Commodity Trading Advisor & Commodity Pool Operator 101
Derivatives POV Final V2
1. Time to Plan, Time to Act
Achieving High Performance by Reforming
the Australian OTC Derivatives Market
Financial Services APAC | Capital Markets
2. Contents
Time to Plan, Time to Act
Achieving High Performance by Reforming
the Australian OTC Derivatives Market
Executive Summary 3
Backround 4
Analysis 6
Recommendations 10
Notes/Additional Resources 11
3. The global financial
crisis of 2008 drew
considerable attention
to OTC derivatives and
sparked reforms around
the world. As a member
of the G20 group of
countries, Australia has
committed to the OTC
derivatives reform
agenda set out by G20
leaders in September
2009.
At a minimum, we can expect Australian
dollar-denominated interest rate
derivatives traded between Australian-
based counterparties to be subject to
mandatory, domestic central clearing.
The implementation details and timeline
for these changes remain uncertain, but
Australian banks must be able to respond
quickly once central clearing is mandated.
Organisations that take steps now to
prepare will be well positioned to invest
when the regulatory fog clears.
Executive Summary
3
4. Global capital markets
reforms
The global financial crisis of 2008 drew
considerable attention to OTC derivatives
and sparked reforms around the world.
Valued at over US$600 trillion, the global
OTC derivatives market is criticised for
being overly complex and insufficiently
transparent—and was widely blamed for
build-up of excessive exposure and
operational inefficiency during the crisis.
On July 21, 2010, US President Barack
Obama signed the Dodd-Frank Wall
Street Reform and Consumer Protection
Act (Dodd-Frank) into law. Meanwhile,
Europe is pursuing the European Market
Infrastructure Regulation (EMIR) and
other, broader initiatives such as Basel III.
Reforms in both the United States and
Europe will have deep and far-reaching
implications for global capital markets
and the business models of market
participants.
As a member of the G20 group of
countries, Australia has committed to
the OTC derivatives reform agenda set
out by G20 leaders in September 2009.
Specifically:
“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.”1
In March 2011, the major market
participants committed to supporting
reform via a strategic roadmap presented
to the OTC Derivatives Supervisors Group.2
Reform efforts have been plagued by
delays. In the United States, the
Commodity Futures Trading Commission
(CFTC) and the Securities and Exchange
Commission (SEC) postponed the deadline
for Dodd-Frank implementation from
July 15, 2011 to the end of the year.
Similarly, the European Parliament has
delayed finalisation of the EMIR.
Despite the uncertainty, a number of
banks—Goldman Sachs, Barclays Capital
and Deutsche Bank, for example—have
already built or are in the process of
building strategic clearing services for
OTC derivatives.3 Meanwhile, Asia Pacific
G20 members such as Japan, China,
India and South Korea have announced
initiatives to create domestic CCPs.4
Objectives of OTC derivatives
reform
OTC derivatives reform aims to reduce
counterparty risk and increase
transparency. Figure 1 summarises key
changes and their implications for the
market and its participants.
Background
4
5. A key pillar of the reforms is the
introduction of mandatory clearing
through a central counterparty (CCP) for
certain classes of OTC derivatives. Until
now, OTC derivatives trading in Australia
has been conducted bilaterally, between
clients and executing banks. Figure 2
describes how that process will change.
As a first step in ensuring Australia meets
its G20 commitment, the Australian
Council of Financial Regulators (the
Council) recently issued a discussion
paper considering the question of central
clearing of OTC derivatives in the
domestic market.5 Unlike the United
States and Europe, Australia does not
have a history of sell-side central clearing.
Local clearing of listed derivatives is
currently conducted by ASX Clear.
Client Executing Bank
Clearing Bank
Clearing House
Key:
Client-side trade leg
Executing Bank trade leg
New trade legs
In certain cases, a single bank will fulfil
the executing and clearing roles.
In other cases, new trade legs will be
required between:
• Client and clearing bank.
• Executing bank and clearing bank.
All trades will be cleared by the clearing
house.
