On 18 April 2012, the Australian Government took the next step towards reform of the over-the-counter (OTC) derivatives market in Australia by its release of a Treasury consultation paper proposing a legislative framework for implementing Australia's G-20 commitment to OTC derivatives reform.
It also released a report by the Council of Financial Regulators, provided to the Government in March. The Council's report recommends regulatory settings for the design of OTC derivatives reforms and details many of the policy considerations that underpin Treasury's proposed legislative framework. The report follows a June 2011 consultation paper and subsequent submissions and consultation with industry that focused on issues around central clearing of OTC derivatives.
The legislative framework proposed by Treasury provides greater certainty in relation to the future direction of OTC derivatives regulation in Australia. In line with Australia's G-20 commitments, it foreshadows that Australian OTC derivatives regulation will fall in step with the rest of the world by requiring a move towards:
- clearing of OTC derivatives through central counterparties (CCPs);
- mandatory reporting of OTC derivatives through trading repositories; and
- executing standardised OTC derivatives on exchanges or electronic trading platforms.
Although the framework establishes a mechanism for regulatory intervention, it also leaves open the possibility for industry-led fulfilment of Australia's G-20 commitments and builds in sufficient flexibility to ensure that Australia will not be out of step with the rest of the world as it implements its reform agenda.
In this article we set out the key features of the proposed legislative framework and explain some of the policy decisions that have shaped the proposals.
Elements of the proposed legislative framework
The legislative framework will be enacted via amendments to the Corporations Act. The framework itself will not impose any obligations on market participants. Rather, it gives power to the Minister for Financial Services and Superannuation and the Australian Securities and Investments Commission (ASIC) to make rules and enact future regulations relating to the reporting, clearing and trading of particular types of OTC derivatives.
By adopting this approach, the Government is giving itself the flexibility to take steps toward fulfilling its G-20 commitments while holding back on the detail until the US and European Union (EU) are closer to finalising their legislative response.
The Minister will have the power, by legislative instrument, to prescribe a class of derivatives as subject to one or more of the following mandatory obligations:
- trade reporting;
- central clearing; or
- trade execution.
The Minister will be required to consult publicly prior to prescribing a class of derivatives, and will be required to prepare a regulation impact statement considering the utility, feasibility and impact on the affected markets.
Once a class of derivatives is prescribed, ASIC may make derivative transaction rules (DTRs) in relation to the mandatory obligations applying to that class of derivatives, subject to Ministerial approval. DTRs will have several functions, including:
- determining which parties to a transaction will be subject to the mandatory obligations, how they are to comply and the timing requirements;
- creating exceptions to mandatory obligations, with ASIC able to specify cases in which certain persons, parties or transactions will not be required to report, clear or execute trades in accordance with the DTRs;
- imposing obligations on trade repositories, CCPs and trading platforms operating in the OTC derivative market;
- governing the extent to which any mandatory obligation applies to pre-existing positions; and
- imposing obligations on parties to prescribed transactions and penalties for compliance failures.
DTRs will be developed by ASIC in consultation with the public and other agencies, such as the Australian Prudential Regulation Authority and the Reserve Bank of Australia. ASIC's DTR-making power will be limited by regulations made under the new legislation.
An important aspect of the new laws will be their jurisdictional reach. Once a class of OTC derivative is prescribed, mandatory obligations will apply to any domestic or foreign person dealing in OTC derivatives of that class where that dealing satisfies the relevant jurisdictional nexus to Australia. The paper currently proposes that any foreign entity should be caught by the new laws if it performs an action within the Australian jurisdiction that "contributes to" that entity becoming a party to the making, modification or termination of a prescribed derivative.
The paper also invites feedback on a range of other options for determining whether a dealing will satisfy the relevant nexus with Australia, including where a party has a presence in Australia or the extent to which the transaction takes place in, or has a substantial and foreseeable effect within, Australia.
Options for implementing the framework
The consultation paper seeks views on a range of possible approaches to activating the mandatory obligations under the new framework, including the approaches that we have highlighted below.
