4 May 2016
PDF version [342KB]
Robert Dolamore
Economics Section
Date introduced: 16
March 2016
House: House of Representatives
Portfolio: Treasury
Commencement: The formal provisions of the Bill commence on
the day of Royal Assent. The operative provisions of the Bill commence on the
28th day after the Bill receives Royal Assent.
Links: The links to the Bill, its Explanatory Memorandum and
second reading speech can be found on the Bill’s
home page, or through the Australian
Parliament website.
When Bills have been passed and have received Royal Assent,
they become Acts, which can be found at the Federal Register of Legislation website.
All hyperlinks are correct as at May 2016.
Purpose of
the Bill
The purpose of the Financial System Legislation Amendment
(Resilience and Collateral Protection) Bill 2016 (the Bill) is to amend the Payment Systems and
Netting Act 1998 (the Act) to:
- ensure Australian entities can comply with new internationally
agreed margin requirements for non-centrally cleared derivatives, which are
expected to be phased in from 1 September 2016
- resolve inconsistencies in Australian law about the circumstances
in which an Australian regulated entity may exercise its termination rights
(that is, when it can close-out transactions related to a contract), and
enforce security, in resolution proceedings and
- provide more certainty about the operation of key financial
market infrastructure (that is, certain payment systems, settlement systems,
exchanges and central counterparties) under the Act.
The Bill also makes a number of consequential amendments
to certain other Acts related to Australian financial markets.
Structure
of the Bill
This Bill has one Schedule, which is divided into three
parts:
- Part 1:
- expands the
protections of Part 4 of the Act (which deals with close-out netting contracts)
to protect the enforcement of security in the context of margin requirements
for non-centrally cleared derivatives
- resolves
inconsistencies between the Act and financial industry Acts[1] about the circumstances in which an Australian regulated entity can close-out
transactions and enforce security in resolution proceedings
- ensures a regulated
entity subject to resolution proceedings can continue to transact in key
financial systems in order to facilitate it continuing as a going concern and
- ensures that
transactions made by an entity to meet an obligation, which are made through
certain specified financial systems, are not void or voidable if the entity is
in external administration.
- Part 2 makes consequential amendments to the Banking Act 1959, Financial Sector (Business Transfer and Group Restructure) Act 1999, Insurance
Act 1973, Life Insurance Act 1995 and Private Health Insurance
(Prudential Supervision) Act 2015.
- Part 3 contains application provisions, which set out how the
amendments in Parts 1 and 2 will apply to before, on or after the time that the
Bill commences.
Background
Complying
with new international margin requirements for non-centrally cleared
over-the-counter derivatives
This Bill seeks to ensure that Australian entities will be
able to comply with new international margin requirements for non-centrally
cleared over-the-counter (OTC) derivative transactions, which are due to come
into force from September 2016. These new requirements have been developed as
part of the international response to the global financial crisis (GFC).
The GFC prompted policymakers to pursue significant reforms
to strengthen the international financial regulatory system. This has included
measures to mitigate the systemic risk posed by derivatives. A derivative is a
financial contract whose value is based on, or derived from, another financial instrument
(such as a bond or share) or a market index (such as the Share Price Index).[2] Derivatives help entities manage risk by providing them with a way of trading
specific types of financial risks (such as interest rate risk, currency, equity
and commodity price risk and credit risk) to other entities more willing or
better suited to taking on or managing those risks. Examples of derivatives
include futures, forwards, swaps and options.
