In brief
Written by Senior Regulatory Counsel Michael Mathieson
The regulatory law repercussions of the GFC remain endlessly fascinating.
Lengthy – the Dodd-Frank Act
As an example, take the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010. It runs to 848 pages. Title VII addresses, perhaps optimistically, 'Wall Street Transparency and Accountability'. My favourite provision is section 716, headed 'Prohibition Against Federal Government Bailouts of Swaps Entities'. This heading suggests that, if there is ever another AIG, it can't be bailed out.
Section 716 says: 'Notwithstanding any other provision of law (including regulations), no Federal assistance may be provided to any swaps entity with respect to any swap, security-based swap, or other activity of the swaps entity'. And there you have it – too-big-to-fail solved by legislative prohibition. If only it was that easy. (And wouldn't a future government, under pressure to do a little bailing out in the face of another crisis, argue that assistance in relation to an entity's financial position, or a financial crisis, falls outside the prohibition?)
Not so lengthy – the G20 Leaders Statement at Pittsburgh
As another example, take the G20 Leaders Statement at the Pittsburgh Summit in September 2009:
All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.
Not 848 pages – just three sentences that have led to some momentous changes to OTC derivative markets. Think trade reporting. Think mandatory central clearing of some OTC derivatives. And, although not covered by this particular G20 statement, think mandatory margining for non-centrally cleared derivatives. I will touch on each of these briefly.
Trade reporting
Have you ever wondered what happens to all that data you have to report about your OTC derivatives? You can find the answer in the 'Report on the Australian OTC Derivatives Market' issued in November 2015 by APRA, ASIC and the RBA. According to that report: 'At this stage, the Regulators' use of… data has focussed largely on examining the quality of the data reported'.
One would think so. If data quality wasn't a concern, you wouldn't need a safe-harbour from non-compliance with the trade reporting rules where you have delegated your trade reporting obligations to someone else.
It also appears that the regulators are using the data to determine their policy recommendations to government. As we shall see shortly, they have used the data in recommending where to set the boundary of the mandatory central clearing regime.
But this all seems pretty modest, in terms of the outcomes achieved. Trade reporting was meant to help stop another AIG. Apparently by making OTC derivative trade and position information transparent, you would prevent markets going haywire. Again, if only it was that easy.
Mandatory central clearing
In September 2015, mandatory central clearing obligations were imposed in Australia for OTC interest rate derivatives denominated in Australian dollars, US dollars, euros, Japanese yen and British pounds. These obligations apply only to internationally active dealers.
In their November 2015 report, APRA, ASIC and the RBA recommended against extending the scope of the mandatory central clearing regime to include interest rate derivatives denominated in other currencies. In case you were previously unaware, you may be relieved to learn that US dollar/Indian rupee forwards were also left outside the boundary of the regime.
The regulators say they will review market activity on an ongoing basis, aided by trade reporting data. They will make future assessments and recommendations based on two criteria: reducing systemic risk and achieving international consistency.
When thinking about mandatory central clearing, think about it applying to a relatively small range of OTC derivatives and to a relatively small group of market participants but, within those confines, to a relatively large volume of OTC transactions.
So what happens where central clearing is not mandated?
Mandatory margining where not centrally cleared
This brings us to the latest wave of changes to hit the OTC derivatives market in Australia – mandatory margining. And in case you thought Australia had any kind of sovereignty in these matters, forget it.
Instead, this is being driven by the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions, through the principles and requirements in their March 2015 report, 'Margin requirements for non-centrally cleared derivatives'.
In the usual way, what emerges from Switzerland is then implemented by APRA. So it was that last month APRA released a discussion paper and draft prudential standard concerning margining and risk mitigation for non-centrally cleared derivatives.
The key aspects of APRA's proposed margin requirements include:
- a requirement to post and collect variation margin;
- a requirement to exchange two-way initial margin on a gross basis;
- a requirement to collect eligible collateral as margin and 'apply haircuts on collateral'; and
- a framework for 'deference to foreign margining regimes based on the BCBS-IOSCO framework'.
That's right, 'deference to foreign margining regimes'.
As APRA, ASIC and the RBA have noted, 'the current practices for the exchange of variation margin (which involve posting and receiving margin on a title transfer basis) are not suitable for initial margin as the BCBS-IOSCO framework requires that the collecting party hold such collateral in a bankruptcy-remote manner'. This is a rather understated way of referring to what will be a momentous change for many OTC derivative users in Australia. And yes, an explicit rationale for mandatory margining, and the burden it involves, is to encourage the use of centrally cleared OTC derivatives in circumstances where central clearing is not, itself, mandatory.
Again, not everyone will be caught by mandatory margining. APRA have prepared a nice flow-chart, which I have reproduced below.
Closing comment
When the firm hosted Mr Barney Frank (the second half of 'Dodd-Frank') for a discussion a few weeks ago, my colleague Michelle Levy asked him whether these regulatory law developments in relation to OTC derivatives were impinging on markets, freedom of contract and the ability of parties to manage risk. Mr Frank politely disagreed. I would politely disagree with Mr Frank – they clearly do impinge on those matters – although whether that is undesirable from a policy perspective is another matter altogether.
