolio compression and reconciliation, so as to reduce the extent of any immediate crystallisation of counterparty credit risk
• report all transactions to trade repositories, so that exposures could be easily identified if necessary to facilitate regulatory or market responses.

International regulatory efforts are also looking to enhance the resilience of the financial system should a large OTC derivatives counterparty default. If large counterparties held initial margin against interdealer positions, such as in accordance with the recent BCBS-IOSCO proposals (discussed in Section 3.2.5), this would provide a buffer for non-defaulting counterparties to cover some of the costs of closing out and replacing defaulted positions. More generally, the FSB's work around the recovery and resolution of systemically important financial institutions will be important in facilitating a globally coordinated and consistent regulatory response to such an event.

The Australian regulators will also continue to explore issues around the development of clearing solutions which appropriately manage both pre-settlement and settlement risk in FX and cross-currency derivatives markets. In parallel, the regulators will examine the merits of other market-wide initiatives to promote the resilience of these product classes.

6.5 Trade Execution

The survey undertaken by the regulators indicated that trading platforms are widely used across participants and product classes. However, their utilisation generally accounts for only around a quarter of trading activity, suggesting that participants use these platforms as part of a suite of execution options.

As discussed in Section 4.5, apart from FX derivatives, the absolute number of transactions in the market is not very high. For single-currency interest rate derivatives, for instance, the largest dealers in the domestic market only execute an average of around 40 transactions a day, across all currency denominations, product subtypes and tenors.

6.5.1 Benefits of increased utilisation of trading platforms in Australia

A long-standing concern with OTC derivatives markets has been whether the relatively opaque nature of these markets poses a challenge to the overall efficiency and integrity of the financial system. While it is not necessarily the case that these concerns have been realised in Australia, the transparency and operating rules associated with exchanges and trading platforms can still be of benefit to market participants. Trading platforms can also introduce operational efficiencies. For instance, automated trade processing can be facilitated where trading platforms incorporate trade capture and confirmation systems, and where they have connectivity with in-house or centralised post-trade systems.

6.5.2 Discussion

Given these benefits, some other jurisdictions are moving ahead quite aggressively with mandatory trade execution obligations. The regulators also agree that there may be in-principle benefits to the Australian financial system of a greater share of OTC derivatives being executed through centralised venues. Generally speaking, though, the regulators would look to promote centralised trade execution in a manner that was sensitive to the particular instrument classes concerned, and which limited as far as possible the potential to adversely affect liquidity or significantly increase the cost of participating in the relevant market. Given the relatively low level of activity in the Australian market, any mandated migration to centralised trade execution would need to assess the effect of this on market liquidity and efficiency.

Should a trade reporting mandate be implemented in Australia in the future, it would be easier to conduct the kind of granular market assessments that would ideally inform policymaking in this sphere. Information from trade repositories would be one key input in considering regulatory action to drive the uptake of trade execution platforms; once data and other policy elements are in place, work on promoting centralised trade execution could follow quite quickly. In developing further market assessments and recommendations, the regulators will be guided by the underlying objectives of the G-20 commitment in this area – improving transparency, mitigating systemic risk, and protecting against market abuse in OTC derivatives markets.

Even without domestic trade execution obligations, other market developments look to be somewhat supportive of trading platforms taking a greater role in Australian OTC derivatives markets. The emergence of central clearing for some OTC derivatives classes could prove to be an important development, to the extent that it introduces operational or product standardisation and reduces counterparty credit risk concerns. Trading platforms emerging in overseas markets may also seek to offer services in the Australian market in the period ahead.

6.5.3 Recommendation and further considerations

At this stage the regulators do not propose to make a concrete recommendation to the government around any mandatory obligations to support the centralised trade execution of OTC derivatives transactions. Additional work will be done before recommendations are made.

That said, if Australian participants or FMIs bring to regulators' attention the desirability of mandating particular instruments (e.g. to facilitate compliance with overseas regulatory requirements) this could be a relevant consideration that might accelerate such a market assessment.

6.5.4 Trading platforms in OTC derivatives markets

One matter that requires further consideration is which form of trading platforms supporting OTC derivatives markets best meets the execution requirements of participants and the policy goals of regulators. As discussed in Section 3.2.6, IOSCO has identified a number of characteristics of trading platforms that best facilitate centralised trade execution for OTC derivatives markets. It remains to be seen whether platforms with all these characteristics will be available in the Australian marketplace. A relevant consideration here is that the Derivative Transactions Bill proposes that, should a mandatory trade execution obligation be implemented, only facilities licensed under the AML regime would generally be eligible as trading venues, unless it is expressly prescribed otherwise.

In that regard, the Treasury has indicated that it is undertaking a review of the licensing regime for Australian financial markets. Depending on the results of this review, and subsequent decisions by the government and the Parliament, the scope of the AML regime or the criteria on which exemptions are granted could be changed, or conceivably new regulatory categories could be established. It is expected that the government would decide whether to make regulations prescribing further classes of platforms beyond the AML category as relevant platforms only once this review has concluded.

While both Europe and the US are moving to mandatory on-platform trade execution requirements, there are significant differences in what are adjudged to be qualifying platforms; this relates particularly to so-called ‘hybrid systems’, which are essentially screen-assisted voice broking systems. These platforms are intended, under the EU's MiFID II and MiFIR proposals, to count as qualifying platforms for the purposes of mandatory trade execution mandates, while under the CFTC and SEC's regimes these systems could not qualify as Swap Execution Facilities for the purposes of the Dodd-Frank Act's trading mandate. In addition, single dealer platforms are qualifying platforms for EU, but not for US, purposes.

The regulators' preliminary view is that multi-dealer systems, as well as hybrid or single dealer systems (such as those permitted in the EU regime, but not the US regime), may be appropriate venues for trade execution in Australia. However, this is a matter for further discussion and consultation in the period ahead.

Footnotes

See ASX (2012), Submission to Treasury on exposure draft of Corporations Legislation Amendment (Derivative Transactions) Bill 2012, August. Available at <http://www.treasury.gov.au/~/media/Treasury/Consultations%20and%20Reviews/2012/derivative%20transcations/Submissions/PDF/ASX.ashx>. [1]

For further discussion of interoperability between CCPs, see Garvin N (2012), ‘Central Counterparty Interoperability’, RBA Bulletin, June. Available at <https://www.rba.gov.au/publications/bulletin/2012/jun/bu-0612-7a.html>. [2]

For further discussion of some of the issues around central clearing of FX transactions, see Manning M, A Heath and J Whitelaw (2010), ‘The Foreign Exchange Market and Central Counterparties’, RBA Bulletin, March, pp 49–57. Available at <https://www.rba.gov.au/publications/bulletin/2010/mar/pdf/bu-0310-8.pdf>. [3]

APRA (2012), Prudential Practice Guide: APG 113 – Internal Ratings-based Approach to Credit Risk', August. Available at <http://www.apra.gov.au/adi/PrudentialFramework/Documents/ADI_PPG_APG113_AUG2012_FINAL.pdf>. [4]