As part of the ongoing reform and investigation into Australia's OTC derivatives market the Australian Prudential Regulation Authority (APRA), Australian Securities and Investments Commission (ASIC) and the Reserve Bank of Australia (RBA) have jointly released their Report on the Australian OTC Derivatives Market (Report).
The Report summarises the state of the OTC derivatives market as well as current regulatory developments in Australia and abroad. Importantly, the report also contains recommendations for the future regulatory landscape re-emphasising the desire for reform to be industry led.
The report highlights the tension that regulators have faced weighing the relative transparency and safety of mandated reporting, executing and clearing against the flexibility and economic incentives provided by bilateral OTC derivatives trades.
Themes of the Report
At the heart of the report are the current four focus areas of global regulatory reform. The reforms being made in Australia are examined against global developments in the OTC derivatives space.
Broadly, the four areas of regulatory reform are:
· trade reporting and the use of Legal Entity Identifiers (LEIs) to enhance transparency in OTC derivatives markets;
· central clearing of derivatives positions to both enhance transparency and minimise counterparty credit risk;
· the use of initial and variation margin, marked-to-market for non-centrally cleared OTC derivatives and the use/rehypothecation of margin; and
· trade execution to enhance transparency and minimise counterparty credit risk.
Additionally, the report canvasses the existing state of Australia's OTC derivatives markets and in particular, the development and progression of Australia's financial market infrastructure (such as central clearing parties, licensed trade repositories, trade platforms for OTC derivatives etc).
Recommendations of the Report
Trade reporting
The Report noted that trade reporting was not currently used in any depth in Australia, and that there was unlikely to be industry led movement in that direction. The Report therefore recommended that a broad-based mandatory trade reporting regime be implemented as soon as practicable, having regard to the existence of any licensed derivatives trade repositories.
While the reporting rules would apply to a broad range of product classes, the Report recommends that the initial phase of mandatory reporting should focus on interest rate, FX and credit derivatives. Similarly, entities subject to the mandatory reporting rules would be phased in, with ADIs, insurers, AFSL holders and other large entities subject to the initial phases of mandatory reporting.
Central clearing
While the Report noted the importance of central clearing, it recommended the mandatory central clearing not occur at this stage. The Report noted that industry has already taken steps towards central clearing as well as noting that the relevant financial market infrastructure to clear certain products (such as AUD interest rate derivatives) is not sufficiently developed to permit central clearing of these types of products.
Risk management for non-centrally cleared transactions
The Report encouraged the increasing use of credit support arrangements currently occurring in the market as well as the growing use of mark-to-market collateralisation of trade exposures. It recommends that large and active market participants should ensure daily collateralisation where possible.
The use of trade compression and portfolio reconciliation services across the market should also be pursued by industry in a co-ordinated fashion to reduce counterparty credit risk.
Trade execution
The use of trade execution services is limited in Australia and the report concluded that no recommendation regarding mandated trade execution on centralised platforms be made.
Next steps
The Corporations Legislation Amendment (Derivative Transactions) Bill 2012 (Cth) (Bill) is expected to be passed towards the end of 2012 or the beginning of 2013. Once the Bill has been passed, the first phase of mandatory trade reporting should be implemented by the first half of 2013.
Simultaneous reforms are also occurring through amendments by APRA to Prudential Standards in relation to capitalisation against derivatives positions, and by the RBA in relation to updating its Financial Stability Standards for clearing and settlement facilities. These reforms are expected to have been passed around the end of 2012 to the beginning of 2013.
