5.4 Proposal and analysis

It is proposed that a determination be made in the second quarter of 2014 that will allow ASIC to make rules requiring the central clearing of G4‑IRD by G4 Dealers.

5.4.1 Products subject to the determination

Commercial and regulatory developments in G4‑IRD have resulted in liquidity moving to centrally cleared trades. Stakeholders have said that, in these instances, not only should there be limited regulatory impact from mandatory central clearing, but opportunities for substituted compliance can provide significant benefits.

It is expected that the net effect will be a significant reduction in the regulatory burden as well as improved business opportunities for Australian banks. Australian banks have submitted that:

Given the scope of our international operations, we may be subject to reporting, clearing and ultimately trade execution requirements imposed by other jurisdictions, such as the EU, in order to implement their G20 commitments …

In that context, we believe that one of the key objectives of the Australian government and agencies in implementing Australia’s G20 commitments should be to ensure international co‑ordination, in order to minimise regulatory duplication and overlapping regulatory requirements.1

The transition to central clearing of G4‑IRD between dealers has accelerated. Australian banks’ notional principal outstanding of IRDs cleared at one of the international clearing houses, LCH.C Ltd, which includes these products, had increased to US$1.4 trillion by November 2013. 2

Dealers operating in the Australian market have reported that most new transactions in G4‑IRD are centrally cleared, especially interdealer transactions entered into with overseas‑headquartered banks, many of which are either already, or expect soon to be, subject to central clearing mandates in place overseas.

These obligations are reflected in Chart 1, which shows that nearly all G4‑Derivatives transactions by Australian banks are with foreign counterparties. These transactions are increasingly subject to foreign central clearing obligations.

In addition, increasing numbers of transactions amongst Australian banks will also need to be centrally cleared. This is because:

  • foreign regulators require central clearing; and
  • there are reduced commercial opportunities to trade without centrally clearing.
Chart 1: Current counterparties to Australian banks (a)
Chart 1: Current counterparties to Australian banks(a)
(a) Taken from the Report on the Australian OTC Derivatives Market, July 2013, Australian Prudential Regulation Authority, Australian Securities and Investments Commission and Reserve Bank of Australia (http://www.cfr.gov.au/publications/ cfr publications/2013/report on the australian otc derivatives market july/pdf/report.pdf).

Definition of G4 Dealers

The Report recommends that the central clearing obligation should apply to dealers with significant cross border activity in G4 IRD (G4 Dealers). The regulators have considered options for identifying G4 Dealers. Further detail is at Appendix A.

It is proposed that entities subject to mandatory central clearing would be financial entities who have reached a certain threshold of activity. There are several possibilities for determining how the threshold should be calculated. For example, one possibility would be to align the threshold with that for phase 2 of the trade reporting obligation prescribed in ASIC’s trade reporting DTRs regime, being $50 billion or more notional OTC derivatives outstanding held by a financial entity as at an agreed date. Another possibility would be to calculate the threshold based on notional OTC IRDs outstanding. The threshold would be calculated on a legal entity basis, so only the outstanding OTC derivatives entered into by the legal entity would be counted (and would not include outstandings of related entities).

In addition, for the avoidance of doubt, it is the intention that public entities such as central banks, debt offices, supra‐national multilateral development banks and entities such as the International Monetary Fund (IMF) would be out of scope of any future central clearing rules.

5.4.3 Exemptions of intragroup trades

The EU and US have both introduced an exemption from the central clearing obligation for intra group transactions. This is to avoid introducing any requirement to centrally clear derivatives transactions that are not transferring any risk into or out of a single corporate group.
It is proposed that intragroup trades would be exempted from central clearing requirements, subject to appropriate conditions (such as notification requirements).

5.4.4 Comparison with other jurisdictions

Japan

Japan began requiring mandatory central clearing in November 2012, beginning with Japanese index based credit default swap (CDS) indices referencing Japanese underliers (that is the iTraxx Japan Index Series) and plain vanilla JPY denominated interest rate swaps referencing LIBOR.

Mandatory central clearing requirements initially apply to transactions between large domestic financial institutions registered under the Financial Instruments Exchange Act (FIEA) that are members of the CCP, Japan Securities Clearing Corporation (JSCC).

Hong Kong

In Hong Kong, the Hong Kong Monetary Authority (HKMA) and Securities and Futures Commission (SFC) have proposed broadly that Hong Kong entities that are counterparty to a central clearing eligible transaction be required to clear this transaction through a designated CCP if both they and their counterparty have exceeded a specified threshold (clearing threshold) and their counterparty is not exempted from the central clearing obligation.

