“All standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”
So said the leaders of the G-20 countries in September 2009. The recently released consultation paper on Central Clearing of OTC Derivatives in Australia recently is a key development in this statement being given effect in Australia as the Australian Council of Financial Regulators considers the case for domestic mandatory central clearing of over-the-counter derivatives.
In the paper, the Council - comprised of the Commonwealth Treasury, ASIC, APRA and the Reserve Bank of Australia - proposes that financial institutions acting in the domestic market be required to centrally clear Australian dollar denominated interest rate derivatives through a local CCP. This represents a significant shift in the policy position of the Australian regulators as stated in the May 2009 Survey of the Australian OTC derivatives. In that survey, the regulators encouraged Australian industry participants to “...make use, where appropriate, of existing counterparty facilities for OTC derivatives. Where Australian-based participants and Australian dollar products are not currently served, participants are encouraged to work with financial authorities to promote access to such facilities.”
The recently released consultation paper considers in detail the risks and benefits associated with central clearing. The stated potential benefits include that central clearing provides a focal point for market oversight and participant default management, which can enhance the resilience of financial markets. A noted counterpoint to this is that “use of a CCP does not necessarily reduce the amount of risk in a market, but rather concentrates it”.
With respect to the class of derivatives that should be cleared, the Council specified three criteria that should be satisfied, namely, that the central clearing of such derivatives class would potentially reduce systemic risk; that central clearing of that class would be viable; and that the requirement to clear that derivatives class would be harmonious with international clearing requirements.
The Council identified Australian dollar-denominated interest rate swaps as the only product class currently meeting those criteria, noting that the market for such swaps is fundamental to domestic funding markets and the hedging of interest rate risk among Australian borrowers and lenders, and therefore the stability and efficiency of the Australian financial system. Further, the dominant products in that market, such as forward rate agreements, overnight indexed swaps and interest rate swaps, are all relatively standardised, suggesting that they are amenable to central clearing. Also, they appear likely to be required to be cleared in overseas jurisdictions.
The paper indicates that FX transactions, which may have otherwise met the three criteria, would be expected to be excluded from any clearing requirement in order to harmonise Australian clearing requirements with those in the United States (where it has been announced that FX swaps and forwards will be exempt from mandatory clearing). Data from AFMA on trading of OTC derivatives indicates that over the year end to June 2010 the average daily turnover of FX derivatives was a little above $100 billion, interest rate derivatives was around $30 billion and credit derivatives was around $650 million.
With respect to whether clearing should occur through a local CCP, the Council considered a range of factors including that the capacity of Australian agencies to intervene in crisis management scenarios is likely to be more straightforward with regards to a local, rather than offshore, CCP. In addition, superior policy outcomes with respect to regulatory clarity, transparency and accountability may be achieved if Australian agencies were the primary regulators of the CCP.
The paper contemplates that mandatory clearing would apply to financial institutions acting in the domestic market, such as Authorised Deposit-taking Institutions (including Australian banks and credit unions, local branches of offshore banks) and Australian Financial Service licencees.
The proposal put forward by the Council appears to have been the result of much research and consideration. Given this, and the commitment by G-20 leaders to clear all standardized OTC derivatives contracts through central counterparties by end-2012 at the latest, there seems to be real possibility that the proposal could be implemented in Australia. Accordingly, if market participants have concerns with the proposal for mandatory clearing enunciated in the consultation paper they should raise these with the Council. Written submissions on the paper are requested by 1 September 2011 (extended from 5 August 2011) and roundtable discussions will be hosted by the Council over the period ahead.