In brief
The Government yesterday released for consultation draft legislation containing 'resilience and collateral protection' measures. Think payment systems, netting and derivatives. But also think superannuation trustees and life companies investing in centrally-cleared OTC derivatives – and restrictions on charging assets. The Government also released a policy paper on how to make the client money provisions more protective. Partners Tom Highnam and Michelle Levy and Senior Regulatory Counsel Michael Mathieson look at some of main points of the new draft legislation.
Payment systems, netting and derivatives
There are two, broad measures being proposed by the draft legislation which relate to derivatives. Both are addressed through amendments to the Payment Systems and Netting Act 1998.
The first relates to the next set of post-GFC derivatives reforms to hit Australia – the requirement for margining under uncleared derivatives. Margining occurs across many uncleared OTC derivatives in Australia already. Typically, it is done by way of outright transfer of cash collateral under an ISDA Credit Support Annex. However, under the new reforms for margining, some margin will need to be provided by way of security and not by the outright transfer of cash. This has a knock-on effect for certain counterparties. Banks typically do not grant security and are subject to laws protecting their assets for the benefit of depositors. Companies in administration are subject to a moratorium which can prevent creditors from enforcing security. The draft Bill will resolve these issues by way of amendment to the Payment Systems and Netting Act which will permit the enforcement of security (within certain parameters) in connection with close-out netting in accordance with that Act.
The second addresses an age-old issue for lawyers and their clients due to the inconsistency between the Banking Act 1959 and the Payment Systems and Netting Act. Section 15C of the Banking Act purported to prevent a party from closing out any transaction with a bank following the appointment of an ADI statutory manager to the bank. A moratorium is imposed. The proposed amendments under the draft bill are technical and involve various permutations as to when the moratorium is temporary or permanent. However, they go a long way to resolving an important issue in Australian financial markets.
Superannuation trustees and life companies
Superannuation trustees and life companies must not grant charges over superannuation fund or statutory fund assets. In each case, there is an exception where the charge is given to comply with the rules of an 'approved body' that requires the performance of obligations associated with 'derivatives contracts' to be secured. The 'approved bodies' are securities exchanges and clearing houses listed in the relevant regulations.
There are some significant problems with the current position. In short, the existing exception is too narrow. It has been rendered outdated by international regulatory developments following the GFC. A good example is that of centrally-cleared OTC derivatives.
Centrally-cleared OTC derivatives often represent a better deal for superannuation trustees and life companies than other OTC derivatives. Apart from anything else, they are generally cheaper. However, bodies that clear OTC derivatives invariably have rules that require security to be granted to support obligations associated with the clearing process. Can the existing exception be relied on?
The answer is 'no', unless the derivative is an options contract or a futures contract. For example, the exception cannot apply if the derivative is an interest rate swap. This is the main problem.
The Government proposes to fix this and other problems by making the following changes:
- expanding the relevant class of derivatives to include anything that is a 'derivative' or a 'foreign exchange contract' within Chapter 7 of the Corporations Act;
- expanding the relevant class of requirements, from the rules of an 'approved body', to include 'a law of the Commonwealth, a state, a territory or a foreign country (including a part of a foreign country) that applies to dealings in the derivatives contract';
- creating an additional exception where:
- the asset over which the charge is given is 'financial property' (such as a share, or currency);
- the obligations secured by the financial property are obligations of the superannuation trustee/life company that relate to a derivatives contract (or are ancillary obligations); and
- the financial property is in the possession or under the control of the secured party or someone acting on the secured party's behalf.
The additional exception appears to relate to the requirement discussed above for margining under uncleared derivatives. However, it is possible that it will also have some work to do in relation to charges that are required by derivatives brokers. The Government is also considering expanding the list of 'approved bodies' and finding a way to update it more easily – with this suggesting the list may be maintained outside the legislation in future.
Enhanced protection of client money
At the same time as it released draft legislation and regulations protecting collateral given by a counterparty to a derivative, the Government released a short policy paper entitled 'Enhanced Protection of Client Money'. The link is that client moneys can be used to satisfy a licensee's obligations in connection with derivatives whether or not that money relates to a dealing in relation to the client. But the most substantial changes will be those that limit a licensee's ability to use retail client moneys. A retail client will be any person who would be a retail client despite the exception that otherwise applies for sophisticated investors as defined in the Corporations Act.
The client money regime in Part 7.8 of the Corporations Act requires a financial services licensee that receives money in connection with a financial service or financial product that has been or will be provided to a client to pay that money to a 'client money' account where it is held on trust for the client. But the licensee's obligations to hold the money for the benefit of the client are subject to very broad exceptions. In addition to the exception in the Act for dealings in derivatives, the regulations permit client moneys to be used by a licensee in accordance with a written direction of the client or to satisfy any 'entitlement' the licensee has to the amount. A broad direction by a client or a term of a contract can be used to permit pretty much anything a licensee might want to do.
And so the Government proposes to amend the Corporations Act and Regulations to limit these broad exceptions and provide greater protection to client moneys held for retail clients. For wholesale clients (which will not include clients that would ordinarily be excluded because they are sophisticated investors), the considerations are different and the paper says that the Government will amend the client money regime so that client money may be used by a licensee to meet obligations from its dealings in derivatives for wholesale clients.
The Government will also give ASIC the power to set rules about reporting and reconciliation requirements in relation to retail clients' client money paid in respect of derivatives and it will give ASIC the power to issue an infringement notice to a licensee for an alleged breach of these rules.
Concluding remarks
The consultation period ends on Friday, 29 January 2016. However, there is more to come before then. Treasury says to expect exposure draft explanatory materials in January. It also says to expect draft legislation in January to implement the client money changes. Financial services regulation – where change is the only constant.