The Hong Kong regulators have stated they are prepared to consider extending these exemptions in respect of transactions with certain public sector entities, as well as to non financial entities using OTC derivatives for commercial hedging purposes, intra group transactions and transactions involving jurisdictions that have a material level of foreign exchange control, and/or other local regulatory restrictions that make it impractical to require central clearing to take place in any jurisdiction other than its own jurisdiction.

European Union

In the EU, EMIR requires transactions be centrally cleared where they involve financial counterparties or non financial counterparties that exceed a specified central clearing threshold (which has been set at EUR 1 billion in gross notional value for OTC credit and equity derivatives, and EUR 3 billion in gross notional value for OTC interest rate, foreign exchange and commodity derivatives).

Transactions involving central banks and other public bodies charged with or intervening in the management of public debt can be exempted by way of a delegated act. The current exemption only relates to the US and Japan, but the EC has been asked to consider including Australia. Certain intragroup transactions are also exempted from a central clearing obligation, as well as transactions by non financial counterparties that are objectively measurable as reducing risks directly related to the commercial activity or treasury financing activity of the counterparty.

The United States

In the US, the CFTC adopted its first mandatory central clearing determination in December 2012 and requires four classes of interest rate swaps and two classes of CDS be cleared. Compliance will be phased in by type of market participant entering into a swap subject to the central clearing requirement, and the first phase commenced on 11 March 2013. Under Dodd Frank and CFTC rules, an exemption from the central clearing obligation is available for non financial entities and small financial institutions (those with total assets of $US 10 billion or less) where the relevant swaps are being used to hedge or mitigate commercial risk.

An exemption from the central clearing obligation is also available for transactions between certain affiliated entities. In June 2012, the SEC adopted rules regarding processes for determining whether specific derivatives contracts will be subject to mandatory central clearing requirements. The SEC has similar powers under Dodd Frank to provide exemptions from central clearing obligations to certain entities, but has not yet finalised the rules that would determine which exemptions would be available.

  1. ANZ, CBA, Macquarie Bank Limited, NAB, Westpac, Comments on Australian Treasury’s December 2012 Consultation Paper on Implementation of Australia’s G20 over the counter derivatives commitments (‘Consultation Paper’) available at http://financialmarkets.tspace.gov.au/implementationg20/submissions/
  2. Information supplied by LCH.C Ltd

3 thoughts on “5.4 Proposal and analysis

  1. GreySpark Partners

    Response to question 2: GreySpark Partners thanks the Australian Treasury for the opportunity to comment on its G4-IRD central clearing mandate proposals paper.
    GreySpark Partners is a global capital markets consultancy firm, with offices in London, Hong Kong and Sydney. GreySpark provides expertise in risk, e-trading and market structure and offers business, management and technology consulting services. In Australia, GreySpark offers the aforementioned services alongside additional services within the market structure remit in OTC reforms, to assist clients in preparing for the impacts of regulatory change. In this deeply client focussed role, GreySpark feels it has both a duty and an obligation to respond to the Treasury’s request for comments and feedback.
    GreySpark welcomes the proposed G4-IRD clearing mandate and views this as a positive development in ensuring Australia is consistent with the changes taking place in the U.S. and the EU. The incremental cost for the dealer community in implementing changes to prepare for clearing will be minimal, due to the fact that the local banks who are already registered as swap dealers with the CFTC are already clearing OTC derivatives trades frequently.
    There is benefit in opening up the dealer-to-dealer clearing mandate to AUD-IRD at the same time as the G4-IRD mandate as well – the key benefit being international consistency. The AUD-IRD mandate would not require significantly more spend from the large dealer banks as they currently clear AUD-IRD with international counterparties. Therefore, the incremental effort and cost for dealers to comply with an AUD-IRD mandate is anticipated to be minimal.
    In the interest of international consistency and ensuring that Australia is not seen to be falling behind in its G20 commitments, it is important that there is a proposed timeframe for client clearing to be mandated in Australia. The costs relating to the buildout and maintenance of an OTC derivatives client clearing offering will, however, be significant for banks who are not already offering a clearing broker offering, as well as hedge funds and buyside firms who will be the key clients in the client clearing model. The technological costs are predominantly around building out new connections to clearinghouses, SEFs, affirmation platforms and trade repositories. There is also the ongoing cost of staffing teams to support the clearing and collateral workflows as well as ongoing projects, process improvements and related testing ongoing enhancements. Investment in enterprise clearing systems such as Murex and Calypso would also require significant funding, buildout and testing.
    To adhere to international norms and standards, it would also be in the interest of the Australian OTC derivatives markets for Credit derivatives and Non-Deliverable Forwards to be cleared in the future. A timeline would need to be proposed by regulators to address this and it is in the interest of the wider market that dates are proposed sooner rather than later and clear proposal made publicly available, to avoid confusion and uncertainty amongst the smaller buyside firms.

