Yesterday we mentioned AFSL obligations in relation to OTC derivatives trading by electricity retailers who operate under an energy retail authorisation. Today we look at this area in more detail.
By Dr Drew Donnelly, Compliance Quarter.
So, what are the rules for OTC derivatives trading? Today’s article is an introduction to the regulatory framework for OTC derivatives in Australia. It is the first of three articles on derivatives trading and compliance. Subsequent articles will look at the rules as they relate to wholesale electricity markets as well as a new law aiming to protect client money provided to retail derivative clients.
What are derivatives?
Derivatives are a type of financial instrument. They can be distinguished from other financial instruments, such as shares and bonds in that the value of a derivative is given by an underlying asset (i.e. it is derived from that asset). Common examples of derivatives are forwards, futures, options and swaps. Derivatives can be listed and traded in markets, or they can be traded ‘over-the-counter’ (OTC) between two people. It is this latter sort of derivative that we are looking at today.
Derivatives are an ancient financial instrument. Aristotle described the philosopher Thales (625-550BC) entering into an option derivative with olive presses as the underlying asset: Sensing a bumper crop, Thales signed a contract (secured by a deposit) giving him the right to use all the olive presses in the region in the autumn. When harvest came, his monopoly on the olive presses yielded him significant profits.
Not only are derivatives themselves ancient, so too is derivatives regulation. Centuries before Thales even existed, King Hammurabi of Mesopotamia (1792-1750BC) regulated the use of options in his famous code.
The call to strengthen regulation of OTC derivatives grew significantly over the last decade in the wake of the global financial crisis. It is commonly thought that the trading of some OTC derivatives (particularly ‘credit default swaps’), contributed to and exacerbated the crisis. A lack of transparency to both the participants in the transaction and regulators as to the underlying financial position of both the counterparties to the derivative, made it difficult to accurately judge risk.
OTC derivative reform in Australia: reporting and mandatory clearing
Responding to the global financial crisis, OTC derivative reform in Australia has been achieved through a substantial amendment to the Corporations Act 2001 in 2013 (establishing a new Part 7.5A) as well as a complex raft of Regulations, Rules and Ministerial Determinations
The two key planks of this reform are new reporting requirements and mandatory clearing requirements.
New reporting obligations contained primarily in the ASIC Derivative Transaction Rules (Reporting) 2013 require many (though not all) parties to a derivative to report information about their transactions and positions to a licensed or prescribed trade repository.
The goal is to significantly increase transparency around these transactions both to market participants and regulators.
Mandatory clearing means that, instead of the two entities directly contracting with each both entities are now required to contract separately with a central clearing counterparty (CCP) who guarantees both ends of the contract.
Note, mandatory clearing currently applies only to prescribed classes of OTC interest rate derivatives (i.e. not all OTC derivatives). Furthermore, mandatory clearing currently only applies to OTC interest rate derivatives entered into by some entities (e.g. large banks).
The goal of mandatory clearing is to increase transparency and reduce overall risk to the system as regulators and participants should be able to have better knowledge of a CCP’s exposure, than they would of all the possible individuals who might enter into a person-to-person derivative. Furthermore, regulators can focus their supervisory efforts on fewer CCPs rather than all those individual entities.
For further general information go to http://asic.gov.au/regulatory-resources/markets/otc-derivatives-reform/.
As the rules are complex and costs of non-compliance substantial, make sure you seek professional advice as to how the OTC derivatives rules may apply to you
 For further information on the history of derivatives and derivative markets see Kummer, S., & Pauletto, C. (2012, May). The history of derivatives: A few milestones. In EFTA Seminar on Regulation of Derivatives Markets.