Derivatives can be traded on recognised exchanges or OTC. In
OTC markets buyers and sellers (that is, the counterparties) trade directly
with each other. Some OTC derivative transactions are cleared by a central
counterparty (CCP)[3] while others are not centrally cleared. The Australian Prudential Regulation
Authority (APRA) defines a non-centrally cleared derivative in the following
terms:
A non-centrally cleared derivative is a bilateral derivative
transaction that is not cleared by a central counterparty. This does not
include any exchange traded derivatives, securities financing transactions, or
derivatives that are cleared indirectly through a clearing member on behalf of
a non-member client. Examples of non-centrally cleared derivative transactions
may include interest rate swaps, foreign exchange forwards and swaps, commodity
swaps, options or forward contracts.[4]
The GFC exposed that OTC derivatives can be a vehicle for
excessive and opaque risk-taking and a source of systemic risk. APRA has
observed:
Counterparty exposures on bilaterally transacted derivatives
contributed to the depth of the global financial crisis. Many of these
exposures were uncollateralised or under collateralised, meaning insufficient
collateral was available to offset losses caused by counterparty defaults and
such losses were subsequently borne by the surviving counterparties. The
build-up of uncollateralised exposures led to contagion and spillover effects
on wider financial markets and the real economy.[5]
When the Group of Twenty (G20) leaders met in Pittsburgh in
2009 they agreed to a series of reforms to reduce the systemic risk posed by
OTC derivatives.[6] Initially, this work programme had four key elements requiring:
- all
standardised OTC derivatives to be traded on exchanges or electronic trading
platforms, where appropriate
- all
standardised OTC derivatives to be cleared through CCPs
- OTC
derivatives contracts to be reported to trade repositories and
- non-centrally
cleared derivatives contracts to be subject to higher capital requirements.[7]
In 2011 the G20 added margin requirements on non-centrally
cleared derivative transactions to the OTC derivatives market reform agenda.[8] Requiring a margin on a derivative transaction essentially provides a safety
cushion in the event one of the counterparties defaults. Counterparties have to
provide collateral to meet the margin. If one of the counterparties defaults
then the margin protects the surviving party by absorbing losses using the
collateral provided by the defaulting party.[9]
The Basel Committee on Banking Supervision (BCBS)[10] and International Organisation of Securities Commissions (IOSCO)[11] were tasked with developing the new internationally consistent margin
requirements for non-centrally cleared OTC derivative transactions.[12] An initial proposal was released for consultation in July 2012. In response to
feedback from interested parties the BCBS and IOSCO released a further
consultation document in February 2013. A large number of additional comments
were received on the proposed requirements.[13]
The BCBS-IOSCO finalised the new margin requirements in
early 2015. Initially, the margin requirements were to have been implemented
from December 2015. However, in recognition of the complexities involved it was
agreed to phase-in their implementation from September 2016.
In relation to the BCBS-IOSCO margin requirements APRA
notes:
The BCBS-IOSCO framework requires the exchange of both
variation margin and initial margin. Variation margin is collateral that is
collected to reflect the current mark-to-market exposure resulting from changes
in the market value of a non-centrally cleared derivative. Initial margin
protects against the potential future exposure that may arise from future
changes in the mark-to-market value of a non-centrally cleared derivative
during the period of time that is assumed to be required to close-out and
replace the position following a counterparty default.[14]
More detailed information about the margin requirements,
including the key principles underlying these requirements and the issues they
seek to address, is provided in the BCBS-IOSCO publication Margin requirements
for non-centrally cleared derivatives.[15]
The Financial Stability Board (FSB)[16] regularly reports on international progress in implementing the OTC derivatives
market reforms, including margin requirements for non-centrally cleared
derivatives. In its latest progress report the FSB reported:
The phase-in period for the
BCBS–IOSCO standards for margin requirements for non-centrally cleared
derivatives will begin in September 2016, and jurisdictions are generally at
early stages of implementation of this reform area. Nonetheless, with the start
date for these requirements already having been delayed once, it is important
that all jurisdictions take the necessary regulatory steps to implement these
requirements on schedule, taking into account the lead time necessary for
market adoption.