    Response to question 3: We feel that the approach by the regulators in Australia has so far been measured and cautious. The phased approach taken by ASIC to mandating reporting to trade repositories has certainly been viewed by Australian market participants as reasonable and practical, as opposed to the “big bang” method applied by the European regulators in implementing the European Market Infrastructure Regulation (“EMIR”), which mandated trade reporting on a singular start date for all market participants.
    While the Australian regulators have indicated that they are keen for the market to naturally move to clearing prior to setting a mandate for central clearing of OTC derivatives, it has been GreySpark’s firsthand experience that the buyside is largely delaying their commitment to and preparation for clearing until a mandate is announced by regulators. The Treasury proposals paper on mandatory clearing for the Interest Rates Derivatives denominated in the G4 currencies (“G4-IRD”) also does not provide a clear indication of when buyside firms will be expected to comply with mandatory clearing and does not also propose a clear timescale for clearing of Interest Rates Derivatives denominated in AUD (“AUD-IRD”). The lack of clear direction for the buyside raises the risk that when liquidity for OTC derivatives inevitably shifts from bilateral to cleared markets, firms who are unprepared for this change may lose access to liquidity if they have not already secured access to clearing via a clearing broker – this scenario is plausible due to the fact that the clearing brokers who are currently operating in the Australian market cannot guarantee that they will on-board every client who wishes to clear with them and will certainly pick and choose which clients they will take on. Therefore, GreySpark’s view is that it would be prudent on the part of Treasury and the Australian regulators to provide buyside firms with an indicative timeline of when an OTC derivatives clearing mandate is expected to impact them, in order to ensure that the market is best prepared in a timely manner for this change.
    In terms of the global OTC derivatives clearing landscape, mandatory clearing is already live in the U.S. and is widely expected to commence in EU in early 2015. From GreySpark’s extensive discussions with Australian industry participants, a reasonable deadline for mandatory clearing for the G4 dealers for AUD-IRD would also be in early 2015, aligning with the proposed G4-IRD mandatory clearing commencement date, which impacts the 13 firms identified as G4 dealers in the Treasury proposals paper. There is benefit in opening up the dealer-to-dealer clearing mandate to AUD-IRD at the same time as the G4-IRD mandate as well – the key benefit being international consistency. The AUD-IRD mandate would not require significantly more spend from the large dealer banks as they currently clear AUD-IRD with international counterparties. Therefore, the incremental effort and cost for dealers to comply with an AUD-IRD mandate is anticipated to be minimal.
    In order to ensure that Australia does not fall too far behind the global timelines for clearing and not be seen as lagging behind in their G20 commitments, it would be judicious to not leave the buyside clearing mandate until 2016 and instead implement this in late 2015 alongside, or shortly after, the AUD-IRD mandate. In the interest of only mandating systemically important counterparties to clear, it would be prudent for the regulators to impose a clearing threshold for ADIs and AFSL holders, to whom this mandate should be made applicable should their OTC derivative activity exceed a pre-set threshold per asset class. This approach would be in line with the phased rollout method adopted by the U.S. regulator Commodity Futures Trading Commission (“CFTC”) in implementing mandatory clearing and would certainly give buyside firms in Australia enough time to prepare. Buyside firms who are currently holding off moving forward with clearing arrangements would also then be able to firmly commit to kicking off their preparations for entering the clearing arena. Providing the buyside with at least a tentative timeline would eliminate much of the uncertainty and confusion that such firms are facing today in relation to future Australian clearing timelines.

