Australian Regulators' Statement on Assessing the Case for Mandatory Clearing Obligations
The Australian Prudential Regulation Authority (APRA), the Australian Securities and Investments Commission (ASIC) and the Reserve Bank of Australia (RBA) (collectively, the Regulators) consider it timely to give market participants and international regulatory peers more clarity around how they will assess the case for introducing clearing mandates. This statement builds on the advice previously provided to the government by the Council of Financial Regulators (CFR), which has to date favoured an approach whereby central clearing arrangements are given time to evolve in response to economic incentives (including from regulatory requirements) and the commercial considerations of market participants and infrastructure providers. It also forms part of Australia's response to the call from by the Financial Stability Board in its fifth implementation report on over-the-counter (OTC) derivatives reforms that:
‘Jurisdictions that do not initially intend to adopt mandatory requirements, because they expect that capital, margin and other incentives will be effective in achieving central clearing of all standardised derivatives, should clearly articulate a timetable, criteria and thresholds for deciding in which cases mandatory requirements would be adopted to achieve G20 goals.’
In particular, this statement sets out the means by which the Regulators will monitor developments in the Australian OTC derivatives market, and the criteria that the Regulators will consider when providing advice to the Minister under the Act, including in response to a request from the Minister. The timing of any mandatory clearing determination will depend on the Regulators' advice and any decisions taken by the Minister after consideration of the Regulators' advice.
The Regulators' approach is consistent with the approach to mandatory clearing agreed under international principles and adopted in other jurisdictions.
2. Legislative framework
Part 7.5A of the Corporations Act 2001 (the Act) establishes a regime for the imposition of mandatory requirements in respect of platform-based trade execution, trade reporting and central clearing of OTC derivatives. The regime became effective at the start of 2013.
Under this regime, the responsible Minister may issue a determination that mandatory obligations with respect to platform-based trade execution, trade reporting or central clearing should apply to a specified class or classes of derivatives. In making the decision to issue a determination, the Minister must have regard to certain matters specified in legislation or regulations. In particular, section 901B of the Corporations Act requires the Minister to consider:
- the likely effect on the Australian economy, and on the efficiency, integrity and stability of the Australian financial system;
- the likely regulatory impact;
- in the case of commodity derivatives, the likely impact on any relevant Australian commodities market or markets; and
- any other matters that the Minister considers relevant, such as relevant international standards and international commitments.
In making such determinations the Minister must consult with the Regulators. The Regulators may also provide advice to the Minister of their own accord.
The government may also issue regulations that restrict the product or institutional scope of mandatory requirements, thereby providing temporary or ongoing exemptions in relation to specified products or entities. As of May 2013, no regulation has been made to restrict the product or institutional scope of any prospective mandatory requirement.
Once the Minister has made a determination, ASIC may make Derivative Transaction Rules that apply to the relevant products. Such rules would set out the details of any requirements, including the institutional scope, product scope, transitional arrangements and the manner and form in which persons must comply with the requirements. In making these rules, ASIC must have regard to the same matters that the Minister is required to consider, and must also consult with APRA and the RBA.
3. Regulators' advice
While the Act does not specify the matters that the Regulators must consider when providing advice to the Minister, the Regulators' advice to the Minister can be expected to address the considerations in section 901B of the Act referred to above.
In order to inform their advice to the Minister, the Regulators are actively monitoring developments in the Australian and overseas OTC derivatives markets. As part of this, the Regulators carry out periodic surveys of the Australian OTC markets and produce assessment reports based on the results of these surveys. In the initial phase of implementation, it is intended that these reports be produced on a semiannual basis. The most recent report was published in October 2012 (the October 2012 Report) and the Regulators are currently preparing a report for publication in mid 2013.
The Regulators are also monitoring developments through ongoing ad hoc engagement with participants and financial market infrastructure providers, public consultations and, as appropriate, specific purpose market surveys. While a reporting mandate is not a prerequisite to a clearing mandate, once trade repositories are operational in Australia, data from this source will also assist the Regulators' monitoring activity. Both quantitative and qualitative information will be considered.
