Over-the-counter derivatives—high risk investments in a largely unregulated market

Bernard Pulle, Economics

Key issue
A main cause of the global financial crisis was the largely unregulated over-the-counter derivatives market internationally. This article sets out briefly the approach of the Australian Government to meeting Group of 20 (G20) commitments entered into at Pittsburgh in 2009 to ensure a transition into a regulated derivatives market.

Introduction

A ‘derivative’ is a security instrument whose price is dependent upon, or derived from, underlying assets such as stocks, bonds, commodities, currencies, interest rates and market indexes.

Derivative products have traditionally been traded through bilateral arrangements between parties or ‘over-the-counter’ (OTC) transactions, and not through a central clearing exchange like a stock exchange or trading platform. There was a lack of transparency concerning the risk profile of participants and the value of transactions.

In 2009, following the global financial crisis of 2008, the G20, which comprises the 19 largest economies, including Australia, and the European Union, committed at Pittsburgh to a global transition from bilateral trading of OTC derivatives to:

trading all standardised OTC derivative transactions on exchanges or trading platforms
centrally clearing all standardised OTC derivative transactions and
reporting of all OTC derivative transactions to derivative trade repositories (TRs).

In response to a request by the Australian Government to ascertain how its G20 commitments might best be implemented, the Council of Financial Regulators (CFR) (which comprises the Reserve Bank of Australia, the Australian Prudential Regulation Authority, the Australian Securities and Investments Commission and Treasury), after an extensive consultative process, provided a report, OTC Derivatives Market Reform Considerations, on 20 March 2012 (the CFR Report).

The Australian OTC Derivatives Market

The CFR report concluded that the volumes and types of OTC derivatives transactions undertaken in Australia are small by global standards, comprising only 2% of global notional turnover. Further, as is the case in most countries, participants in the Australian-located OTC derivatives market undertake a large amount of cross-border activity.

The CFR report states that financial institutions use a wide variety of derivatives in the Australian market. Some participants use simple single-currency interest rate derivatives to hedge interest rate risks. Others use a range of single and cross-currency derivatives, foreign exchange (FX) derivatives and credit derivatives to manage exposures. Corporates use derivatives covering single and cross-currency interest rates, FX and commodity derivatives.

Proposed financial market infrastructure

The CFR report proposes the establishment of a financial market infrastructure (FMI) comprising three institutions, namely, trade repositories (TRs), central counterparties (CCPs) and exchanges and trading platforms to meet the G20 commitments. It also specifies the roles of each of these institutions.

Briefly, a TR is a centralised registry that will maintain an electronic database of records of derivatives transactions. Trade information will be submitted to a TR by one or both counterparties to a transaction and will include transaction maturity, price, reference entity and counterparty.

A CCP will play a key role in central clearing and settlement of derivatives transactions. Clearing relates to identifying the obligations of both parties to a transaction and settlement occurs when the transfer of the securities and funds takes place. A CCP does this by replacing all bilateral contracts between derivative market participants by a simpler set of exposures between the CCP and each individual participant. Because a CCP deals with several transactions of various participants, it is in a position to take more risks because several bilateral exposures are replaced by multilateral netting of contracts within the control of a CCP.

The CFR Report proposes that increased uptake in CCP centralised arrangements for OTC derivatives transactions should be an industry-led initiative. The incentive for participation in the CCP arrangement would be a lower capital requirement for participants.

The legislative framework in Australia

The Corporations Act 2001 (Corporations Act) was amended in December 2012 to provide a framework for making rules to cover derivative transactions. In July 2013, the Corporations Act and other Commonwealth laws were amended to assist CCPs in managing defaults of clearing participants.

The ASIC Derivative Transaction Rules (Reporting) 2013, which commenced on 11 July 2013, is a legislative instrument which sets out the rules that govern the reporting of derivative transactions to TRs in Australia.

Progress reports by the FSB

The G20 Pittsburgh Statement required the Financial Stability Board (FSB) to assess regularly the implementation of G20 commitments by all members, including Australia. The Fifth Progress Report on Implementation by the FSB was issued on 15 April 2013.

It recorded that legislation was in place in Australia to require reporting OTC derivatives contracts. Reporting requirements were expected to begin for some participants in the third quarter of 2013, and to be fully phased in over 18 months.

It also noted that although necessary laws are in place to implement mandatory trading obligations, authorities have not yet required any products to be traded on organised trading platforms. They are waiting for comprehensive trade repository information before requiring any specific products to be traded on organised trading platforms.

The Sixth Progress Report is expected in October 2013.

Parliamentary committee overview

The Parliamentary Joint Committee on Corporations and Financial Services (the Committee), in a report dated 15 May 2013, recommended that ASIC update the Committee on Australia’s implementation of OTC derivatives market reforms.

The Committee approved the strategic approach that the Australian regulators have taken in implementing the law governing derivatives and the central clearing arrangement.

The Committee expects Treasury and ASIC to update it on the progress made by Australia in implementing the reforms, one month after the release of the October 2013 FSB report.