Report on the Australian OTC Derivatives Market 3. Regulatory and Industry Developments

Australian Prudential Regulation Authority
Australian Securities and Investments Commission
Reserve Bank of Australia
October 2012

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3.1 Introduction

The global drive for increased usage of centralised infrastructure, as well as other reforms to OTC derivatives markets, has been associated with a large number of international and national regulatory efforts. International standard-setting bodies have developed or revised standards and recommendations for OTC derivatives regulators, market participants and infrastructure providers in support of this transition. Reflecting this, the Australian financial regulators have recently undertaken a substantial volume of domestic policy reviews.

Many other jurisdictions are in the process of implementing regulatory requirements in support of their policies regarding OTC derivatives market reforms. Overseas requirements are having some influence on the Australian market, due to the cross-border nature of participation in the Australian OTC derivatives market. This means it is important to understand how the interaction of the domestic and overseas regulatory regimes may affect Australian market activity into the future.

In adapting to these national and international regulatory developments, global OTC derivatives market participants have recognised the benefits of international industry coordination in a number of areas. Industry groups have therefore been working on ways to increase standardisation and promote best practice.

3.2 International Standards and Initiatives

3.2.1 G-20 commitments

The international policy consensus regarding OTC derivatives market infrastructure has been most prominently articulated by the G-20 leaders. The key statement in this regard was made at the September 2009 summit in Pittsburgh:

All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.[1]

Subsequent G-20 meetings have endorsed continued progress on OTC derivatives reforms and initiatives, such as margining requirements for non-centrally cleared transactions and the development of a global Legal Entity Identifier (LEI) framework; these initiatives are discussed further below.

3.2.2 Financial Stability Board

The FSB continues to play a coordinating role in the global implementation of reforms to OTC derivatives markets. Following a request by the G-20 leaders, the FSB has been monitoring individual jurisdictions' progress in implementing the G-20 commitments. To this end, the FSB has to date published three progress reports: in April 2011, October 2011 and June 2012; a fourth report is currently in development. These reports have sought to facilitate the consistent, effective and timely implementation of reforms to OTC derivatives markets. Importantly, they have also served as a forum for discussion of the practical challenges faced by jurisdictions – both individually and collectively – in implementing the reforms.

The FSB has sought to understand the risks that may arise from the migration to centralised infrastructure under the reforms. In January 2012 the FSB established the OTC Derivatives Coordination Group (ODCG), comprising the chairs of the FSB and relevant international regulatory and central bank groups:

  • Basel Committee on Banking Supervision (BCBS)
  • Committee on the Global Financial System (CGFS)
  • Committee on Payment and Settlement Systems (CPSS)
  • International Organization of Securities Commissions (IOSCO).

To date the ODCG has focused on ensuring four safeguards are in place to promote a resilient global framework for CCPs:

  • fair and open access by market participants to CCPs, based on transparent and objective criteria
  • cooperative oversight arrangements between all relevant authorities, both domestically and internationally, that result in robust and consistently applied regulation and oversight of CCPs serving multiple jurisdictions
  • resolution and recovery regimes that ensure the core functions of CCPs are maintained during times of crisis and that consider the interests of all jurisdictions where the CCP is systemically important
  • appropriate liquidity arrangements for CCPs in the currencies in which they clear.

The establishment of the four safeguards is ongoing through the various reform efforts of standard-setting bodies and individual jurisdictions that are home to, or hosting, OTC derivatives CCPs.

3.2.3 CPSS-IOSCO

Principles for Financial Market Infrastructures

As the peak standard-setting bodies for financial market infrastructure, CPSS and IOSCO have been heavily involved in the post-crisis reform agenda. In recent years these bodies' most significant workstream has been the development of the Principles for Financial Market Infrastructures (PFMIs) – a set of strengthened international standards for payment systems, CCPs, securities settlement systems, central securities depositories and trade repositories.[2] This set of principles, released in April 2012, unifies and replaces three previous sets of recommendations and principles published by CPSS and IOSCO with respect to particular types of FMI – payment systems, CCPs and securities settlement systems. The development of standards for trade repositories reflects their increasing prominence following the G-20 commitment to reporting of all OTC derivatives.

With global reforms to OTC markets requiring participants to make greater use of centralised financial market infrastructure, often on a cross-border basis, establishing an internationally harmonised set of standards, such as the PFMIs, is essential. Authorities around the world are expected to incorporate the PFMIs into their respective regulatory regimes (see Sections 3.3.3 and 3.3.4 for details of Australian implementation). Moreover, the PFMIs strengthen previous international standards in a number of areas, including in the coverage of credit risk, the management of liquidity risks, and governance. This is particularly important given the challenges associated with the central clearing of OTC derivatives.