As at end-September, all but one FSB member jurisdiction
(Korea) reported that they had the necessary legislative frameworks or other
authority in force, or published for consultation or proposed, to implement
this commitment. Since end-June two jurisdictions (Canada and Singapore) have
issued proposed standards for consultation. While no jurisdiction has yet
adopted final requirements, Canada, Russia and the US expect to adopt some
final requirements by end-2015. The majority of, though not all, FSB member
jurisdictions expect to have their framework for margin requirements in force
by end-2016.[17]
Why adopt
internationally consistent margin requirements for non-centrally cleared
derivatives?
Adopting internationally consistent margin requirements for
non-centrally cleared OTC derivative transactions is seen as having two main
benefits: reducing systemic risk and promoting the central clearing of these
types of derivative transactions.
In relation to the potential to reduce systemic risk the
BCBS and IOSCO argue:
Only standardised derivatives are suitable for central
clearing. A substantial fraction of derivatives are not standardised and cannot
be centrally cleared. These non-centrally cleared derivatives, totalling
hundreds of trillions of dollars [US dollars] in notional amounts, pose the
same type of systemic contagion and spillover risks that materialised in the
recent financial crisis. Margin requirements for non-centrally cleared
derivatives would be expected to reduce contagion and spillover effects by
ensuring that collateral is available to offset losses caused by the default of
a derivatives counterparty. Margin requirements can also have broader
macroprudential benefits, by reducing the financial system’s vulnerability to
potentially destabilising procyclicality and limiting the build-up of
uncollateralised exposures within the financial system.[18]
Further, the BCBS and IOSCO argue setting internationally
consistent margin requirements for non-centrally cleared derivative
transactions will promote central clearing:
In many jurisdictions, central clearing will be mandatory for
most standardised derivatives. But clearing imposes costs, in part because CCPs
require margin to be posted. Margin requirements on non-centrally cleared
derivatives, by reflecting the generally higher risk associated with these
derivatives, will promote central clearing, making the G20’s original 2009
reform programme more effective. This could, in turn, contribute to the
reduction of systemic risk.[19]
These benefits are put at risk if individual countries do
not introduce rules consistent with the new international margin requirements.
In this regard there are two key concerns: the potential for financial
institutions to shop around for the most favourable regulatory environment
(that is regulatory arbitrage) which would undermine the effectiveness of the
reforms; and the resulting creation of an uneven playing field with financial
institutions in jurisdictions with low margin requirements gaining a
competitive advantage.[20]
Why are the
measures in this Bill necessary?
APRA has the authority to develop and implement margin
requirements for non-centrally cleared OTC derivative transactions and this
process is well underway.[21] The problem is that under the existing law, Australian entities may not be able
to exchange and enforce margin (that is collateral) in a way consistent with
the BCBS-IOSCO margin requirements.
The current practice of posting and receiving collateral for
non-centrally cleared OTC derivative transactions is on an absolute (that is
title transfer) basis.[22] The BCBS-IOSCO preferred approach is for this to happen in a bankruptcy‑remote
manner by way of security. The Council of Financial Regulators (CFR)[23] has highlighted a number of legal impediments under existing Australian law
that affect the creation and enforcement of a collecting party’s rights in
respect of collateral provided by way of security.[24]
Under the BCBS-IOSCO framework,
covered entities are required to hold initial margin in a manner that ensures
that it is immediately available to the collecting party in the event of the
counterparty’s default, but at the same time ensures that the posting party is
protected in the event that the collecting party enters bankruptcy. There are
two main methods of exchanging collateral: title transfer and security
interest. Title transfer does not meet the bankruptcy-remote requirement as the
collateral becomes the property of the collecting party. While exchanging
collateral by way of security interest should ensure that the posting party is
protected in the event that the collecting party enters bankruptcy (in that the
collateral should not form part of the collecting party’s estate on its
insolvency), currently under certain circumstances the collateral posted by way
of security interest may not be immediately available to the collecting party
in the event that the posting party defaults. This is because the granting of
security interests generally involves a number of additional enforceability,
validity and perfection requirements, which means that a collecting party may
be restricted from enforcing its security interest if the posting party is subject
to certain insolvency proceedings.
