Central Clearing of OTC Derivatives in Australia – June 2011 5. Proposed Clearing Regime Design and Application

5.1. Proposed Elements of a Clearing Regime for OTC Derivatives in Australia

The preceding analysis lays out some of the challenges facing Australia in implementing a requirement for standardised OTC transactions to be centrally cleared. The Council agencies have not concluded what such a regime should look like. However, a preliminary position is that a regime for mandatory central clearing of OTC derivatives in Australia should contain the following elements:

1. Any mandatory requirement that a class of OTC derivatives be centrally cleared should reflect the following factors:
   1. the potential reduction of systemic risk that might result from this move;
   2. the viability of central clearing of that product class; and
   3. the international harmonisation of clearing requirements across product classes.
2. Similarly, the determination of the market participants to whom a mandatory clearing requirement would apply should reflect:
   1. the potential contribution to systemic risk of these participants; and
   2. harmonisation with international requirements.
3. The process for determining which products should be subject to a mandatory clearing requirement should allow for both the ‘bottom-up’ and ‘top-down’ approach, though it would be expected that the detail of developments would be predominantly industry-led.
4. Regarding CCPs operating in the domestic OTC derivatives market, static and dynamic efficiency must be considered as well as stability outcomes, recognising that there may be some conflicting considerations. In particular:
   1. a CCP's participation criteria may influence the degree of dealer competition and service provision within Australian financial markets;
   2. a CCP's participation criteria may alter concentrations of exposures and other risks within the Australian financial system;
   3. a CCP's participation criteria should not undermine its capacity to appropriately manage the risks it faces;
   4. economies of scale and network effects can reduce the scope for competition in clearing services;
   5. the efficiency and viability of a CCP is likely to increase the more transactions it processes and the more netting opportunities it provides participants; and
   6. Council agencies will need to consider how a mandatory clearing requirement might interact with the market for clearing services, and whether provision of clearing is provided in an efficient manner to market participants.
5. Reflecting jurisdictional considerations, Council agencies see merit in Australian-domiciled clearing solutions, particularly where a market is systemically important, for the following reasons:
   1. having Australian agencies as the primary regulators of a CCP operating in the domestic market provides superior policy outcomes with respect to regulatory clarity, transparency and accountability;
   2. Australian regulators' capacity to intervene in crisis management scenarios is likely to be more straightforward with regards to a local CCP; and
   3. in enforcing a mandatory clearing requirement, undertaking clearing through Australian-domiciled CCPs avoids the prospect of Australian regulation having an outcome that would require Australian entities to submit to a foreign jurisdiction, if that was a consequence of directly or indirectly participating in a foreign-domiciled CCP.
6. It is appropriate that cross-margining or interoperability arrangements be considered, subject to appropriate regulatory oversight and approval. This provides scope to preserve netting benefits across multiple CCPs for market participants with large or complex clearing needs.
7. Authorities should continue to be open to licensing CCPs domiciled in foreign jurisdictions, particularly for the clearing of non-systemically important markets.

5.2. Proposed Initial Application of this Regime

Given the discussion of Australian OTC derivatives market activity in Section 3.2, a product class that would appear likely to meet the tests set out above is Australian dollar-denominated interest rate derivatives. This reflects the following considerations:

• this market is fundamental to domestic funding markets and the hedging of interest rate risk among Australian borrowers and lenders, and therefore the stability and efficiency of the Australian financial system;
• these instruments are widely used across a multitude of both sell-side and buy-side domestic counterparties;
• the duration of counterparty risk exposures of these instruments is long-lived in many cases;
• the dominant products, such as forward rate agreements, overnight indexed swaps and interest rate swaps, are all relatively standardised, suggesting they are amenable to central clearing;
• there would appear to be significant scope to net down some large gross outstanding positions held by institutions; and
• interest rate derivatives appear likely to be mandatorily clearable in offshore jurisdictions.

A clearing requirement might be imposed for this market if a CCP was to be licensed to clear this product, or if relevant agencies came to the conclusion that it should be clearable. Under the ‘bottom-up’ approach, industry participants may engage with an existing or new CCP operator to develop a clearing solution for this market.

In the event that a ‘top-down’ approach was taken, analysis and consultation undertaken by regulators may conclude that clearing these products should be mandatory. In that situation, regulators would investigate reasons for why central clearing had not yet been implemented, and would explore various regulatory avenues with participants to move the market in that direction.

In either case, the Council agencies consider that there may be a case for an Australian-domiciled CCP to clear this market. The agencies recognise that this may have detrimental effects on some market participants' capacity to net across products that might be cleared through other CCPs. On the other hand, default and crisis management arrangements might be more straightforward and certain in a local CCP. In the Council agencies' view, these domestic stability and jurisdictional considerations should be given more weight in such a systemically important market (which is consistent with making it subject to a mandatory clearing regime).

Institutions or firms (such as many non-financial institutions) that predominantly hedge using only Australian dollar-denominated interest rate derivatives are likely to be largely indifferent to some of these netting considerations, and therefore a local CCP is unlikely to impose significantly greater collateral costs for them. For other participants, though, a reduction in cross-currency or cross-product netting opportunities may result in increased costs due to additional collateral requirements. The Council agencies would be concerned if a consequence of this was a serious disruption to the functioning of domestic markets. One way to mitigate this, and to retain or create netting efficiencies for more active market participants, would be through the Council agencies considering appropriately designed arrangements for links between CCPs (with a view to minimising risks).