With all of the current hullabaloo on Dodd-Frank and FATCA in Australian financial institutions, the release yesterday of a report on derivatives by the Australian financial regulators could have been overlooked. It should not be.
This speaks for itself – that it is the cross-border impact of United States laws which is causing concerns and issues in the Australian derivatives marketplace, not the local derivative reform process. But the measured and thoughtful nature of the Australian process should not be misunderstood – derivatives regulation here will increase – hopefully without any hullabaloo.
In this Alert, we briefly summarise the Australian report, describe where we are with the prospective Australian derivatives law, and touch on some concerns of the Australian market in the current “main game”: Dodd-Frank.
The Australian report
The Australian report (found here) is a useful summary of the current state of the Australian derivatives market, the reform journey on which the marketplace has been taken, and the prospective changes to Australian law. For those involved in the market, and this process, this report is unlikely to be a revelation. The Australian reform process so far has been consistent and transparent. For example, the Australian regulators had, prior to the report, already made it clear that trade reporting of derivatives is to be the initial focus and that a mandate on central clearing will wait. So, the report is useful, but not shocking – as most would want a regulator’s report to be on such a systemically important market.
However, the report is not without interest, for example:
- There is a clear recognition from the regulators of the importance of the derivatives market. For example, the regulators state both that “the availability of OTC derivatives contracts provides important benefits to the Australian financial system” and “OTC derivatives markets now play a core role in the global financial system”. Market participants are likely to welcome this affirmation, particularly as it remains common for commentary on derivatives to include less objective statements as to the role which they play.
- The use of margin for over-the-counter (OTC) derivatives has increased, such that around half of ISDA master agreements include a credit support annex (primarily governed by Australian or English law). Use of these arrangements is strongly encouraged by the regulators in the report.
- The regulators recognise that other factors are driving Australian participants towards behaviours which might otherwise have needed to be mandated, such as central clearing. These commercial factors include foreign regulatory requirements, capital standards and pricing differences.
- Although AUD interest rate swaps are the current focus of the regulators in relation to clearing, there is also a recognition of “strong in-principle benefits” from central clearing cross-currency swaps and foreign exchange. However, it is also noted that no viable central clearing solution exists for these products.
The Australian law
The release of the Australian report coincides with the conclusion of the Inquiry into the Corporations Legislation Amendment (Derivative Transactions) Bill 2012 (Cth) conducted by the Parliamentary Joint Committee on Corporations and Financial Services and the reintroduction of that Bill into parliament (a link to the Bill can be found here).
The result of the review process for the Bill appears to be only a few changes to the original exposure draft (our Alert on that exposure draft is here). Two of those changes are:
- A ‘derivative transaction’ no longer automatically includes “any other transaction relating to a derivative”. This could have captured, for instance, the operative components of a project finance transaction (such as loans, guarantees and security transactions) where the transaction was hedged by a derivative. Now, a class of transactions “relating to” a derivative will have to be prescribed by regulation to be caught by the Act.
- Both the Minister and ASIC will now need to have regard to the effect on the underlying physical market prior to making a determination mandating a commodity derivative or making a derivative transaction rule. This was to address concerns that limitations on use of OTC derivatives may affect the effective operation on the underlying physical market (for example, the National Electricity Market).
It appears most likely that the Bill will be passed by parliament in the second half of November 2012. The derivative transaction rules should follow, initially for the trade reporting requirements of the Bill. This process, and the associated consultation, is anticipated to be complete by the middle of 2013. No timeline has been set for clearing or swap execution aspects of the new framework. For those, we must wait.
The Dodd-Frank deadline
Of course, all of this obscures the primary derivatives compliance issue facing Australian financial institutions at present – Dodd-Frank. As noted in the Australian report, and unlike some of their counterparts in Asia, Australian banks are intending to register as swap dealers under the US Dodd-Frank legislation beginning as of the end of this year. This gives rise to a substantial number of issues including conflicting requirements of Australian and United States law and the ability (or inability) to rely on compliance with Australian derivatives regulation to satisfy the United States regulators. None of these are easy to resolve, and it would be fair to say that work is being carried out in the hope that a sensible solution will be reached to the cross-border issues before it becomes too late.
This doubt and uncertainty is not optimal for such a systemically important industry. But it is a direct consequence of the new world of global financial market regulation – in a worldwide marketplace Australia cannot expect to have sole influence over its own regulatory landscape. In derivatives, some regulatory sovereignty has been ceded by Australia. Interestingly, although we are at the dawn of the Asian century, this has not been to any other part of Asia, but to the undisputed regulatory powerhouse of global financial markets: the United States.