Figure 2: How central clearing of OTC derivatives will work
Figure 1: Overview of global OTC derivatives reform
Regulation Description Implication
Central Clearing • Financial companies to clear swaps centrally,
with existing swaps to be grandfathered
• Exception: non-financial companies
(end users)
• Liquidity demand of high initial margin
• Daily variance margin
• Cash form of margin
Exchange Trading • All standardised swaps to be exchange-traded,
where an exchange or swap-execution facility
exists
• Exception: non-financial companies
(end users)
• Inability to customise (important for hedging)
• Standardisation of swaps
• Higher volume
Capital Requirements • Conservative requirements for dealers and
major participants on cleared swaps
• Higher capital requirements for dealers on
OTC positions
• Higher trading costs
• Greater focus on efficient capital allocation
Margin Requirements • Stringent initial margin requirements with
clearing houses; further daily variance margins
• Minimum margin requirements under debate
for OTCs
• Shrinking spreads (per-trade profit)
• Daily margin calls
• Higher OTC trade costs
Post-Trade Reporting • Real-time price and volume reporting
(T+1 for OTCs)
• Existing swaps also to be reported
• Price transparency
• Standardisation of swaps
• Reporting infrastructure
5
6. Analysis
Top considerations for
Australian regulators
As the Council develops its policy
response and implementation plan, a
number of considerations are top of
mind:
Financial stability
The failure of any large Australian
financial institution would ripple
through the banking system and have
repercussions for the entire economy.
We were reminded how interconnected
global markets really are in May 2011,
when Moody’s downgraded credit
ratings for Australia’s four largest banks
due to concerns over their dependence
on offshore funding.6
Security of key markets
Like regulators in other countries, the
Council must be convinced that its
chosen solution provides adequate
control and oversight for markets and
trades that are strategically important
to the domestic economy.
Market disruption
Given Australia’s existing regulatory
framework and small share of the global
OTC derivatives market, the Council must
decide whether downside risk is best
mitigated by implementing certain G20
reforms—for example, increased capital
charges for highly bespoke transactions
and enhanced transaction reporting—or
other measures better suited to the
domestic market.
Pre-Reform Post-Reform
In addition to revenue channel changes, trade volumes are expected to increase as
products become more “listed-like”.
Revenue
Channel
Change Comment
Per-TradeMargin
Trade Volume
P&L
P&L
Per-TradeMargin
Trade Volume
Execution Bid-ask spreads, broker fees and administration and legal
fees expected to shrink due to increased standardisation,
transparency and liquidity
Clearing Clearing fees, once explicit, likely to reduce over time
due to increased price transparency
Collateral Potential for clearing banks to earn a fee to optimise
the use of client collateral (see separate “call-out”)
Figure 3: Changing nature of the OTC derivatives market
6
7. Market efficiency
The Council acknowledges that the
ultimate configuration of CCPs—single
versus multiple, local versus
international—will have important
consequences for market efficiency,
including the cost of clearing and the
ability of clearing members to net
effectively across their trade portfolios.
Regulatory coordination
Although countries are focused on
their own strategically important
markets, harmonisation of rules across
jurisdictions is a key G20 objective.
The Council’s plans must be compatible
with those of US and European regulators.
Should Australia fail to move in lock
step with these jurisdictions, the Council
risks creating regulatory arbitrage
opportunities, particularly for the world’s
14 largest OTC dealers (G14 dealers).
Political goodwill
The Council’s chosen solution must
protect national interests and the
domestic market, and still be perceived
internationally as honouring Australia’s
G20 commitments.
Based on the information available to
date, we expect the scope of trades that
will be subject to mandatory central
clearing in Australia to:
• Include interest rate derivatives
denominated in Australian dollars
involving Australia-based
counterparties.
• Exclude interest rate derivatives
denominated in other currencies.
• Exclude equity, credit and other
derivative asset classes where
Australian trading is limited.
• Exclude foreign exchange swaps and
forwards, which are exempted from
central clearing under Dodd-Frank.7
Sydney-based ASX Clear will probably
be the only CCP clearing interest rate
derivatives in the domestic market in the
foreseeable future, but LCH.Clearnet has
shown interest in providing services to
the Australian market. LCH.Clearnet’s
SwapsClear is the biggest global CCP
for interest rate derivatives, responsible
for clearing 50 percent of interest rate
swaps trades between G14 dealers. But
first, the UK-based company will need to
overcome two significant challenges:
interoperability with a local CCP and
the up-front capital commitments for
smaller banks. The global CCP market
will likely continue to be fragmented in
the near term, but consolidation is
expected over time as CCPs merge to
take advantage of scale efficiencies.
Top considerations for
Australian financial
institutions
In the coming years, the OTC derivatives
market is expected to become more
“listed-like,” meaning more product
standardisation, increased price
transparency and liquidity, and higher
trade volumes. These forces will exert
downward pressure on bid-ask spreads
and fees, reducing per-trade margins and
challenging the effectiveness of banks’
current business models (see figure 3).
Impending regulatory reform, while not
responsible for this trend, will certainly
exacerbate it. Clearing banks could profit
from transforming client collateral into
CCP-eligible cash and securities, provided
they successfully navigate the wider
collateral management reform implications.
Australian banks will feel the effects of
OTC derivatives reform throughout their
organisations. Figure 4 examines which
functions will be impacted and how.