Recovery and resolution of FMIs

Although the PFMIs are intended to ensure that CCPs are highly robust, CPSS and IOSCO are seeking to further promote a resilient global framework for CCPs (in accordance with the third of the ODCG's safeguards) by developing principles around the recovery and resolution of FMIs. Specifically, CPSS and IOSCO released a consultation paper in July 2012, Recovery and Resolution of Financial Market Infrastructures – Consultative Report ,[3] which considers the application of the FSB's Key Attributes of Effective Resolution Regimes for Financial Institutions[4] to FMIs. This report, and ongoing work in this area, is crucial to giving market participants using, and relevant authorities (including those in host jurisdictions) with a regulatory interest in, systemically important FMIs the confidence that the failure of such FMIs would be managed in an appropriate and transparent manner.

Guidance around trade repository data

CPSS and IOSCO have also led the development of policy relating to data held by trade repositories. They have published standards for the nature and format of data to be reported, and the methodology by which these data should be aggregated globally.[5] CPSS and IOSCO are also currently developing guidance for trade repositories and regulators on regulatory access to data. Importantly, it is expected that the issues addressed by this guidance will include concerns regarding cross-jurisdictional privacy and confidentiality.

3.2.4 BCBS

Since 2009, the BCBS has been working to give effect to the G-20 goal of creating incentives for banks to increase their use of CCPs for OTC derivatives, while at the same time ensuring that banks' exposures to CCPs are adequately capitalised. As part of this process the BCBS released a package of reforms in December 2010 to raise the level and quality of regulatory capital in the global banking system (known as ‘Basel III’), with a revision issued in June 2011.[6]

The Basel III framework includes several improvements to the risk sensitivity of the capital adequacy framework. While the existing credit risk framework captured counterparty credit default risk, the experience of the recent financial crisis was that a large proportion of counterparty credit risk losses incurred were not in fact due to counterparty defaults. Instead, many losses were due to declining valuations of exposures following a deterioration in the creditworthiness of the counterparty. Under Basel III, the risk of this occurring will be capitalised by incorporating a credit valuation adjustment (CVA) risk capital charge for bilateral OTC derivatives. Where there was a deterioration in the credit quality of an OTC derivatives counterparty, this will result in a lower (credit adjusted) value being ascribed to the future expected payments to be received from that counterparty, which is captured as a CVA (or mark-to-market) loss. Derivatives that are centrally cleared through a qualifying CCP will not be subject to the CVA risk capital charge, but will instead be subject to a much lower capital risk weighting, reflecting the very small (but non-zero) risk of a CCP default.[7]

Following these releases the BCBS further refined the counterparty credit risk requirements with interim rules set out in the Capital Requirements for Bank Exposures to Central Counterparties in July 2012.[8] These rules consider the need to create incentives to increase the use of CCPs, including where this is undertaken through indirect clearing arrangements. The interim rules therefore include provisions on indirect clearing that allow clients of direct clearing members to benefit from the preferential capital treatment of central clearing. It is intended that these will come into effect from 1 January 2013, thereby allowing for the implementation of Basel III, while recognising that additional work is needed to further develop an improved capital framework; this work will take place in 2013.

3.2.5 BCBS-IOSCO working group on margin requirements for non-centrally cleared trades

At the November 2011 summit in Cannes, the G-20 leaders asked international standard setters to develop internationally consistent principles for margin requirements for non-centrally cleared OTC derivatives (i.e. transactions that remain bilateral between counterparties). In response, the BCBS-IOSCO Working Group on Margin Requirements (WGMR) issued draft principles for consultation and commenced a Quantitative Impact Study (QIS) in July 2012, with a view to issuing final principles by the end of December 2012.[9]

The draft principles relate to appropriate margining practices for non-centrally cleared derivatives and the treatment of collateral. The principles seek to mitigate the systemic risk arising from OTC derivatives that are not cleared by a CCP, by limiting the level of uncollateralised OTC derivatives exposures, and ensuring collateral is available to offset the losses resulting from a counterparty default. They also seek to ensure that cross-border OTC derivatives transactions are subject to consistent and non-duplicative regulation.

The QIS being conducted by the WGMR has sought to assess the likely impact of the draft principles on the demand for, and availability of, collateral in the global financial system.

3.2.6 IOSCO

Standards for Derivatives Market Intermediaries

In June 2012, IOSCO published a report International Standards for Derivatives Market Intermediary Regulation.[10] This report provides recommendations for the regulation and supervision of derivatives market intermediaries – market participants that are in the business of dealing, making a market or intermediating transactions in OTC derivatives. The recommendations seek to ensure derivatives market intermediaries are subject to appropriate regulation so as to assist in mitigating systemic risks and managing counterparty risk in OTC derivatives markets and, where appropriate, setting business conduct obligations for these intermediaries.

The report made recommendations in the following areas:

  • registration or licensing standards
  • capital standards or other financial resources requirements for non-prudentially regulated derivatives market intermediaries
  • business conduct standards
  • business supervision standards
  • record-keeping standards.

Trading platforms for OTC derivatives

In recent years IOSCO has published two reports in relation to the electronic trading of OTC derivatives.[11] These reports discuss preconditions for viable on-platform trading of OTC derivatives, and explore the different forms in which electronic trading can and does take place; they were not prescriptive in recommending which types of trading should be imposed by individual jurisdictions.

