Executive Summary | Central Clearing of OTC Derivatives in Australia June 2011 | Consultations

Central Clearing of OTC Derivatives in Australia – June 2011 Executive Summary

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The agencies of the Council of Financial Regulators are considering the question of central clearing of over-the-counter (OTC) derivatives transacted in Australian financial markets. This issue is one in which all Council agencies have an interest. To co-ordinate the development of recommendations to the Government, the agencies have issued this discussion paper as a basis for consultation with all interested stakeholders.

The impetus for issuing this discussion paper arises in part from the substantial reforms in this area underway in many offshore jurisdictions. Along with these international developments, the interests of the Australian agencies also reflect a commitment by the G20 group of countries (of which Australia is a member) to undertake significant reforms to the functioning of OTC derivatives markets. In particular, these countries committed to see all standardised OTC derivatives transactions centrally cleared by the end of 2012, as part of a package of several measures to strengthen OTC derivatives markets. The package also included measures to promote the use of trading platforms and trade reporting, and to increase capital requirements for uncleared transactions & the Council agencies are considering these matters separately, and will undertake consultations with interested stakeholders as appropriate.

A key aim of the international reform process underway is to harness the benefits of central counterparty (CCP) arrangements to increase the resilience of global financial markets & of which OTC derivatives markets are an important part & while also reducing the interconnectedness of major global banks that dominate many of these markets. To a large extent, these considerations are more relevant for Europe and the United States than they are for smaller markets such as Australia. Nonetheless, the Council agencies agree that central clearing could be of benefit for some parts of the Australian market. However, the agencies also note that the nature of CCPs is such that they can have significant effects on market structure and functioning, which should be taken into consideration if a move to central clearing in Australia were to occur. In particular, a CCP concentrates counterparty and operational risk to a substantial degree, introducing a different set of risks to that existing in bilateral markets. Furthermore, the design of a CCP necessitates some tiering in the relationships among intermediaries and other market participants, which may have wider implications for the efficiency and stability of the domestic market. Although central clearing has been a part of financial markets for many years, these arrangements have evolved organically, and the push for mandatory clearing in certain markets is a new development. Therefore, a significant challenge facing regulators in implementing a requirement for increased central clearing is to minimise any unintended consequences that this move might have for risks within domestic and global financial systems.

An analysis of available data on Australian OTC derivatives markets suggests that the products most actively traded by domestic market participants are interest rate and foreign exchange derivatives, and that it is likely that there would be some scope for central clearing of at least some of this activity. In considering whether domestic markets might be amenable to clearing, it is also important to note that the Australian market is relatively small compared to the largest offshore markets, and that the composition of dealers in the local market is somewhat different to major offshore markets. Whereas activity in the largest offshore markets is highly concentrated among a fairly small group of global dealers, the Australian market (like many other regional markets) also has important participation from more locally or regionally focused institutions.

In thinking through these issues, the Council agencies have focused on four key considerations. The first is the availability of central clearing services to Australian-based market participants. There is currently no central clearing of OTC derivatives in Australia. Offshore clearing solutions, where they exist, are configured to suit the large European and US markets more so than for smaller markets such as Australia. At the same time, the global market for CCP services is currently undergoing considerable change, in response to a range of commercial and regulatory factors. This rapidly evolving global landscape for central clearing makes it difficult to foresee how clearing of the Australian OTC derivatives market might evolve.

Secondly, the Council agencies recognise the significance of the cross-border linkages that are a part of the Australian (and most other countries') OTC derivatives markets. The depth and efficiency of the domestic market are enhanced through local participants being able to transact with offshore counterparties, while domestic-based participants are in turn able to access offshore markets and products through the global presences of Australian and foreign intermediaries. At the same time, these close linkages mean that overseas market and regulatory developments are an important force in shaping the Australian market.

A third consideration is the implications that central clearing might have for financial stability. On the one hand, a CCP can enhance the resilience of a market, through a range of direct and indirect channels. These include reducing some interdependencies of market participants, as well as providing a centralised mechanism to assist in resolving participant defaults and other crisis management arrangements. On the other hand, there might be systemic risk implications if a greater concentration of exposures or dependencies among market participants resulted from a shift to centrally cleared arrangements. Of course, the greatest concentration of risk is with the CCP itself, thereby embedding the systemic importance of these facilities. Though risks can be mitigated through the efforts of CCP operators, market participants and regulators, they can never be eliminated. Given the central role of a CCP, any failure of a CCP would have serious consequences for financial markets. The management of a participant's default may also have significant implications for domestic market functioning. There may be an expectation or need for some involvement of domestic agencies in these situations.

Fourth, the configuration of CCPs could have important effects on the efficiency and functioning of a market. Fragmentation of clearing could see a reduction in netting opportunities and collateral efficiencies, which might raise costs to participants (and, indeed, increase exposures among participants). Overall costs in a market will also depend on the degree of competition among CCPs and market participants, as well as numerous other effects. However, the structure of intermediaries' local and global operations, the choice of markets they participate in, end-users' derivatives utilisation, and the scope and design of CCPs serving these markets are all determined endogenously to a significant extent.

These various considerations add to the complexity of assessing how central clearing might best be achieved in the Australian market. Use of large offshore CCPs might allow for greater efficiencies while also facilitating the cross-border nature of many OTC derivatives markets. On the other hand, risk and stability considerations point towards a domestic solution. In weighing these various factors, the Council agencies are also guided by the underlying objectives of the regulatory reform of global OTC derivatives markets, to increase the resilience of these markets and to reduce the degree of interconnectedness among participants.

Given this, the Council agencies suggest the following propositions regarding what might be the future path of central clearing of Australian OTC derivatives markets:

In the absence of Australian regulatory action, domestic CCP solutions may not emerge. Hence decisions by regulators and participants in major overseas OTC derivatives markets may have the effect of inducing Australian-based market participants to use offshore CCPs for a significant part of their business. This might be the case even in the absence of any Australian clearing requirements.
Where offshore CCPs are clearing domestic markets that are of systemic importance, this may introduce risks to the Australian financial system that do not currently exist. It is likely that Australian regulatory agencies would have less scope to oversee offshore CCPs relative to domestic ones, and to respond as needed in conditions of stress. For this, and other public policy reasons, the Council agencies have reservations about a mandatory clearing requirement that resulted in a systemically important domestic market being cleared though offshore CCPs.
The Council agencies consider that the market for Australian dollar-denominated interest rate derivatives (such as overnight indexed swaps, forward rate agreements, and interest rate swaps) is systemically important within Australia, given the wide range of domestic participants that use these instruments, and the interdependencies between these derivatives markets and other domestic capital and credit markets.
In light of this, the Council agencies are considering the case for a requirement that activity in Australian dollar-denominated interest rate derivatives be centrally cleared and whether this should take place domestically. A mandatory clearing requirement to that effect would generally apply to financial institutions acting in the domestic market (such as Authorised Deposit-taking Institutions and Australian Financial Services Licensees); the Council agencies would expect that some market participants would be exempt from this mandatory requirement, depending on their size or class.

The purpose of this discussion paper is to seek feedback on the Council agencies' views and propositions before making any recommendations to the Government on this matter. The agencies recognise that many of the issues are highly complex, and that not all stakeholders' interests may be aligned. The paper sets out a consultation process through which the perspectives of interested stakeholders can be taken into consideration.