Malcolm Edey: OTC derivatives regulation
Keynote address by Mr Malcolm Edey, Assistant Governor (Financial System) of the
Reserve Bank of Australia, to the International Swaps and Derivatives Association (ISDA)
Conference, Sydney, 18 October 2012.
* * *
I would like to thank Mark Manning for his assistance in preparing this speech.
Good morning, and thank you once again for the opportunity to speak to you today.
A great deal has happened since I last addressed this gathering a year ago. Markets around
the world remain under pressure, with the sovereign debt crisis and fears over the future of
the Euro continuing to weigh on confidence. Australia has been somewhat sheltered from
these developments. As reported in the Bank's recent Financial Stability Review, Australian
banks' asset quality has held firm, their usage of wholesale funding has been wound back,
and overall bank funding costs have fallen over the past year.
While Australia's financial sector and the condition of the real economy remain favourable by
international comparison, many of the lessons of the global financial crisis remain as relevant
in Australia as elsewhere. The Australian authorities have continued to be involved in both
domestic and international debates over refinements to regulatory settings. The aim of
course is to reduce the likelihood of further distress, and to ensure that in the event that
problems do emerge the authorities have the appropriate tools to deal with them effectively.
Over the past year, the agencies that comprise the Council of Financial Regulators have
progressed a number of regulatory initiatives, consulting extensively with industry
participants on matters such as the implementation of Basel III in Australia, enhancements to
the resolution regime for banks, and reforms to the regulation of financial market
infrastructure. But today I'd like to focus again on the area of reform I discussed here a year
ago: the regulation of OTC derivatives markets.
As everyone in this room is aware, at the Pittsburgh Summit three years ago the G-20
leaders agreed that, 'all standardised 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. OTC derivatives contracts should be reported to
trade repositories. Non-centrally cleared contracts should be subject to higher capital
requirements'.
When I spoke to this group last October, the Council of Financial Regulators was engaged in
a consultation on central clearing of OTC derivatives. I talked about a number of policy
challenges that the Council agencies were grappling with, including whether central clearing
of Australia's most systemic OTC derivatives markets should be mandatory, and whether
such clearing should be required to take place through a domestic central counterparty.
Consultation on these matters continued through the remainder of 2011 and the early part of
this year. At the same time, arrangements in other international jurisdictions, most notably in
the United States and Europe, were becoming clearer and domestic financial institutions
were beginning to examine and adapt to the third-country reach of the prospective new rules.
Also, in part reflecting strong views expressed by the Australian authorities, the Financial
Stability Board developed the notion of 'four safeguards' for a resilient global framework for
central counterparties. This work recognised that, in meeting the G-20 commitments, market
participants in some jurisdictions may be reliant on offshore-based central counterparties.
Authorities and market participants alike therefore needed to have confidence that such
arrangements would protect their interests, both for domestic financial stability and for the
effective functioning of markets.
Specifically, the four safeguards comprise: ensuring effective international cooperative
oversight of global CCPs; fair and open access criteria; appropriate liquidity arrangements in
all relevant currencies; and procedures for effective resolution. The Principles for financial
market infrastructures, released in April by the Committee on Payment and Settlement
Systems and the International Organization of Securities Commissions (IOSCO) this year,
embed some elements of the four safeguards; other elements are left to domestic authorities
to implement in their own regulatory frameworks and approaches.
Having considered the views of stakeholders and assessed the implications of developments
internationally, the Council delivered a policy recommendation to the Deputy Prime Minister
and Treasurer in March this year. The recommendation had three main elements:
1. Don't mandate immediately, but establish the power to do so
The Council agencies recommended that, where possible, industry-led solutions - in part
reflecting appropriate regulatory incentives - should be relied upon to steer the market
towards the desired outcome. Nevertheless, they also recommended that the authorities
should be granted a legislated power to mandate outcomes in the event that the incentives
prove insufficient to drive the necessary change on an acceptable time frame. One concern
would be if there were perceived to be an opportunity for regulatory arbitrage between the
Australian regime and those of other jurisdictions. Another would be if, in assessing the
sufficient equivalence of the Australian regime, other jurisdictions took into account whether
or not a regulatory mandate was in place.
