Report on the Australian OTC Derivatives Market 1. Introduction and Executive Summary

The Australian Prudential Regulation Authority (APRA), the Australian Securities and Investments Commission (ASIC) and the Reserve Bank of Australia (RBA) (together, the regulators) have been considering for some time the desirability of reforms to the functioning of domestic over-the-counter (OTC) derivatives markets. The regulators' ongoing interest in these markets reflects their various mandates regarding market and participant supervision, as well as broader financial stability and prudential considerations. This interest encompasses the structure and functioning of markets, the infrastructure that supports these markets, and the nature and behaviour of participants.

A key question for the regulators has been whether there is a need for direct regulatory intervention to drive additional reforms in the Australian market. The regulators have a number of existing regulatory tools available, mainly with respect to conduct and prudential requirements applying to licensed market participants. Additionally, the Australian Government has introduced into Parliament the Corporations Legislation Amendment (Derivative Transactions) Bill 2012 (Derivative Transactions Bill). This Bill proposes amendments to the Corporations Act 2001 to create additional regulatory tools to implement reforms in OTC derivatives markets. In particular, mandatory trade reporting, central clearing or trade execution obligations could be imposed for specified classes of products and participants. The Bill requires that the regulators be consulted when any such obligations are proposed or implemented.

The regulators recognise that the efficiency, integrity and stability of domestic OTC derivatives markets can be enhanced through the use of centralised infrastructure such as trade repositories, central counterparties (CCPs) and trading platforms. In promoting a transition to such an environment, the regulators also recognise the importance of retaining the benefits of OTC derivatives markets wherever possible. Accordingly, the regulators would therefore seek to promote the adoption of centralised infrastructure in a flexible manner to permit an industry-led transition as appropriate. The regulators also recognise that not all products and participants are amenable to a transition to centralised infrastructure; in such cases, however, it is important to ensure other risk management measures are rigorously applied.

The regulators will also take into account whether imposing mandatory central clearing, trade reporting or trade execution requirements would support the recognition of Australia's regulatory regime as comparable or equivalent to those of key overseas jurisdictions. This would 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.

The Australian 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. To provide an additional empirical basis for further exploring these issues, in July 2012 the regulators undertook a voluntary survey of more active market participants, covering large domestic and international banking groups, smaller authorised deposit-taking institutions (ADIs), fund managers, government borrowing authorities, corporate treasuries and electricity companies.

Based on an assessment of the state of play in the domestic OTC derivatives market, the regulators make the following recommendations around infrastructure usage and risk management:

Trade reporting

In the view of the regulators, having as many OTC derivatives transactions as possible reported to trade repositories would enhance the efficiency, integrity and stability of the Australian financial system.

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

The parameters of a trade reporting mandate, including the specific products and participants subject to the mandate and the data reported, could be addressed in regulations or rules. Trade reporting requirements could be introduced under appropriate phasing arrangements, taking into account the relative importance of particular instrument classes and categories of reporting entity, as well as the availability of licensed trade repositories.

Central clearing

The regulators are of the view that central clearing of the Australian dollar-denominated interest rate derivatives market would bring substantial benefits to the efficiency, integrity and stability of the Australian financial system. This benefit would be most immediately realised if larger market participants, such as the large Australian-based banks, were to participate in central clearing.

The available evidence suggests that a migration of these participants towards central clearing is underway; larger foreign financial institutions are already (or will soon be) participating in central clearing for these instruments. Once a licensed CCP that clears these products is available in Australia, the regulators would expect that a transition to central clearing should accelerate.

Given this, at this stage additional regulatory intervention does not appear warranted in order to achieve a substantial uptake of central clearing in this market.

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.

There could also 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, the 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.

The regulators will continue to assess market developments, with a view to considering where central clearing for other products might be warranted. While there are strong in-principle benefits from central clearing in product classes such as cross-currency swaps, foreign exchange (FX) and credit derivatives, at present no viable central clearing solution exists for these.

Risk management for non-centrally cleared trades

In reviewing market participants' risk management practices, a number of issues were identified where further attention from participants or regulators would seem warranted. In particular:

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

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.

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 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.

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 addition to industry-led changes to the use of credit support for non-centrally cleared transactions, international standard setters are considering principles for margin requirements applicable to such transactions. The regulators will continue to monitor these developments and provide advice to the government as appropriate.

The results of the survey also indicate shortcomings in the counterparty credit risk management practices of some participants in the OTC electricity derivatives market, relative to other OTC derivatives markets. The regulators consider that further work should be undertaken to explore these issues.

Trade execution

The regulators see in-principle benefits in a greater utilisation of trading platforms in the Australian OTC derivatives market. However, further analysis is required to identify where or how these benefits might be best realised, and therefore at this stage the regulators do not propose to make any specific recommendations as to possible trade execution obligations.

The remainder of the report is structured as follows:

• Chapter 2 provides more context to the policy concerns around OTC derivatives markets, discusses regulatory responses and the merits of centralised infrastructure in these markets, and relevant aspects of the Australian regulatory framework
• Chapter 3 discusses domestic and international regulatory developments regarding OTC derivatives markets, and industry work that is complementing these
• Chapter 4 sets out key characteristics of the Australian OTC derivatives market, using information collected through the regulators' survey as well as a variety of other data sources
• Chapter 5 discusses developments in risk management practices in the Australian market, including participants' use of financial market infrastructure
• Chapter 6 discusses more fully the regulators' recommendations around centralised infrastructure and risk management, drawing on the discussions in earlier chapters
• Chapter 7 concludes and sets out some next steps.