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Council of Financial Regulators

Application of the Regulatory Influence Framework for
Cross-border Central Counterparties – March 2014

Application to CCPs in Different Markets

This section considers how the Regulators would expect to apply the regulatory influence framework to cross-border CCPs operating in the various Australian product classes: OTC derivative markets; cash equity markets; and exchange-traded derivative markets.

The analysis in this section is intended to give current and prospective licensees high-level guidance, reflecting the Regulators' current views on the characteristics of each product class and assuming a particular profile for a new entrant or licensee. Since the scenarios considered here are not exhaustive, and given the need to respond to future developments in product markets and licensees' profiles, the Regulators retain the flexibility to consider each case on its merits.

OTC derivative markets

The framework for ensuring appropriate regulatory influence over cross-border CS facilities has already been applied in the clearing of OTC derivative markets. LCH.C Ltd obtained a licence in April 2013 to clear energy, commodity and environmental futures to be listed on the soon-to-be-launched Financial and Energy Exchange (FEX). This licence was subsequently varied in July 2013 to permit LCH.C Ltd to offer its SwapClear OTC derivative clearing service in Australia. In assessing which requirements should apply to LCH.C Ltd's SwapClear service, the Regulators took the view that the service could rapidly become systemically important in Australia. This view reflected the integral role of the sizeable ($9.2 trillion notional) AUD interest rate derivative market in interest rate risk management, the significant share of the market already cleared via LCH.C Ltd by international participants, and the prospect that Australian banks would become direct participants of the service.

Consistent with this conclusion, LCH.C Ltd has applied to open an ESA at the RBA and has taken steps to establish the local presence required to operate an ESA. LCH.C Ltd is also opening an account with Austraclear to hold AUD securities collateral. Once the ESA is in place, LCH.C Ltd will begin settling its AUD margin flows across this account.[4] In addition, the RBA participates in the supervisory college established by the Bank of England for oversight of LCH.C Ltd's SwapClear service.

Although LCH.C Ltd is regarded as systemically important in Australia, the Regulators have concluded that LCH.C Ltd does not have a strong domestic connection. In the Regulators' view, the AUD interest rate swaps market is part of a much larger global market for OTC interest rate derivatives. International participants in this market organise their trading activity and post-trade processes on a multicurrency basis. The clearing service provided by LCH.C Ltd is similarly organised on a multicurrency basis and Australian-based participants constitute only a small share of LCH.C Ltd's highly international participant base.

Table 2: Cross-border Regulatory Influence Application to OTC Derivative Markets
  Considerations on systemic importance Considerations on domestic connection Regulators' expectations
AUD interest rate derivatives

Overseas CCP clearing significant volume of AUD derivatives as part of multicurrency offering
Underlying product inherently systemically important and integral to interest rate risk management in the financial system

A CCP clearing a significant share of the AUD OTC interest rate derivative market, including for Australian banks, would be likely to be considered systemically important

AUD derivatives expected to be a relatively small part of a linked multicurrency product offering

A large international CCP with a multicurrency offering would be expected to have a highly international participant base; Australian direct participants would be expected to comprise a small share

Possible interoperable links

While proportionally small, Australian participation nevertheless likely to be material

Likely to be systemically important, especially with the direct participation of large Australian banks

Given the international nature of the market, unlikely to conclude that the CCP had a strong domestic connection
Foreign currency-denominated interest rate derivatives

Overseas CCP clearing a limited volume of AUD derivatives, or none at all
Foreign currency-denominated underlying products not expected to be considered systemically important in Australia

CCP could expand activity in AUD products
Primarily international products

Largely international participation base

Possible interoperable links – may be limited by the degree of overlap in product coverage
Australian participation may not be material, at least at the outset

Unlikely to be systemically important without a significant expansion of activity in AUD products

Given the international nature of the products, unlikely to conclude that the CCP had a strong domestic connection

In the case of a CCP that provided a clearing service in only (or primarily) interest rate swaps denominated in currencies other than Australian dollars, it is likely that the service would be regarded as neither systemically important nor having a strong domestic connection (Table 2). The Regulators would recommend that such a CCP be required to obtain an Australian CS facility licence if it offered its services to Australian participants. However, if it did not clear a significant volume of AUD products, its links to the Australian financial system would not be expected to pose large direct stability risks.

Should an interoperable link be introduced between an overseas-based OTC derivative CCP and an Australian-based CCP, to allow a participant in one CCP to clear trades entered into with a participant in the other CCP, this would strengthen the overseas CCP's domestic connection. However, this would be unlikely by itself to lead Regulators to conclude that there was a strong domestic connection. Risks arising from any such link would be managed and overseen in accordance with CCP Standard 19 (FMI Links).

