Benefits of an Australian mandate on central clearing of G4‑IRD
Clearing of OTC derivatives through a CCP reduces counterparty risk through multilateral netting of transactions and mutualisation of losses through a default fund.
Stakeholders have pointed to a number of benefits.
- Many stakeholders see economic value in improved financial stability that can be achieved through the widespread use of central clearing as well as reduced risks and uncertainty for their own business.
- Liquidity in OTC derivatives markets is moving to centrally cleared trades. In practice this has meant that many derivatives contracts are being offered on better commercial terms for centrally cleared trades than for non‑centrally cleared trades.
- Under the Basel III reforms introduced by APRA in January 2013, an authorised deposit‑taking institution’s (ADI’s) exposure to trades centrally cleared through a Qualifying CCP (as defined by the BIS) is subject to lower risk weights than in the case of non‑centrally cleared trade exposure. This reduces the comparative cost of centrally clearing trades.
- Comparative costs of central clearing have also been reduced through increasing requirements for initial and variation margining of uncleared trades, which have come about in response to requirements for margining and improved industry bilateral risk management practices. It is anticipated that these requirements will continue to increase.
An important consideration for stakeholders has been the international context of an Australian decision to mandate central clearing.
As was noted in the First Proposals Paper, fulfilling Australia’s obligations in a globally coordinated way will help to ensure that global markets remain open to Australian business.1 Companies wishing to purchase or sell a derivative contract will benefit from reduced market impact costs to trading2 and extra liquidity, which allows them to trade when they wish to trade. This benefits the economy as a whole.
Participating in global derivatives markets also allows companies to better tailor their derivatives to their risks. This is of value to Australian companies and the economy as a whole.
Global implementation of the G20 commitments also ensures that Australian businesses, investors and corporations have the benefit of improved risk management practices and transparency when they participate in international markets.
The CFTC and European authorities have commenced a process of assessing the comparability or equivalence of the Australian regulatory regime for OTC derivatives, with a number of assessments already completed. Under certain circumstances, positive assessments will allow Australian participants to choose to comply with Australia’s domestic regulatory regime instead of the CFTC’s or EMIR rules. This will lower the cost of compliance.
The value of substituted compliance to Australian businesses can take a number of forms.
- On balance, it is deregulatory. It allows businesses to avoid the heavy burden of adhering to multiple and often conflicting requirements, for example, employing legal counsel and government liaison representatives around the world to monitor and respond to rules that are covered by similar provisions in Australia.
- The CFTC’s recent decision to grant substituted compliance for its entity-level requirements is an example of such a scenario allowing the main Australian banks registered as swap dealers in the US to avoid the additional costs of complying with the US OTC derivatives regulatory regime in a number of key aspects.
- In some cases a positive assessment is required for Australian businesses to continue to offer services in the US and EU. For example, clarification of Australia’s regulatory regime for CCPs issued in August 2013 assisted ESMA’s conclusion that this regulatory regime is equivalent, which is a necessary pre‑condition for ASX to continue to offer clearing services to EU banks. 3
- In many cases Australian businesses have reported benefits in the recognition of the Australian regime by overseas regulators and authorities, which can provide a simple means for counterparties to confirm that Australian banks meet their regulator’s requirements.
- Five of the eight Asian region banks who have registered as swaps dealers in the US are Australian banks (ANZ, CBA, Macquarie, NAB and Westpac). This illustrates the importance of the US market for Australian banks, and also the fact that they may be the main beneficiaries in this region of the CFTC’s substituted compliance determination which only applies to registered swaps dealers.
Recently, following the implementation of trade reporting requirements in Australia, ESMA has recommended to the EC that the Australian trade reporting regime be considered equivalent with EU law. This means that Australian businesses face the lowest possible regulatory barriers when dealing in European markets in relation to trade reporting.
Shaping obligations to reflect Australian priorities
A domestic central clearing mandate tailored to the Australian context may mitigate the risk of unintended consequences for Australian participants from foreign regulation.
