The Australian Securities and Investments Commission (ASIC) proposes to increase the cash flow and regulatory capital required by issuers of contracts for difference (CFDs) and other retail over-the counter (OTC) derivatives. This reflects ASIC’s particular concerns with retail CFDs and is also consistent with the trend to increase regulatory capital for banks and non-banks.
Our March article looked at proposed increases in regulatory capital for non-banks, namely responsible entities, superannuation trustees, life companies, general insurers and clearing brokers.
Who do the proposals apply to?
ASIC consultation paper 156 “Retail OTC derivative issuers: Financial requirements” sets out its proposal and their rationale. The proposals apply to any holder of an Australian financial services (AFS) licence that authorises it to make a market in derivatives to retail clients and who owes liabilities by entering into derivatives with retail clients. The proposals are intended to extend to all AFS licenses that are in the business of issuing OTC derivatives to retail clients. However, bodies regulated by the Australian Prudential Regulation Authority (APRA) will be excluded, as will certain participants in licensed markets or clearing and settlement facilities with adequate financial requirements. If it applies, the new financial requirements appear to apply to the whole of the licensee’s cash flows and revenue (i.e. not just those that relate to retail OTC derivatives).
These proposals would replace the existing options for relevant issuers for satisfying ASIC’s cash needs requirements (which generally require three month cash flow projections), as well as the current surplus liquid funds requirements and the adjusted surplus liquid funds requirements. Other existing requirements (such as the solvency and audit requirements) would remain unchanged.
New cash flow requirements
The new proposals would require relevant issuers to prepare quarterly rolling individual entity cash flow forecasts over at least 12 months in a “business-as-usual” situation. These forecasts must be based on appropriately documented calculations and assumptions, updated where material changes occur, approved by the directors of the issuer and made available to ASIC on request. An issuer will also be required to demonstrate that it has access to sufficient financial resources to meet its liabilities over the next 12 month term.
Net tangible assets
In addition to the new cash flow requirements, relevant issuers would also be required to hold net tangible assets (NTA) equal to the greater of:
- $1 million (which is broadly aligned with applicable requirements in Singapore and the United Kingdom, but considerably below the requirements of the US Commodity Futures Trading Commission (CFTC)); and
- 10% of average revenue (which is defined very broadly).
50% of the required NTA must be held in cash and cash equivalents (excluding cash in client segregated or trust accounts) and 50% must be held in liquid assets (which in broad terms must be realisable within a six month period). Reporting and other requirements would also apply, including annual reporting, monthly reporting triggers where an issuer’s NTA falls to or below 110% of its required level, prescribed client disclosures if a fall below 100% is not replenished within two months and trading restrictions if NTA levels drop to or below a 75% NTA floor.
Rationalisation of retail OTC issuers
ASIC has commented that aligning the minimum NTA requirement with the US$20 million threshold imposed by the US CFTC would be overly onerous, and so proposed to align more broadly with jurisdictions such as the United Kingdom. However the new requirements will still have the effect of increasing the capital and reporting burdens of Australian retail OTC derivatives issuers. ASIC is very transparent about the effect that these proposals might have:
Implementation of these proposals may lead to some consolidation and rationalisation of the sector. Some issuers may be forced to restructure to raise the requisite capital or may merge with others in order to meet the financial requirements. There are potential benefits in reducing the number of issuers if those that remain are well capitalised and more stable as a result.