Valentine’s Day saw Australia’s House of Representatives pass a Bill which will materially restrict how dealers in OTC derivatives use money deposited with them by their retail clients. The Bill is currently before the Senate.
The proposed restrictions in brief
In short, Australian Financial Services (AFS) licensees who issue derivatives won’t be able to use client money to meet any of their own obligations (say, to the AFS licensee’s liquidity providers) unless the AFS licensee centrally clears all OTC transactions through an appropriately licensed settlement and clearing facility.
If AFS licensees do centrally clear and settle those transactions, then they may only use client money to meet obligations directly connected to that derivative.
The bill is likely to pass
Despite the somewhat unpredictable nature of dealings in the Australian Senate at present, as the Bill has a consumer protection focus, it is likely to pass and become law.
The provisions relating to OTC derivatives would take effect 12 months from the date of Royal Assent, giving AFS licensees some opportunity to change their habits.
How do the laws work at the moment, and how will they change?
At the moment, the Corporations Act 2001 requires AFS licensees to place the client money into a designated account, and places restrictions on what an AFS licensee can do with client money or property.
However there is an exemption where the client money is held in connection with a financial service which is or relates to a dealing in a derivative, or financial products which are derivatives. In those circumstances, the client money:
…may also be used for the purpose of meeting obligations incurred by the licensee in connection with margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee (including dealings on behalf of people other than the client).
So the two significant changes are:
- First – If the trades in OTC derivatives are not centrally cleared, then the exemption will not apply to the client monies
- Second – If the trades in OTC derivatives are centrally cleared, then the exemption will only apply to allow the AFS licensee to use the client monies and property to meet certain obligations of the licensee – ie. if the licensee incurred the obligation in connection with the derivative, under the rules of the facility.
So as well as limiting when the exemption is available, the changes also narrow the purpose for which the retail client monies can be used.
The current exemption on the use of client money in relation to derivatives, allows client money to be used for the AFS licensee’s own purposes, including to provide to counterparties as collateral for margining, and guaranteeing and securing obligations.
If an AFS licensee becomes insolvent, then the client money is put at risk through no fault of the client.
Parliament has expressed concern at the fact that, although wholesale and institutional clients can evaluate and assess these risks, retail clients as a whole very rarely understand those risks fully. Parliament cites ASIC’s Report 205 – Contracts for Difference and Retail Investors – which found that retail clients:
- had a lack of understanding of key concepts and key aspects of how Contracts for Difference (CFDs) work
- do not clearly understand the key risks.
Accordingly, one presumes, the view is that disclosure of the risks is not sufficient protection.
So it’s only ‘retail client money’? Well, yes and no.
Yes the focus is on protecting retail clients as defined by the Corporations Act 2001.
However if a client is a wholesale client only because they meet the requirements in section 761GA of the Corporations Act 2001 – about ‘sophisticated investors’ – then for the purposes of the client money rules, they will be treated as retail clients.
Won’t this cause difficulties for these AFS licensees?
Parliament reports that there are about sixty-five AFS licensees that actively issue OTC derivatives, seven of whom are prudentially regulated. That leaves fifty-eight which are not prudentially regulated, but whom Parliament says deal with clients who:
…bet that their provider (the issuer) is in a sound financial position and will be able to meet their obligations to the investor (the client).
One would think that the Bill effectively targets those fifty-eight, non-prudentially regulated entities. Of those fifty-eight, ASIC considers that five of them make 93 percent of that industry sector’s net profit.
Parliament, presumably at ASIC’s urging, is unconcerned at the ramifications of the client money changes for OTC derivatives issuers – including where the changes may render that aspect of the AFS licensee’s business uncommercial. A relatively clear objective of the new rules is to:
- require those AFS licensees which are thinly capitalised to either strengthen their balance sheet, or cease issuing OTC derivatives
- undertake that balance sheet repair with moneys other than client moneys.
In Parliament’s opinion:
While some businesses may become less viable, or lose interest in operating in the Australian market, the Government does not consider this to be a bad outcome – if it is because they are unable to meet the costs of doing business and it enhances the protection of derivative client money for retail investors.
In various places in the Explanatory Memorandum, reference is made to the fact that retail clients have a limited capacity to understand complex financial products. The introduction of these new rules is another step towards a regulatory approach which:
- encourages simplified product design for retail investors, such that attendant risks and benefits can be more easily explained, and better understood
- prevents access to more complex financial products to those clients who understand the intricacies of complex financial markets.