Over-The-Counter But Below-The-Belt: Derivatives Regulation in Australia

Posted: 13th March 2017

By: Terence Zhou

It was the 25th of September 2009, almost two years after the Global Financial Crisis began. For the third time in a year, a G20 meeting had been called. Fittingly, the chosen location was Pittsburg, Pennsylvania, a city then dotted with empty smoke-stained steel factories, colossal tombstones for the workers made redundant by previous economic collapses.

The mood in the Convention Centre was sullen, yet introspective. The world economy was finally showing evidence of life; its pulse was slow and at times syncopated, but undoubtedly rising. The frantic urgency from the first G20 had dissipated, and the angry finger-pointing from the second G20 had similarly died down. Instead, the world leaders hesitantly discussed what needed to be done in the future, to prevent a further subprime mortgage crisis. And whilst it is likely that no one explicitly stated it, each world leader slowly arrived at the same consensus: the general public is really, really dumb, and really, really need to be protected from themselves. The days of wanton freedom and deregulatory stances needed to finally come to an end. Instead, the focus shifted to developing hybrid models of governance: keep the big players free, but protect the little guy.

As such, on that day, Australia, alongside with the other G20 participants, declared its commitment to substantial reform of its current OTC derivative framework. Now, almost eight years later, we are finally on the brink of game-changing reform. Earlier in December 2016, the Australian government issued a Proposal Paper that seeks to greatly limit the over-the-counter derivatives that will be available to unsophisticated investors, and provide ASIC with product intervention powers. However, a quick glance around us shows that this world around us isn’t the same as the 8 years, immediately after the GFC crash. We now exist in some awkward transition period. Yes, Australia now has more hard-line laws that impose stricter punishments for breaches of financial regulation. But our economy is also defined by financial innovation and deregulation (the Treasury even offers regulatory sandbox features to fin-tech). Is the topic of OTC derivatives still relevant, or should we treat this Proposal Paper as merely an afterthought, a futile attempt at deriving regulation from a bygone era?

What are OTC Derivatives

A derivative is a form of security that has its value determined (or derived) from an underlying asset. There are many different forms of derivatives in the market today, including options, warrants, contracts-for-difference (CFDs) and futures. However, the majority of derivatives share common features that can ultimately result in high risks.

Firstly, derivatives are often leveraged. In layman’s terms, leverage refers to borrowing funds from others to increase your position, and obtain more profit. Many derivatives, such as options, are inherently leveraged and therefore, their pricing is a lot more volatile. It is more than possible to gain upwards of 50% profit in a few hours by buying options on a blue-chip company. Of course, it is also possible to lose 50% of your investment (or 100% if you’re playing binary options) in a few hours as well. Further, as your investment is leveraged (which as stated above, means that you’re borrowing money), it is possible in some cases to actually go into debt if your investment goes lopsided, depending on the type of derivative.

Secondly, the ‘fair’ price of a derivative is difficult to determine due to a lack of liquidity in the majority of derivative markets. In simple terms, derivatives are generally ‘bets’ between two parties, who can also decide on the terms of the derivative as well. In markets where one side (generally the seller) dominates, they can offer unfair prices and terms to wide-eyed investors.

Now, the good news is that according to the BIS, roughly 40% of derivatives (with a market value of ~$200 billion) in Australia are exchange-traded, which means that they are traded on a transparent, highly-regulated and standardised marketplace. Obviously, these factors all offer some degree of protection for your ordinary retail investor. However, the other 60% of derivatives are over-the-counter (OTC), which means that they are privately negotiated between two parties – which sounds fine, until you realise that one party is generally a sophisticated network of institutional investors, backed by a global team of seven-figure analysts and eight-figure software. The other party is Becky, the starry-eyed housewife who watches way too many day-time TV adverts. One of these two sides is a lot more likely to end up making huge losses.

A Short History of OTC Derivatives Reform in Australia

Returning back to the G20 reform pledge, we can take away the fact that derivatives, particularly OTC derivatives, are dangerous for ordinary mortals such as you and I. This doesn’t mean that they should be banned of course, but rather, that they should be held under stricter regulation in regards to retail investors. And to a degree, Australia has sought to implement new OTC derivative regulation. In 2013, the ASIC Derivative Transaction (Reporting) Rules were made under section 901A of the Corporations Act 2001. In essence, these rules required classes of reporting entities (tabled in Rule 1.2.5) to disclose information regarding the derivative transaction to a nominated repository. Whilst these rules were relaxed via amendments in 2015, this reporting has increased the transparency of the process, and indirectly shut the doors on some of the more manipulatively priced transactions.

