What lies beneath? ASX shines light on dark trades

For the past two years the Australian Council of Financial Regulators has been pondering inconclusively how Australia should meet its G20 commitment to strengthen over-the-counter derivatives markets. It decided last year it wouldn’t mandate the use of centralised infrastructure in this market, leaving it to the market to sort out where and how to trade and clear its transactions.

Today the ASX, supported by a range of banks, fund managers and state treasuries, announced an important development in its attempt to fill the vacuum left by the regulators (and create another significant income stream for itself in the process).

Late last year ASX said it was working with seven domestic and international banks to develop an interest rate derivatives clearing service to provide central counterparty clearing for OTC-traded Australian dollar denominated interest rate derivatives. That’s a market with turnover of more than $140 billion a day, or $18 trillion a year.

Today ASX said that it plans to extend that service to deliver a client-clearing solution, which would effectively enable end-users of the platform to keep their positions and collateral separate from those of other market participants, protecting them against the collapse of a market participant and the kind of chaos that followed the collapse of MF Global in 2011.

In the event that an intermediary were to fail, the ability to identify and transfer positions and collateral to a different participant would be relatively straightforward.

It is working with nine fund managers and state treasuries, managing around $750 billion, to develop the domestic clearing solution.

While the objective of the G20 direction that OTC derivatives should, after the global financial crisis, become more transparent and be centrally cleared was laudable in practice it has been difficult to implement.

There is a particular issue for the smaller markets, given that derivative trading tends to be dominated by international banks and investment banks and by cross-border activity, which means they will tend to clear and settle transactions in the most efficient/larger jurisdictions.

While the Council of Financial Regulators decided that it wouldn’t mandate central and domestic clearing of OTC derivatives but leave it to the market to lead developments, there is no doubt both regulators and domestic market participants (generally banks) and end-users would be more comfortable if they can clear transactions on a local platform provided it is efficient to do so.

It is difficult for Australian regulators to be confident about the exposures of institutions they regulate, or of the functioning of markets that have systemic importance, if most of the clearing is occurring in London, or Chicago and being regulated by offshore regulators.

There are inter-dependencies between some OTC derivative markets and other domestic capital and credit markets which create both potential systemic risks and opportunities for more efficient trading and clearing.

Indeed, a major stated reason for the Federal Government’s decision to block ASX’s proposed merger with Singapore’s SGX was the sensitivity of allowing ASX’s equities clearing and settlement systems to be owned offshore.

Market participants and their domestic end-users would presumably prefer to trade, settle and clear within their own time zones, in their own currency, on a platform provided by a credible and well-regulated operator and within an environment where they have some clout of their own to influence the development, operation and regulation of the platform.

That presumably explains why so many big institutions are co-operating with ASX to try to develop a domestic platform, albeit that they haven’t relinquished their option of clearing transactions offshore. It would give them the option of domestic clearance on locally-regulated infrastructure where they can feel reasonably confident their collateral is well-protected.

The development of its OTC derivatives 'clearing solution' is well within ASX’s skill set and core capabilities and the sheer size of the markets for Australian dollar-denominated interest rate swaps and futures – they are of global significance – makes its attempt to keep at least a large proportion of that activity from drifting offshore a significant commercial opportunity for ASX.

More significantly, however, it will also be an important expansion of the national financial system infrastructure and a meaningful part of the attempt to maintain the relevance of the country’s financial markets at a time when Singapore and Hong Kong are beefing up their financial markets infrastructure and established centres of financial markets activity, like London and Chicago, are also trying to take advantage of the wave of global regulatory reforms designed to bring derivatives trading out of the shadows and onto regulated and centralised platforms.