Report on the Australian OTC Derivatives Market 2. Background

2.1 Introduction

Risks inherent in OTC derivatives markets have long been recognised, and regulatory efforts to promote risk mitigants have been underway for a number of years.^[1] There is now an international policy consensus that embedding centralised infrastructure – trade repositories, CCPs and trading platforms – in OTC derivatives markets is the most effective mechanism for addressing many of the concerns of regulators and market participants. Regulatory reform efforts in a number of jurisdictions are now underway to implement a transition to this market structure.

The Australian financial regulators have consulted widely in recent years to understand better how the benefits of centralised market infrastructure might be realised in the Australian OTC derivatives market. In 2009 the regulators made a number of recommendations to market participants around risk management enhancements for the Australian OTC derivatives market.^[2] Since then there has been ongoing industry consultation and engagement to both pursue these recommendations and to explore the implications of international reform efforts for this market.

A number of regulatory tools are currently available to Australian regulators to implement reforms to the Australian OTC derivatives market. The government has proposed additional tools through amendments to the Corporations Act (discussed below). The existing and prospective Australian regulatory framework does not presuppose the use of a particular regulatory tool in shaping reforms to the OTC derivatives market. In some instances it may be that regulatory intervention will not be required, to the extent that desired reforms are being effectively implemented by market participants themselves. In other areas, there may be a stronger case for action by regulators – for instance, where existing incentives or coordination problems are not conducive to the desired changes. Additionally, it is desirable for Australia to have in place regulatory requirements equivalent to those in force in other jurisdictions to foster a globally harmonised regulatory approach to OTC derivatives.

2.2 Policy Concerns around OTC Derivatives Markets

The availability of OTC derivatives contracts provides important benefits to the Australian financial system. The more flexible nature of these markets, in comparison to exchange-traded markets, creates greater scope for counterparties to negotiate contracts that are tailored to hedge specific risks or generate specific exposures.

Reflecting these advantages, there has been very strong growth in these markets in recent decades, and OTC derivatives markets now play a core role in the global financial system.

Given the importance of these markets, regulators have sought to enhance the resilience, transparency and operational efficiency of these markets where possible. The bilateral nature of these markets is not only the source of many of their advantages, but also the source of risks to the broader financial system.

Much of the underlying demand for OTC derivatives comes from smaller financial and non-financial market participants looking to hedge risks relating to real economic activity. This demand is generally intermediated by dealers (typically larger financial institutions), who may have only a relatively small exposure to any one of these counterparties. In order to hedge risks from making markets to service client demand, dealers often execute offsetting trades with other dealers. Over time, these interdealer exposures result in a complex web of bilateral, and often long-lived, exposures. With market participants directly and indirectly exposed to the effectiveness of the operational and credit risk management practices of their counterparties, should one large participant experience financial or operational difficulties, this could quickly be transmitted to the wider market.

With details of OTC derivatives transactions generally held only at individual counterparties, it is difficult for market participants or regulators to readily monitor market developments. This lack of transparency has the potential to undermine market confidence, particularly in times of heightened market stress. Regulators are also less able to identify the build-up of concentration risk or understand linkages between participants.

Due to the bilateral nature of these markets, over time many individual participants' operational systems and processes have evolved in an ad hoc manner. This lack of industry standardisation reduces the prospects for interoperability between systems, in turn limiting the scope for operational improvements to better support market activity and reduce operational risks.

2.3 OTC Derivatives Market Infrastructure

Centralised market infrastructure can be a very effective mechanism to address many of the concerns outlined above. For some time, therefore, both market participants and regulators have been exploring how these might be incorporated into OTC derivatives markets. As a complement to this, risk management and operational enhancements adopted by individual market participants could also result in system-wide benefits.

2.3.1 Trade reporting

A trade repository provides a centralised registry that maintains an electronic database of records of transactions. Trade information is submitted to a repository by one or both trade counterparties, and typically covers information such as transaction maturity, price, reference entity and counterparty. In the absence of trade repositories, transaction data are widely dispersed among market participants and various service providers (e.g. dealers, CCPs, trading platforms and asset custodians), and are often stored in incompatible proprietary systems.

Regulators can use the information held in trade repositories when carrying out responsibilities such as:

• risk assessments
• market surveillance and enforcement
• participant supervision
• recovery and resolution activities.

