Finance houses in Australia have been making changes to their internal arrangements because of new regulations, which came into effect March 11. It is quite clear that these changes will create uncertainty and discomfort, and there will be a period of settling-in. When the industry looks back on the changes, the adjustment and readjustment, particularly to over-the-counter derivative transactions, the hope is that the end result will be better than the previous law.
The previous law was designed in 1984 for exchanges and never directly regulated over-the-counter transactions. Since that time, the growth in OTC transactions has eclipsed the trading on exchanges and at last count the turnover in the OTC derivatives markets was several times the size of the futures and equity derivatives markets combined.
At a Senate inquiry a number of years ago, the Australian Financial Markets Association was questioned as to the impact the introduction of e-commerce would have on the OTC markets. Our response was short and in two parts. First, the OTC markets are early adopters of e-commerce and have been using it for 20 years. One example is foreign exchange dealing. Second, there may be increased access to the OTC markets for retail clients. While the question was fair, it was also a fair indicator that while the legislators understood the traditional exchanges; they were unfamiliar with the much larger OTC markets.
What Financial Markets Are Covered
In The New Law?
Financial markets include stock markets and futures markets, all other over-the-counter markets, and global markets like foreign exchange, at least where one side of the deal is in geographic Australia. The financial products include all the usual suspects: securities, derivatives (including futures), and bonds. Under the same law are financial products that don't mix well with markets such as banking products, general and life insurance, managed investments, and superannuation.
OTC Derivatives
The lawmakers have redefined the term derivative. The new law applies a definition of derivative that is the result of years of research and agreement by industry and the Companies & Securities Advisory Council.
The new definition includes all traditional on-market and OTC derivatives, which is an extension from the previous law. It also includes all foreign exchange with a settlement date of more than 2 business days, that is all forward FX. Also new to the definition is electricity swaps. Specifically excluded are commodity derivatives where there is a 100% certainty of delivery of the commodity--particularly rural produce.
After redefining what a derivative is the lawmakers took a fairly simple approach to reforming the law. Wherever the term futures or options was used in the old law, replace it with derivative. The consequences of this decision to apply laws that were designed for exchanges to OTC markets are profound. Of course, this is also the tail wagging the dog. Putting aside the rhetoric, the policy and the public relations spin, the majority of derivatives in Australia are traded OTC, not on the futures or stock exchanges. At last count in the 2000-2001 financial year, the annual turnover in the Australian OTC derivatives markets was AUD23 trillion (USD12 trillion), while the futures markets accounted for AUD12 trillion.
The growth in the OTC markets has outstripped, and will continue to outstrip, the exchange markets. Contrary to remonstrations by exchanges, applying a regulatory framework redolent with policy and shamelessly exchange-orientated will not stem the advance.
Sudden Impact
The Australian OTC markets--particularly derivatives markets--have been self-regulating since 1985, and have been free of the highly publicized rogue trader scandals in other jurisdictions. In part this is because Australia is a pro-compliance culture where organizations understand the intent of the laws. In part it is because OTC trading relies on reputation and the management of reputation risk. Having a bad reputation in a non-anonymous market means that you will be last on the list to be called. That is a significant difference to the exchange based system of anonymity.
Most of the new law will take effect over the two years of transition between March 11 2002 and 2004. However there are major new laws in the reforms related to OTC derivatives that have taken effect since March 11. The laws that have been introduced include a prohibition on trading with inside information, with criminal and civil offence provisions that will require the action of a court. This is a world first for OTC markets. After it has been implemented correctly and understood by participants, it will prevent any inefficiency that could arise from inside trading using OTC derivatives. The old law only referred to equity derivatives.
Other new offences include front-running client orders, hawking financial products (that is coldcalling), and a raft of other formerly exchange-based laws such as market manipulation (trading to create an artificial price also know as cornering), false trading (churning, wash sales), market rigging, false and misleading statements, and misleading and deceptive conduct.
For most of these offences, there are criminal and civil remedies which can be initiated by Australian Securities and Investments Commission (ASIC) or another person. For civil offences, there generally is no requirement to demonstrate the intent of the offender and it can be strict liability. Directors are potentially at higher risk with the application of the criminal code when they have not taken sufficient steps to initiate a compliant culture, as they may be guilty of aiding and abetting in an offence.
The immediate impact of the new laws will be that traders will need to know the new laws intimately--particularly the ones that involve criminal offences. After that initial shock, organizations will need to prepare and get a new one-size-fits-all license. In that process licensees will need to ensure that their staff are educated and trained to an appropriate level.
New Financial Services Industry
Laws What Industry?
In this new millennium, do not expect a Financial Services Act; the new Australian laws are hidden away in the Corporations Law. The new laws are a single large chapter in between the chapters on corporate fundraising and miscellaneous. Financial Services and Markets is arguably the largest chapter in the Corporations Law and could be a separate act, as it relates to far more than how companies raise their debt and equity.
It is also curious that the financial services industry is not referred to directly in the law and the objectives do not recognize the industry--just transactions, consumers, and providers.
New Minister(s)--Which Ministers
After the election in November last year there were new ministers to focus attention on. The former Howard government decided to heed industry advice and create a junior Ministry of Financial Services. The Minister effectively shepherded the financial services reforms through the Commonwealth parliament. Unfortunately, the Ministry had a life of only one government and the responsibility to implement the reforms, arguably the bigger part of the task, is split three ways. The responsible minister is the Treasurer, whose other responsibilities include collecting taxes and the budget process. The Treasurer has an Assistant Treasurer to focus on revenue, and a Parliamentary Secretary, Senator Ian Campbell, who will become the focus of industry attention as the creases are ironed out of the law. Financial services hope that these changes do not signal the end of the days of a coordinated approach to policy. The Howard government maintains its policy of promoting Australia as a global financial center based on an well-educated and innovative workforce, world class computing and communications, and low cost. The challenge to that policy is the need to reshape taxation and regulations to be part the global financial service economy.
Transparency
One of the policy pillars of the new law is greater transparency. However, market transparency is not an economic good where more is better. If it were so exchanges would have greater transparency, which is clearly possible according to International Organisation of Securities Commissions (IOSCO), and would not pursue variations of transparency for large order systems. Research shows transparency must match the requirements of the participants. If the participants are all sophisticated, a low transparency market works best. Sophisticated and wholesale participants don't want their trading intentions flagged to the whole world. It is arguable that spot foreign exchange trading is the best example of this. It is clearly the largest and most efficient market in the world, and has low market transparency. For example, it is impossible to ascertain the price, volume, or parties to the last trade. And it is impossible to ascertain what the next (market) price will be.
The new financial service laws have made significant progress in relation to making the distinction between retail and wholesale customers or clients. Retail and wholesale are defined terms in the law and there are differences in the way counterparts are managed by licensees depending on whether they are retail or wholesale. A good example is the documentary and reporting obligations to retail customers that are not required for the big end of town. While the new laws are clearly designed for the protection of the retail customer, this segregation in policy does not extend to the operation of markets.
This week's Learning Curve was written by John Rappell, director of consulting and policy at the Australian Financial Markets Association.
