7 March, 2016
What you need to know
The Federal Government has proposed amendments to the Corporations Act and Regulations governing the handling of client money by Australian financial services licensees. If implemented:
- further restrictions will be imposed on the use by licensees of client money received from retail clients in connection with OTC derivatives
- Licensees may agree with their wholesale clients that the client money rules do not apply in relation to money received by the licensee in connection with non-centrally cleared derivatives
- ASIC will be given the power to make client money reporting rules in respect of derivative retail client money
What you need to do
Licensees who deal in derivatives with or for their clients should consider the impact of these changes on their operating model, including margining and hedging arrangements, and on their client documentation should the new laws come into effect.
On 22 December 2015, Treasury released a policy paper which set out the Government's key proposals to enhance client money protection for retail clients. The draft legislation and regulations to give effect to those proposals were released for comment on 29 February 2016.
Despite the arguments in favour of a more comprehensive review and reform of the Australian client money rules, the proposals focus on two particular items relevant to the derivatives markets:
- Retail OTC derivative providers (such as CFD and Margin FX providers) will no longer be permitted to rely on section 981D of the Corporations Act and use client money to meet their own margin obligations under their hedging arrangements.
- OTC derivative providers will be able to agree with their wholesale clients that the client money rules do not apply at all in relation to money received by the provider in connection with non-centrally cleared derivatives.
We discuss these briefly below.
Retail OTC derivative providers
Historically many retail OTC derivative providers, such as those providers of CFDs and Margin FX products who operate on a "direct market" model, have relied on section 981D of the Corporations Act to use client money to fund the hedging which the provider undertakes, as principal, with hedge counterparties. Under ASIC Regulatory Guide 212, providers have been required to disclose to retail clients whether they use client money for this purpose.
The intent of the proposed reforms is that retail OTC providers would be prohibited from using client money to fund their hedging transactions, where the clients are retail clients. To achieve this, the draft legislation introduces a new concept of "derivative retail client money" which captures money received in connection with a financial service relating to a dealing in a derivative held by a retail client. For this purpose, the term "retail client" includes sophisticated investors who may ordinarily be considered as wholesale clients.
Section 981D would continue to apply in respect of derivative retail client money received by a licensee in connection with exchange traded derivatives entered into, or acquired, on a licensed market, where the money is used to meet obligations incurred by the licensee under the market integrity rules or operating rules of the market or clearing facility. It would also apply in respect of money received in connection with OTC derivatives which are cleared through a licensed clearing and settlement facility. This leaves open a question of how licensees who provide services on offshore markets (such as offshore futures exchanges) will fund margin requirements.
The use of general directions to allow licensees to use derivative retail client money will also be restricted. The draft regulations would prohibit licensees from obtaining general directions from retail clients (including sophisticated investors) to use the money for working capital or other general purposes, consistent with ASIC guidance to date in respect of directions which might be regarded as appropriate under regulation 7.8.02(1)(a).
ASIC would also be given powers to make reporting and reconciliation rules in respect of derivative retail client money. A liability regime has also been established under the draft legislation in connection with this new reporting framework.
Uncleared derivative transactions for wholesale clients: dis-applying the client money rules
The December 2014 policy paper foreshadowed that wholesale client participation in derivative markets should be facilitated and supported, and legislation should ensure that the client money regime does not prevent participants in those markets from complying with other regulatory obligations such as meeting margin requirements.
The draft legislation does not completely deliver on that promise. Under the draft legislation, the client money rules would not apply to derivatives that are not cleared through a central counterparty, where the licensee has obtained the wholesale client's written agreement to the money being dealt with other than in accordance with the Australian client money rules.
However the draft legislation does not dis-apply the client money rules in respect of centrally cleared derivatives. Money received from wholesale clients in respect of exchange traded or centrally cleared derivatives would still fall to be dealt with as client money under the client money rules, although section 981D would apply to permit such money to be used by the licensee to meet obligations to the clearing and settlement facility.
If, from a policy perspective, it is considered appropriate to permit wholesale clients to opt out of the client money rules in respect of uncleared derivatives, it seems strange that a similar outcome would not be considered appropriate for exchange traded and cleared derivatives. Also, an issue commonly faced by global providers is how they comply with the Australian client money rules in respect of money received in connection with dealings across multiple exchanges and clearing houses, particularly in the context of cross border money flow. The Government's proposals do not address these issues and may add a further degree of complexity to the handling of client monies.
What next?
Consultation on the draft legislation and regulations closes on 25 March 2016. The proposed reform is one which will have a far reaching impact on licensees who deal in derivatives with retail clients. Licensees who deal with wholesale clients may benefit from the reforms which would dis-apply the Australian client money rules to uncleared derivatives.
For further information, please contact:
Jonathan Gordon, Partner, Ashurst
jonathan.gordon@ashurst.com