To the extent that trade reporting enhances the risk management capacities of individual market participants, this further supports financial system stability. The centralisation of trade data may assist institutions in understanding their own risks and exposures, while access to standardised data could allow internal and external auditors and risk management personnel to more effectively verify and track transactions and exposures. Through trade repositories, aggregate market data could be made publicly available on a regular basis as an enhancement to market transparency and functioning, further enhancing market integrity.

Trade repositories' use of standardised reporting formats could also enhance the efficiency of the financial system, by facilitating increased operational efficiencies in post-trade processing. The standardised information held in trade repositories could be used to support asset servicing, payment settlements, trade novation and affirmation, portfolio compression and reconciliation, and collateral management activities.

2.3.2 Central clearing

The use of CCPs is a highly effective way to enhance the efficiency, integrity and stability of financial markets. Key to central clearing is that, through a legal process known as novation, the numerous bilateral exposures of a market participant can be substituted for a single net exposure to a CCP. The resulting multilateral netting has the potential to substantially reduce the size of individual counterparties' outstanding obligations relative to bilateral arrangements, which could reduce market-wide collateral needs. By acting as a central hub for market participants, CCPs can improve the effectiveness of default management arrangements, as well as coordinate operational improvements and efficiencies. For instance, CCPs can bring standardisation of legal frameworks, streamlined day-to-day payment flows and calculations, and reduced collateral management complexities. They can also provide a focal point for regulation and oversight of market-wide risk management, while reducing information asymmetries in the market more generally.

In order for a CCP to clear a certain class of products safely and reliably, a number of preconditions must be satisfied:

• the product class must have a robust valuation methodology for that product, so that the CCP can confidently determine margin and default fund requirements
• there must be sufficient liquidity in the market to allow for close-out and/or hedging of outstanding positions in a default scenario
• there must be sufficient transaction activity and participation so that the fixed and variable costs of clearing the transaction are covered
• there must be some standardisation of contracts, to facilitate the CCP's trade processing arrangements.

For traditional exchange-traded instruments, these tests are typically quite straightforward. In contrast, they may be more difficult for some OTC derivatives products, particularly those with highly bespoke contract terms or difficult-to-model price movements. In these situations, it is arguably not appropriate for these products to be centrally cleared. Nonetheless, there are numerous classes of OTC derivatives that are actively traded in quite standardised forms, suggesting that the preconditions for central clearing are potentially met.

Notwithstanding the substantial benefits of central clearing, a CCP is a single point of failure for the participants and markets it serves. It is therefore crucial that the financial and operational risk management of the CCP be held to an extremely high standard.

2.3.3 Trade execution

Centralised trading venues can be highly effective in promoting market efficiency and integrity. They provide a single location for buyers and sellers to meet, reducing search costs and promoting pricing competition and market confidence through pre- and post-trade transparency. They can also contribute to the stability of the financial system through facilitating more resilient and liquid markets. Electronic trading venues can provide a host of additional operational benefits, such as verification of trade information through electronic confirmations, and facilitation of straight-through processing to CCPs and other transaction processing systems.

However, as with CCPs, there are certain preconditions for products to be successfully traded through a centralised venue. Chief among these are that products be sufficiently standardised and liquid. There are many factors that affect market liquidity, such as:

• trading volume
• product characteristics
• transaction size
• transaction frequency
• market participant characteristics.

Where markets are liquid, buyers and sellers are able to enter and exit their positions without concern that their transactions will unduly change market prices. However, where there are fewer buyers and sellers for a product, transparency around a participant's trading intentions could move market prices in anticipation of a trade being executed. This has the potential to reduce a participant's willingness to proceed with the transaction, in which case price transparency could result in a reduction in market liquidity. However, a range of OTC derivatives transactions are actively traded in standardised forms, indicating that at least some of the preconditions for viable centralised trading venues are in place for these products.

In some instances, the availability of central clearing for a particular product class can further enhance the viability of centralised trading venues. A CCP can standardise operational arrangements and ensure robust counterparty risk management across all market participants, thereby removing some of the impediments for multilateral trading.

2.3.4 Other risk management tools

While trade repositories could, in principle, operate for all product classes, trade execution and central clearing is generally only appropriate where markets are already quite standardised and liquid. Recognising that there are, and will likely continue to be, significant components of the market in which these conditions do not hold, regulators are also keen to ensure that transactions that remain bilateral are appropriately risk managed.

To manage counterparty credit risk, the chief tools that are generally used in bilateral arrangements include:

• due diligence and counterparty approvals
• agreement of robust legal documentation
• collateralisation of exposures.

