Report on the Australian OTC Derivatives Market – October 2012 5. Risk Management and Infrastructure Usage in Australia

5.1 Introduction

This chapter reviews developments in the risk management practices and market infrastructure usage of participants in the Australian OTC derivatives market. As discussed in Section 2.2, due to the bilateral nature of many OTC derivatives markets, the resilience of these markets is highly dependent on each market participant's risk management practices. The regulators are therefore keen to ensure that major market participants implement and maintain robust risk management practices. Centralised infrastructure can further enhance individual participants' risk management, while also reducing some of the interdependencies between participants.

As discussed in Section 2.5.1, in May 2009 the Australian regulators undertook a survey of Australian OTC derivatives market participants to better understand risk management and infrastructure usage in Australia. Based on those survey results, the regulators made a number of recommendations to the industry to:

• 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 central counterparties for OTC derivatives products
• expand the use of automated facilities for confirmations processing
• expand the use of multilateral portfolio compression and reconciliation tools.

The July 2012 survey undertaken by the regulators has provided an insight into the domestic market's progress with regards to these recommendations, as well as other developments around risk management and infrastructure usage. In general, the survey results reveal that some enhancements to risk management processes have been made in recent years, and generally appear to be appropriate to the scale and nature of the domestic OTC derivatives market. Within this, though, there would appear to be some areas where additional improvements are warranted. Usage of centralised infrastructure is not yet well entrenched, though some increased uptake is evident.

5.2 Counterparty Credit Risk Management

5.2.1 Trade documentation

As part of a trading relationship, it is common for the rights and obligations between two counterparties to be governed by a master agreement that applies to all transactions. A master agreement typically allows one counterparty to calculate a net exposure across all its positions with respect to another counterparty, and sets out the circumstances under which positions can be closed out. ISDA has developed a master agreement that is widely used among active market participants, including in Australia. Most dealers reported that they had between 100 and 1,000 master agreements in place with counterparties in the Australian market; a small number of dealers reported having more than 1,000 agreements in place. Master agreements would appear to be in place between the majority of larger counterparties; utilisation for smaller market participants would appear to be somewhat lower. For internationally active participants the governing law of master agreements or other related contracts was reported to be a mix of Australian, English and New York law. For participants active only in the local market, Australian law was reported to be the most prevalent governing law. There was also some limited incidence of other governing laws.

5.2.2 Credit support arrangements

The survey results indicate that around half of these master agreements are supplemented by Credit Support Annexes (CSAs) or similar agreements that set out how and when a set of bilateral exposures might be marked-to- market, whether exposures should be collateralised, the form of this collateralisation and the governing law for the agreement.

Survey respondents reported that the largest percentage of credit support arrangements were typically with interbank and professional counterparties as opposed to customer- or corporate-related activity (Table 3). For most dealers, use of credit support is predominantly with financial institutions and fund managers, of which overseas-based financial institutions make up the largest component. Of the aggregate number of CSAs in place with dealers, on average around 40 per cent were established with overseas financial institutions, while around 20 per cent were established with Australian financial institutions. CSAs are less widely used for non-financial counterparties.

Smaller domestic market participants tended to use Australian law CSAs exclusively. English law CSAs are by far the most widely used by the larger participants in the Australian market, followed by New York law, with Australian law CSAs also used to some degree by these larger participants.

For internationally active Australian banks and local presences of foreign banks, CSAs typically specify that multi-currency collateral can be posted – the main currencies reported were AUD, EUR, GBP, JPY and USD. There is a clear trend that domestically focused market participants predominantly use AUD collateral, while foreign currency denominations are more widely used when transactions involve offshore entities. Smaller domestic respondents with CSAs in place typically only specify AUD, largely due to their limited access to foreign currency-denominated collateral.

Consistent with the 2009 survey results, the vast majority of respondents who make use of collateral only accept cash or government securities (Table 4). However, there would appear to be some expanded use of some other collateral types such as corporate bonds, covered bonds, equities, letters of credit and guarantees, perhaps reflecting changes in the availability of high quality liquid assets.^[1]

Survey respondents noted that a significant percentage of current documentation generally allows for some rehypothecation or reuse of collateral under existing CSAs. Around 50 per cent of respondents noted that rehypothecation is not permitted under at least some of their CSAs.