3.1 Scope and prioritisation of products to be assessed
Against this background, the Regulators will make periodic assessments of the need for a clearing mandate in respect of particular products. Consistent with IOSCO (2012) and the CFR's recommendations in its March 2012 report, the regime under the Act enables the Regulators to take both a top-down and a bottom-up approach to determine which products should be subject to a mandatory clearing obligation.
- Under the top-down approach, OTC derivatives products will be considered for mandatory clearing based on a broad range of information available to the Regulators about activity in the OTC derivatives market and product characteristics.
- Under the bottom-up approach, OTC derivatives products already cleared (or prospectively to be cleared) by a central counterparty licensed to operate in Australia will be considered for mandatory clearing.
As acknowledged in IOSCO (2012), ‘the set of products to be investigated [under the top-down approach] may be large, and it may be necessary to assign priorities to investigations'. In prioritising their considerations, the Regulators will consider the factors suggested in IOSCO (2012), namely the relative systemic importance of the products, whether the product is already under a clearing obligation in another jurisdiction, and whether the product is designed as a deliberate attempt to avoid an existing clearing obligation. Assessments of products under the bottom-up approach will be similarly prioritised.
Under both top-down and bottom-up approaches, the Regulators would initially consider whether a product is suitable for central clearing. As noted in CFR (2012), and consistent with the international standards established in IOSCO (2012) and FSB (2010), a number of preconditions must be satisfied in order for a central counterparty to clear a product safely and reliably:
- the product must have a robust valuation methodology so that the central counterparty can confidently determine margin and default fund requirements;
- there must be sufficient liquidity in the market to allow for close out and/or hedging of outstanding positions in a default scenario;
- there must be sufficient transaction activity and participation so that the fixed and variable costs of clearing the transaction are covered; and
- there must be some standardisation of contracts to facilitate the CCP's trade processing arrangements.
Benefits from central clearing
As articulated in CFR (2012) and reiterated in the October 2012 Report, central clearing may be a highly effective way to enhance the efficiency, integrity and stability of financial markets.
- By substituting the numerous bilateral exposures of a market participant for a single multilateral net exposure to a central counterparty, central clearing simplifies the network of interconnections between financial institutions and can reduce total counterparty credit exposures.
- By streamlining the counterparty risk management process, central clearing can also facilitate platform trading.
- Centralisation can carry other efficiency benefits. For instance, by acting as a hub for market participants, a central counterparty can improve the effectiveness of default management arrangements and coordinate operational improvements and efficiencies across the system – such as through the standardisation of financial products and associated documentation, the streamlining of the transaction workflow, and the simplification of collateral management.
- Central clearing can also provide a focal point for regulation and oversight of market-wide risk management, while reducing information asymmetries in the market more generally.
The potential benefits of central clearing set out above will reflect the level of trading activity in a particular derivatives product, its characteristics, and the profile of participation in the market. For instance, the stability benefit of a transition to central clearing is likely to be greatest for products that are traded widely in the Australian OTC derivatives market and which give rise to sizeable counterparty credit exposures between large financial institutions when cleared bilaterally. As a result, the assessment of such products will be prioritised. Conversely, there will be products for which there is limited activity in the Australian OTC derivatives market. For these products the benefit of central clearing would be low.
In assessing the potential benefit of central clearing, therefore, the Regulators may consider factors such as:
- absolute and relative notional outstanding of the product under consideration, and metrics for associated risk (e.g. market value and gross credit exposure);
- magnitude and dispersion of bilateral counterparty exposures;
- profile of participation (e.g. dealer, non-dealer bank, non-bank financial institution, corporate); and
- potential impact of central clearing on market functioning (e.g. liquidity, price discovery).
3.2 Criteria for mandatory clearing
Implications for the Australian financial system and participants
In accordance with the legislation, the Regulators will consider the implications for the efficiency, integrity and stability of the Australian financial system as a whole, as well as the regulatory impact on market participants and financial market infrastructure active in the Australian market. For each product identified and prioritised through the process described above, the Regulators will focus on the incremental benefits and costs of imposing mandatory clearing, relative to allowing the market to transition to central clearing in response to private or other regulatory incentives.