Reliance in the first instance on market incentives is particularly relevant in the case of
central clearing. Premature regulatory intervention could interfere with the competitive and
commercial responses of central counterparties, clearing participants and other service
providers. A flexible approach should allow for the transition to occur with maximum choice
available to participants on issues such as the commercial terms of agreements, the choice
of counterparties and central counterparties, and operational changes that might be needed.
The Council's assessment was that higher capital requirements for non-centrally cleared
transactions, as well as the implementation of emerging international standards for margin
requirements on non-centrally cleared OTC derivatives, should create a sufficiently strong
economic incentive to channel trades through a central counterparty. Once a critical mass of
market participants have begun to clear centrally, it is likely that other market participants will
follow, so as to be able to trade with counterparties who have already shifted to central
clearing. The policy responses of other jurisdictions are also important in this regard. To the
extent that financial institutions headquartered in other jurisdictions are required to centrally
clear by their local regulators, they are likely to - or, in some cases, may have to - also
centrally clear transactions executed in the Australian market.
2. A qualifying central counterparty may be either domestic or overseas-based
A central counterparty operating in Australia must have either an Australian Clearing and
Settlement Facility Licence or a valid exemption. The regulatory regime in Australia
specifically permits an overseas-based central counterparty to operate in this jurisdiction, as
long as its home regulatory regime is deemed to be sufficiently equivalent to that in Australia.
The consultation last year sought views on whether it should be mandated that any central
counterparty clearing OTC derivatives markets of systemic importance to Australia be
located in Australia. Having given this further consideration during the consultation process,
the Council agencies concluded that to do so would unduly constrain market participants'
choices, reduce the effectiveness of economic incentives in driving outcomes, and potentially
have other unintended consequences.
In the Council's view, any additional risks associated with reliance on an overseas-based
central counterparty may be managed through implementation of the Financial Stability
Board's four safeguards. In the spirit of these safeguards, the Council has developed a
framework for regulatory influence over cross-border clearing and settlement facilities.
Specific requirements would be expected to be applied in a graduated and proportional
manner and would include the following:
• all licensed CCPs must demonstrate legal compatibility of the facility's rules with
Australian regulatory objectives, and have adequate mechanisms to demonstrate
compliance with all licence obligations;
•
where licensed CCPs have material Australian-based participation and/or provide
services in Australian-related products, they must have governance and operational
arrangements that promote stability in the Australian financial system;
•
where a CCP is deemed to be systemically important by the Reserve Bank, it must
hold an Exchange Settlement Account (ESA) at the Bank to better manage liquidity
and settlement risks around Australian dollar obligations.
The Australian regulators are also closely engaged with ongoing international work on the
recovery and resolution of financial market infrastructure. This work will be a key input into
the development of a fully articulated recovery and resolution regime for financial market
infrastructure in Australia. It will also establish a benchmark for assessment of the recovery
and resolution regimes applicable to overseas-based facilities seeking to operate in
Australia.
3. Establish a licensing regime for trade repositories
The Council recommended that a licensing regime for trade repositories be established,
largely modelled on the existing licensing regimes for market operators and clearing and
settlement facilities under the Corporations Act. ASIC will have primary responsibility for
administering this regime and overseeing any trade repositories licensed under the regime.
These elements have since been reflected in draft legislation issued by Treasury for
consultation in July and introduced to Parliament in September. It is anticipated that the
framework will be in place by year-end. Under the proposed framework, the Minister for
Financial Services and Superannuation will have the power to prescribe certain classes of
derivatives as subject to mandatory reporting to a trade repository, mandatory clearing by a
central counterparty, or mandatory execution on a trading platform. To give effect to any
mandate, ASIC will be tasked with developing "derivative transaction rules". These rules will
clarify matters such as the institutional and product scope of the obligation.