Responses from electricity market participants indicate electricity derivatives tend to be documented under ISDA master agreements tailored to this product class. Their responses also highlighted important differences in counterparty credit risk management practices compared with other markets. A majority of respondents do not use CSAs for credit support; instead, they use other arrangements such as letters of credit or parent guarantees. Some may negotiate collateral-giving on a transaction-by-transaction basis. As a result of these practices, it is not common for cash collateral or other forms of collateral to be posted between counterparties. These differences in practices are discussed further below.

5.2.3 Margining practices

Since the 2009 survey, and consistent with recent margin surveys undertaken by ISDA, there is evidence of an increased use of collateral in the Australian market, reflecting a number of factors: at-times tight credit market conditions; ongoing rating action against financial entities; and an appreciating local currency creating large mark-to-market exposures for foreign currency derivatives positions.

Respondents noted a range of criteria for setting initial margin, threshold and transfer amounts. These are consistent with the 2009 survey responses and include the following:

• credit policies and guidelines
• assessment by the credit risk resource responsible for the counterparty
• bilateral negotiation with the counterparty, that considers counterparty creditworthiness and the liquidity, funding and operational implications of the exposures
• external rating considerations, with some specific counterparty types having zero thresholds and low minimum transfer amounts
• industry standard considerations
• volatility of exposures and operational practicalities.

In general, most CSAs allow two-way variation margin (or mark-to-market collateralisation). However, some government, corporate and funds management counterparties appear to be resistant to entering into two-way CSAs given the potential liquidity and cash-flow implications of variation margin calls.

For larger bank respondents initial margins are not typically posted. Only a very small number of CSAs require that a counterparty post initial margin (or independent amounts); there would appear to be only a small number of these arrangements, which are mainly used to facilitate transactions with smaller or weaker counterparties.

It is common practice for an unsecured threshold to be provided under CSAs with two-way mark-to-market arrangements along with a specified minimum transfer amount across all nominated products. Some of these arrangements in effect result in one-way collateralisation and reflect assessments about the creditworthiness of the counterparty; for instance, for some highly rated entities the threshold can be set very high with provisions in place to reduce the threshold amount should the perceived creditworthiness of the entity deteriorate.

There were variations between the respondents in relation to the amount of collateral posted, and the mark-to-market value of their derivatives books. Some respondents post close to $1 of collateral for each $1 of mark-to-market exposure. Others, however, would appear to over-collateralise their positions; this may be in order to reduce the operational burden of managing daily collateral flows.

Again, the responses from OTC electricity market participants highlighted some important divergences from standard practices seen in other OTC derivatives markets. As noted above, it appears to be uncommon for counterparties to exchange cash or other property to collateralise their OTC electricity derivatives exposures, especially if they are perceived as a significant entity with good credit standing. Instead, these market participants effectively establish a line of credit for their trading counterparties through setting trading limits, which in turn are based on assessments of counterparty creditworthiness. Where bilateral trading limits have been reached, some market participants indicated that additional transactions would be executed on-exchange (through ASX 24) and collateralised pursuant to the exchange's standard clearing processes. However, the responses indicate that, overall, very low volumes of transactions are conducted on-exchange.

These responses suggest that participants in the OTC electricity derivatives market sometimes have large uncollateralised exposures, thus making them vulnerable in the event of a counterparty default. Because market participants in the OTC electricity derivatives market are predominantly corporates transacting with similar corporates, the quality of each of these entities' risk management practices is important to ensuring the resilience and stability of this market.

5.3 Post-trade Practices

5.3.1 Trade capture

Automated trade capture facilitates straight-through processing and connection to post-trade infrastructure thereby reducing operational risks. For a majority of product classes, use of automated trade capture (both through internal front office systems and external platforms) is prevalent. There has been increased use of these services since the 2009 survey, although some products are still captured through manual processes.

5.3.2 Trade compression

Active traders in OTC derivatives can build up large volumes of economically redundant contracts over time. Through a multilateral process, trade compression services can facilitate the termination of many such transactions, replacing them with a smaller number of trades that result in economically equivalent exposures. Results from the 2009 survey indicated limited use of tear-up or trade compression services by large Australian and international banks. These services are now being more actively used by these participants across the major product classes. Around half of the 2012 survey respondents reported they are using trade compression for some or all of their interest rate derivatives positions.