The reports identify the following benefits to increasing the use of trading platforms:

  • more efficient price discovery
  • increased competition which may potentially lower trading costs and improve liquidity
  • reduction in systemic risk (due to enhanced market liquidity)
  • improved regulatory supervision of the market for misconduct (as a result of increased centralisation).

In discussing which trade platforms may be appropriate for OTC derivatives markets, the following characteristics were agreed:

  • registration of the platform with a competent regulatory authority, including requirements relating to financial resources and operational capability
  • access for participants based on objective and fair criteria that are applied in an impartial, non-discriminatory manner
  • pre- and post-trade transparency arrangements which are appropriate to the nature and liquidity of the product and the functionalities offered by the platform
  • operational efficiency and resilience including appropriate linkages to post-trade infrastructure and measures to handle potential disruption to the platform
  • active market surveillance capabilities, including audit trail capability
  • transparent rules governing the operation of the platform
  • rules that do not permit a platform operator to discriminate between comparable platform participants in relation to the interaction of buying and selling interests within the system, whether fully electronic or hybrid.

Guidance on mandatory clearing

In February 2012, IOSCO published a report on Requirements for Mandatory Clearing; its recommendations covered matters such as:

  • processes for determining whether a mandatory clearing obligation should apply to a product or set of products
  • the factors to be considered around potential exemptions to a mandatory clearing obligation
  • the establishment of appropriate communications among authorities and with the public
  • the consideration of relevant cross-border issues in the application of a mandatory clearing obligation
  • the importance of monitoring and reviewing the overall process and application of a mandatory clearing obligation.[12]

While the report is mainly addressed to regulators implementing mandatory clearing regimes, it also provides information for stakeholders subject to any mandatory clearing obligations.

3.2.7 LEIs

LEIs will enable a market participant's counterparties to be uniquely and consistently identifiable, which should greatly enhance the interoperability and automation of in-house and third-party systems. It should also enable individual participants and their supervisors to more readily aggregate and analyse cross-product class exposures, as well as enhance market regulators' surveillance capacities. The use of LEIs may also enhance regulators' or bankruptcy professionals' ability to identify creditors and debtors in an insolvency scenario.

At the Cannes summit in November 2011, the G-20 leaders endorsed the creation of a global LEI framework.[13] In response to the G-20 leaders' request, the FSB has established an Implementation Group (IG) to establish global LEIs. A report by the IG in June 2012 provided recommendations to establish a global LEI system, in line with industry consensus standards developed by the International Standards Organisation. The G-20 leaders have endorsed a proposed three-tier structure for the global LEI system. The structure comprises:

  • a Regulatory Oversight Committee, which has responsibility for governance of the system
  • a Central Operating Unit, which is the operational arm with responsibility for ensuring globally consistent operational standards and protocols are applied
  • Local Operating Units, which will have responsibility for local implementation of the LEI system including validation and maintenance of certain data.

The IG is seeking to establish the Regulatory Oversight Committee and Central Operating Unit by March 2013. The IG has also established a Private Sector Preparatory Group which will work on specific issues, such as the numbering scheme for the global LEI system. The Private Sector Preparatory Group has been asked to consider factors such as flexibility, costs, and operational requirements of the LEI system from the standpoint of short-term implementation and integration of local systems, as well as long-term flexibility and resilience of the global system.

3.2.8 BCBS-CPSS report on FX risks

In May 2008, CPSS released a paper that found that the financial services industry had made significant progress in reducing FX settlement risk. However, the report noted that 30 per cent of the market still settled in a manner that did not mitigate FX settlement risk; half the value of these obligations were at risk overnight; and that participants' bilateral settlement exposures were large relative to their capital.

In 2011 the CPSS and BCBS established a joint working group to revise supervisory guidance previously issued in September 2000, to ensure that financial institutions are adequately controlling their FX settlement exposures. As a result of this work, in August 2012 the BCBS issued a consultative document Supervisory Guidance for Managing Risks Associated with the Settlement of Foreign Exchange Transactions.[14]

The proposed new guidance aims to ensure that risks are properly managed and provides more comprehensive and detailed guidance than that issued in 2000. In addition, it promotes the use of payment-versus-payment arrangements, where practicable.

The guidelines cover: governance; principal risk; replacement cost risk; liquidity risk; operational risk; legal risk; and capital for FX transactions.

3.3 Domestic Regulatory Developments

Much of the international work discussed above has been reflected in Australian regulatory developments over the past year. For market participants, the implementation of Basel III by APRA will result in ADIs' OTC derivatives positions being subject to higher capitalisation requirements where transactions are not centrally cleared. Domestic regulators are still waiting for the finalisation of other international reform efforts directly applicable to market participants – such as the development of minimum margin requirements for non-centrally cleared derivatives transactions – before considering how these might be applied in Australia. Other regulatory developments focus on FMIs, but with a key objective being to support domestic market participants' uptake of central clearing for OTC derivatives.