Among the regulators, therefore, ASIC will have the primary role in implementing the new
framework and in doing so will work closely with the Bank and APRA. The Bank, in particular,
will have three main functions in the new regime:
•
A market-monitoring function. In carrying out its market operations and in its
financial stability role, the Bank will need to understand the implications of market
developments in response to the new rules; and in particular the evolution of
participant behaviour and the participation structure of the market. This will include
the analysis of data sourced from trade repositories, monitoring the interaction
between the centrally cleared and non-centrally cleared segments of the market,
and observing changes in collateral demand and usage.
•
An advisory function. Before prescribing a class of derivatives under the framework,
the Minister must seek the advice of the Bank, as well as APRA and ASIC. ASIC
must also consult with both the Bank and APRA before issuing any derivative
transaction rules.
•
An oversight function. In its role in overseeing clearing and settlement facilities
operating in Australia, the Bank will, with ASIC, advise the Minister on any licence
applications from central counterparties seeking to provide OTC derivatives clearing
services in Australia. And, once a licence has been granted, the Bank will oversee
any newly licensed central counterparty against the Financial Stability Standards.
In parallel with the passage of the legislation through Parliament, the Council agencies are
monitoring developments in the Australian OTC derivatives market to establish whether
economic incentives are already beginning to work. A comprehensive survey was circulated
to market participants in July, and an analysis of the results is expected to be published
towards the end of this month. The results of this assessment will be an important input into
possible recommendations to the government around mandatory obligations. The Australian
agencies currently anticipate that additional assessments will be undertaken over the next
year or so, in order to monitor the Australian market's progress in making the transition to
central clearing, along with the other G-20 commitments around OTC derivatives reforms.
Even if these assessments conclude that the industry is making adequate progress, the
Australian agencies will also continue to examine whether the existence of mandatory
obligations could deliver other benefits. For instance, there could potentially be a case to
impose a mandatory obligation for central clearing if to do so would make it more likely that
other relevant jurisdictions considered the Australian regime to be sufficiently equivalent, and
therefore reduced the compliance burden for domestic market participants when trading with
overseas-based counterparties.
The current assessment is likely to confirm the previous position that Australian dollar
interest rate swaps, cross-currency swaps and other foreign exchange derivatives are likely
to be the priority asset classes for the purposes of meeting the G-20 commitments.
Developments in these asset classes are likely to be monitored most closely in future
assessments.
In the near term, the priority for any recommendations around mandatory obligations is likely
to be trade reporting. As noted elsewhere, the Council agencies regard trade reporting to be
not only good practice, but also a means of ensuring the availability of good data to monitor
market developments in support of regulators' financial stability and market conduct
objectives. However, given the time-frames required to consult on and pass the relevant
legislation, it could be some months before a definite move towards mandatory reporting
obligations could be made. ASIC would then have to develop the associated derivative
transaction rules, which would be subject to a regulatory impact study and further industry
consultation. It would also be necessary to license at least one trade repository to operate in
this jurisdiction. As a result, it could be well into next year before any mandate is actually in
force.
The effectiveness of the regime will also require a range of responses from market
participants. If the transition to new arrangements, whether or not triggered by the issuance
of a mandate, is to occur on an acceptable time-frame, institutions should already be making
the operational and organisational changes needed to move towards greater use of
centralised infrastructure. Based on the Council agencies' market assessment and ongoing
dialogue with stakeholders, I'd like to identify five areas in which more work will need to be
done.
First, international banks and the large domestic banks have already had to begin making the
transition, in part in response to regulatory reforms already underway in some jurisdictions. In
the case of central clearing, efforts to date also reflect the economic incentive of an emerging
price differential between cleared and non-cleared transactions. This work is ongoing.