Despite this increased usage, data from one of the main providers of trade compression services suggest that participation in compression cycles is somewhat sporadic. Partial participation reduces the effectiveness of trade compression, since to the extent that the process relies on multilateral netting, the effectiveness of multilateral compression is greater with a larger number of market participants. This suggests that more effective use of trade compression services by larger market participants in Australia might be possible.

5.3.3 Portfolio reconciliation and trade disputes

As noted in Section 3.5.2, there has been ongoing international work in recent years to develop an agreed industry approach around disputed OTC derivatives collateral calls, as well as portfolio reconciliation guidelines. Some respondents to the 2012 survey made reference to these arrangements; while the international banks active in Australia have all agreed to the international protocol, only one of the large Australian banks is an adherent.

In part, the lower level of interest demonstrated by Australian participants in these developments reflects the relatively low level of disputes that are experienced in the Australian market. Although respondents noted some ongoing margin disputes, including some major ones relating to collateral or valuation processes, these were typically cleared within a normal dispute resolution time horizon. Survey respondents noted that some incidence of valuation disputes was considered to be normal, provided that these were not prolonged or did not remain unresolved.

Some disputes were noted as being due to the omission of trades, rather than as a result of different valuations. There has been some increase in portfolio reconciliation to reduce the incidence of these problems. Four of the five largest Australian banks are now regularly using third-party services in this area, as are the large international dealers; this compares well to the 2009 survey results, which indicated only sporadic utilisation of portfolio reconciliation.

For those respondents calculating margin or mark-to-market valuations for collateral purposes, internal models were being used across all applicable product classes. Since the 2009 survey a mix of internal and vendor supplied solutions continue to be utilised as collateral management systems.

5.4 Market Infrastructure

5.4.1 Trade reporting and related developments

Large overseas-based financial institutions active in Australia are all utilising trade reporting for at least some transactions executed or booked in Australia. In part this reflects their transition to mandatory reporting obligations that will apply in their home jurisdictions. In contrast, the adoption of trade reporting by Australian-based participants has been somewhat slower. Section 6.2 discusses some of the factors behind this in more detail.

Trade reporting for credit derivatives is most well entrenched, reflecting the fact that a trade repository for these products has been established now for a number of years. Australian-based participants report little, if any, utilisation of trade repositories for other product classes.

5.4.2 Central clearing

Global data from CCPs clearing Australian dollar-denominated OTC interest rate derivatives suggest that a little under $4 trillion of notional outstanding amounts are currently centrally cleared, which is around half of global outstandings reported by the BIS for this product class. Central clearing of OTC derivatives is only just starting to penetrate the Australian market.

No Australian-owned institution directly participates as a clearing member in any CCP clearing the main classes of OTC derivatives traded in Australia. Anecdotally, though, the Australian regulators are aware of some discussions between Australian banks and existing or prospective providers of central clearing services regarding direct participation. In the absence of direct clearing memberships, some Australian financial institutions, including the large Australian banks, have negotiated or are negotiating indirect access to CCPs (i.e. as clients of existing direct participants) to centrally clear interest rate and credit derivatives. This move is being largely driven by three factors:

• Some counterparties of Australian institutions will soon be required to centrally clear certain product classes, due to regulatory requirements in their home jurisdictions. Australian-based participants that are active in these jurisdictions may also be captured by these requirements.
• Proposed changes to APRA's counterparty credit risk standards, in line with Basel III, will lower the capital charge for centrally cleared relative to non-centrally cleared derivatives exposures (as discussed in Section 3.3.1). These updated credit standards are proposed to become effective in Australia from the start of 2013. Other jurisdictions are looking to similarly adopt these Basel III standards, with a consequent effect on banks based in these jurisdictions.
• Reflecting this, many Australian institutions are beginning to observe a differential in the dealer-quoted prices of centrally cleared versus non-centrally cleared contracts as a result of impending Basel III capital charges.