Cash Equity Markets

In its report ‘Competition in Clearing Australian Cash Equities: Conclusions’, the CFR provided guidance on how it would apply the regulatory influence framework to a CCP clearing Australian equities listed by ASX.[5] In February 2013, on the advice of the CFR, the government announced that no licence application from a competing CCP for ASX-listed equities would be considered for at least two years. It is nevertheless instructive to consider how the Regulators would apply the framework in this product class if the current prohibition on competition were to be lifted following the CFR's review at the end of the two-year period.

The market capitalisation of the Australian cash equity market ($1.5 trillion) and its daily on-market turnover (around $3.8 billion) are low relative to notional values in exchange-traded and OTC interest rate derivative markets, and indeed the Australian fixed-income market. However, the cash equity market is highly visible and is often seen as a barometer of wider investor confidence in the Australian financial system. A CCP with a material share of this market would therefore be deemed to be systemically important. A CCP that cleared a material share of the market for ASX-listed cash equities would also be regarded as having a strong domestic connection due to the high level of retail participation (either directly or through superannuation and other managed funds) in this market, its links to securities issuers in the real economy, and the need for such a CCP to link to key trading and settlement infrastructure.

Table 3 considers two scenarios: an entrant CCP clearing for a competing trade execution venue for ASX-listed cash equities; and an entrant CCP clearing for a competing listing market.

An entrant CCP for ASX-listed cash equities traded on a competing execution venue might quickly become integral to the functioning of the Australian cash equity market. It might therefore soon be regarded as being both systemically important and having a strong domestic connection. As set out in the CFR's conclusions on competition in clearing Australian cash equities, a number of factors argue in favour of setting a threshold market share for domestic incorporation and licensing at a low level:

  • the importance and profile of the Australian cash equity market
  • the central role of the Australian cash equity market in the Australian financial system
  • the high level of retail participation in the Australian cash equity market
  • the connections that a competing CCP would have to other components of the domestic financial market infrastructure
  • stakeholder expectations as to the handling of client monies related to Australian equity trades.

The considerations relevant to a CCP clearing equities listed on an alternative exchange would differ from those for ASX-listed equities (Table 3). Existing alternative listing markets for equities in Australia are small and typically focused on particular industry segments. This is likely to remain the case in the near term, given the dominant position of ASX in listings. It is therefore unlikely that a CCP seeking to clear for an alternative listing market would become systemically important on a short time horizon. The strength of the CCP's domestic connection would also be limited by the narrow industry focus. A business model focused on specialised listings would also limit the potential for the service to become systemically important over time.

Table 3: Cross-border Regulatory Influence Application to Cash Equity Markets
  Considerations on systemic importance Considerations on domestic connection Regulators'
expectations
ASX-listed equities

CCP for a competing alternative trade execution venue for ASX-listed equities
Activity is highly visible to the public; any disruption to services could damage investor confidence

Share of on-market transactions on a competing trade execution venue likely to be sufficient to be regarded as systemically important

Could gain a larger share with interoperability
Domestic underlying market, with material retail participation

Likely to have a mixed domestic and international participation base, both in the underlying market and the competing CCP

Indirect links to domestic issuing companies; direct links to other FMIs (e.g. ASX Settlement and, in the event of interoperability, possibly also ASX Clear)
Given the profile of the underlying product class, Australian participation is likely to be material

Could be systemically important from the outset

Since the CCP would also be likely to have a strong domestic connection, domestic licensing and incorporation likely to be necessary at a relatively low threshold market share
Non-ASX-listed equities

CCP for alternative listing market
A competing listing market would be likely to be small, at least initially

With a small size, disruption to services would have limited implications for investor confidence, especially if listings were concentrated in a single or few industries
Domestic listing market, but likely to focus on a narrow industry segment

Direct links both to domestic issuers and to other FMIs in Australia (e.g. ASX Settlement)
Australian participation likely to be material

Unlikely to be deemed to be systemically important if narrowly focused

Unlikely to have a strong domestic connection, given narrow industry focus

Exchange-traded derivative markets

A wide range of exchange-traded derivative contracts are currently traded in Australia. These are primarily listed on the ASX 24 market and cleared by ASX Clear (Futures). They span financial futures (interest rate and equity index futures), electricity and commodity contracts. ASX also has an important equity options business referencing ASX-listed cash equities. These products are cleared by ASX Clear.