In addition to the centralised infrastructure discussed above, proprietary and third-party systems have been developed to further support and streamline risk management throughout the life cycle of OTC derivatives transactions (Figure 1).

• Electronic trade capture and trade confirmation allow for the immediate and comprehensive recording of mutually agreed contract terms, and can reduce the potential for human error associated with manual processes.
• To further ensure counterparties have the same information regarding bilateral exposures, and to avoid or resolve disputes over collateral obligations or contract valuations, portfolio reconciliations can be undertaken.
• Collateral management systems can streamline processes for posting and receiving cash and securities collateral, as well as marking-to-market underlying counterparty positions and the collateral posted against these.
• Where gross bilateral positions are higher than net bilateral positions due to the build-up of economically redundant transactions, this can result in a disproportionate operational and counterparty risk management burden. Portfolio compression services allow for redundant trades to be terminated and replaced with a smaller set of trades that result in economically equivalent counterparty exposures.

Many of these tools only achieve their full effectiveness where they are used by a large number of market participants. There is therefore also a case for regulators to promote the market-wide usage of many of these tools.

2.4 International Policy Response

Given the benefits discussed above, there is now an international policy consensus that greater utilisation of centralised infrastructure can be the most effective mechanism to address many of the risks inherent in OTC derivatives markets. Reflecting this international consensus, in 2009 the leaders of the G-20 made several commitments to institute reforms to OTC derivatives markets. This was most recently reaffirmed at the June 2012 leaders' summit in Los Cabos, Mexico:

We reaffirm our commitment that all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012, OTC derivative contracts should be reported to trade repositories and non-centrally cleared contracts should be subject to higher capital requirements … We acknowledge the progress made to develop the key principles to promote internationally consistent minimum standards for the margining of non-centrally cleared derivatives and encourage international standard setters to finalize the proposed global margin standards by the end of this year …^[3]

In October 2010 the Financial Stability Board (FSB) published a set of recommendations to assist jurisdictions in implementing the G-20 commitments.^[4] The FSB has been monitoring progress towards meeting these commitments, with a third progress report published in June 2012 (a fourth report is currently in development).^[5]

A large number of jurisdictions are in the process of implementing regulatory reforms to give effect to these commitments; these reforms are discussed further in Section 3.4.

2.5 Australian Stakeholder Engagement

In recent years the Australian regulators have undertaken a number of studies to better understand risks in Australian OTC derivatives markets practices, and explore the benefits of the various types of market infrastructure discussed above.

2.5.1 May 2009 survey

In May 2009, APRA, ASIC and the RBA reported on a survey they had undertaken of the OTC derivatives market in Australia. This survey sought to understand the legal and operational infrastructure in use in the Australian market, and discussed in more detail some of the measures available to market participants in mitigating risks in bilateral transactions (such as those described in Section 2.3.4).

The survey found that the overall level of activity in Australia, while large in a domestic context, was low relative to major offshore markets. Within the local market, trading was dominated by interest rate and FX derivatives, with only small amounts of activity in equity, commodity and credit derivatives. Moreover, the types of products and the nature of participants and their use of derivatives were fairly straightforward compared with some offshore markets.

Although no immediate concerns were identified, the regulators noted that there was some scope for improvements in market practices, and highlighted additional measures that the local industry should consider. The recommendations of this report were that the local industry should:

• promote market transparency
• ensure continued progress in the timely negotiation of industry-standard legal documentation
• expand the use of collateral to manage counterparty credit risks
• promote Australian access to CCPs for OTC derivatives products
• expand the use of automated facilities for confirmations processing
• expand the use of multilateral portfolio compression and reconciliation tools
• increase Australian influence in international industry forums.

2.5.2 2011 discussion paper

One of the key recommendations of the 2009 survey was that the Australian industry should explore how central clearing might be adopted in the domestic market. In the period after this report was released, the international policy community firmly backed a greater uptake of central clearing of OTC derivatives, as seen in the 2009 G-20 commitment and work of the FSB.

In June 2011 the Council of Financial Regulators (the Council) issued a discussion paper on how central clearing of OTC derivatives might be adopted in Australia, to better understand the implications of this international push, and to explore some of the issues emerging from ongoing dialogue between the regulators and market participants resulting from the 2009 survey.^[6] This paper set out a number of considerations that the regulators wished to explore with interested stakeholders, including:

• the availability of central clearing services to Australian-based market participants
• the cross-border nature of the Australian OTC derivatives market
• implications of central clearing for financial stability
• the effect of central clearing on market efficiency and functioning.