Accordingly, for each product being considered the Regulators will take into account:
- the extent to which market participants are already centrally clearing that product;
- the availability or accessibility of central clearing of that product for different types of Australian market participants, whether as direct participants or as clients;
- whether participants have already established appropriate commercial and operational arrangements with central counterparties or whether such arrangements are still under negotiation for particular types of participants; and
- evidence of commercial pressure or regulatory incentives to centrally clear that product (which may include regulatory incentives as a result of the cross-border reach of regulation in other jurisdictions).
Where no central counterparty has yet been licensed to clear a particular product, or only one central counterparty has been licensed, the issuance of a mandate would constrain Australian participants' choices. In particular, participants would be unable to select clearing arrangements that best fit the scale and scope of their business, operationally and financially, with potential adverse effects for market functioning. In such circumstances, the incremental regulatory cost of imposing a mandate could be relatively high. As the transition to clearing progresses, however, and a choice of central counterparties with different profiles emerges, the likely incremental costs of imposing a mandatory clearing requirement in Australia might be expected to decline, potentially substantially. The Regulators' advice to the Minister will address such questions as they apply to the specific products under consideration.
In accordance with the scope of the Act, the Regulators will also address relevant international standards and international commitments. International consistency is an important consideration in assessing the case for mandatory clearing. In particular:
- in the absence of broadly harmonised requirements, there may be potential for regulatory arbitrage or other distortions in market participants' choices as to where to conduct business or book trades; accordingly, relying on incentives while other jurisdictions adopt central clearing mandates could create reputational risks for Australia;
- it could also affect other jurisdictions' assessment of the equivalence or comparability of the Australian regime, thereby disadvantaging Australian-based participants in their international activities; and
- where a product was subject to a mandate overseas but not in Australia, overseas requirements may have unintended consequences for Australia due to differences in market structure and conditions; an Australian mandate could, in such circumstances, better tailor requirements to the Australian context, while not compromising broad equivalence with overseas jurisdictions' regimes.
Such considerations were acknowledged in the October 2012 Report, which stated that ‘mandatory obligations may be warranted for regulatory equivalence purposes, or to ensure that opportunities for regulatory arbitrage were not being exploited. Should evidence suggest that there would be some benefit from mandatory clearing obligations in these regards, the Regulators would respond accordingly’. In so doing, the Regulators will consider the approaches adopted in other jurisdictions, and the extent to which rules issued in overseas jurisdictions would affect Australian market participants.
The scope of products considered in this regard could therefore extend beyond those prioritised purely on the basis of product characteristics and activity, to capture other products for which a mandate has been introduced in other jurisdictions and for which there is material activity in the Australian OTC derivatives market. The Regulators' considerations on these issues would be informed by appropriate information exchange with regulators, consistent with the recommendation of IOSCO (2012).
Specific considerations for commodity derivatives
There is a close relationship between the functioning of commodity derivatives markets and the functioning of the markets for the underlying physical commodity markets referenced by these derivatives. Consequently, in the case of commodity derivatives, in addition to the criteria outlined above, the Regulators will pay particular attention to the potential impact of imposing a central clearing mandate on underlying commodity markets and the participants in these markets. This is consistent with the requirement in the Act that in the case of commodity derivatives, the Minister consider the likely impact on any relevant Australian commodities market or markets.
4. Next steps
This section considers how the approach articulated above will be applied in the coming period. As described above, the Regulators will assess the case for imposing central clearing mandates using both the top-down and bottom-up approaches.
- Top-down: The report intended for publication in mid 2013 will be an important vehicle for the Regulators to provide advice to the Minister about the case for imposing a central clearing mandate in Australia, with particular emphasis on instruments identified as of interest in the October 2012 Report (principally Australian dollar-denominated interest rate derivatives). The Australian regulators would also expect to consider whether to recommend that the Minister impose a central clearing mandate for other products, where an overseas regulator has introduced a mandate and the specified product has material relevance to the Australian market or market participants. A primary input into the Regulators' consideration of these matters will be the results from a survey of the Australian OTC derivatives market, administered in March 2013. The survey requests information on Australian market participants' activities in Australian dollar-denominated interest rate derivatives, as well as those products that have been mandated by the US Commodity Futures Trading Commission (CFTC).
- Bottom-up: In addition, whenever a central counterparty is licensed to clear OTC derivatives in Australia, the Regulators expect to provide advice to the Minister about whether the products that the central counterparty is authorised to clear should be mandated for central clearing in Australia. The Regulators intend to provide such advice in a timely manner, whether as part of the periodic reports on the Australian OTC derivatives market or on an ad hoc basis.