3.3.1 APRA implementation of Basel III counterparty credit risk capitalisation

As a member of the BCBS, APRA supports the implementation of Basel III reforms in Australia. In order to ensure that the Australian prudential framework is consistent with global standards, APRA proposes adopting the minimum Basel III requirements (except where it considers that there are strong reasons for departing from the framework). To this end, in August 2012, APRA released a discussion paper Implementing Basel III Capital Reforms in Australia – Counterparty Credit Risk and Other Measures.[15] The paper proposes the implementation of the Basel III reforms as discussed above in respect of counterparty credit risk from 1 January 2013, and seeks comment from industry and other interested stakeholders prior to the issuance of the final prudential standards (scheduled for November 2012).

As an additional measure, APRA also outlined that it envisages that ADIs with significant exposure to OTC derivatives counterparty credit risk will seek to mitigate operational risk by regularly undertaking portfolio reconciliations, trade valuations and collateral valuations with counterparties and, where practical, take opportunities to participate in portfolio compression exercises.

3.3.2 Regulatory influence over cross-border clearing and settlement facilities

The uptake of central clearing by the Australian market is likely to involve the use of overseas-based CCPs. While domestic solutions may emerge for some classes and currency denominations, these are unlikely to cover the full range of contracts transacted by Australian participants. The provision of such services in the Australian market will, in most cases, require licensing as a CS facility under the Corporations Act. However, overseas-based facilities are likely to apply for a CS facility licence under section 824B(2) of the Act, which is available only to overseas-based facilities subject to regulation in their home country that is sufficiently equivalent to that in Australia. For a CS facility licensed under this section, ASIC and the RBA would place reliance on information and reports provided by the CS facility's home regulator in assessing the CS facility's compliance with its licence obligations. In addition, overseas licensed facilities are not subject to the operating rule disallowance process under section 822E of the Act.

In regulating an overseas-based CS facility, the Council agencies would seek to ensure Australian regulatory influence regarding this facility was sufficiently strong. To that end, in July 2012 the agencies prepared a paper Ensuring Appropriate Influence for Australian Regulators over Cross-border Clearing and Settlement Facilities. This articulated a proposed approach to overseas-based CS facilities licensed under section 824B(2) of the Act, with a view to:

  • establishing conditions whereby Australian regulators have effective oversight of a cross-border CS facility and can exercise sufficient influence to ensure that the facility meets domestic and international standards for systemic risk management, provides its services in a fair and effective way, and offers due protection to Australian participants
  • minimising potential disruption and loss to Australian financial institutions, financial markets and the real economy in the event of a participant's default or other financial stress to a CS facility
  • ensuring continuity of provision of clearing and settlement services to the most systemically important Australian financial markets.[16]

The policy developed by the Council seeks to ensure that the imposition of such measures on overseas facilities is done in a graduated and proportionate fashion. It spans the following:

  • Foundational requirements
    • – for all CS facilities licensed in Australia: legal compatibility of the facility's rules with Australian regulatory objectives; adequate channels to demonstrate compliance with the RBA's Financial Stability Standards (FSSs) and other obligations as CS facility licensees under Part 7.3 of the Corporations Act
    • – for CS facilities licensed in Australia that have material Australian-based participation and/or provide services in Australian-related products: governance and operational arrangements that promote stability in the Australian financial system.
  • Additional requirements for systemically important CS facilities: holding an Exchange Settlement Account (ESA) with the RBA; strengthened influence for regulators (possibly through membership of relevant cooperative oversight groups).
  • Additional requirements for CS facilities that have a strong domestic connection: holding a domestic CS facility licence (and hence submitting to primary regulation by Australian regulators), which may also require a domestic legal presence; and controlling the degree of offshore outsourcing of critical functions, including systems, data and staffing.

As an illustration of how these graduated measures might be applied, it is likely that a CCP clearing a large share of the Australian dollar-denominated interest rate derivatives market would be required to meet both the foundational requirements and the additional requirements for systemically important CS facilities. Such a CCP may not, however, need to meet requirements associated with having a strong domestic connection given the market in Australian dollar-denominated interest rate derivatives – although of systemic importance to the Australian financial system – is international in nature.

3.3.3 RBA Financial Stability Standards for clearing and settlement facilities

Under the Corporations Act, the RBA has the power to determine FSSs for the purpose of ensuring that licensed CS facilities conduct their affairs in a way that causes or promotes overall stability in the Australian financial system. In 2003, the RBA determined FSSs for two classes of CS facilities: CCPs and securities settlement facilities. The FSSs are each supported by a set of measures that the RBA considers relevant in assessing compliance, and which are broadly aligned with the previous CPSS-IOSCO recommendations for CCPs and securities settlement systems.