To help focus discussion around these issues, the Council paper put forward four propositions:

• 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.

These were very much preliminary propositions rather than conclusions, and the Council agencies sought to canvass a wide range of views. Around 30 written submissions were received in response to this discussion paper. Meetings were held with Australian and foreign-owned banks, credit unions and building societies, market infrastructure providers, fund managers and institutional investors, non-financial corporations, government borrowing authorities and industry associations.

This paper further noted that central clearing was only likely to be effective in markets that were already fairly standardised and liquid. While this was expected to be the case for the main classes of Australian-dollar interest rate derivatives, it was recognised that other derivatives may not be so amenable to central clearing. In these cases, more weight might instead be given to other risk mitigation tools.

2.5.3 2012 report on policy considerations and consultation paper

Based on the discussions held in response to the 2011 paper, as well as other stakeholder discussions and reviews of international developments held over recent years, the Council provided a report to the government in March 2012.^[7] This report outlined various recommendations that might be taken into account when considering reform proposals in the OTC derivatives market, particularly around the use of centralised infrastructure such as trade repositories, CCPs and trading platforms.

The report recommended 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. Underpinning this recommendation was the expectation that various regulatory and commercial incentives would have the effect of driving the market towards centralised arrangements. However, given the systemic risks inherent in existing bilateral arrangements, slow progress in the uptake of centralised arrangements was undesirable. The report therefore recommended the development of a capacity to mandate outcomes in this area.

The report also recommended that market participants' choices regarding whether to clear OTC derivatives through domestic or offshore CCPs should not be unduly constrained. In part, however, the Council agencies' comfort around this was contingent on the satisfactory outcome of a number of domestic and international regulatory developments in train (see Chapter 3 for more detail on these).

Building on these recommendations, in April 2012 the Treasury released a consultation paper setting out proposals that would allow mandatory reporting, clearing and trading obligations to be imposed.^[8] Following a period of stakeholder consultation, in July the Treasury released an exposure draft of a bill that would give effect to these proposals through amendments to the Corporations Act. The government has now introduced this bill into the Australian Parliament, outlined in Section 2.6.2 below.

2.6 Australian Regulatory Framework and Approach

For the reasons discussed above, the starting proposition of the Australian regulators is that the efficiency, integrity and stability of domestic OTC derivatives markets can be enhanced through the use of centralised infrastructure. However, in promoting a transition to this environment, the regulators are concerned to retain where possible the existing benefits of OTC derivatives markets. They would also seek to promote the adoption of centralised infrastructure in a flexible manner to permit an industry-led transition as appropriate.

2.6.1 Existing regulatory tools

In the first instance, the regulators are keen to engage in debate and discussion with stakeholders, promoting industry best practice and voluntary changes by market participants. This engagement has been underway for a number of years, beginning with the regulators' May 2009 report on the Australian OTC derivatives market.

The Australian regulators can also impose specific requirements on a range of market participants active in OTC derivatives markets. APRA issues prudential standards for many of the largest OTC derivatives market participants – ADIs, insurers and superannuation funds – covering governance, capital and liquidity requirements, and operational risks. ASIC also sets requirements for holders of Australian Financial Services Licences (AFSLs). These include risk management requirements and financial resources requirements for licensees that are not regulated by APRA.

Requirements can also be imposed on licensed financial market infrastructures (FMIs) – exchanges, other trading platforms and clearing and settlement (CS) facilities – by ASIC, the RBA and the relevant Minister.

However, given the OTC derivatives market has typically operated outside of centralised infrastructure such as these, the effectiveness of such requirements will only be effective to the extent that OTC derivatives markets have migrated to such infrastructure.

In considering requirements for OTC derivatives market participants and FMIs, Australian regulators are guided by recommendations of international standard-setting bodies; relevant work by these bodies is discussed further in Chapter 3.

2.6.2 Proposed amendments to the Corporations Act

The Derivative Transactions Bill is currently before the Australian Parliament.^[9] The Bill proposes amendments to the Corporations Act to establish a framework to implement reforms in OTC derivatives markets. Under the proposed framework, a Minister may determine certain classes of derivatives as being subject to derivative transaction rules (DTRs) that can implement mandatory obligations relating to the use of trade repositories, CCPs and/or trading platforms. A determination would not in itself create mandatory obligations; this would go into effect only after ASIC had made DTRs setting out the details of such mandatory requirements. The processes of issuing a determination and making DTRs would be subject to consultation, and any decisions would be required to have regard to:

• the likely effect on the Australian economy, and on the efficiency, integrity and stability of the Australian financial system of imposing a mandatory obligation
• the likely regulatory impact of imposing a mandatory obligation.

