The recommendation is contained in the 2014 report on the Australian OTC Derivatives Market of the three Australian financial regulators: the Reserve Bank of Australia, the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority (a copy of the report can be found here). The report is the latest snapshot from the regulators’ perspective of the state of play in Australia on G20 derivative reform, a comparison with overseas progress and a view on what comes next.
For many in the market, the key area of interest in the sixty pages of the report will be the discussion of the clearing mandate. However, the discussion on platform trading and risk mitigation is worth noting too.
Clearing mandate in Australia
This recommendation for clearing of inter-dealer transactions in Australian dollar denominated interest rate derivatives (AUDIRD) follows a similar recommendation which has been made in respect of interest rate derivatives denominated in the G4 currencies (USD, GBP, JPY and EUR). The process for implementing that mandate has already progressed to the consultation stage (our alert on this consultation can be found here). Interestingly, a key question in the Government’s G4 consultation paper was on the appropriateness of a clearing mandate in AUD IRD. Although that consultation paper is still open, it seems that it may have been slightly overtaken by this latest recommendation.
The recommendation on clearing AUD IRD is clear:
“Having monitored Australian-headquartered dealers’ progress in implementing appropriate clearing arrangements, the Regulators are satisfied that the incremental cost of mandatory central clearing of Australian dollar-denominated interest rate derivatives would be very low for trades between internationally active dealers in the Australian market. Consequently, it is recommended that the government consider a central clearing mandate for trades between internationally active dealers in Australian dollar-denominated interest rate derivatives.”
The appropriate clearing arrangements referred to are those made by Australian-headquartered dealers with the OTC derivative clearing houses operated by the ASX and LCH. The paper also notes that it is generally expected that AUD IRD are soon to be mandated by offshore regulators which also regulate some Australian entities. This is consistent with Australian market expectations, which had anticipated that the CFTC in the United States would be extending the US clearing mandate to include AUD IRD in the near future. This is particularly important to those banks which registered Swap Dealers in the US and which are operating in the Australian market – which includes five Australian banks. The paper notes that coordination between the Australian and offshore regulators is hoped to “achieve a smooth transition to central clearing”.
Application to credit derivatives
However, the Australian regulators currently believe that the case for Australian clearing does not extend to credit derivatives and the Regulators do not see a case for implementing a clearing mandate in North American, European and Japanese referenced credit index derivatives “at this time”. In particular, this is because “Australian market activity in these products involves at least one EU- or US-headquartered counterparty.”
Application to non-dealers
Importantly, the paper outlines the current Australian regulatory view with respect to market participants who are not dealers. The regulators are “not convinced” of the public policy case for introducing mandatory central clearing of OTC derivatives for non-dealers. This is because such activity is “relatively limited” and “motivated primarily by hedging of underlying cash flows and exposures”. On this basis, the regulators have found that the current systemic risk reduction achieved by a clearing mandate on non-dealers “is likely to be limited”. Also the report also acknowledged that, for some non-dealers, there is no evidence at this stage that the regulatory benefits would ever outweigh compliance costs and for these entities “close consideration” would be given to a specific exclusion from any future clearing mandate.
The issue of extension to non-dealers is to be kept under review by the regulators, with a view to the impact of international regulatory developments. For “buy-side” Australia, this level of consideration is likely to be welcome, although as the report notes economic incentives (such as pricing differentials between cleared and uncleared transactions) may eventually lead to non-dealers seeking access to clearing before any extension of the mandate to them.
The paper (on its final page) indicates that the recommended clearing obligations should commence in 2015, although the report also states that this timing is to be determined in consultation with market participants and other stakeholders. The next steps are consultation by the Government and ASIC on the proposed mandate (including the scope of the mandate) and on draft Derivative Transaction Rules (our Alert on the process can be found here).
Trading platforms and risk mitigation practices
The report also discusses two other aspects of the G20 derivatives reforms not yet mandated in Australia: trading platforms and risk mitigation practices.
Consistent with previous government statements, no current recommendation is made with respect to use of trading platforms. This is because of the lack of consensus across key overseas jurisdictions on the characteristics which such platforms should possess, because of lower liquidity in the Australian marketplace than in overseas markets and because of a forthcoming policy review by the Government on the licensing regime used for financial markets in Australia (to which trading platforms are likely to be subject). However, it is noted that international consistency could become a key driver of this policy if overseas regimes were to implement mandatory use of trading platforms for products or asset classes which are widely traded in Australia.
The report contained a generally positive scorecard on conformance to good market standards on risk mitigation practices, such as the use of trade compression and margining. It did not contain any recommendation for the introduction of legal obligations to adhere to such practices. However, Regulators will keep a watching brief on developments overseas with respect to risk mitigation practices and there is encouragement from the Regulators for Australian market participants to explore ways to overcome impediments on trade compression of AUD IRD.
The Regulators have indicated their next report on the Australian OTC market will be published in 2015, at which time they will be able to utilise data from trade repositories (amongst other sources) to compile the report.