    Response to question 4: In the interests of international consistency, there are benefits for the Australian regime in following the example set under EMIR in implementing a clearing threshold for non-financial counterparties, where such a counterparty is exempted from the clearing mandate if its positions remain under a pre-defined threshold. The clearing threshold is pre-set in gross notional value and demarcated at individual levels per asset class.
    The gross notional methodology of calculating the clearing threshold is a useful one and in our view, would be useful to implement by asset class (for OTC IRDs as opposed to OTC derivatives overall). The reason a split per asset class would be useful is due to the fact that the methodology defined for clearing thresholds would hold good for not only the dealer banks, but also hedge funds and buyside firms who will no doubt be forced to clear via the client clearing model at some stage in the future. Many hedge funds and buyside firms in Australia have a key focus on one or a few asset classes rather than trading across the whole product set and as a result, it would be more practical and in their interest to calculate clearing thresholds per asset class. A gross notional threshold methodology would also be more accurate that a net position methodology, which would result in buyside firms who hold unidirectional positions having to clear more than banks which would hold multidirectional positions in the market.
    Similar to EMIR, it would also be useful for OTC trades executed for hedging purposes which are directly linked to commercial activity/funding/treasury to be excluded from the calculation of these clearing thresholds.
    Under EMIR, if a non-financial counterparty exceeds a threshold in an asset, then the clearing threshold would be considered as breached for the whole OTC derivatives portfolio and the counterparty would no longer be exempt and would be obligated to clear all swap classes. This approach may not be practical given the size of the Australian market. It would be a more feasible approach to only enforce mandatory clearing for the asset class in which the threshold breach has occurred.

  2. GreySpark Partners

    Response to question 3: We feel that the approach by the regulators in Australia has so far been measured and cautious. The phased approach taken by ASIC to mandating reporting to trade repositories has certainly been viewed by Australian market participants as reasonable and practical, as opposed to the “big bang” method applied by the European regulators in implementing the European Market Infrastructure Regulation (“EMIR”), which mandated trade reporting on a singular start date for all market participants.
    While the Australian regulators have indicated that they are keen for the market to naturally move to clearing prior to setting a mandate for central clearing of OTC derivatives, it has been GreySpark’s firsthand experience that the buyside is largely delaying their commitment to and preparation for clearing until a mandate is announced by regulators. The Treasury proposals paper on mandatory clearing for the Interest Rates Derivatives denominated in the G4 currencies (“G4-IRD”) also does not provide a clear indication of when buyside firms will be expected to comply with mandatory clearing and does not also propose a clear timescale for clearing of Interest Rates Derivatives denominated in AUD (“AUD-IRD”). The lack of clear direction for the buyside raises the risk that when liquidity for OTC derivatives inevitably shifts from bilateral to cleared markets, firms who are unprepared for this change may lose access to liquidity if they have not already secured access to clearing via a clearing broker – this scenario is plausible due to the fact that the clearing brokers who are currently operating in the Australian market cannot guarantee that they will on-board every client who wishes to clear with them and will certainly pick and choose which clients they will take on. Therefore, GreySpark’s view is that it would be prudent on the part of Treasury and the Australian regulators to provide buyside firms with an indicative timeline of when an OTC derivatives clearing mandate is expected to impact them, in order to ensure that the market is best prepared in a timely manner for this change.
    In terms of the global OTC derivatives clearing landscape, mandatory clearing is already live in the U.S. and is widely expected to commence in EU in early 2015. From GreySpark’s extensive discussions with Australian industry participants, a reasonable deadline for mandatory clearing for the G4 dealers for AUD-IRD would also be in early 2015, aligning with the proposed G4-IRD mandatory clearing commencement date, which impacts the 13 firms identified as G4 dealers in the Treasury proposals paper. There is benefit in opening up the dealer-to-dealer clearing mandate to AUD-IRD at the same time as the G4-IRD mandate as well – the key benefit being international consistency. The AUD-IRD mandate would not require significantly more spend from the large dealer banks as they currently clear AUD-IRD with international counterparties. Therefore, the incremental effort and cost for dealers to comply with an AUD-IRD mandate is anticipated to be minimal.
    In order to ensure that Australia does not fall too far behind the global timelines for clearing and not be seen as lagging behind in their G20 commitments, it would be judicious to not leave the buyside clearing mandate until 2016 and instead implement this in late 2015 alongside, or shortly after, the AUD-IRD mandate. In the interest of only mandating systemically important counterparties to clear, it would be prudent for the regulators to impose a clearing threshold for ADIs and AFSL holders, to whom this mandate should be made applicable should their OTC derivative activity exceed a pre-set threshold per asset class. This approach would be in line with the phased rollout method adopted by the U.S. regulator Commodity Futures Trading Commission (“CFTC”) in implementing mandatory clearing and would certainly give buyside firms in Australia enough time to prepare. Buyside firms who are currently holding off moving forward with clearing arrangements would also then be able to firmly commit to kicking off their preparations for entering the clearing arena. Providing the buyside with at least a tentative timeline would eliminate much of the uncertainty and confusion that such firms are facing today in relation to future Australian clearing timelines.