The most actively traded Australian exchange-traded contracts are financial futures. These derivatives are integral to financial risk management in the Australian financial system and are actively used by both domestic and international banks as well as a wide range of Australian investment institutions. Should a competing trade execution venue and CCP emerge for these products and begin to attract liquidity from ASX, the competing CCP could rapidly become systemically important with a strong domestic connection. As in the case of ASX-listed cash equities, given the role and importance of these products and the strong domestic orientation of activity in this market, the Regulators would expect to set the threshold market share for domestic incorporation and licensing of a competing CCP operating in these markets at a relatively low level (Table 4). The Regulators would expect to reach a similar conclusion for equity options referencing ASX-listed equities, with particular emphasis on their links to the prominent cash equity market.

By contrast, the Regulators would be unlikely to conclude that a CCP operating primarily in the market for non-AUD financial futures, Australian electricity derivatives or commodity derivatives was systemically important with a strong domestic connection. While the electricity market is undoubtedly systemically important in a ‘whole economy’ sense, electricity derivatives are not highly integrated with the wider financial system and any disruption to clearing in that market might be unlikely to give rise to financial contagion. Similarly, commodity derivatives are not highly integrated with broader financial market activity. Further, the Regulators would be unlikely to conclude that a CCP operating primarily in these product classes had a ‘strong’ domestic connection. As noted earlier, when launched, FEX is expected to list derivative contracts in energy and commodity products. Accordingly, in respect of its clearing for this exchange, only the foundational requirements would apply to FEX's appointed CCP, LCH.C Ltd.

Links to other components of the financial market infrastructure are also likely to be important to the Regulators' assessment. For instance, if a competing trading venue and CCP emerged for exchange-traded derivatives, participants could seek interoperable links between the competing CCP and ASX Clear (Futures). This could strengthen the competing CCP's domestic connection.

It is instructive to consider why the expected regulatory settings for a CCP operating in the AUD exchange-traded interest rate futures market are different to those for a CCP clearing AUD OTC interest rate swaps. In both cases, the underlying market would be regarded as systemically important in Australia. However, while a clearing service for AUD interest rate futures would be deemed to have a strong domestic connection, it is likely that (on the basis of prevailing market characteristics) the opposite conclusion would be reached for AUD OTC interest rate swaps. The rationale for this position is as follows:

  • the underlying market for exchange-traded interest rate futures is largely domestic, while the OTC derivative market is global
  • the OTC derivative market is a largely wholesale market, dominated by a small number of large institutions, including the international broker-dealers and the large domestic banks; the exchange-traded interest rate futures market, while considerably smaller in outstanding notional terms, has broader participation, higher turnover ($149 billion notional daily, versus $73 billion), and is integral to the risk management and investment activities of a wider range of domestic financial institutions
  • in the OTC derivative market, participants are able to take independent decisions on their preferred clearing venue (subject to agreement with their bilateral counterparties); in the case of exchange-traded derivatives, the clearing venue is determined by the execution venue
  • for many international dealers in the OTC interest rate swaps market, trading and post-trade processes – including counterparty relationships, documentation and risk management – are organised on a multicurrency basis; these dealers therefore seek to organise their clearing arrangements on a similarly multicurrency basis
  • AUD interest rate futures, by contrast, are not inherently linked – neither in how they are traded, nor how they are cleared – to similar futures products denominated in other currencies.
Table 4: Cross-border Regulatory Influence Application to Exchange-traded Derivative Markets
  Considerations on systemic importance Considerations on domestic connection Regulators' expectations 
AUD interest rate/equity index futures

CCP for AUD financial futures traded on a competing domestic exchange
Large, systemically important market for Australia

Integral to interest rate and broader financial risk management in the financial system

Any entrant CCP might have a low market share initially, but based on experience in other markets internationally its share could grow rapidly if liquidity began to shift
Domestic products, linked to domestic underlyings

Products not inherently linked with international exchange-traded derivative products

Any entrant CCP would be likely to have a mixed domestic and international participation base

Link to domestic exchange and possible interoperable links
Australian participation likely to be material

An entrant CCP could rapidly become systemically important if market liquidity began to shift

Since the CCP would also be likely to have a strong domestic connection, domestic licensing and incorporation likely to be necessary at a relatively low threshold
ASX-listed equity options

CCP for ASX-listed equity options traded on a competing domestic exchange
Visible market with close links to the prominent market for ASX-listed equities

Any entrant CCP might have a low market share initially, but based on experience in other markets internationally its share could grow rapidly if liquidity began to shift
Domestic products, linked to domestic underlyings; material retail-linked activity

Products not inherently linked with international exchange-traded derivative products

