Central Clearing of OTC Derivatives in Australia – June 2011 4. Key Policy Design Considerations

4.1 Introduction

In developing recommendations regarding central clearing of OTC derivatives, the Council agencies are looking to balance the implications for both the efficiency and stability of the Australian financial system, given the role and structure of the Australian OTC derivatives market and participants, the nature of central clearing, and other domestic and international regulatory considerations.

4.2. What Products Should be Subject to a Clearing Requirement?

Although higher capital charges for non-centrally cleared transactions may provide an incentive for increased use of CCPs, internationally regulators are developing mandatory clearing requirements. One consequence of this is that Australian market participants, to the extent that they are trading with counterparties from these jurisdictions, may find they are indirectly subject to mandatory clearing, irrespective of any local decisions. In part to provide more certainty to Australian participants in this event, as well as to harmonise the domestic regulatory regime with international developments, the Council agencies consider that some domestic mandatory clearing requirement may be appropriate.

The Council agencies are of the view that any mandatory requirement to centrally clear products should take into account both the potential systemic risk reduction benefits of central clearing over bilateral arrangements, and the viability and appropriateness of products being centrally cleared. This will, in part, reflect the volume of activity in a given product class, as well as the nature and range of market participants. As well, the Council agencies believe that the products subject to a clearing mandate should, as much as possible, be harmonised with other jurisdictions' requirements (recognising that market differences may mean complete harmonisation is not appropriate).

The Council agencies also believe that there are merits in an Australian regulatory regime containing both the ‘bottom-up’ and ‘top-down’ approaches for determining which products should be clearable, similar to the regulatory frameworks being established in several major foreign jurisdictions (discussed in Section 1.3.1). Although it would be expected that industry-led (bottom-up) solutions would predominate, having top-down provisions would give regulators scope to overcome possible industry co-ordination difficulties in circumstances where a clear case for central clearing could be made.

The decision to designate a product as clearable may also have some implications for competition in the market for both clearing services and intermediation services. Potentially, a CCP that was authorised to clear a product that was mandated to be centrally cleared might be in a monopolistic position; the efficiency implications of this are unclear, though regulators may need to consider imposing access arrangements or other conditions for this CCP. Depending on the structure of the CCP's participation criteria, mandating a product as clearable might also have implications for tiering across market participants dealing in that product. These issues will need to be considered carefully.

As discussed in Section 3.2, the Australian OTC derivatives market is dominated by activity in the interest rate derivatives market and the FX derivatives market. Only relatively small amounts of activity are seen in products that have received heightened attention in other jurisdictions, such as credit derivatives. This suggests that, in practice, the only OTC derivatives products traded in the Australian market that might currently meet the tests of systemic risk reduction, clearing viability and global harmonisation, are interest rate derivatives and some FX derivatives (namely FX options). As noted in Section 1.3.1, the US Treasury Secretary has exempted FX swaps and forwards from a clearing requirement. Council agencies would expect that Australian requirements would be harmonised with this.

4.3.   Which Market Participants Should be Required to Clear?

As with the decision regarding which products to clear, Council agencies believe that deciding which participants should be subject to a clearing mandate should reflect the scope for systemic risk reduction, as well as international harmonisation. In both the European Union and the United States, exemptions appear likely to apply to many corporate end-users and smaller market participants, in part because of the smaller effect on systemic risk made by these entities. Council agencies consider a similar approach would be sensible for Australia, though any final regulatory framework would require more detail around how to define appropriate exemption criteria (say, around participant class, or thresholds of activity). It is also noted again that domestic participants may be faced with a clearing obligation if they are transacting in overseas markets, depending on the final regulatory regime that offshore jurisdictions develop.