The RBA has recently undertaken a consultation to update the FSSs in line with the PFMIs (discussed in Section 3.2.3).[17] The RBA's proposed approach is to fully adopt the PFMIs relevant to stability in the new FSSs. This will involve a significant change in the structure and form of the proposed FSSs. The current FSSs each comprise a high-level requirement (i.e. that a CS facility licensee ‘conduct its affairs in a prudent manner, in accordance with the standards of a reasonable CS facility licensee in contributing to the overall stability of the Australian financial system, to the extent that it is reasonably practicable to do so’), accompanied by measures relevant to the RBA's assessment of whether a licensee has complied with the applicable FSS.

By contrast, in aligning with the structure of the PFMIs, the RBA is proposing a more granular (and detailed) set of FSSs for each type of CS facility. In particular, each PFMI would be adopted as a legally enforceable standard, with each ‘key consideration’ adopted as an associated and individually legally enforceable ‘sub’-standard. Further, in relation to overseas licensees, the RBA is proposing to place reliance on authorities in sufficiently equivalent regulatory regimes in respect of assessment against only those FSSs for which a ‘materially equivalent’ standard is explicitly applied in the overseas regime. Where the RBA is not satisfied that a materially equivalent standard exists, or is not satisfied with the documentary evidence received from the overseas regulator, the RBA proposes to directly assess an overseas licensee's compliance with the relevant FSS. The proposed FSSs also seek to embed the Council's proposed policy approach regarding sufficient regulatory influence over overseas-based facilities, as discussed in Section 3.3.2.

It is expected that the final FSSs will be issued before the end of 2012, to take effect shortly thereafter.

3.3.4 ASIC Regulatory Guidance for clearing and settlement facilities

ASIC's Regulatory Guide 211 Clearing and Settlement Facilities: Australian and Overseas Operators (RG211), sets out ASIC's approach to the licensing and regulation of CS facilities in Australia.[18] RG211 provides guidance on when an Australian CS facility licence will be required; how to apply for a CS facility licence; and ASIC's approach to exemptions.

ASIC has recently consulted on proposed amendments to RG211 to take into account the updated PFMIs (discussed in Section 3.2.3) and the Council of Financial Regulators' paper on regulatory influence for Australian regulators over cross-border clearing and settlement facilities licensed in Australia.[19] The updated guidance is intended to provide greater clarity for CCPs, both domestic and offshore, intending to become licensed to clear OTC derivatives for Australian market participants.

Consultation closed in October 2012 and ASIC intends to have amended RG211 by the end of 2012. The proposed amendments would take effect immediately from that time.

3.4 Developments in Other Jurisdictions

The Australian OTC derivatives market is highly internationalised. The local presence of offshore-domiciled dealers contributes to the liquidity and efficiency of the domestic market. A number of Australian-owned institutions also have substantial operations in offshore markets. Because of this, it is highly likely that at least some of the activity that is undertaken in Australia or that involves an Australian-based counterparty will, at some point, fall within the scope of OTC derivatives regulatory regimes being developed in other jurisdictions (notably the European Union (EU) and United States). It is therefore important to understand how the design of these regimes may be a force shaping the Australian OTC derivatives market. For domestic market participants and FMIs active in overseas markets – whether Australian- or foreign-domiciled – there may be some need to understand and demonstrate the equivalence of foreign regimes with that of Australia to avoid duplicated or conflicting regulatory requirements.

3.4.1 United States

Dodd-Frank Act

In the US, Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 (Dodd-Frank Act) introduces a regulatory regime for OTC derivatives (termed ‘swaps’ in the US regime), and requires the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) to adopt rules to implement the details of the regime. The CFTC is in the process of issuing rules in the following areas:

  • joint rule with the SEC further defining product terms such as ‘swap’ and ‘security-based swap’
  • registration and regulation of Swap Dealers and Major Swap Participants, including capital and margin rules for non-banks, segregation of collateral and business conduct requirements
  • clearing, including registration and regulation of CCPs (termed Derivatives Clearing Organizations (DCOs) in the US), clearing requirements and exemptions from clearing requirements
  • data, including registration and regulation of trade repositories (termed Swap Data Repositories (SDRs) in the US), data record-keeping and reporting, real-time public reporting and reporting relating to commodity trading
  • trading, including registration and regulatory requirements for Swap Execution Facilities (trading platforms) and requirements to make swaps available to trade.

Recently, the CFTC finalised a rule establishing a schedule for compliance with mandatory clearing requirements for swaps and proposed the first classes of swaps that will be subject to mandatory clearing.

The CFTC's rules took effect from 12 October 2012, although large market participants have until end-December 2012 to register as Swap Dealers or Major Swap Participants.

In July 2012 the CFTC published proposed guidance on its approach to cross-border issues. Other jurisdictions have provided feedback raising a number of issues for further discussion as to potential overlap, potential conflicts and the need for further clarification. ASIC and the RBA have engaged with regulators in Hong Kong and Singapore on this issue, and signed a joint letter to the CFTC identifying key concerns for Asia-Pacific market participants that will be required to register as Swap Dealers and for financial market infrastructure based in this region.

As part of the implementation of trade capture and reporting requirements, the CFTC has implemented a CFTC Interim Compliant Identifier, an LEI which complies with the proposed global standard set for LEIs, discussed above in Section 3.2.7.