Capability Implications
• High volume of new legal documents and
CSAs to be negotiated and agreed
Legal & Compliance5
• Greater use of balance sheet on a short-term
basis by large volume clearing clients
• Significant new reporting requirements to
clearing houses, regulators and clients
Balance Sheet
Management
Transaction and
External Reporting
Finance4
• Changes in ability to net across clients and
products
• Client collateral and increased connectivity
Operations3
Reference
Data
Clearing and
Settlement
Collateral
Management
Operational Risk
Management
• Shift towards more standardised products
• Time sensitive risk assessment associated
with trade give up and take up
Risk2
Trading Risk
Management
Credit Risk
Management
Liquidity Risk
Management
• Holistic view of client relationships needed
• Pricing strategy overhaul
• Multiple system connectivity with the
market
Front Office1
Account
Management
Trade
Structuring
Trade
Execution
Pricing
Figure 4: Functional areas affected by OTC derivatives reform
7
8. Choosing an appropriate
operating model
In a “worst-case” scenario, G20 regulators
will hold to the end-2012 deadline for
introducing central clearing. Given this
tight timeline, Australian banks must
decide soon whether to enter the clearing
business and, if so, how extensively to
invest. Figure 5 identifies three possible
operating models and outlines the pros
and cons of each option.
Banks that choose to build a clearing
capability for the Australian market
will need to assess the desirability and
feasibility of extending these services
to their international operations. The
country’s largest banks already provide
OTC services in Europe, the United States
and Asia, all of which will be subject
to mandatory central clearing shortly.
Adding clearing to the mix would
require linking up with other CCPs
and investing in the necessary trade
routing infrastructure—a highly complex
endeavour that is expected to be
prohibitively expensive in the near term.
By applying the classic prisoner’s
dilemma model to the Australian banking
market, we can gain insight into the
considerations facing bank leaders as
they select an operating model (see
figure 6).
Each bank sees an incentive to invest
in clearing capabilities in an attempt
to gain market share in the execution
business—an opportunity that evaporates
when other banks also choose to invest
in clearing capabilities. The industry
would maximise its total payoff by
collectively agreeing not to invest in
clearing capabilities, but that would
require trust and communication among
individual players. Left to their own
devices, all of the banks will choose to
invest in clearing and end up worse off
than if they had cooperated.
In reality, no one knows how much there
is to gain—in terms of profit and market
share—from investing in Model 3. Not
only is the size of the pie uncertain, but
also banks cannot be sure how many
ways it will be split and so how big their
piece will be.
Accenture’s work with G14 dealers
suggests that they have similar
reservations. Many international banks
view clearing investments primarily as a
way to protect their execution businesses.
Although these capabilities could lure
clearing business away from other banks
and result in new revenue streams, most
believe the upside is limited.
If the American and European experiences
are any indication, the significant capital
and complex operational change required
to create a clearing capability will limit
local CCP participation.
Figure 5: Operating model options for Australian banks under mandatory central clearing
The bank continues to provide an
execution service to clients, but clients
need to clear through another dealer
Limited additional investment needed to
support a move to client clearing
Limited documentation required to
commence trading
Limited credit exposure to the client once
the trade has been given up to the clearer
Changes the client relationship to
transactional in nature, and introduces the
client to a competitor bank
Requires agreements to be in place with
clearing banks jurisdiction of trade
Transparency of price to the clearing bank
The bank builds a clearing service
to support its execution business
Offer full suite of services to existing
clients
Capture revenue stream associated with
clearing (clearing fees, margin interest)
May require less investment than clearing
trades executed with other banks
Maintain confidentiality of execution price
Up-front investment needed to build a
clearing capability and to negotiate legal
agreements
Does not take advantage of potential
revenue streams from non-executing
clients
Potential for competitor clearing banks to
offer a clearing service at a lower cost
The bank builds a clearing service
that will support its execution business,
in addition to offering clearing for
non-executing clients
Offer full suite of services to existing
clients, as well as potentially capture new
clearing-only clients
Dominant brand positioning
May facilitate agreements with global
banks for clearing on each others behalf in
relevant location
Potentially significant up-front investment
needed to develop a deep understanding of
the regulations, to negotiate legal
agreements with clients and executing
banks and to build a clearing capability
Clearing business is likely to be highly
price competitive and may not offer good
margins in the long term
Executing Bank Executing Bank
Clearing Bank
Executing Bank
Clearing Bank +
Model 1 Model 2 Model 3
8
9. Also, the clearing business will be even
less attractive to banks if some potential
clients are exempted from mandated
clearing due to their small market
footprints.
Compete or collaborate?