Consistent with the regulatory proposals in major offshore jurisdictions, Council agencies would intend for most financial counterparties in Australia to be subject to any mandatory clearing requirement for designated products. As an indication of the expected scope of this, this obligation would cover transactions undertaken or facilitated (as a principal or as broker or agent) by Authorised Deposit-taking Institutions (ADIs) and Australian Financial Services Licence (AFSL) holders (again, subject to any size or class exemptions that might be considered appropriate). Some additional or alternative definitions of entity coverage may be appropriate to ensure the scope of the clearing obligation is applied evenly and to minimise regulatory arbitrage opportunities.

The Council agencies are conscious that the cross-border nature of much activity in OTC derivatives markets can make it difficult to clearly define the jurisdictional nexus for a particular contract. For instance, a transaction may be facilitated by a broker or dealer located in one jurisdiction, but the trade may ultimately be booked in the names of counterparties that are domiciled in two separate jurisdictions.

Questions around jurisdiction are therefore important in delineating what Australian regulators can consider to be the Australian OTC derivatives market. Broadly speaking, the Australian jurisdiction covers all entities domiciled in Australia, and the activity of entities that have been licensed to operate in Australia – the existing statutory and regulatory framework around this is discussed in the Annex. As some concrete, though not exhaustive, examples of what this means in practice, the Council agencies would consider the following OTC derivatives activity to be occurring within the scope of the Australian regulatory regime:

  • a transaction booked between an Australian ADI and an Australian funds manager;
  • a transaction booked between two Australian ADIs (say, an Australian-incorporated bank and a local branch of a foreign bank);
  • a transaction booked between an Australian-incorporated ADI and a foreign bank not licensed in Australia as an ADI; or
  • a transaction booked between an Australian-incorporated entity and a foreign bank not licensed in Australia, where the transaction was facilitated by a dealer or broker licensed to offer this financial service under the conditions of an AFSL, or where this service provision is otherwise governed by Australian laws (such as where the dealer or broker is acting under an exemption from the requirement to hold an AFSL).

In implementing a mandatory clearing requirement in Australia, the Council agencies are also aware that this may give rise to potential conflicts of laws and extraterritorial effects. The Council agencies also recognise there may be practical and cost issues for market participants – both domestic and international – if market participants are required to clear the same product classes through different CCPs. Similarly, it is also recognised that other jurisdictions' OTC derivatives reforms may have some extraterritorial effects on transactions and participants that Australian regulators consider to be within the Australian jurisdiction. For example, other jurisdictions may require that their local participants clear particular financial products through CCPs that have been licensed or recognised in that jurisdiction. While a detailed consideration of these issues is outside the scope of the current discussion paper, these matters will clearly be important for many market participants and for the design of Australia's policy response. The Council agencies believe that the impact of these issues can be minimised by restricting any mandatory Australian requirements to financial products that are of greatest systemic importance within Australia, rather than seeking to capture all financial products traded by Australian ADIs and AFSL holders.

4.4. Considerations Regarding OTC Derivatives Central Counterparties in Australia

4.4.1. The role of central counterparties and market functioning

As discussed in Section 2.4, CCPs can have a significant impact on the efficiency of the markets they clear. For instance, a CCP that is in a monopolistic position could potentially charge excessively for the clearing services it provides. The dynamic efficiency of the market for clearing services might also be reduced if a monopolistic incumbent had little incentive to bring innovation to the market. On the other hand, a CCP's operation is likely to exhibit increasing returns to scale, and network effects mean that its attraction to participants is likely to increase the more comprehensive are its products on offer and its base of participants. One way in which a CCP may increase its scope would be if it were to operate in other markets as well as Australia. This may have the additional benefit for local markets of straightforwardly accommodating the extensive cross-border activity that takes place between domestic and offshore counterparties. The Council agencies appreciate that this activity contributes to the overall efficiency of the domestic financial system.

However, CCPs with greater scope might have a limiting effect on competition within the local dealing market. In particular, the scale of risks managed by a large cross-product CCP might mean that – for what could well be sound reasons – direct participation was only available to a relatively small group of larger dealers. This could be detrimental for local competition for a number of reasons. As discussed in Section 3.3, activity in the Australian OTC derivatives market is concentrated in a few products, with the absolute size of these markets quite small compared to markets in North America or Europe. CCPs that were largely designed around the size and product range of these offshore markets might have participation criteria that are not well calibrated to the Australian market.