    Response to question 4: In the interests of international consistency, there are benefits for the Australian regime in following the example set under EMIR in implementing a clearing threshold for non-financial counterparties, where such a counterparty is exempted from the clearing mandate if its positions remain under a pre-defined threshold. The clearing threshold is pre-set in gross notional value and demarcated at individual levels per asset class.
    The gross notional methodology of calculating the clearing threshold is a useful one and in our view, would be useful to implement by asset class (for OTC IRDs as opposed to OTC derivatives overall). The reason a split per asset class would be useful is due to the fact that the methodology defined for clearing thresholds would hold good for not only the dealer banks, but also hedge funds and buyside firms who will no doubt be forced to clear via the client clearing model at some stage in the future. Many hedge funds and buyside firms in Australia have a key focus on one or a few asset classes rather than trading across the whole product set and as a result, it would be more practical and in their interest to calculate clearing thresholds per asset class. A gross notional threshold methodology would also be more accurate that a net position methodology, which would result in buyside firms who hold unidirectional positions having to clear more than banks which would hold multidirectional positions in the market.
    Similar to EMIR, it would also be useful for OTC trades executed for hedging purposes which are directly linked to commercial activity/funding/treasury to be excluded from the calculation of these clearing thresholds.
    Under EMIR, if a non-financial counterparty exceeds a threshold in an asset, then the clearing threshold would be considered as breached for the whole OTC derivatives portfolio and the counterparty would no longer be exempt and would be obligated to clear all swap classes. This approach may not be practical given the size of the Australian market. It would be a more feasible approach to only enforce mandatory clearing for the asset class in which the threshold breach has occurred.

  3. GreySpark Partners

    GreySpark Partners thanks the Australian Treasury for the opportunity to comment on its G4-IRD central clearing mandate proposals paper.
    GreySpark Partners is a global capital markets consultancy firm, with offices in London, Hong Kong and Sydney. GreySpark provides expertise in risk, e-trading and market structure and offers business, management and technology consulting services. In Australia, GreySpark offers the aforementioned services alongside additional services within the market structure remit in OTC reforms, to assist clients in preparing for the impacts of regulatory change. In this deeply client focussed role, GreySpark feels it has both a duty and an obligation to respond to the Treasury’s request for comments and feedback.
    GreySpark welcomes the proposed G4-IRD clearing mandate and views this as a positive development in ensuring Australia is consistent with the changes taking place in the U.S. and the EU. The incremental cost for the dealer community in implementing changes to prepare for clearing will be minimal, due to the fact that the local banks who are already registered as swap dealers with the CFTC are already clearing OTC derivatives trades frequently.
    There is benefit in opening up the dealer-to-dealer clearing mandate to AUD-IRD at the same time as the G4-IRD mandate as well – the key benefit being international consistency. The AUD-IRD mandate would not require significantly more spend from the large dealer banks as they currently clear AUD-IRD with international counterparties. Therefore, the incremental effort and cost for dealers to comply with an AUD-IRD mandate is anticipated to be minimal.
    In the interest of international consistency and ensuring that Australia is not seen to be falling behind in its G20 commitments, it is important that there is a proposed timeframe for client clearing to be mandated in Australia. The costs relating to the buildout and maintenance of an OTC derivatives client clearing offering will, however, be significant for banks who are not already offering a clearing broker offering, as well as hedge funds and buyside firms who will be the key clients in the client clearing model. The technological costs are predominantly around building out new connections to clearinghouses, SEFs, affirmation platforms and trade repositories. There is also the ongoing cost of staffing teams to support the clearing and collateral workflows as well as ongoing projects, process improvements and related testing ongoing enhancements. Investment in enterprise clearing systems such as Murex and Calypso would also require significant funding, buildout and testing.
    To adhere to international norms and standards, it would also be in the interest of the Australian OTC derivatives markets for Credit derivatives and Non-Deliverable Forwards to be cleared in the future. A timeline would need to be proposed by regulators to address this and it is in the interest of the wider market that dates are proposed sooner rather than later and clear proposal made publicly available, to avoid confusion and uncertainty amongst the smaller buyside firms.

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