The prisoner’s dilemma model suggests
that cooperation among banks is unlikely,
but certain market realities leave the
door open for collaboration. Unlike the
organisations in our model, the four large
banks that dominate Australia’s banking
market have an incentive to behave
prudently, recognising that their decisions
today will have implications for future
interactions with their peers. Figure 7
identifies three possibilities for industry
collaboration and outlines the pros and
cons of each option.
BankA
Bank B
Does not
invest in
clearing
Does not invest in clearing
Invests in
clearing
Invests in clearing
Figure 6: Prisoner’s dilemma model applied to the Australian banking market
Figure 7: Options for collaborating on central clearing in Australia
Option1
Create a single, shared, not for-profit
clearing bank
Could reduce the per-bank investment
required to meet Australia’s central
clearing obligations
Eliminates duplication of clearing
technology across multiple banks
Makes it difficult to ensure confidentiality
of proprietary data
Could be logistically challenging
Could prove more expensive than
individual banks investing in their own
clearing capabilities
Option 2
Agree to limit clearing to own
execution business
Minimises impacts on the competitive
environment of Australia’s banking
industry
Requires the cooperation of all domestic
and foreign banks operating in the local
market
Creates a strong incentive for banks to
renege on any agreement to chase
additional clearing revenue and maximise
their return on investment
Option 3
Lobby against mandatory central
clearing in Australia
Acknowledges that Australia already has a
robust regulatory framework and a strong
banking system
Recognises that, since the financial
crisis, global counterparts have increased
capital buffers, de-leveraged, exited
exotic trades and improved risk
management
Could result in trading that is systemically/
strategically important for the Australian
market being cleared abroad
May be perceived as inconsistent with
Australia’s public commitment to G20 OTC
derivatives reform
9
10. Once central clearing
is mandated, Australian
banks will need to begin
deploying their chosen
operating models
quickly. Whether that
occurs by the end-2012
implementation date or
later, banks that take
steps now to prepare
will be well positioned
when the regulatory
fog clears.
Accenture recommends that Australian
banks immediately:
• Appoint senior executives to
coordinate strategy on OTC derivatives
reform.
• Analyse the implications of these
reforms for business models, products
and clients.
• Meet with clients to discuss their
service needs.
• Meet with regulators to understand
reforms and influence policy
development.
• Meet with other domestic and
international banks to discuss service-
sharing options.
Irrespective of the operating models
that they ultimately decide to deploy,
banks should delay investments until
local regulation has been defined and
implementation timelines have been
confirmed. Now is the time to make
strategic plans because the time for
action is coming.
Recommendations
10
11. Notes
1 Leaders‘ Statement, G20 Pittsburgh
Summit, September 25, 2009.
2 Industry Letter to the OTC Derivatives
Supervisors Group, Operations Steering
Committee, March 31, 2011,
http://www.isda.org/ c_and_a/pdf/
Supervisory_Commitment_Letter-31_
March_2011_FINAL.PDF.
3 “Barclays Capital Executes & Clears IRS
E-Transaction for Citadel,” Bloomberg
(Press Release), April 16, 2011 and
“Goldman Sachs and BlackRock
Complete Electronically Executed and
Centrally Cleared Credit Default Swap
Trade,” Business Wire (Press Release),
June 30, 2011.
4 “Regulatory reform puts risk
management under threat in Asia,”
Asia Risk, July 5, 2011.
5 “Central Clearing of OTC Derivatives
in Australia,” Council of Financial
Regulators, June 2011.
6 “Big four in ratings downgrade,”
Sydney Morning Herald, May 19, 2011.
7 “US Treasury will exempt FX swaps and
forwards from Dodd-Frank,” FX Week,
May 2, 2011.
Additional resources
2010 Australian Financial Markets
Report, Australian Financial Markets
Association, 2010.
“2011 OTC Derivatives Prime Brokerage
Survey: Into the unknown,” Global
Custodian, January 1, 2011.
“ASX vs LCH in race to be Australia‘s
OTC clearer,” Risk Magazine,
August 1, 2011.
“Baum: lower margins but higher volumes
in the new world order,” Futures and
Options World, July 1, 2011.
“Centralized Clearing of OTC Derivatives:
Devil in the Details,” Greenwich
Associates, January 2010.
“Client clearing poses acute liquidity
risks,” Risk Magazine, July 1, 2011.
“Collateral transformation needs to be
carefully planned by clearing members,
says Isda’s O’Connor,” Risk Magazine,
July 12, 2011.
“LCH.Clearnet looking to provide
competition to ASX Clear,” Reuters,
June 21, 2011.
“Reforming OTC Derivative Markets: A UK
Perspective,” Financial Services Authority
and HM Treasury, December 2009.
“Rehypothecation is being redefined,”
Financial News, September 13, 2010.
“VIEWPOINTS: OTC Derivatives Market
Is Just Shifting,” American Banker,
November 17, 2010