The Bill would also establish a licensing regime for trade repositories; responsibility for regulating these facilities would sit primarily with ASIC.

2.6.3 Considerations in implementing OTC derivatives market reforms

The regulators recognise that the costs and benefits of using centralised infrastructure (and related risk management requirements) may differ across types of product classes and participants. It is also recognised that many of these reforms represent a significant change to existing market practices and organisation. Many market participants will need to make modifications to their legal and operational arrangements. Changes in collateralisation practices may affect some market participants' balance sheets, and may also affect wider conditions in the market for eligible collateral assets.

Recognising the potential magnitude of some of these changes, the regulators would encourage industry-led reforms where possible, to allow arrangements to evolve in response to the commercial considerations of market participants and infrastructure providers.

As discussed later in this report, it is expected that many market participants will face incentives (such as price signals and network effects) that will strongly encourage a transition to central clearing in particular. However, it is also recognised that the magnitude of the changes necessary may result in some participants moving at a slower-than-desirable pace. Notwithstanding the expected effect of incentives, some market participants might still only respond if a mandatory obligation is in place. The certainty of a mandatory obligation might also reduce coordination problems among stakeholders.

The existence of mandatory obligations may also, in some circumstances, result in a reduced compliance burden for domestic market participants trading with offshore counterparties. In particular, there may be some merit in exploring mandatory obligations further if it was considered that having these in place was a net benefit to Australia, such as by reducing the cost of Australian- or foreign-based market participants engaging in cross-border transactions, or by providing greater certainty to participants as to how they may satisfy their regulatory obligations.

Additionally, Australian regulators would be concerned if, by adopting a flexible approach, opportunities for regulatory arbitrage emerged between the Australian regime and those in effect in other jurisdictions. Australian regulators fully expect to realise OTC derivatives reform outcomes that are closely aligned with those in other jurisdictions. Mandatory obligations might therefore be warranted to ensure that opportunities for regulatory arbitrage were minimised.

Footnotes

See, for instance, CPSS (2007), New Developments in Clearing and Settlement Arrangements for OTC Derivatives, Bank for International Settlements, March. Available at <http://www.bis.org/publ/cpss77.pdf>. Also, Counterparty Risk Management Policy Group (2005), Toward Greater Financial Stability: A Private Sector Perspective, July. Available at <http://www.crmpolicygroup.org/crmpg2/docs/CRMPG-II.pdf>. [1]

APRA, ASIC and RBA (2009), Survey of the OTC Derivatives Market in Australia, May. Available at <http://www.apra.gov.au/Media-Releases/upload/Survey-of-the-OTC-Derivatives-Market-in-Australia-report.pdf>. [2]

G-20 Summit, Los Cabos, 19 June 2012, Leaders' Declaration (Article 39). Available at <http://www.g20mexico.org/images/stories/docs/g20/conclu/G20_Leaders_Declaration_2012.pdf>. [3]

FSB (2010), Implementing OTC Derivatives Market Reforms, October. Available at <http://www.financialstabilityboard.org/publications/r_101025.pdf>. [4]

FSB (2012), OTC Derivatives Market Reforms: Third Progress Report on Implementation, June. Available at <http://www.financialstabilityboard.org/publications/r_120615.pdf> [5]

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/>. [6]

Council of Financial Regulators (2012), OTC Derivatives Market Reform Considerations, March. Available at <https://www.rba.gov.au/payments-system/clearing-settlement/ otc-derivatives/201203-otc-derivatives-market-reform-considerations/>. [7]

Treasury (2012), Implementation of a Framework for Australia's G20 Over-the-counter Derivatives Commitments, April. Available at <http://www.treasury.gov.au/ConsultationsandReviews/Submissions/2012/Over-the-counter-derivatives-commitments-consultation-paper>. [8]

The text of the Bill as first introduced to Parliament is available at <https://parlinfo.aph.gov.au/parlInfo/download/legislation/bills/r4879_first-reps/ toc_pdf/12149b01.pdf;fileType=application%2Fpdf#search=%22legislation/bills/r4879_first-reps/0000%22>. [9]