Two sides to the clearing debate

Two years ago, the Australian Council of Financial Regulators decided to leave it to the market to determine where over-the-counter derivatives transactions should be cleared. ASX chief executive Elmer Funke Kupper, however, is still arguing the case for mandating domestic clearing while investing heavily in developing its own platform.

In a speech delivered in Sydney today, Funke Kupper outlined the thrust of the submission ASX will make to the financial system inquiry. He warned that competition from offshore clearing platforms could undermine an ASX business model built on the diversity of its income base and the fact that it is a fully-integrated securities and derivatives exchange group with a single clearing house for all its derivatives transactions.

Last year ASX raised $553 million of equity, most of which was devoted to its derivatives clearing operations in order to meet new and higher global capital requirements. ASX has a single clearing house for all its derivative products, and says that scale is vital to lowering costs and creating an efficient risk-management solution for its customers.

Over a year ago, ASX began work with a range of banks, fund managers and state governments to develop an interest rate derivatives clearing service to provide central counterpart clearing for OTC-traded Australian dollar-denominated interest rate derivatives.

That decision flowed from the G20 direction in the wake of the financial crisis that OTC derivative trading should become more transparent and should be centrally cleared. With a central counterparty for both sides of a derivatives transaction, the risk is borne by the clearing house, limiting the market impact of a default by one of the participants.

As Funke Kupper said today, there are two sides to the debate about whether or not Australia should mandate domestic clearance of OTC derivative transactions.

On one side are domestic institutions, which would prefer to have their risk and collateral managed locally and under Australian law. On the other side are the global banks that want to concentrate all their risk in a single location. Australia isn’t a natural global centre for clearing financial transaction.

Funke Kupper cited the MF Global experience to highlight the potential perils of allowing domestic OTC transactions to be cleared offshore. When MF Global, a derivatives trader, collapsed in 2011, it emerged that much of the client collateral was held in Europe, complicating and delaying the return of funds to the clients.

ASX is not arguing against competition in clearing, but rather that the government should mandate the location of clearing houses for all markets with the potential to create systemic risk. In practice, however, it is unlikely there would be too many parties willing to duplicate existing infrastructure and commit the capital and tie up the collateral that would be required to establish an Australian platform.

The council of financial regulators did consider whether offshore clearing of domestic transactions might pose systemic risks. It concluded that domestic and international regulatory arrangements had given it increased comfort that satisfactory arrangements around the use of offshore facilities could be developed.

ASX’s position is that if domestic clearing is not mandated then, to level the playing field, ASX itself should be relieved of its domestic infrastructure obligations and be allowed to move its infrastructure offshore or engage in exchange consolidation.

A key reason cited by the then-Treasurer Wayne Swan for vetoing the proposed merger of ASX and Singapore’s SGX in 2011 was the sensitivity of allowing ASX’s equities and derivatives clearing and settlement systems to be owned offshore.

If, however, there is no policy issue in relation to clearing derivatives transactions offshore, it would be difficult to argue against a revival of the ASX/SGX proposal or a merger with some other offshore exchange that could eventually lead to the infrastructure for the Australian markets being located elsewhere. It would also be difficult to argue against ASX re-locating its infrastructure hub in pursuit of lower costs or additional capital flows.

The implications of offshore clearing within a level playing field are quite stark, according to Funke Kupper.

If policymakers chose to allow offshore clearing, he said, regulators would effectively be outsourcing systemic risk to another jurisdiction and relying on that jurisdiction to support Australian investors in a crisis.

That’s not so much a threat as an illustration of the trade-offs between the benefits of increased competition from offshore clearing houses and the risks of giving away regulation of the key infrastructure for markets that carry latent systemic risk.

It is conceivable, of course, that the Federal Government could open the door to offshore competition while maintaining the ASX-specific requirements. If that ultimately undermined its ability or willingness to raise capital and invest, however, a set of national infrastructure platforms that are critical to the functioning and efficiency of the financial system could be devalued.