Where Australian participants are directly subject to overseas regulators’ requirements differences in market structure and conditions will result in conflicts of law, inconsistencies, and legal uncertainty for Australian entities. It will be difficult for foreign regulators to foresee or mitigate these problems.
Mandating central clearing of derivatives in Australia allows us to shape obligations to reflect our priorities:
- reflecting the Australian legal system;
- reflecting existing Australian business practices and industry‑led solutions; and
- targeting Australian goals of increased transparency and reduced systemic risk.
It is hoped that, in implementing the ‘stricter rule applies’ approach, overseas jurisdictions will recognise and take into account differences in institutional characteristics and structures across jurisdictions.
Costs of an Australian mandate on central clearing of G4‑IRD
Stakeholders have also raised concern that central clearing of OTC derivatives can result in considerable costs. The main costs that have been identified are detailed below.
- Significant changes to market practices and legal arrangements will be required, which will result in costs and burdens, such as:
- renegotiating contractual arrangements to reflect that risk management will be handled by the CCP rather than bilaterally by the two counterparties to the OTC derivative contract; and
- administrative and legal changes to contracts to reflect the requirements of CCPs.
- Posting initial margin to CCPs will increase many market participants’ collateral needs above levels that are characterised by current bilateral arrangements, particularly where these do not currently require exposures to be collateralised.
- It is, however, noted that there is an international program under way which will impose collateralisation requirements on non-centrally cleared trades.
- The CCP requirement that participants exchange variation margin introduces liquidity risk, which end‑users may have difficulty managing, particularly as currently many end‑users are not required to exchange variation margin on bilateral trades. To manage this liquidity risk end‑users are likely to be forced to hold more liquid assets that generate lower returns.
- Market participants who join CCPs as direct members are obligated to make a contribution to pooled risk resources, as well as hold capital against their trades and any contingent obligations to the CCP and pay fees to clear trades.
- The capital treatment of exposures to CCP default funds has also emerged as a concern for many banks. In some instances the treatment of these exposures could push up the relative costs of centrally clearing.
- As CCPs tend to focus on a selection of derivatives products, central clearing can lead to increases in some counterparty exposures, particularly where previously offsetting bilateral exposures in different products are ‘un‑netted’. This could be exacerbated if the various centrally cleared components of a participant’s portfolio are cleared through different CCPs.
- While a CCP may pay interest on any collateral held, such interest when paid to a non‑resident may be subject to interest withholding tax. Stakeholders have raised concerns that the imposition of withholding tax can add to the cost of central clearing.
1. Do you have comments on the benefits and costs of complying with a mandatory central clearing obligation, from the point of view of your business and/or that of your customers?
We request that, in commenting, you quantify compliance costs as far as possible, including whether costs are likely to change over time, are transitional or projected ongoing costs. For example, costs may include:
- legal costs;
- staff cost — for example number of staff hours and training costs;
- IT costs; and/or
- increased costs of managing risks or funding projects.
Please separate additional costs that would come about as a result of this proposal, as well as other regulatory costs that could be mitigated if you are able to comply with Australian regulation rather than many different countries’ regulations.
To assist this analysis it would be useful to know whether your trades, and/or those of your clients, are becoming subject to central clearing obligation from other countries and whether your counterparties prefer central clearing of trades.
- Implementation of Australia’s G20 over-the-counter derivatives commitments, December 2013, available at http://financialmarkets.tspace.gov.au/implementationG20/ ↩
- Market impact is the adverse price movement that can occur when a trade is executed; larger, more liquid markets have lower market impact costs ↩
- ASX letter, ‘RBA interpretation of Financial Stability Standards applies “Cover 2” to ASX Clear (Futures)’, 16 August 2013 (http://www.asxgroup.com.au/media/PDFs/RBA_interpretation_of_FSS_applies_to_Cover_2.pdf) ↩