3.4.2 European Union

EMIR

The European Union Regulation on OTC derivatives, Central Counterparties and Trade Repositories (known as EMIR) entered into force in August 2012. EMIR enables the imposition of mandatory clearing requirements on OTC derivatives contracts entered into by financial entities, as well as those of non-financial entities that exceed a clearing threshold. Once fully implemented, OTC derivatives contracts not subject to the clearing mandate will be subject to alternative risk mitigation requirements, including the exchange of collateral or holding of additional capital. Counterparties to all OTC derivatives transactions will be required to report details of transactions to a trade repository. EMIR requires CCPs to be registered, and imposes prudential and business conduct requirements on registered CCPs. EMIR also imposes certain requirements on trade repositories.

In September 2012, the European Securities and Markets Authority (ESMA) issued draft technical standards to implement a number of provisions in EMIR. The technical standards are expected to be adopted by the European Commission as regulations by the end of 2012. The standards, if adopted, will:

  • define the details of derivatives transactions that need to be reported to trade repositories
  • define details of supervision of trade repositories, and the data that would be made available to relevant authorities and the public
  • set out how thresholds for clearing obligations will operate; entities above these thresholds will be subject to a clearing mandate
  • set out the mandatory risk mitigation techniques for OTC derivatives that are not centrally cleared, such as trade confirmation, portfolio compression and reconciliation
  • define a set of organisational, conduct of business and prudential requirements for CCPs including margin requirements, default fund, default waterfall, liquidity risk management and investment policy, as well as stress- and back-testing arrangements.

Other European supervisory authorities have also consulted on, or published, related draft technical standards; for instance, the European Banking Authority has proposed draft technical standards on capital requirements for CCPs.

The cross-border application of EMIR will depend on whether a transaction (including a transaction where a counterparty is established in a third country) is likely to have a direct, substantial and foreseeable effect within the EU. EMIR also provides a mechanism for market participants to be deemed to have complied with relevant clearing, reporting and risk mitigation rules where at least one of the counterparties is established in a non-EU jurisdiction that the European Commission has determined to have an equivalent regulatory regime, which is applied in an equitable and non-distortive manner.

MiFID / MiFIR

On 20 October 2011, the European Commission adopted proposals for a revised Markets in Financial Instruments Directive (MiFID) and a new Markets in Financial Instruments Regulation (MiFIR). The proposed Directive and Regulation would:

  • extend the existing harmonised European financial services and markets regime, in terms both of instruments and firms covered (so that, for example, certain commodity trading firms would fall within the scope of the regime)
  • impose regulatory requirements on firms undertaking algorithmic trading (including high-frequency trading)
  • impose position limits on the trading of commodity derivatives
  • impose restrictions on third-country firms providing services in the EU
  • introduce enhanced corporate governance requirements for investment firms
  • introduce enhanced pre- and post-trade transparency provisions in respect of both equities and non-equities.

3.4.3 Other jurisdictions

Outside of the US and EU, Japan is one of the jurisdictions most advanced in the implementation of its G-20 commitments. Amendments were made to Japan's Financial Instruments and Exchange Act in May 2010 which require the central clearing and reporting of certain classes of OTC derivatives, as set out in cabinet ordinances by the Japanese Financial Services Agency (JFSA). The first such ordinance is due to be passed in November 2012. For central clearing, it is proposed that clearing obligations will apply to credit default swaps referencing Japanese entities and yen-denominated interest rate swaps eligible for clearing at the Japanese Securities Clearing Corporation (JSCC). While the legislation requires that derivatives with credit events closely associated with Japanese corporate bankruptcy law be cleared by a Japanese CCP (currently JSCC only), other stipulated derivatives may be cleared through foreign CCPs licensed by the JFSA or which have interoperability arrangements with a Japanese CCP. For trade reporting, a broad scope of OTC derivatives is likely to be stipulated, with direct reporting to the JFSA of derivatives for which there is no established trade repository. Trade execution requirements are not as well advanced, although draft legislation was proposed in March 2012.

In other jurisdictions, such as Hong Kong, Singapore and Canada, the design and implementation of legislation and regulation to impose mandatory requirements is less progressed but well underway. Similar to Australia, these jurisdictions have found value in observing developments in other large markets before crafting their own regimes. The design and implementation of the frameworks being adopted in these other jurisdictions would also appear to be somewhat similar to that of Australia. Although the final aspects of the regimes in these jurisdictions are, in many cases, still subject to consultation and further consideration by regulators, some common characteristics are likely to emerge:

  • mandatory trade reporting is likely to form part of the initial application of the regimes
  • single-currency interest rate swaps, denominated in the local currency, are being considered for the initial application of any mandatory central clearing requirements
  • participants are likely to be able to meet any mandatory central clearing obligations using central counterparties outside of the local jurisdiction in many cases
  • participant exemptions from mandatory central clearing are being considered for public entities and end users that use derivatives solely to hedge.