Also in 2015, the ASIC Derivative Transaction (Clearing) Rules were made under the same section of the Corporations Act 2001. These rules imposed a central clearing house on certain OTC derivatives, but had little effect on unsophisticated retail investors.
As such, it’s clear that Australia’s previous attempts at reform have subscribed to the efficient market hypothesis, a phrase that may induce uncontrollable shuddering from some veterans of Finance 101 lectures. That is, our regulatory framework is premised on the belief that so long as institutional investors disclose everything, individuals will make calm, informed choices about their investments. This theory works great with large companies, but it’s hardly applicable to our dear housewife Becky, who’s captured by the giddy hip-shakes of the infomercial actor on her screen, as badly photo-shopped notes rain onto her like a kaleidoscope, and the words boom out from the bottom: “INVEST WITH US AND THIS COULD BE YOU”. There is a deeper, psychological drive behind an individual’s desire to invest in derivatives, and many investors do not mind exploiting it.

I have only provided a very abridged summary of reform, and excludes some success stories. However, the simple take-away is that up until now, not enough has been done in Australia to protect the individual from manipulative OTC practices. The reason? There is no real singular excuse, but most likely, it is because individual investors only comprise a miniscule percentage of the total market size. Objectively, passing legislation that encourages fairness and transparency for larger, institutional firms trading with each other makes much more practical sense. However, what we must remember is that the money an individual can lose, whilst relatively miniscule compared to an investment bank’s daily volume, is usually life-changing. Debt and bankruptcy are common, and as such, there is almost a social duty for the government to provide greater protection instruments to the general public.

The Proposal Paper

And finally, we return back to the present-day. On 13 December 2016, the Treasury released a Proposal Paper titled ‘Design and Distribution Obligations and Product Intervention Power,’ with the intent of generating discussion on new legislation concerning all financial products. Relevantly, it states that its objective is to ‘reduce the likelihood of customers acquiring (or being mis-sold) products without fully understanding the associated risks and that are misaligned with their financial situations, objectives and needs’. However, what differentiates this proposal compared to previous attempts is that instead of the usual disclosure-focused regulation, it proposes to grant the ASIC far-reaching product intervention powers.

The Proposal Paper: Design and Distribution Obligations

Before we analyse the product intervention powers, let’s look at the other component of the proposal paper. The Paper proposes that security issuers must identify appropriate target and non-target markets for their products. For example, an issuer of highly-leveraged swaps (another form of derivative) will likely not get away with identifying housewives like Becky as their key consumer audience. Once, the issuer has identified the target market, they must decide on distribution channels which are appropriate for their target market. So again as an example, advertising credit swaps during day-time TV would likely be frowned upon. The issuer is also responsible for conducting periodic reviews to ensure that the distribution channels are hitting the correctly nominated target market.

One potential drawback of this change is that the proposed legislation places the onus on the issuer to report any defects in their target market/distribution channels. But there is very little incentive for an issuer to do so. They obviously wish for their product to reach as many people as possible, and as such, it’s not totally unreasonable that they would turn a blind eye towards some of the more duplicitous practices of their distributors. Marketing in itself is such a subjective, broad channel that it wouldn’t be difficult to mask deliberately predatory marketing. Whilst I’ve used the example of television advertisements in this article, in reality, advertising directed towards individuals is always more subtle, more insidious. It could be a few off-hand comments from your local financial adviser, or a Google search ad triggered by a few key words. As an issuer, you could simply brush off these unsavoury tactics as accidentally catching retail individuals in your steel mesh whilst you were trawling for institutional whales. By the time the ASIC has caught onto the pattern of exploiting retail investors, any shrewd institutional investors would have shut their doors and run away.