Furthermore, under certain circumstances, the existence of
priority regimes under the current legislative framework in Australia, which
apply in respect of the assets of certain types of entities, may result in
other parties’ claims to the posting party’s assets (including the collateral
provided by way of security interest) having priority over the claim of the
collecting party.[25]
This Bill addresses the current legal impediments to
exchanging and enforcing collateral by way of security. In this way it
facilitates Australian entities complying with the BCBS‑IOSCO margin
requirements. This is comprehensively discussed in the Explanatory Memorandum
(see pp. 42‑73).
Australia potentially faces serious economic consequences
if it does not have a facilitative regulatory regime in place by the time the
BCBS-IOSCO margin requirements come into effect. This reflects that the
capacity of Australian entities to trade internationally with major
counterparties would be progressively eroded, limiting their ability to hedge
their risks offshore and access liquidity.[26] The Explanatory Memorandum notes:
Even a short delay in creating a facilitative regulatory
regime is likely to involve significant cost to the Australian finance sector.
To give a sense of the scale of OTC derivative trade: The notional amount of
outstanding OTC derivative contracts is ~US$553 trillion globally. The
Australian Financial Markets Association (AFMA) recently estimated that there
is an annual turnover of AUD$80 trillion in notional OTC derivatives in
Australian financial markets.[27]
Providing
certainty for the application of stays on exercising termination rights and
enforcing security
The Bill seeks to resolve inconsistencies between the Act
and financial industry Acts about the circumstances in which an Australian
regulated entity can exercise its termination rights (i.e. when it can
close-out transactions related to a contract), and enforce security, in
resolution proceedings. In so doing, the Bill aims to bring Australian law into
line with international best practice. The measures support the objective of
Australian regulators being able to efficiently resolve (that is take action to
stabilise or liquidate) financial institutions which are in distress.
One of the challenges policymakers have been grappling with
since the GFC is how to resolve financial institutions in an orderly way
without exposing taxpayers to the risk of having to bail them out, while at the
same time trying to maintain the continuity of the vital economic functions
these institutions perform.[28]
Sitting beneath this broad objective is a range of complex
issues. One issue is the possibility that a counterparty to the financial
institution in resolution may seek to exercise its termination rights and
enforce security, but in so doing put at risk the ability of regulators to
resolve the financial institution in an orderly way. To address this problem it
is considered appropriate that regulators are able to stay such rights in
certain circumstances and subject to appropriate safeguards to protect the
integrity of financial contracts.
What
constitutes international best practice?
In response to the GFC the FSB set out the core elements it
considers necessary for an effective regime to resolve financial institutions
in distress.[29] The G20 endorsed this framework at the Cannes Summit in November 2011.[30]
The FSB specifies twelve essential features which it
considers should be part of the resolution schemes of all jurisdictions.
Relevant to the consideration of this Bill is ‘key attribute’ number four—‘set‑off,
netting, collateralisation, segregation of client assets’.
In relation to this key attribute the FSB recommended:
The legal framework governing
set-off rights, contractual netting and collateralisation agreements and the
segregation of client assets should be clear, transparent and enforceable
during a crisis or resolution of firms, and should not hamper the effective
implementation of resolution measures.
Subject to adequate safeguards,
entry into resolution and the exercise of any resolution powers should not
trigger statutory or contractual set-off rights, or constitute an event that
entitles any counterparty of the firm in resolution to exercise contractual
acceleration or early termination rights provided the substantive obligations
under the contract continue to be performed.