Mandatory requirements imposed in jurisdictions outside of the EU and US are less likely to have a material and direct effect on the OTC derivatives activity of Australian entities. Any such requirements are expected to target products in specific currency denominations that are less traded by Australian entities. Also, these jurisdictions do not appear to be developing registration requirements for foreign entities that trade with local entities.

3.5 Global Industry Developments

In recent years global OTC derivatives market participants have initiated or accelerated a number of workstreams around the standardisation of data and processes, either as direct responses to regulatory requirements or as industry-driven proposals. These efforts in part reflect a recognition that common standards can have substantial benefits for participants and other stakeholders, and that these benefits increase as the number of transactions and participants in the market increase. They also partly reflect an assessment that many jurisdictions' regulatory agendas are closely aligned, and that globally consistent industry initiatives are likely to be a more efficient approach to introducing such reforms for market participants that engage in cross-border transactions.

3.5.1 Data standardisation

A key area of work has been the development of standardised identifiers when recording transaction details. As well as facilitating trade reporting, such standardised identifiers can also facilitate increased straight-through-processing and other aspects of trade automation, thereby reducing operational risks in OTC derivatives markets. A key initiative in this regard is the LEI project, discussed above in Section 3.2.7. It has been a deliberate strategy of the regulatory community to ensure market participants and industry groups are closely engaged in this work.

Operational risk management and trade reporting will also be enhanced by the development of Unique Product Identifiers (UPIs). While the specifications of an OTC derivatives transaction are often quite standardised within a product class, there is often substantial variation in the terms and conventions of trades across different product classes. By embedding some standardisation around these parameters, and enabling the identification of the specific product class of a transaction, UPIs should help simplify and increase the accuracy of transaction record-keeping, and further facilitate trade processing enhancements. Recognising this, global industry groups such as the International Swaps and Derivatives Association (ISDA) and the Global FX Division (GFXD) have proposed product taxonomies and related standards.

Several industry groups also have work underway to develop Unique Trade Identifiers (UTIs) – also known as Unique Swap Identifiers (USIs). UTIs allow for individual transactions to be identified within and across counterparties. As with UPIs, having a standard approach to generating these identifiers would greatly enhance operational efficiency and data management.

To facilitate process standardisation and system interoperability, a number of industry groups are promoting the greater uptake of common messaging standards, such as the FIX, FpML and SWIFT protocols.

3.5.2 Portfolio reconciliation and collateralisation arrangements

Industry groups have also been undertaking work on market conventions and best practice for market participants. ISDA has, for a number of years, surveyed market participants on collateral practices. Building on these surveys, it has published best practice guidelines around collateralisation in OTC derivatives markets.[20] As part of this work, it has developed a protocol around the management of disputed valuations and collateral calls. A related workstream looks to promote regular portfolio reconciliations, so as to reduce the incidence of missed or incorrectly captured trades, in turn reducing the likelihood of trade and collateral disputes. As part of this global effort, an Asia-Pacific Collateralised Portfolio Reconciliation Memorandum of Understanding has been developed, to which close to 30 firms from the Asia-Pacific region are adherents.[21]

3.5.3 Documentation

OTC derivatives documentation has evolved in response to recent and anticipated regulatory developments. ISDA, in particular, has worked with industry participants and associations to produce standard documentation that seeks to assist market participants make the transition to revised or new OTC derivatives regulatory regimes.

Standardised credit support annexes

The high degree of heterogeneity in bilaterally negotiated credit support annexes (CSAs) that collateralise OTC derivatives positions has given rise to a number of risks. Larger dealers, who may have several thousand CSAs in place, face significant operational complexity in managing these arrangements. Further, where a counterparty has the option to provide a variety of different forms of collateral against a position, valuing this optionality in a standardised and transparent way has proved difficult at times. As well as complicating the valuation of bilateral positions, uncertainties around the valuation of optionalities in CSAs can also slow the process of transferring bilateral trades to CCPs. To overcome some of these difficulties, ISDA has released a standard credit support annex (which market participants may take up voluntarily) that seeks to standardise the calculation of collateral requirements for multi-currency exposures.

Client clearing and related documents

In response to the rules being promulgated under Title VII of the Dodd-Frank Act, ISDA has released an optional protocol in August 2012, allowing participants to incorporate standard representations into contractual terms that would satisfy customer business conduct rules issued by the CFTC. MarkitWire and ISDA have launched, the ISDA Amend platform for both sell-side and buy-side participants, to allow participants to satisfy the CFTC's business conduct requirements by exchanging information in pre-completed questionnaires and providing standard representations.

For transactions executed through a broker, the US Futures Industry Association (FIA) and ISDA released the Cleared Derivatives Execution Agreement in June 2011, releasing a revised version of the Agreement in September 2012. Consistent with final CFTC rules on swap relationship documentation for Swap Dealers and Major Swap Participants, the revised Agreement does not permit the disclosure of the identity of a client's counterparty to the client's Futures Clearing Merchant (FCM – a specific term for direct clearing participants in the US regime); includes a requirement for parties to accept trades for clearing as soon as technologically possible; and allows the parties to set out cut-off times for determining responsibility for trade breakage costs.

