The Australian Treasury has published explanatory material to accompany the previously released draft legislation and regulations, which seek to reform a number of Australian laws ahead of the introduction of margin requirements for uncleared derivatives.
The draft legislation, which was released in December 2015, will have significant and wide-ranging impacts on the financial services industry in Australia. It is complex in nature, and thus the explanatory material released on 29 January 2016 will be welcomed by market participants (and their lawyers!) who are in the process of reviewing and commenting upon the potential impact of these laws.
A copy of the 96-page Explanatory Memorandum to the Financial System Legislation Amendment (Resilience and Collateral Protection) Bill 2016 and the Financial System Legislation Amendment (Resilience and Collateral Protection) Regulation 2016 can be found here. The Treasury has also published a shorter Explanatory Statement, which can be found here.
Background: OTC derivatives reform
The implementation of G20 commitments has been progressing steadily in Australia over the past few years, with transaction reporting and central clearing rules representing the most significant changes to date. However, the industry will be required to cope with yet more regulatory change when rules requiring parties to an uncleared derivative to provide margin to one another are implemented in Australia.
While these rules will be based on internationally agreed principles, they will necessitate a fairly significant shift in the manner in which collateral arrangements are agreed and documented in Australia, as counterparties move away from the absolute title transfer method, and towards the security interest method (which is commonly used in New York law governed documents).
With consultation on these new rules expected to begin shortly, the Australian Government has turned its attention to first tackling the necessary areas of law reform that are required in order to accommodate the new margin requirements.
Key changes proposed by the legislation
The changes proposed by the new legislation are important, and will have several key consequences for financial market participants. Three of the main amendments that have been proposed are:
Netting Act protections
It is proposed that amendments be made to the Payment Systems and Netting Act 1998 to extend the protections that are currently afforded to close-out netting contracts with respect to close-out netting, so as to also cover the actual enforcement of security granted in respect of such contracts. It is proposed that certain security interests granted over "financial property" will be afforded special legal safeguards to ensure their enforceability, where the security interest has been granted in respect of a close-out netting contract. This is an important concept that, similar to the statutorily-guaranteed effectiveness of close-out netting, serves to provide stability and certainty to financial market participants. The adequacy of statutory protection of these enforcement rights is seen as critical in ensuring the smooth implementation of mandatory margin requirements.
Granting of security by super funds and life insurance companies
Another key reform is the proposed broadening of the circumstances in which a superannuation entity or life insurance company may grant a security interest over all or part of its assets. The draft legislation contemplates extending the current exceptions to the rule that such entities cannot grant security, in certain circumstances which include:
- where the charge is given to comply with a requirement of an approved body or Australian or foreign law in relation to dealing in derivatives; or
- where a charge is given to secure obligations under derivative contracts and the secured property is "financial property" (where that financial property is in the possession or control of the secured party or a third party).
These extensions are designed to facilitate compliance by these entities with the new margin requirements.
Statutory management, stays and close-out rights
The third key change introduced by the new legislation seeks to address a perceived inconsistency under Australian law, in connection with the ability of a party to close-out a transaction with an Australian bank counterparty, where that bank counterparty has become subject to statutory management under the terms of the Banking Act 1959. The draft legislation aims to address this inconsistency, and clarify the circumstances in which a party's close-out rights may be overridden, in the event that a statutory manager has been appointed. The draft legislation also includes similar provisions for super funds and life insurance companies.
Enhanced Protection of Client Monies
The Government has also released a policy paper in relation to changes to client money provisions in the Corporations Act 2001. The changes are intended to enhance protection of retail clients' monies, including by limiting the scope of section 981D of the Act, which relates to the use of client monies for margining purposes and other purposes related to dealing in derivatives.
The Government has indicated that it will release draft legislation to give effect to these proposed changes shortly, with a period of consultation to follow.
The Treasury is currently consulting with industry, regulators and other key stakeholders as to the potential impact of the proposed laws, and whether they effectively remove the legal impediments that are required to be removed, in order for margin requirements to be implemented in Australian in a manner that is consistent with internationally agreed practices.
While the explanatory materials that have been released go some way towards setting out the legislative intention behind the proposed changes, the fact remains that this is a complex area, and market participants need to give careful consideration to the ways in which these draft laws may effect operational aspects of their businesses.
Submissions on the draft laws are due by 5 February 2016. It is anticipated that the final version of the legislation will be introduced to the parliament by March 2016, with potential passage into law during the winter sitting.