Many of the global banks who are active in the Australian market are already centrally clearing OTC derivatives. A small number of these global banks offer OTC derivatives client clearing services in Australia. As these banks are clearing participants in a number of overseas OTC derivatives CCPs, they typically offer their Australian clients a choice of CCP through which to clear (where multiple CCPs serve a given contract type or product class).

They also typically offer a choice in account structures. Survey responses indicate that a choice between individually segregated and legally segregated/operationally commingled (LSOC) accounts has been offered.

Some, though not all, Australian clients have also been offered choices between gross and net commingled omnibus accounts.^[2] Account structures with greater segregation of collateral offer a higher probability that a client will be able to access the margin it has posted to its clearer in the event that the clearer defaults. However, segregated account structures are more costly to administer and offer few netting benefits to the clearer – these costs are consequently passed onto clients. A client's choice of account structure thus represents a trade-off between these two considerations. An additional consideration for Australian entities is that collateral posted to their clearers will likely be held offshore and subject to foreign legal jurisdiction.

International financial institutions that deal in OTC derivatives in Australia centrally clear some of their portfolios through their offshore parents or affiliates which are already members of CCPs. Products cleared by these institutions typically include single-currency interest rate derivatives, but also extend to other product classes.

Some of the remaining Australian market participants – including smaller financial institutions – have not identified sufficient commercial incentives to move away from bilateral arrangements, or have identified that there are no acceptable clearing solutions available for some of the contracts they trade. Other market participants are considering or negotiating potential client clearing arrangements on acceptable terms.

Domestic participants have been most focused on central clearing of interest rate derivatives. Where clearing solutions are currently available, anecdotal evidence suggests that, at this stage, market participants are not moving to clear their entire single-currency interest rate derivatives portfolios through their client clearing arrangements; rather, as discussed above, the establishment of these arrangements has been in part to ensure an uninterrupted capacity to trade with offshore counterparties if these are obliged to centrally clear non-Australian dollar-denominated interest rate derivatives in the near future. It follows that the largest component of Australian banks' single-currency OTC derivatives portfolios – Australian dollar-denominated interest rate derivatives, and in particular Australian dollar-denominated interest rate swaps – remains largely bilaterally managed.

5.4.3 Trade execution

The results of the survey, and analysis of ASIC data on licensed trading platforms, suggest that Australian market participants are able to access and utilise a wide range of electronic and other trade execution facilities.

In terms of the availability of trading platforms in Australia, there are currently 11 Australian market licence (AML) holders offering derivatives trading in Australia (of which five are domestically licensed and six are overseas licensed), together with 15 entities that have been exempted from holding an AML. These platforms together offer trading services across five broad instrument classes (see Annex 2 for further details of these platforms).

All major market participants reported using brokers or multilateral electronic trade execution facilities for at least some transactions across all product types. Within this, though, there was substantial variation in the share of transactions reported by individual participants, and across different product types.

Survey respondents reported significant variation in their use of trade execution platforms and brokers across product classes. In almost all markets, some respondents reported less than 10 per cent of transactions were executed through platforms or brokers, while other respondents reported more than 90 per cent of transactions were executed through these channels. Foreign banks generally reported higher percentages of platform or broker execution than domestic banks. This variation may reflect differences in the composition of counterparties, with domestic banks tending to have a larger share of corporate and smaller institutional clients, while foreign banks tend to have a more wholesale client base. The differences may also reflect the types of products used by some classes of respondents, some of which may be more standardised and therefore suitable for platform execution, while others may be more bespoke and more suited to bilateral dealings. OTC electricity derivatives market participants reported a large proportion of transactions were conducted through brokers, with the percentage ranging from around 60 per cent to more than 90 per cent. These respondents reported no use of trade execution platforms for electricity contracts.

Footnotes

For further discussion of issues around the demand and supply of high quality liquid assets in Australia, see Heath A and Manning M (2012), ‘Financial Regulation and Australian Dollar Liquid Assets’, RBA Bulletin, September, pp 43–52. Available at <https://www.rba.gov.au/publications/bulletin/2012/sep/bu-0912-6a.html>. [1]

These various types of account structures are explained more fully in Council of Financial Regulators (2012), OTC Derivatives Market Reform Considerations, March. Available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/otc-deriviatives/reports/201203-otc-derivatives-market-reform-considerations/>. [2]