In August 2012, FIA and ISDA released a Cleared Derivatives Addendum as a supplement to a futures and options agreement between an FCM and a client. The Addendum facilitates the making of representations about matters including treatment of client collateral, and sets out provisions relating to tax, close-out methodology for cleared swaps and valuation of terminated trades.

In Europe, work is also underway with buy-side and sell-side participants on standard documentation for clearing of OTC derivatives.

Footnotes

G-20 Summit, Pittsburgh, 24–25 September 2009, Leaders' Statement (Article 11). Available at <http://www.g8.utoronto.ca/g20/2009/2009communique0925.html>. [1]

CPSS-IOSCO (2012), Principles for Financial Market Infrastructures, Bank for International Settlements, April. Available at <http://www.bis.org/publ/cpss101a.pdf>. [2]

CPSS-IOSCO (2012), Recovery and Resolution of Financial Market Infrastructures – Consultative Report, Bank for International Settlements, July. Available at <http://www.bis.org/publ/cpss103.pdf>. [3]

FSB (2011), Key Attributes of Effective Resolution Regimes for Financial Institutions, November. Available at <http://www.financialstabilityboard.org/publications/r_111104cc.pdf>. [4]

CPSS-IOSCO (2012), Report on OTC Derivatives Data Reporting and Aggregation Requirements, Bank for International Settlements, January. Available at <http://www.bis.org/publ/cpss100.pdf>. [5]

See BCBS (2011), Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems – Revised Version June 2011, Bank for International Settlements, June. Available at <http://www.bis.org/publ/bcbs189.htm>. [6]

Under these proposals, a CCP would be qualifying if it was domiciled and prudentially supervised in a jurisdiction where the relevant regulator has established and publicly indicated that it applies to the CCP, on an ongoing basis, domestic rules and regulations that are consistent with the PFMIs. [7]

See BCBS (2012), Capital Requirements for Bank Exposures to Central Counterparties, Bank for International Settlements, July. Available at <http://www.bis.org/publ/bcbs227.htm>. [8]

BCBS-IOSCO (2012), Margin Requirements for Non-centrally-cleared Derivatives, Bank for International Settlements, July. Available at <http://www.bis.org/publ/bcbs226.htm>. [9]

IOSCO (2012), International Standards for Derivatives Market Intermediary Regulation, June. Available at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD381.pdf>. [10]

The initial report was IOSCO (2011), Report on Trading of OTC Derivatives, February. Available at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD345.pdf>. This was supplemented by IOSCO (2012), Follow-on Analysis to the Report on Trading of OTC Derivatives, January. Available at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD368.pdf>. [11]

IOSCO (2012), Requirements for Mandatory Clearing, February. Available at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf>. [12]

G-20 Summit, Cannes, 4 November 2011, Final Declaration (Article 31). Available at . [13]

BCBS (2012), Supervisory Guidance for Managing Risks Associated with the Settlement of Foreign Exchange Transactions – Consultative Document, Bank for International Settlements, August. Available at <http://www.bis.org/publ/bcbs229.pdf>. [14]

APRA (2012), Implementing Basel III Capital Reforms in Australia – Counterparty Credit Risk and Other Measures, August. Available at <http://www.apra.gov.au/adi/PrudentialFramework/Pages /Basel-III-Counterparty-Credit-Risk-and-other-measures-August-2012.aspx>. [15]

Council of Financial Regulators (2012), Ensuring Appropriate Influence for Australian Regulators over Cross-border Clearing and Settlement Facilities, July. Available at <http://www.treasury.gov.au/ConsultationsandReviews/Submissions/2012/cross-border-clearing>. [16]

RBA (2012), Consultation on New Financial Stability Standards, August. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/consultations/201208-new-fin-stability-standards/>. [17]

ASIC (2010), Regulatory Guide 211: Clearing and Settlement Facilities: Australian and Overseas Operators, April. Available at <http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rg211.pdf/$file/rg211.pdf>. [18]

ASIC (2012), Consultation Paper 186: Clearing and Settlement Facilities: International Principles and Cross-border Policy (Update to RG211), September. Available at <http://www.asic.gov.au/asic/asic.nsf/byHeadline/12-221MR%20ASIC%20consults%20on%20
amendments%20to%20clearing%20and%20settlement%20facilities%20guidance?opendocument>. [19]

ISDA (2011), ISDA 2011 Best Practices for the OTC Derivatives Collateral Process, November. Available at <http://www2.isda.org/attachment/Mzc5MA==/2011%20ISDA%20Best%20Practices%20for%20the%20OTC%20
Derivatives%20Collateral%20Process%20-%2030%20Nov%202011%20FINAL.pdf>. [20]

Details of the Memorandum of Understanding and adhering firms are available at <http://www2.isda.org/attachment/MzA4OA==/asiapacific_mou.html>. [21]