18 July, 2016
Proposed law reform – client money and derivatives
On 22 December 2015, the 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 argument for more comprehensive review and reform of the Australian client money rules, the proposals focus on two particular items relevant to the derivatives markets, which we discuss below.
Retail OTC derivative providers
Historically, many retail OTC derivative providers, such as those providers of CFDs and Margin FX products operating 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 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 would otherwise be considered to be 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.
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 been established under the draft legislation in connection with this new reporting framework.
Uncleared derivative transactions for wholesale clients
The December 2015 policy paper foreshadowed that wholesale client participation in derivative markets would 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 disapply 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.
Extra funds for ASIC's war chest
On 20 April 2016, the Federal Government announced a reform package which includes promises of additional funding for the Australian Securities and Investment Commission (ASIC). The proposals are a direct response to the ASIC Capability Review paper of December 2015, which made 34 recommendations in relation to the manner in which ASIC's capabilities could be improved. The key headline items of these proposals and the implications for the industry and consumers are set out below.
Investigation and data analysis resources
The reforms have allocated A$61.1m to improve ASIC's data analytics, surveillance resources and information management systems, and a further commitment of A$57m for surveillance and enforcement projects on an ongoing basis.
The ASIC is to be removed from the Public Service Act 1999 (Cth) so as to make it a more flexible and competitive employer, enabling it to attract and retain staff with specialist skills.
Industry funding model
The announcement reaffirms the Government's commitment to implement industry funding for ASIC. It is anticipated that this will come into effect in 2017 in what is proposed to be an extensive consultation with the industry to "refine and settle this funding model".
Medcraft extended and a new Commissioner
The Government announced that it will recommend to the federal Attorney-General that the tenure of ASIC chairman Greg Medcraft be extended for an additional eighteen months, to provide continuity in the leadership of ASIC.
Law reform response to the FSI
The Government has also allocated A$9.2m to accelerate the implementation of certain recommendations of the FSI.
Customer complaints and dispute resolution
In order to improve the way consumer complaints are handled, the Government proposes to establish a panel to advise on the external dispute resolution and complaints schemes and to assess the merits of integrating these schemes. The panel is due to report back to the Government by the end of 2016. In addition, the Government is also providing A$5.2m worth of funding to the Superannuation Complaints Tribunal to deal with legacy complaints and improve internal processes.
ASIC consults on digital robo advice
The ASIC recently released a draft Consultation Paper on digital advice – "Consultation Paper 254 Regulating digital financial advice" (CP254), and a draft Regulatory Guide – "000 Providing digital financial product advice to retail clients"(the draft RG).
Digital advice systems asks clients questions about their personal, financial and lifestyle objectives and circumstances. More sophisticated systems use algorithms to process the clients' answers.
ASIC's approach to regulation
The issues posing the biggest challenge for ASIC are how to apply the organisational competence obligations to an automated advice model, and what level of standard should be required to monitor and test the underpinning algorithms.
The "best interest" obligations will still apply to automated advice, and if a client is not a suitable candidate for the advice, the advisory relationship should cease.
New market participants are expected to have a strong grasp on Australia's regulatory requirements, a strong compliance culture and a commitment to technical quality.
The future of digital and automated advice in Australia
Since 2015, Australian banks have openly discussed offering digital automated advisory advice to clients either through an online banking platform or for a low fee. Automated advice is expected to develop into a more sophisticated offering, probably combining with money management tools, behavioural tools, big data and becoming part of our everyday internet banking offerings.
For further information, please contact:
Jonathan Gordon, Partner, Ashurst
jonathan.gordon@ashurst.com