The Regulators' assessment will have a particular focus on transitional and timing issues. In particular, the Regulators will address the following points:
- the degree to which the Australian markets have already, or are anticipated to, move to central clearing arrangements. This will include the extent to which pricing differentials between centrally cleared and bilaterally cleared trades, and the cross-border reach of overseas clearing mandates are already forcing such changes on Australian market participants;
- the status of Australian market participants' negotiations/commitments with central counterparties, and operational readiness for central clearing; and
- the costs and benefits to the Australian economy and/or financial system of a mandated transition to central clearing, including the potential benefits of an Australian clearing mandate in delivering regulatory consistency with overseas jurisdictions and ensuring that Australian-based participants are not disadvantaged in their international activities.
As noted, the incremental costs of mandatory central clearing mandates are likely to reduce over time, once the initial transition to central clearing has occurred. Consideration of these matters will therefore be important in the Regulators' analysis of the incremental costs and benefits of issuing a mandate. For example, should the Regulators recommend that the Minister impose a mandatory central clearing requirement, the Regulators may also recommend that any mandatory clearing determination would come into effect only once one or more central counterparties licensed to operate in Australia were clearing the product. ASIC and the RBA have also acknowledged their responsibility for dealing expeditiously with any applications from central counterparties seeking to provide services in Australia.
- Financial Stability Board, OTC Derivatives Market Reforms: Fifth Progress Report on Implementation, April 2013, available at <http://www.financialstabilityboard.org/publications/r_130415.pdf>.
- The introduction of mandatory trading, reporting and clearing obligations are independent decisions.
- While a Ministerial Determination is required, it is not sufficient to impose mandatory obligations; ASIC rule-making is required for mandatory obligations to be effective.
- For example, in December 2012, the government proposed a trade reporting determination, and is expected to make such a determination shortly. In anticipation of this determination, on 28 March 2013, ASIC launched a consultation on rules to implement a trade reporting obligation, the first phase of which is expected to be in place by the end of 2013. See Consultation Paper 205: Derivative Transaction Reporting, March 2013, available at <http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/cp205--published-28-March-2013.pdf/$file/cp205--published-28-March-2013.pdf>.
- See APRA, ASIC and RBA (2012), Report on the Australian OTC Derivatives Market, October, available at <https://www.rba.gov.au/payments-system/clearing-settlement/otc-derivatives/201210-otc-der-mkt-rep-au/index.html>.
- ASIC has consulted on the proposed regime for regulation of trade repositories; see Consultation Paper 201: Derivative Trade Repositories, March 2013, available at <https://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/cp201-published-15-March-2013.pdf/$file/cp201-published-15-March-2013.pdf>. It is expected that at least one trade repository will be licensed in the second half of 2013.
- See IOSCO (2012), Requirements for Mandatory Clearing, February, available at <https://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf>.
- See CFR (2012), OTC Derivatives Market Reform Considerations, March, available at <https://www.rba.gov.au/payments-system/clearing-settlement/otc-derivatives/201203-otc-der-mkt-ref-con/index.html>.
- See FSB (2010), Implementing OTC Derivatives Market Reforms, October, available at <http://www.financialstabilityboard.org/publications/r_101025.pdf>.
- This is also consistent with the statement from a group of authorities with responsibility for the regulation of the OTC derivatives markets in various jurisdictions (of which ASIC is a part) that ‘once one of the authorities decides that a certain product or class of products should be subject to a clearing requirement, then each [other] will consider whether the same product should be subject to the same requirement in our jurisdictions, having regard to the characteristics of [its respective] domestic markets and in accordance with the applicable determination processes in [its] respective legal [regime]’. See Joint Press Statement of Leaders on Operating Principles and Areas of Exploration in the Regulation of the Cross-border OTC Derivatives Market, 4 December 2012, available at <http://www.sec.gov/news/press/2012/2012-251.htm>.
- With effect from 11 March 2013, a clearing mandate is in force in the US, implemented and enforced by CFTC. The CFTC's mandate applies to interest rate swaps in the top four global currencies (USD, EUR, JPY, GBP), as well as two credit default swap indices.