New reforms regulating the application of client monies in retail over-the-counter derivatives transactions will restrict the use of client funds for hedging purposes.
The Treasury Laws Amendment (2016 Measures No.1) Bill contains the proposed retail client money reforms in the OTC derivatives sector. The House of Representatives passed the Bill on 13 February 2017.
What is the effect of the proposed amendment?
Australian financial service licence holders can currently use money held on behalf of retail derivatives clients for a wide range of purposes, including for working capital.
The proposed reform will restrict the use of client funds for hedging purposes connected with OTC retail derivatives.
What is the proposed retail client money rule?
AFS Licence holders will be required to hold retail derivative client money on trust and a financial services licensee may only use retail client money related to a derivative to meet an obligation where:
(i) the entry into the derivative was or will be cleared through an authorised clearing and settlement facility, that is:
- the operation of which is authorised by an Australian CS facility licence; or
- the operator of the facility is authorised to operate the facility in the foreign country in which the operator’s principal place of business is located; and
(ii) the licensee incurred the obligation in connection with the derivative, under the operating rules of the facility.
Prior to the amendment OTC derivative providers could rely on section 981D of the Corporations Act and use client money to meet their own margin obligations under their hedging arrangements and to fund hedging with hedge counterparties as well as meeting obligations in connection with guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee. This exemption will no longer be available to retail OTC derivative providers.
What client monies are affected?
The Rule will apply to ‘derivative retail client money’, which is money received in connection with a financial service relating to a dealing in a derivative held by a retail client.
For the purposes of the Rule, a ‘retail client’ will include a retail client as defined in section 761GA and will be extended to include clients who are sophisticated investors.
The Explanatory Memorandum for the legislation explains that:
- this ensures that the sophisticated investor carve-out contained in section 761GA cannot be exploited to circumvent the legislative amendments; and
- while sophisticated investors are generally high net worth individuals, like other retail clients, they may not always have the requisite knowledge of complex financial services such as derivatives to evaluate the risks associated with how licensees use derivative client money.
However, an AFS Licensee may agree with a wholesale client that the client money rules do not apply. That is, the Rule will not apply to wholesale client money if the wholesale client opts out of the client money rules in relation to money received by an AFS Licensee in connection with non-centrally cleared derivatives (for example, to meet domestic and international security-based margining requirements).
The agreement to ‘opt out’ must be in writing.
The restrictions imposed on the use of derivative retail client money does not apply to derivatives cleared through an authorised clearing and settlement facility, in recognition that such derivatives are subject to stringent capital, reporting and reconciliation requirements imposed by the relevant clearing house in relation to client money.
Who is affected?
Retail OTC derivative providers such as CFD and Margin FX providers.
Retail clients as defined in the Corporations Act and in some circumstances, sophisticated investors as described above.
The current law will otherwise continue to operate in respect of client money held by financial services licensees on behalf of wholesale clients.
What is the regulatory protection?
The fundamental protection that the trust requirement seeks to ensure is for client money to be returned to clients, and not paid to creditors, in the event of the licensee’s insolvency.
ASIC also will have the power to make client money reporting and reconciliation rules in relation to derivative retail client money.
Can the exemption in section 981D be applied to any retail derivative arrangements?
Section 981D will continue to apply for Licensed Market compliance. If derivative retail client money is received by an AFS Licensee in connection with exchange traded derivatives entered into, or acquired, on a Licensed Market then client monies may be used to meet obligations incurred by the licensee under the market integrity rules or operating rules of the market or clearing facility.
Is there a transition period?
There will be a 12-month transition period in which to implement the reforms from the date the Bill is finally passed. We anticipate that the Bill will become law shortly.
Meridian’s Financial Services Principal, Michael Bracken can provide further guidance and advice on the proposed Derivative Retail Client MoneyRule, regulation of OTC derivatives and the impact of the legislative amendments. Michael has recently advised the liquidators of a global commodity broker on derivative and commodity financial product regulation and determining client entitlements to derivative client money and mixed client monies upon an insolvency.