Should contractual acceleration or early termination rights
nevertheless be exercisable, the resolution authority should have the power to
stay temporarily such rights where they arise by reason only of entry into
resolution or in connection with the exercise of any resolution powers.[31]
The other key piece of international guidance on what
constitutes best practice in this area is the International Swaps and
Derivatives Association’s[32] (ISDA’s) 2015 Universal Resolution Stay Protocol (the Stay Protocol).[33] The current Stay Protocol replaces an earlier version which was launched in
2014. By way of background ISDA notes:
The ISDA 2015 Universal Protocol
was developed by a working group of ISDA member institutions (including
representatives from buy-side and sell-side institutions), in coordination with
the Financial Stability Board (FSB). It is a major component of a regulatory
and industry initiative to address the ‘too big to fail’ issue.
A key challenge in developing effective resolution strategies
for some SIFIs [Systemically Important Financial Institutions] has been the
effect of parties to OTC swaps and other financial contracts exercising
close-out rights and cross-default rights triggered by a SIFI’s financial
distress or entry into resolution proceedings. New statutory regimes developed
in response to the financial crisis of 2008, called ‘special resolution
regimes’ (SRRs), generally temporarily stay or permanently override the exercise
of certain direct defaults and cross defaults that arise in the context of
resolution, provided that certain creditor protections are satisfied. However,
the enforceability of such stays in foreign jurisdictions is not certain, and
statutory recognition of foreign resolution actions is permissive, not
mandatory.[34]
The Stay Protocol is designed to contractually recognise
the cross-border application of special resolution regimes (SRR) applicable to
certain financial institutions and provide clarity over the circumstances in
which a counterparty’s right to close-out and terminate OTC derivatives and
securities financing transactions (SFT) can be overridden by regulators in the
event a financial institution enters resolution. ISDA observes:
The Protocol opts adhering
parties into certain existing and forthcoming special resolution regimes, with
the aim of ensuring cross-border derivatives and SFT [Securities Financing
Transactions] transactions are captured by statutory stays on cross-default and
early termination rights in the event a bank counterparty enters into
resolution. These stays are intended to give regulators time to facilitate an
orderly resolution of a troubled bank. …
Statutory resolution regimes have been rolled out in several
jurisdictions, including the US and European Union. These regimes provide
resolution authorities with broad tools and powers to effect a resolution,
including the imposition of a temporary stay on counterparties’ early
termination rights in the event a bank enters into resolution. However, it is
uncertain whether these stays would extend to contracts governed by foreign
law. By adhering to the Protocol, firms are opting to abide by certain overseas
national resolution regimes, ensuring cross‑border trades with other adhering
counterparties in those jurisdictions are subject to the stays.[35]
Why are the
measures in this Bill necessary?
There are currently inconsistencies between the Act and
financial industry Acts around the application of stays on exercising
termination rights and enforcing security. These inconsistencies create
uncertainty where the law governs both the resolution regime applying to
financial institutions in distress and contracts those institutions are party
to. In particular, clarity is needed about the circumstances in which a party’s
right to close-out transactions and enforce security are stayed in the event a
statutory manager or judicial manager has been appointed to a financial
institution.[36] This issue is summarised on pages 15‑18 of the Explanatory Memorandum.
As the Explanatory Memorandum outlines, such uncertainty
is undesirable.
This uncertainty has the potential to impede the efficiency
of financial markets in Australia by making it more difficult for Australian
entities to enter into financial market transactions (including hedging
arrangements) as well as impeding the ability of the Commonwealth to
effectively manage distress in regulated financial institutions.[37]
The Bill seeks to address these legal inconsistencies. The
Explanatory Memorandum states:
The reforms in this Bill will clarify the ability of market
participants to exercise certain termination rights (also known as close-out
rights), and enforce security, in resolution proceedings and are intended to
ensure that the Australian resolution stay regime applies in accordance with
international best practice for resolution regimes. These reforms will ensure
that an appropriate balance is struck between ensuring that counterparties can
effectively manage their risks whilst also giving APRA the best chance to
resolve an important financial institution, such as an Australian bank, which
is in distress.[38]
Given that large financial institutions operate across
national borders it is desirable that Australia’s law in this area is
consistent with international best practice. The Explanatory Memorandum
observes:
Due to the increasing importance of cross-border resolution
proceedings for large international financial institutions, it will be
important that the stays imposed under Australian statutes, including the stay
imposed under the [Financial Sector (Business Transfer and Group
Restructure) Act 1999], operate in accordance with international best
practice, as described in the FSB Key Attributes of Effective Resolution
Regimes and the Stay Protocol.[39]
A comprehensive discussion of these issues is provided in
the Explanatory Memorandum (see pages 73‑100).[40]
Providing
more certainty about the operation of key financial market infrastructure
The Bill seeks to provide legal certainty about the
operation of key financial market infrastructure (that is, certain payment
systems, settlement systems, exchanges and CCPs) under the Act.
