Survey of the OTC Derivatives Market in Australia – May 2009 6. Summary and Assessment

The Australian OTC derivatives market has grown strongly in recent years, with turnover across products increasing by an average of more than 11 per cent per annum during the four years to June 2008. Although the Australian market remains relatively small, it plays an important role in the overall functioning of the Australian financial system. The OTC derivatives market contributes to price discovery, and facilitates bespoke hedging solutions and the establishment of tailored risk positions. Furthermore, any disruption to activity in this market could have spillover effects in other linked markets. While the Australian market generally remained robust to the bankruptcy of Lehman Brothers in September 2008, there was considerable price volatility across products, deterioration in liquidity, and widespread uncertainty as to the size and location of residual exposures.

To help ensure market resilience to such shocks, it is therefore important that risk-management and operational practices in the Australian OTC derivatives market promote market transparency, the legal robustness of trades, sound management of counterparty credit risks, and efficient and reliable provision of information to risk-management systems and regulators.

This report has documented important developments in each of these areas in the Australian market in recent years. In part, these have been driven by international regulatory initiatives, but they also reflect an increased focus on risk management arising from the turbulence in financial markets. Among the most notable developments are the following:

• Market transparency: As demand for complex or structured products has declined, there has been an increased emphasis on vanilla products, mitigating uncertainties surrounding the degree of leverage in the market and individual participants’ market exposures.
• Legal robustness of trades: The legal robustness of trades has been promoted by increased acceptance over time of the importance of timely execution of industry-standard legal documentation. Furthermore, in an increasingly risk-focused environment, participants have sought to include tighter close-out options in Master Agreements. All sell-side survey respondents actively trading credit derivatives have also signed the new ISDA protocol underpinning auction-based cash settlement of credit derivatives contracts.
• Sound management of counterparty credit risks: The focus on risk has also made it easier, and in some cases more imperative, for market participants to negotiate Credit Support Annexes attached to Master Agreements, thereby increasing the coverage of collateral arrangements and improving participants’ ability to manage counterparty credit risks.
• Efficient and reliable provision of information to risk-management systems: In order that reliable data is fed into risk-management systems and other downstream processes, it is essential that trade data is captured and matched rapidly and accurately to facilitate timely confirmation of trades. With a heightened regulatory focus in this area overseas, the automation of these processes has gathered momentum. A similar, but more gradual, shift is taking place in Australia, largely driven by the large overseas banks.

While acknowledging these developments, Australia's financial authorities have concluded that there is scope for further enhancement to the operational and risk-management practices in the Australian OTC derivatives market to ensure that they meet international best practice.

Perhaps reflecting the smaller scale of activity in the Australian OTC derivatives market and the fact that existing processes have to date proved to be scalable and resilient to shocks, enhancements to risk-management and operational practices have often been pursued with less urgency than has been the case internationally. Some sell-side participants suggested that additional support from the authorities would accelerate progress towards more automation and straightthrough processing. Scale has also tended to be a barrier to the use of external services for portfolio reconciliation and portfolio compression, which, respectively, can improve the reliability and flow of information to risk-management systems, and reduce operational and counterparty risks by terminating economically redundant contracts.

The limited use of central counterparty facilities among Australian OTC derivatives market participants likely reflects wider industry factors. To the extent that the Australian OTC derivatives product markets are too small to support a stand-alone domestic facility, participants would have to rely on international facilities to cover Australian dollar products and admit Australian participants. However, the few central counterparties currently offering clearing services for OTC derivatives do not typically cover Australian products and/or they have high access criteria. To realise the potential benefits of central counterparty clearing, Australian interests would need to be represented through dialogue with international industry associations, existing and emerging providers of central counterparty services in OTC derivatives markets, and their regulators.

Given these considerations, the Australian financial authorities encourage industry participants to consolidate and build on recent enhancements to practices in this area and in particular to take the following steps, working with the authorities as appropriate:

• Promote market transparency: The industry is encouraged to work towards improving the efficiency and transparency of the OTC derivatives market, including: the standardisation of contract terms where feasible and appropriate; the use of electronic trading platforms where available; and the provision of data to regulators (and, where appropriate, to other participants) on trading activity, pricing, and the size and location of exposures. Furthermore, where OTC derivatives instruments retain complex features, market participants should be able to clearly document their key characteristics and communicate these to regulators, also demonstrating their contribution to risk exposure with reference to relevant scenarios. It is acknowledged that developments in these areas should not unduly constrain flexibility in structuring, negotiating and executing OTC contracts to facilitate tailored risk and portfolio management and hedging of exposures.
• Ensure continued progress in the timely negotiation of industry-standard legal documentation: Where appropriate, Australian industry participants are encouraged to review existing processes to ensure that the volume of trade undertaken in the absence of completed documentation is minimised. Where trades are executed without the appropriate documentation in place, industry participants are encouraged to ensure that potential legal risks are minimised (eg, by agreeing long-form confirmations; setting exposure limits; and/or agreeing early termination options).
• Expand the use of collateral to manage counterparty credit risks: Australian industry participants are encouraged to expand, where practicable to do so, the use of CSAs attached to Master Agreements and review the application of initial margin, unsecured thresholds and minimum transfer amounts. Where collateralisation is not appropriate, alternative risk mitigants should be in place (eg, position/exposure limits; termination and right-to-break clauses in Master Agreements; and/or negotiation of charges over balance sheet assets).
• Promote Australian access to central counterparties for OTC derivatives products: Australian industry participants are encouraged to make use, where appropriate, of existing and emerging central counterparty facilities for OTC derivatives. Where Australian-based participants and Australian dollar products are not currently served, participants are encouraged to work with the financial authorities to promote Australian access to such facilities.
• Expand the use of automated facilities for confirmations processing: Australian participants are encouraged to work towards industry standards for connecting to automated facilities for confirmations processing and, where available, to make use of trade data warehouse facilities and linked settlement services. This will promote straight-through processing, minimise delays in confirming trades and ensure a reliable data feed to risk-management systems. There is also a case for considering the use of ‘economic affirmation’ of the key economic terms of a trade soon after execution to mitigate risks arising prior to confirmation.
• Expand the use of multilateral portfolio compression and reconciliation tools: Australian industry participants are encouraged, where appropriate, to make more extensive use of multilateral portfolio compression services, ie, facilities which are designed to identify trades held on participants’ books that could be terminated without altering the participants’ economic exposure beyond a stated tolerance. Participants are also encouraged to move towards emerging industry standards for the frequency and automation of portfolio reconciliation to help ensure a reliable data feed to internal risk-management systems.
• Increase Australian influence in international industry fora: Through active engagement with international industry committees, Australian market participants should take all opportunities to ensure that the interests of the Australian market are adequately reflected in industry debate on the evolution of market practices.

Australia's financial authorities will initiate discussions with industry participants on each of these topics in the near future, with a view to prioritising efforts, and developing arrangements to monitor progress over time.