Any entrant CCP would be likely to have a mixed domestic and international participation base

Link to domestic exchange and possible interoperable links
Australian participation likely to be material

An entrant CCP could rapidly become systemically important if market liquidity began to shift

Since the CCP would also be likely to have a strong domestic connection, domestic licensing and incorporation likely to be necessary at a relatively low threshold
Non-AUD interest rate/equity index futures

CCP for non-AUD financial futures traded on an international exchange
Scale of Australian participation likely to be relatively low

Direct interconnections with the Australian financial system likely to be limited since the products traded/cleared would be referenced to non-Australian underlyings
International products traded on an international exchange

Largely international participation base
Australian participation may not be material, at least at the outset

An entrant CCP clearing non-AUD financial derivatives would be unlikely to be systemically important in Australia

Given the international nature of the products, also unlikely to conclude that there was a strong domestic connection
Electricity derivatives

CCP for electricity derivatives traded on a competing domestic exchange
The market for exchange-traded Australian electricity derivatives is small both in absolute terms and relative to the market for AUD financial futures

While integral to financial risk management in a prominent real sector, electricity derivatives are not highly integrated with broader risk management activities in the financial system
Narrow, but prominent domestic underlying segment

Largely domestic participation base

Link to domestic exchange
Clear connection to a prominent domestic real sector

If an entrant CCP operated only (or primarily) in this niche, and/or with a low market share, unlikely to conclude that it was systemically important or that it had a sufficiently strong domestic connection to justify domestic licensing and incorporation
Commodity derivatives

CCP for commodity derivatives traded on a competing domestic exchange
The market for exchange-traded commodity derivatives in Australia is small both in absolute terms and relative to the market for AUD financial futures

While important for some companies' financial risk management, commodity derivatives are not highly integrated with broader risk management activities in the financial system
Some commodity products closely linked to Australian real economy; others largely international products

Mixed domestic and international participation base

Link to domestic exchange
Some connection to domestic real sector

If an entrant CCP operated only (or primarily) in this niche, and/or with a low market share, unlikely to conclude that it was systemically important or that it had a sufficiently strong domestic connection to justify domestic licensing and incorporation

The framework is, however, sufficiently flexible to accommodate changing market structures and a changing market environment. Consider for instance the hypothetical scenario of a regional or global trend whereby currently nationally siloed exchange-traded interest rate futures markets were gravitating to international exchanges served by international CCPs. Under such a scenario, market participants' business models could change and the ‘domestic connection’ of these markets could weaken, potentially causing the Regulators to reconsider the case for domestic incorporation and licensing requirements. To the extent that such a facility remained systemically important, however, the requirement to hold an ESA with the RBA would continue to apply. The Regulators would also seek to influence regulatory outcomes through a combination of bilateral arrangements with both the CCP's home regulator and the CCP itself, and through any multilateral college arrangements.

Summary

On the basis of the analysis in this paper, Table 5 summarises the Regulators' likely recommendations or determinations on location requirements for each of the product classes considered. The table takes the case of an entrant CCP that has material domestic participation and either has or is likely quickly to gain a significant share of the market for the relevant product class.

An entrant CCP would be expected to be subject to domestic incorporation and licensing requirements at a relatively low market share threshold in each of the following product classes: ASX-listed cash equities; ASX-listed equity options; AUD interest rate futures; and AUD equity index futures.

Table 5: Summary of Regulatory Settings for CCPs Clearing Different Markets
  Regulators' likely assessment for a facility with material Australian participation and a significant market share Highest expected additional regulatory requirements once market share threshold reached
ASX-listed equities, AUD interest rate/equity index futures, ASX-listed equity options Systemically important

Strong domestic connection
Domestic CS facility licence

Domestic incorporation

Offshore outsourcing restrictions
AUD OTC interest rate swaps Systemically important

No strong domestic connection
ESA at the RBA

Strengthened influence for Australian regulators
Non-AUD OTC interest rate swaps, non-ASX-listed equities, non-AUD interest rate/equity index futures, electricity derivatives, commodity derivatives Not systemically important

No strong domestic connection
Governance and operational arrangements that promote stability in the Australian financial system

Footnotes
  1. Two Australian banks have joined as direct participants of SwapClear. The other large Australian banks have client clearing arrangements that allow them to clear trades indirectly through this service; these banks are expected to join as direct participants in coming months.
  2. The report is available at <http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2013/Council
    %20of%20Financial%20Regulators%20advice%20on%20competition/Downloads/Competition%20in%20clearing
    %20and%20settlement%20of%20the%20Australian%20cash%20equity%20market.ashx>.

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