International banks active in the Australian market are generally already actively clearing
Australian dollar-denominated interest rate swaps via offshore entities that participate in
LCH.Clearnet's London-based SwapClear service or CME Clearing in the United States. In
most cases, the large domestic banks have taken the initial step of concluding client-clearing
agreements for some of their OTC derivatives business. For several of these institutions, the
transition to central clearing for this segment of their business is having profound implications
for the organisation of their operations. Indeed, these institutions have been confronted with
a number of legal and operational issues, such as clearing agreements that often contain
more restrictive contractual terms than in their existing ISDA Master Agreements with
bilateral counterparties. They have also had to adjust to new operational dependencies on
the clearing participants through which they channel their business. For the Council
agencies, the experience of these institutions has illuminated a number of issues that may
warrant further consideration, and which may shape the design of derivative transaction rules
should mandatory clearing be imposed.
Second, it is evident that in the absence of similar pressures, smaller and more domestically
focused institutions are generally at an earlier stage in this process. Given the complexity of
the required adjustment, these institutions are encouraged to accelerate their transition
plans. In the case of central clearing, it is likely that these institutions will be reliant on a
relatively limited number of large, probably international, providers of client-clearing services.
Recognising these dependencies, the Council agencies continue to examine matters such as
client monies rules, so as to ensure adequate protections for Australian institutions. Client
monies remain an important area of focus for regulators around the world, with international
work under way under the auspices of IOSCO.
Third, the scope for Australian-domiciled institutions to access central counterparties directly
to clear Australian-dollar denominated derivatives is limited by the fact that no central
counterparty is yet licensed to provide these services in Australia. Similarly, no trade
repository is yet licensed to operate in Australia. ASIC and the Bank acknowledge their
responsibility for dealing with any licence applications received from central counterparties
or, once the new regime is in place, trade repositories seeking to provide services in
Australia. The large Australian banks continue to discuss operational, legal and commercial
terms of access with both domestic and overseas-based central counterparties that are
interested in providing services in this area. An important consideration is how any
international services would be adapted to the Australian market and time zone, including in
relation to the provision of operational support, valuation methodology, margin collection and
collateral eligibility criteria. The tax treatment of payments to an overseas-based central
counterparty has also been identified as a potential issue. Ultimately, any central
counterparty offering services to Australian-domiciled institutions will need to meet the needs
of the Australian market place, the requirements for cross-border regulatory influence
articulated by the Council, and possible future requirements that might be set out in
derivative transaction rules in support of any mandatory clearing obligations.
Fourth, at the November 2011 Summit in Cannes, the G-20 leaders called for international
standards for the margining of non-centrally cleared OTC derivatives. In accordance with this
request, an international working group led by the Basel Committee on Banking Supervision
and IOSCO released, in July, a set of draft principles for consultation. The principles propose
harmonised margining arrangements, consistent with those in place for central
counterparties. While variation margin is already typically exchanged in respect of
non-centrally cleared trades, the application of initial margin is less widespread.
Implementation of the principles is therefore likely to lead to a substantial increase in demand
for collateral assets that are eligible to meet initial margin requirements. The working group
has conducted a quantitative impact study to assess the possible magnitude of the increase
globally, the results of which will inform the group's final proposal. The Council agencies
have been considering how the new arrangements might be implemented in the Australian
context, a key area of concern being the increase in demand for high-quality collateral.
Finally, the Council agencies will continue to assess how best to enhance transparency in
OTC derivatives markets, within the parameters of the new regulatory framework. This work
will consider the role platform-based execution might play in enhancing pre- and post-trade
transparency. It will also examine any legal and confidentiality constraints to making
aggregated trade-repository data on OTC derivatives market activity publicly available.
So, clearly, there has been a lot of progress over the past year. But our work is far from
done. While the Council's direction is clear and the legislative process underpinning the
framework is well underway, there remains a fair amount of work ahead to complete the
transition; for market participants, infrastructure providers, and regulators alike. I hope that
when this group meets in a year's time, many of these outstanding issues will have been
resolved.
Once again, thank you very much for the opportunity to speak today, and for your attention.