The consultation paper indicates that mandatory trade reporting obligations are likely to be introduced for a broad range of derivative classes. The current proposal is to introduce these as early as this year in order to provide the regulators with important information to allow them to more accurately assess the importance and timing of exercising their powers to mandate central clearing and trading under the new framework.
The paper also seeks feedback on whether there are specific entities or classes of transaction that should be excluded from the reporting obligations. Although under the Government's favoured option most parties would be captured by trade reporting obligations, the paper contemplates that the DTRs may allow an end user to rely on a dealer or counterparty to report transaction data.
In relation to the mandatory clearing of standardised OTC derivatives, the Council stated in its March report that it expects certain market forces to drive participants towards clearing through CCPs, including to avoid the more burdensome regulatory capital and collateral requirements in respect of non-centrally cleared OTC derivatives. Consistent with the Council's observations, Treasury proposes an initial "wait and see" approach to allow market forces to provide the initial impetus for parties to migrate to CCPs, rather than immediately mandating for this.
However, given the risk that the transition to central clearing could be slow or uneven across market participants, powers to impose mandatory clearing will be enacted as part of the proposed framework. Depending on how the anticipated changes play out, regulators may prioritise the mandatory migration to CCPs of particular OTC derivatives identified as systemically important to Australia, such as AUD denominated interest rate swaps. Treasury indicates that it will monitor and assess market activity and overseas regulatory changes relating to clearing on a continuous basis to enable the Government to better assess the appropriateness of mandating clearing under its new powers.
Notably, in its June 2011 consultation paper, the Council expressed a preference that certain OTC derivatives systemically important for Australia be cleared through CCPs based in Australia. However, in light of submissions expressing concern about fragmentation of the global market for such derivatives, and considering international regulatory developments that have given the Council increased comfort on the use of overseas clearing facilities, the Council has stepped back from its earlier view. Nevertheless, the paper indicates that in some circumstances Australian regulators may ultimately insist on particular entities establishing a presence in Australia, or seek assurances as to the compatibility of an entity's rules with Australian law.
The "wait and see" approach is also proposed in relation to the trade execution aspects of the structural reforms. Treasury considers that more information is required to enable the identification of markets that are suitable for mandatory trade execution requirements. This is in line with the Council's observations that it would be premature to impose any mandatory trade execution obligations before the Government has conducted more analysis on the volume and liquidity characteristics of markets for particular derivatives classes and the emergence of suitable trading platforms.
The paper acknowledges that volume and liquidity are important prerequisites to any electronic trading platform and on this basis appears to favour organic uptake by market participants. In this regard, the paper observes that the standardisation of OTC derivatives as a result of central clearing is likely to result in a market-led increase in electronic trading.
The paper presents proposals for the introduction of a licensing regime for trade repositories, along the lines of the current Australian Market Licence and Australian Clearing and Settlement Facility Licence regimes for trading and clearing facilities. In recognition of the need to facilitate mutual recognition and the offering of services in Australia by foreign operators, the regime is likely to be equivalent to similar regimes in the EU and US and provide alternative licensing criteria for overseas operators who are subject to equivalent regulation in their home jurisdictions. Licensed entities (whether trade repositories, CCPs or trading platforms) will be "eligible" entities under the DTRs.
Licences will include requirements for data protection and access to data, proper operation for the protection of clients and risk management.
The consultation paper seeks initial views on:
- entities and transactions that should be excluded from the scope of ASIC's DTR-making power;
- the jurisdictional nexus test with Australia that should enliven the rules;
- other regulations that should be included in the framework; and
- the derivatives classes that should be subject to one or more mandatory obligations.
The paper also poses 46 specific "feedback questions", covering all aspects of the proposals. The focus of the consultation is on the framework and the powers it creates, as well as the proposals for the initial exercise of those powers.
Draft proposals for mandating derivative classes and for regulations limiting ASIC's DTR-making power will be released for stakeholder feedback following the consultation. After the scope of the rule-making power is settled, ASIC will consult stakeholders further in relation to the final form of the DTRs.
Feedback on the proposals in the consultation paper is due by 15 June. In addition, Treasury will be conducting stakeholder consultation meetings during the consultation period and has requested that persons wishing to arrange a meeting register their interest by 4 May.