Mandatory Central Clearing of “G4” Interest Rate Derivatives
On 27 February 2014, the Australian Government issued a Proposals Paper in which it outlines its proposed
approach for mandating the central clearing of certain OTC derivatives in Australia. The approach proposed is based on recommendations from APRA, ASIC and the RBA, as published in their joint Report on the Australian OTC Derivatives Market (July 2013).
In summary, the key proposals which are being put forward are:
- That a determination be made in Q2 of 2014 that will enable ASIC to make rules requiring the central clearing of US Dollar, Euro, British Pound and Yen denominated interest rate derivatives (referred to in the Proposals Paper as "G4-IRD")
- That the clearing obligations will apply only to "large" financial institutions with "significant" cross-border activity in these products (referred to in the Proposals Paper as "G4 Dealers").
At the 2009 G20 Summit in Pittsburgh the Australian Government, along with other jurisdictions, committed to implementing substantial reforms to the trading of over-the-counter (OTC) derivatives. The 3 key commitments made by the G20 were:
- To improve transparency by requiring all OTC derivatives to be reported to central registries known as trade repositories
- To improve market efficiency and risk management by requiring standardised OTC derivatives to be cleared through specialised entities known as central counterparties
- To improve market efficiency and integrity by requiring all standardised OTC derivatives to be executed on exchanges or electronic trading platforms, where appropriate.
The Australian Government has already taken steps to comply with its G20 commitments, by:
- Amending the Corporations Act 2001 (Cth) (Act) to allow the Minister to make a determination with respect to a G20 commitment providing authority for ASIC to develop detailed rules implementing the determination
- The making of a Ministerial determination to mandate the reporting of trades in OTC derivatives, which is currently being implemented in respect of certain derivatives through a phased approach.
The proposals now put forward in the Proposals Paper represent the next step in the Government's fulfilment of its G20 commitments. Essentially, the approach being proposed is as follows:
- A Ministerial determination will be made that will allow ASIC to make rules requiring the central clearing of G4-IRDs by G4 Dealers. The rationale for this is that most transactions in G4-IRDs are centrally cleared and that nearly all transactions in G4-IRDs by Australian banks are with foreign counterparties, with these transactions becoming increasingly subject to foreign central clearing requirements.
- G4 Dealers will be limited to dealers with significant cross-border activity in G4-IRD: that is, dealers who have reached a minimum threshold of activity. For example, the threshold for phase 2 of the trade reporting requirements could be applied: namely, $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 will be calculated on a stand-alone legal entity basis.
- The central clearing requirements will not apply to intra-group trades, which will be exempt subject to certain conditions (e.g. notification requirements). Central clearing of AUD-IRD will not be mandated at this stage. This is because until recently there has been a lack of availability of direct clearing for domestic market participants. However, there are now two CCPs who have regulatory approval to offer clearing of AUD-IRD to Australian participants, and a number of Australian participants have established clearing arrangements as direct clearing members of these CCPs. There also appears to be a move towards entral clearing of AUD-IRD amongst Australian participants. Accordingly, the preferred approach for now seems to be to monitor industryfs progress in implementing central clearing of AUD-IRD on a voluntary basis, before recommending mandatory central clearing.
- At this stage the Government has elected not to mandate the central clearing of North America and European referenced credit derivatives. This is because of the low level of activity in these products in Australia by market participants, including Australian banks and Australian/domestic participants, as well as due to the fact they can't directly clear North America and Europe referenced credit derivatives.
- To ensure that Australian market participants have appropriate access to CCPs, the Government may decide to prescribe CCPs, for example, to ensure domestic participants' access to clearing through an overseas CCP that is making services available to Australian entities but has been judged not to be operating in Australia and therefore not required to hold an Australian clearing and settlement facility licence.
The following timetable is proposed for implementing mandatory central clearing:
- Q2 2014: a draft Ministerial determination relating to G4-IRD will be exposed for comment
- Q2 2014 (concurrently with the above): ASIC will consult on rules detailing the central clearing obligations
- Q4 2014: the central clearing rules will be finalised
- Q1 2015: commencement of the central clearing obligations.
The proposals reflect the Government's moderate and balanced approach to date in implementing its G20 commitments. In particular, they are underpinned by a desire for international consistency and to enable Australian market participants to benefit from "substituted compliance". That is, so that Australian participants who are subject to mandatory central clearing requirements in Australia will be able to comply with off-shore regimes by being able to demonstrate that they are subject to a "sufficiently equivalent" regime in Australia.
- At this point in time, Australian swap dealers subject to APRA and ASIC regulatory regimes can rely on substituted compliance in respect of certain "entry level" requirements under the CFTC regime. However, at this stage the CFTC has made no such determination as to substituted compliance for transaction-level requirements (e.g. mandatory clearing, portfolio reconciliation and compression and swap relationship documentation). Accordingly, the proposals are intended to enable Australia to seek a determination from the CFTC as to substituted compliance in respect of transaction-level requirements such as mandatory clearing.
- The proposals are intended to enable the Australian regime for CCPs to be assessed as equivalent to that under the European framework, EMIR, with the result that Australian counterparties who are subject to mandatory central clearing requirements in Australia can comply with EMIR (as necessary) by complying with the Australian requirements.
The Government sees that Australian participants will benefit from being subject to a domestic central clearing mandate which is tailored to the Australian context, reflects the Australian legal system and reflects existing Australian practices, rather than being directly subject to overseas regulators' requirements which could have a detrimental impact on Australian participants.
The Proposals Paper identifies a number of additional benefits which stakeholders have attributed to central clearing of OTC derivatives:
- Improved financial stability, which brings with it economic benefits as well as reduced risk and uncertainty.
- As liquidity moves to centrally cleared trades in OTC derivatives, many OTC derivatives are being offered on better commercial terms for centrally-cleared trades.
- The comparative cost of centrally clearing trades has been effectively reduced under the Basel III reforms (introduced by APRA in January 2013), since an ADIfs exposure to trades centrally cleared through a "Qualifying CCP" (as defined by the Bank for International Settlements) is subject to lower risk weights than those that apply to exposures under noncentrally cleared trades.
The Proposals Paper also acknowledges however that stakeholders have identified the potential for central clearing of OTC derivatives to contribute to high costs, for example, because of the need for major changes to market practices and legal relationships and the requirement to post initial margin to CCPs, particularly where current exposures do not need to be collateralised.
In connection with delivering on its G20 commitments the Government is also:
- Reviewing licensing arrangements for financial markets, to identify whether the framework is adequate to deal with derivative trading platforms that would be suitable for mandatory trade execution.
- Awaiting recommendations from the regulators as to whether to mandate platform trading of certain OTC derivatives.In the meantime, the regulators will be monitoring developments in other jurisdictions and gathering more detailed information on the Australian market, so that they can more clearly articulate what a suitable trading platform would look like.
- Considering granting a permanent exemption to end-users for trade reporting, pending the regulators completing their analysis to ensure that all systematically important information is being captured under the existing trade reporting framework without requiring reporting by end-users.
Interested parties are invited to comment on the proposals by 10th April 2014. Given that the Government has indicated that its proposed approach may be modified following its assessment of the feedback received, interested participants in the OTC derivatives market should ensure that they review the Proposals Paper and provide their feedback to ensure that any framework for mandatory central clearing is appropriate and workable for them.