The Australian Government has released draft laws which are to enable banks, insurance companies, superannuation trustees and other participants to provide the margin that is required to meet forthcoming global derivatives regulation and to access international clearing houses. The draft laws also address other legal issues which have concerned financial market participants and should facilitate greater access to the increasingly regulated international marketplace.
The laws proposed are a significant reform to Australia’s laws on security and insolvency in a financial market context. However, the complexity of the issues addressed, and the draft laws which are aimed at them, should not be underestimated. In this article we highlight three key points arising from the draft laws.
The draft laws released are exposure drafts of:
- the Financial System Legislation Amendment (Resilience and Collateral Protection) Bill 2016;
- the Financial System Legislation Amendment (Resilience and Collateral Protection) Regulations 2016.
These were released by the Australian Treasury on 21 December and can be found here. A policy paper regarding client money was also released and can be found in the same place.
This reform package is directed to the Government’s commitment to “develop legislative amendments to clarify domestic regulation to support globally coordinated policy efforts and facilitate the ongoing participation of Australian entities in international capital markets” in the second half of 2015 as set out in its response to the Financial System Inquiry (a link to our Alert on this is here). The draft laws modify some highly complex laws relating to security, insolvency, netting, derivatives and key financial market infrastructure. In doing so, they touch on very significant statutory protections provided to Australian market participants and financial market infrastructure and purport to resolve a range of issues which have been causing market participants, their legal advisers and their regulators, concern for some time. All of this appears to have been done whilst taking into account international developments in the regulation of derivative markets and participants.
The draft legislation itself is not going to be everyone’s choice for Christmas reading. For those who prefer some brief guidance on some key areas of reform, we’ve set out a brief summary of three of them below.
Enabling regulated superannuation entities and life companies to access international markets
A reform which will be welcomed by a number of superannuation entities, life insurance companies (and their managers) is the extension of the security which these entities are allowed to grant to their derivative counterparties, exchanges and clearing houses. Restrictions in both the Superannuation Industry (Supervision) Regulations and Life Insurance Regulations have been limiting these entities from accessing cleared derivative markets which require such security to be granted, such as those in the United States. This has been of particular concern to these entities because of the deep liquidity in those markets.
The exposure draft of the regulations addresses this by broadening the existing exceptions to these restrictions so that they permit the granting of security for over-the-counter derivatives as well as exchange traded derivatives, when particular conditions are met. These conditions include that the security is required by applicable law, or the rules of an “approved body” (which are markets and clearing houses listed in the regulations). The Government has also noted that the “approved bodies” concept in both the Superannuation Industry (Supervision) Regulations and Life Insurance Regulations is subject to review and that an updated list will be provided during consultation.
There is also a further extension to allow charges to be given to secure obligations under derivative contracts over “financial property” which is in the possession or control of the secured party (or a third behalf on its behalf). This links to the changes made in the reform package to address global derivative margining requirements, as described next in this Alert.
Enabling Australian entities to comply with global derivative margining requirements
The waves of G20 derivatives reforms have continued to wash over Australian market participants in 2015. Trade reporting has been implemented (see background here) and clearing rules have also been made (available here). However, the largest wave of the G20 derivative reforms has been visible only on the horizon until recently. That is the requirement for parties to uncleared derivatives to provide margin to each other (the internationally agreed principles for this are available here). This reform progresses at different speeds in different countries, but in the most recent market assessment published by the Australian Council of Financial Regulators in November (available here), it is noted that APRA is expected to consult on prudential standards to implement these margin requirements in early 2016.
The changes to be made by the new draft laws are needed because the new margining requirements will result in some margin for derivatives having to be provided by way of security, and not by absolute transfer (absolute transfer is the form most commonly used in Australia now). However, there are significant legal impediments which restrict some Australian entities from providing this in a manner which is sufficiently effective to comply with the international principles. These include provisions of the Banking Act relating to the allocation of a bank’s assets, provisions in the Corporations Act relating to the ability to enforce security against a company in administration and provisions of the Personal Property Securities Act relating to enforcement and priority.