As discussed in Section 2.3.2, there may be substantial competitive advantages to being a direct member of a CCP. As such, if a CCP's membership arrangements were inappropriately scaled to the risks that need to be managed in the local market, this might unduly limit the diversity of local dealers, which over time could result in higher costs, less innovation, and greater concentration of exposures for end-users in the Australian market. A particular concern would be an outcome where no local market participant is able to clear directly, since this might see an increase in the Australian financial system's exposures to, or dependence on, offshore intermediaries.

Even if a cross-border CCP's participation criteria currently permitted some local financial institutions to become clearing members, this may change over time if these criteria were altered in response to offshore market or regulatory developments. Participation criteria that were more responsive to offshore developments may also limit the potential for new entrants to the local market. The large differential in the size of Australian OTC derivatives markets compared with major offshore markets is therefore a key consideration for Council agencies in the appropriate design of a clearing regime for Australia.

Consideration of the role of a CCP clearing an Australian OTC derivatives market must also take into account the underlying economic nature of those derivatives and their importance to the Australian financial system. Australian-dollar denominated interest rate swaps, for instance, are an integral part of the domestic funding market, operating in parallel to physical borrowing and lending markets. The duration of these contracts can be quite long, meaning that counterparty risk exposures might need to be managed for several years or more. Forward contracts for commodities, by contrast, serve mainly as a risk management tool for producers and purchasers in the face of short- to medium-term price uncertainty. These considerations will inform the assessment of a CCP's design and functioning, such as payment or settlement arrangements, or location of facilities or legal domicile. In some circumstances this may point to the desirability of a domestic CCP, whereas for other markets an offshore CCP may be appropriate.

4.4.2. Client clearing arrangements

Whatever the participation criteria of a CCP, it can be expected that direct participation will always be restricted to a subset of market participants. This is appropriate, to the extent it is necessary for the CCP's risk management arrangements, so long as access criteria are determined based on fair, transparent and objective risk-based criteria. But for market participants who are unable or unwilling to join as direct members, mandatory clearing of certain OTC derivatives transactions should not result in an increase in counterparty risks due to a requirement to clear through a direct participant. As such, a CCP that is clearing mandated OTC derivatives should have client clearing arrangements that ensure, as much as possible, that equivalent protections are given to both direct and indirect participants.

A crucial issue here is the treatment of clients' margin monies in the event of a clearing participant's default. As noted in Sections 1.3.1 and 2.3.2, increased attention is being given to the portability and segregation of client assets, with these being configured differently in Europe and the United States based on the prevailing clearing structures in use. The Council agencies, too, are keen to ensure that client positions can be protected to the extent possible in the case of a clearing participant default or, indeed, in the event of a CCP's default. For CCPs operating in Australia it will be important, therefore, to understand whether these arrangements can be implemented given the existing Australian insolvency regime, or whether changes to aspects of this regime might be necessary. This is also a question that the agencies are considering in the context of the revised CPSS-IOSCO recommendations with regards to central counterparties.

4.4.3. Regulatory and jurisdictional considerations

As discussed in the Annex, the existing Australian regulatory regime provides for the oversight of CCPs operating within Australia. Any CCP that was authorised to clear OTC derivatives would be subject to that regime.[45] Given the relatively small size of the Australian market compared with the largest offshore markets, it is possible that clearing could be undertaken by a CCP located and domiciled offshore and which was also clearing other countries' markets. In this situation, Australian regulators would not be likely to have primary oversight responsibilities – this would instead sit with authorities in the country in which the CCP was based. As discussed in Section 2.3.1, the legal arrangements of an offshore CCP would most likely mean that its default resources (such as margin monies and pooled default funds) and default resolution processes would be governed by the laws of its home jurisdiction rather than the laws of Australia.