However, you may argue, wouldn’t the issuers care about the penalties they may face? The argument remains the same: it is difficult to catch you for a crime of intent that could happen by accident so very easily. Furthermore, the regulatory tools proposed by the paper are cookie-cutter. Administrative actions, such as cancellation of a licence, are rarely taken and require serious breaches – something which is almost impossible to prove in regards to predatory OTC derivatives. Criminal penalties fall within the same category. It is more likely that anyone who does get caught will be subject to a fine – which caps out at a paltry $1 million for a company, or $200,000 for an individual. From a cost-benefit viewpoint, it seems far more profitable to exploit consumers and risk the payment.

The Proposal Paper: Product Intervention Power

Conclusively, we’ve stated that the main problems with the regulatory framework and proposal so far are as follows:

  1. It focuses too much on disclosure
  2. It is difficult to efficiently enforce
  3. It places too much faith in the self-regulating abilities of the issuers

Indeed, the government has slowly realised that the dangerous part about OTC derivatives isn’t the OTC part, the lack of information and disclosure, but rather, the gambling-lure nature of derivatives themselves.

This is where the second limb of the Proposal Paper charges in, like an ink-clad superhero. The Proposal Paper also seeks to grant the ASIC with a Product Intervention Power (PIP). This means that the ASIC has the power to interfere with financial products, including OTC derivatives. Intervention powers include forcing warning statements or increasing the disclosure of products, restricting advertising channels, eliminating features of the product, or literally just outright banning it from sale. The PIP can apply to a singular product, or can be broadly showered onto an entire category of products as well. The Proposal Paper recommends that interventions made under the PIP should last up to 18 months, giving the government time to consider whether the intervention should be permanent or not.

Obviously, the ASIC cannot simply rely on the PIP to spray down corrupt companies like a legal gatling gun – there are certain criteria that must be met first. Indeed, interventions can be appealed through administrative and judicial review, requiring the ASIC to err on the side of caution. The requirements (or the ‘test’) for triggering the PIP are still being debated at this point, but it is noted that the Financial System Inquiry states that it should focus on intervention where ‘potential detriment is significant to an individual consumer’.

It is important to view the PIP not individually, but as merely another instrument in the ASIC’s orchestrated attempt to battle unsavoury OTC-derivative issuers. The current framework of disclosure and compliance has already discouraged many providers, or at least limited their potential operations. The PIP’s purpose is to hunt down the remaining stragglers, those who have slipped past the gated regulation, and effectively freeze them until a permanent solution can be found.

As such, we can see that the proposed model of PIP is incredibly versatile, and well-suited for dealing with OTC derivatives. They allow the ASIC to respond quickly to individual threats, whether these arise from misleading advertisement, overly-complex product features or any other exploitative methods. Internationally, similar legislation has been passed in the US (which can intervene where practices are ‘unfair, deceptive or abusive’), Hong Kong, and most recently, UK. All of these countries hold fewer reports of deceptive behaviour in OTC derivatives compared to Australia, percentage-wise.

Of course, a criticism of the PIP that we can expect is that it may foreshadow an unsettling trend towards over-regulation. Whilst protection of the ignorant masses is important, so too is preventing bureaucratic processes from slowing the economy down to treacle sludge. Furthermore, the PIP may negatively contribute to the experience of more informed retail investors, who are now a bit more limited in their choice of speculative derivatives. But all of these factors can be prevented by setting well-defined limitations to the jurisdiction of the PIP, restricting its potential audience and power.

Final Thoughts

Soon, it will be the 7th of July 2017, almost 10 years after the GFC began. The next G20 meeting will take place in Hamburg, Germany – a sapphire port-city flecked by fuzzy golden lights. There will likely be no more talk of derivatives, no more talk of better tomorrows, as the world leaders wander onto other, more ominous issues. The matter of OTC-derivatives, aside from bragging rights, is no longer an international matter. It has slowly trickled down the spires, become a federal matter at first, and now, with this Proposal matter, an individual matter.

What is written in the proposal is not set in stone. It is not guaranteed that the PIP, or even the disclosure obligations, will extend to all derivative issuers, or even exist. Through issuing this proposal paper, the Treasury has asked us to reach over the counter, and extend our hands in acknowledging this issue. And whilst I personally don’t have the intervention powers to compel the government, I hope that this Proposal Paper does turn into reality, because tracing back to the G20’s (very abbreviated and/or abridged) words: ‘the general public is really, really dumb, and really, really need to be protected from themselves.’