It is desirable for financial stability and the interests of
depositors and policyholders if a distressed financial institution subject to
resolution can continue to transact using key financial market infrastructure.
However, given the risks involved it is important to ensure there are
appropriate protections in place to protect the financial market
infrastructure. The Bill seeks to ensure:
- a
regulated entity subject to non-terminal administration proceedings can
continue to transact in approved Real Time Gross Settlement (RTGS) systems and
netting arrangements in order to facilitate it continuing as a going concern
- transactions
made by an entity to meet an obligation, which are made through Australia’s
cash equity settlement system, are not void or voidable if the entity is in
external administration and
- payments
or transfers of property by an entity to meet an obligation under a market
netting contract (such as to a CCP) are not void under Australian insolvency
law.
A comprehensive discussion of these issues is provided in
the Explanatory Memorandum (see pages 100‑106).
Committee
consideration
Senate
Selection of Bills Committee
On 16 March 2016, the Senate Selection of Bills Committee
recommended that the Bill not be referred to a committee for inquiry.[41]
Senate
Standing Committee for the Scrutiny of Bills
At the time of writing the Senate Standing Committee for the
Scrutiny of Bills had not yet considered the Bill.
Policy
position of non-government parties/independents
At the time of writing the policy position of the
non-government parties and independents was unknown.
Position of
major interest groups
In her second reading speech the Assistant Treasurer said:
The government has consulted the public on various forms of
the measures in this Bill, and made a call for submissions on the entire reform
package following the release of the draft Bill. Submissions primarily came
from the financial services sector, including from Australian and international
industry bodies and other market participants. As a whole, they were highly
supportive of the reforms.[42]
At the time of writing, Treasury had not published these
submissions on its website.
However two of these submissions were available on the
submitting organisation’s website.
The Australian Institute of Superannuation Trustees (AIST)
welcomes measures aimed at improving the resilience and stability of
Australia’s financial system as well as facilitating participation in
international derivatives markets. AIST noted:
We support measures aimed at protecting retail clients, and
we support efficiencies in wholesale derivatives markets, particularly where
participants are Australia’s superannuation funds.[43]
The Australian Financial Markets Association (AFMA) is
generally supportive of the legislation and although its submission included a
number of technical drafting suggestions this did not detract from the
organisation’s overall support for the legislation. AFMA observed:
AFMA generally supports the legislation and acknowledges the
policy support it demonstrates for improving legal certainty and the
effectiveness of contractual relationships between market participants. The
following comments go to technical drafting matters aimed at fully achieving
the objectives of the Bill and Regulation and do not detract from our overall
support for these pieces of legislation.[44]
Financial
implications
The Explanatory Memorandum states the Bill has no financial
impact.[45]
Statement of Compatibility with Human Rights
As required under Part 3 of the Human Rights
(Parliamentary Scrutiny) Act 2011 (Cth), the Government has assessed the
Bill’s compatibility with the human rights and freedoms recognised or declared
in the international instruments listed in section 3 of that Act. The
Government considers that the Bill is compatible.[46]
Parliamentary
Joint Committee on Human Rights
The Parliamentary Joint Committee on Human Rights considers
that the Bill does not raise human rights concerns.[47]
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