Australian authorities would naturally look to establish co-operative oversight arrangements in this situation. Nonetheless, despite mutual best endeavours, there may be doubts over the effectiveness of any directions to the CCP from Australian regulators in crisis situations, and the potential also exists for any such directions to be in conflict with those of the CCP's home-country authorities. A CCP servicing multiple jurisdictions, with a potentially large number of authorities requiring some oversight, is an even more complex possibility. If all regulators were looking to actively participate in oversight arrangements, there is a danger that the effectiveness of oversight diminishes as a CCP expands its services into new jurisdictions and the number of regulators involved increases. There is also an increased potential for competing, if not conflicting, requirements across regulators, which may be particularly problematic in a crisis situation. To date, the establishment of cross-border oversight and crisis management arrangements for CCPs has received only very preliminary consideration in international fora, in part because CCP activity has, until recently, largely taken place within national boundaries. The push for central clearing of OTC derivatives, and the cross-border nature of much of this activity, is bringing to the fore the need for global regulators to develop appropriate arrangements to manage cross-border considerations. To be fully effective, though, it may be that these arrangements need to be legally binding on national authorities, which would require considerable time to be implemented. The history of developing similar arrangements for cross-border banking groups highlights the complexities of these issues, in part reflecting differences in insolvency regimes across countries.[46]

Based on jurisdictional considerations, the Council agencies' predisposition is to be cautious with regards to imposing mandatory clearing requirements on Australian participants that have the effect of requiring them to use offshore CCPs, particularly in relation to products that are systemically important within the domestic financial system. It is acknowledged that the prospect of a CCP getting into severe financial difficulties is remote. As with other prudentially regulated institutions, a CCP would only be licensed in Australia if it operated to a very high standard, with this reinforced by ongoing regulatory oversight; the inherent design characteristics of CCPs also reduce the prospect of a failure. However, as noted in Section 2.4.1, a residual risk always remains, and consequences could be significant. It is also unknown if the underlying risks within the financial system – and partly absorbed by CCPs – will change as an unintended consequence of the international push for central clearing of OTC derivatives.

If mandatory clearing of OTC derivatives was implemented in Australia, this would effectively dictate to local market participants that they take on the counterparty risk of a CCP or its clearing members, and potentially other contingent liabilities related to CCP membership. The Council agencies accept that they should be directly accountable for the regulatory outcomes of this policy. Given this, the agencies note that, for a number of legal and operational reasons, and given the current state of cross-jurisdictional regulatory arrangements, they presently have a greater capacity to oversee a CCP, and to assist in financial or operational crisis management, where that CCP is domiciled in Australia.

A related public policy question is whether it would be an appropriate outcome if it were mandatory for Australian participants to clear (either directly or indirectly) through a CCP whose legal arrangements were based in a foreign jurisdiction. Such an outcome may require Australian-based direct clearing participants, in agreeing to be bound by the CCP's membership rules, to submit to foreign laws and jurisdiction. Similarly, Australian-based indirect clearing participants may be reliant on the foreign jurisdiction's legal framework around bankruptcy, and account segregation and portability. In each of these situations, understanding and working within a foreign jurisdiction's legal framework may impose a significant burden on participants, with this burden likely to sharply increase if a clearing-related matter was to be litigated. However, this also needs to be weighed against the relative costs to participants of possible direct, indirect, onshore or offshore clearing arrangements.

Footnotes

A separate review of some aspects of this regime is currently underway by the Council agencies, following a request by the Australian Government; more information is available at: <http://www.treasurer.gov.au/DisplayDocs.aspx?doc=pressreleases/2011/030.htm&pageID=003&min=wms&Year=&DocType=0>. [45]

For an update on recent progress on cross-border arrangements regarding systemically important financial institutions, see FSB (2011b). For a report on lessons learned regarding crisis management of cross-border banking groups during the recent financial crisis, see BCBS (2010c). [46]