Derivatives Update

April 2012 Authors: Tessa Hoser, Vittorio Casamento

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Australian government seeks consultation on proposed legislative framework to facilitate regulation of OTC derivatives

The Australian Council of Financial Regulators (which comprises the RBA, APRA and ASIC), in a consultation paper released yesterday, announced that it is proposing to introduce legislation to amend the Corporations Act 2001(Cth) as part of its commitment to implement Australia's G20 commitments relating to the regulation of OTC derivatives. The precise timing for this implementation is not yet clear from the consultation paper.

The announcement has come after the Council received submissions from market participants in response to its June 2011 discussion paper on central clearing of OTC derivatives in Australia, which sought the views of market participants on a number of relevant matters, including, which derivatives products and market participants should be subject to mandatory central clearing requirements, the extra-territorial affect of such requirements and whether there should be a requirement that central counterparties (CCPs) be located in Australia.

However, anyone expecting clear answers to these key questions will need to wait. Instead, the government has announced that it will first seek to establish a legislative framework for the introduction of regulations relating to OTC derivatives. It is interesting that the government has taken this approach, at this stage, rather than issuing draft regulations for industry comment. It is apparent from comments in the consultation paper that the Council will wait to monitor the development of regulations in the US and EU before proposing regulations for Australia, in order to achieve consistency (to the maximum extent possible) between Australian standards and the evolving global standards. The proposed legislative framework is intended to allow the Council to swiftly implement regulatory measures once their preferred approach is finalised.

Broadly speaking, the proposed legislative framework is to provide for prescribed classes of derivatives (determined by the Minister for Financial Services and Superannuation following public consultation) to be subject to one or more mandatory obligations relating to trade reporting, clearing through a CCP or execution on a trading platform.  Following this, ASIC is to have the power to make “derivatives transaction rules” to give effect to these obligations, by prescribing such matters as the types of persons who will be subject to the requirements and how they will satisfy them. It is expected that further public consultation will be undertaken at each stage of the rule-making process.

The consultation paper contains a number of interesting comments regarding the possible contents of the mandatory trade reporting, clearing and trade execution obligations, including:

  1. that an operator of a central clearing facility will be required to provide non-discriminatory access on fair and open terms to Australian market participants. This opens the way for direct access to central clearing facilities for participants who, it was thought, would otherwise have been required to participate indirectly through clearing members that are able to meet the membership requirements imposed by the operator of the clearing facility; and
  2. that the rules may require market participants to provide information regarding derivatives positions entered into before the commencement of the mandatory trade reporting obligations.

The Council is seeking submissions by 15 June 2012 in response to its consultation paper.

Proposed European capital requirements may influence Australia’s approach to derivatives clearing arrangements

A key driver to mandate the use of CCPs in the OTC derivatives market is to reduce counterparty risk and systemic risk that arises from bilateral trading relationships. This is achieved by interposing a CCP into any given bilateral OTC transaction. Like other clearing systems or exchanges, the CCP becomes the counterparty to each party to the transaction, which facilitates the reduction of gross exposures through the process of multilateral netting across all participant members in the CCP.

However, mandating the use of CCPs is unlikely to be a simple panacea for market participants. By interposing a CCP into every OTC transaction, default risk is effectively concentrated in the CCP. This then focuses attention on ensuring that the CCP is financially sound and robust with a capital structure that can withstand the failure of a number of its members. Accordingly, it is expected that any proposals made by the Council will include requirements to ensure that any mandated CCP maintains sufficient levels of capital.

This issue has been clearly recognised by the European Commission, which has required the European Banking Authority (“EBA”) to make regulations relating to the capital requirements to be met by CCPs. In this regard, on 6 March 2012, the EBA issued a discussion paper setting out its preliminary views.

The EBA discussion paper concluded that a CCP should hold capital (including retained earnings and reserves) that is at least equal to the higher of:

(a) its operational expenses during an appropriate period for winding down or restructuring its activities; and
(b) the aggregate of the capital requirements for its overall operational risk (for its clearing and non-clearing activities) and its credit, counterparty and market risk relating to its non-clearing activities,

and that these capital requirements should be determined in accordance with regulatory capital standards that apply to banks. The views of the EBA are informative as to the approach that may be adopted by the Council in Australia, which has previously commented that it will seek to achieve consistency (to the maximum extent possible) between the Australian standards and the evolving global standards.

It should be noted that the capital requirements espoused by the EBA relate to the operational or non-settlement activities of the CCP itself. Whereas coverage of credit/counterparty risks that arise as a result of transactions that are cleared through the CCP are intended to be mitigated through the use of posted margin and default funds that are pre-funded by the CCP’s member participants. For example, if a counterparty to a transaction with a CCP defaults, it is intended that the CCP will continue to honour its obligations under “matching” transactions to other counterparties. The CCP will have access to the posted margin and the default funds in order to cover its losses. The posted margin and default fund requirements are likely to form part of the CCP’s “rules”, which will likely need to be approved by the regulators as part of the process of officially mandating a CCP to clear OTC derivatives in Australia.

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ISDA documentation case law – Flawed Asset provision

UK judgment confirms effect of Section 2(a)(iii) condition precedent

In Lomas and others v JFB Firth Rixson Inc and others, the English Court of Appeal considered the effect of section 2(a)(iii) of the ISDA Master Agreement, which provides that a party’s payment and delivery obligations are subject to a number of conditions precedent, including the condition precedent that no “Event of Default” has occurred and is continuing in relation to the other party. Section 2(a)(iii) is often called the flawed asset provision of the ISDA Master Agreement because a party’s right to be paid or receive a delivery depends on it satisfying Section 2(a)(iii).

The English Court of Appeal confirmed that, following an Event of Default, section 2(a)(iii) suspends for a period of time (which potentially could be indefinitely) the Non-defaulting Party's payment and delivery obligations until the Event of Default is cured or the Non-defaulting Party elects to terminate the outstanding Transactions. Significantly, the English Court of Appeal disagreed with the view of the lower English High Court that suspended payment obligations are extinguished at the maturity date of the Transaction (meaning that such payment obligations would not be taken into account in determining the Early Termination Amount if the scheduled Termination Date of that Transaction has not yet occurred).

The decision of the Court of Appeal has been welcomed by many derivatives market participants, as it is consistent with the market’s view of the effect of the ISDA Master Agreement’s flawed asset provision in section 2(a)(iii).

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