The reforms set out in the draft legislation propose changes to the Payment Systems and Netting Act to facilitate the enforcement of particular forms of security. This legislation has long been a “gold standard” for the systemically important protection of close-out netting in derivatives arrangements and the operation of critical financial market infrastructure. The proposed amendments extend the current protection of close-out netting under “close-out netting contracts” (which applies “despite any other law”) to the enforcement of security over obligations under those contracts. However, like the current protections, the new protections are subject to safeguards built into the draft legislation. These safeguards appear take much from the equivalent European laws, including the need for the security to be over “financial property” which is in the possession or control of the secured party. The amendments create their own fabric of terms and concepts which are adapted from the international principles rather than replicating Australia’s Personal Property Securities Act.
These reforms are critical to Australian entities which need to manage their risks in the global capital markets. Without them, the consequences for those entities could be expensive, and potentially risky. However, the changes are complex and market participants should closely consider the scope of protections and the conditions which must be satisfied in order for the protections to apply.
For ease of reference, most of these changes to the Netting Act are in items 20 to 27 of the exposure draft of Bill (and the associated definitions).
Giving counterparties to Australian banks and insurers clarity on stays on close-out rights
Since 2008, there has been concern in Australia, and internationally, that there was an inconsistency between parts of the Banking Act and the Netting Act. The inconsistency related to closing out transactions with an Australian bank on the basis that it had become subject to statutory management, which is a form of external management which can be used in the case of a bank’s insolvency. This inconsistency also exists for life insurance companies and general insurance companies. The lack of clarity has caused problems for some of these entities when dealing with international counterparties, sometimes limiting market access.
Following this, it has been recognised that the inconsistency needed to be resolved in Australia. The Australian Council of Financial Regulators noted in its 2015 CFR report (copy can be found here) that legislative changes are required to “clarify the circumstances in which a party’s right to close-out OTC derivatives can be temporarily overridden in the event that a statutory manager or judicial manager is appointed”.
There have been international developments since the issue arose in Australia. This reached a milestone in 2014 when a group of global regulators and international financial institutions in developed international best practice as to how close-out rights should be stayed on the resolution of a systemically important financial institution (the ISDA Resolution Stay Protocol, the current form which is available here).
The draft legislation seeks to address the need for resolution of the inconsistency in the Australian law in a manner which is consistent with those international developments. Of course, this is a highly technical area of financial markets law and it takes some time to work through when, and for how long, the stays imposed will prevail over the protections of theNetting Act. It will also be important to work through the circumstances in which such a stay will only have temporary effect, and then the conditions which must be satisfied in order for the stay to become permanent. However, it seems clear that a significant effort has been made in developing draft laws to address the complexities relating to the failure of a systemically important institution.
For ease of reference these changes to the Netting Act are in item 28 of the exposure draft of the Bill. However, the amendments made to other legislation in the exposure draft of the Bill are also relevant.
Is there anything else worthy of note?
Well, yes. Quite significant additional reforms. It is worth noting that the reforms proposed in the draft legislation also touch on the protections provided in the Netting Act in respect of:
- approved real time gross settlement systems (such as the Reserve Bank Information and Transfer System);
- approved multilateral netting arrangements (such as payment systems and the settlement systems for Australian shares); and
- netting markets (such as clearing houses).
The Government has noted that these changes are intended to enhance financial system stability by protecting the operation of approved financial market infrastructure. Market participants interested in these matters should review these parts of the draft legislative package.
What are the next steps?
The Australian Government has asked for comments on the draft laws by 29 January 2016.
The draft laws are intended to remove impediments to international market access which Australian entities are suffering, or will suffer, primarily because of the level of global regulation of derivative markets following the financial crisis. This purpose will be welcomed by many market participants, including banks, funds, managers and other companies. However, these impediments apply to the business of different Australian entities in different ways. Accordingly, market participants should take some time to work out whether the reforms do address their concerns effectively. This is particularly important whilst consultations on them remain open. The Government has stated that:
“The Government welcomes the comments of interested parties, including comments as to whether these reforms provide a sufficiently robust framework for enforcing rights in respect of margin provided by way of security and whether the safeguards proposed are sufficient to adequately protect the interests of depositors.”
The Government is seeking to introduce legislation in early 2016. Once done, it should be expected that regulatory focus will quickly move from removing impediments to further reform like margining requirements, to implementing it.