Australian financial regulator proposes changes to capital requirements for market participants

The Australian Securities and Investments Commission (ASIC) has just published a Consultation Paper, outlining its proposals for changes to the capital requirements for market participants.

The regulator notes that it took over the supervision of capital and reporting requirements from ASX in 2011 in their existing form, and it has not reviewed the adequacy of these requirements until now.

ASIC also believes that the current capital requirements have fallen out of step with the financial requirements of the AFS licensing regime (which was most recently updated in 2015). For instance, ASIC often requires certain AFS licensees to hold more capital than market participants for the same level of risk, and impose liquidity management requirements on AFS licensees (but not market participants). The regulator also notes that while the Securities Capital Rules impose a $100,000 core capital requirement on market participants, the financial requirements of the AFS licensing regime require retail OTC derivative issuers to hold net tangible assets of $1 million, and foreign exchange dealers to hold $10 million in tier 1 capital.

Let’s take a look at the key proposals.

The proposed changes to the Futures Capital Rules are:

• requiring market participants of futures markets to comply with a risk-based capital regime instead of the existing net tangible asset regime;
• creating a single capital rule book for securities and futures market participants; and
• introducing a commodity position risk amount.

This proposal would require market participants of futures markets (the ASX 24 and FEX markets) to calculate their total risk requirement, and at all times hold liquid capital in excess of this amount.

The proposed single capital framework for both securities and futures market participants would operate in pretty much the same way as the existing risk-based capital requirements of the Securities Capital Rules, and would not change the capital requirements of market participants of securities markets. All of the existing requirements of the Securities Capital Rules, apart from the minimum core capital requirement, would apply to futures market participants.

ASIC proposes that market participants of futures markets would be required to comply with a minimum core capital requirement of $1,000,000.

In addition, ASIC proposes to introduce a commodity position risk amount to the position risk requirement. This would require market participants to hold additional capital to account for the position risk of holding commodity derivatives or commodity spot positions.

The proposed commodity position risk amount is calculated by converting commodity derivative positions to ‘commodity equivalents’ and applying a position risk factor, or by applying a position risk factor to the spot price.

The proposed changes to the Securities Capital Rules include:

• an increased core capital requirement;
• new requirements such as reporting a net asset balance of zero or lower and an underwriting risk requirement;
• the removal of some rules and risk calculation methods; and
• amended definitions of key terms.

In proposing this, the regulator notes that the core capital requirement has remained at $100,000 for more than 17 years, during which time the risks associated with operating a financial services business have increased. Movements in inflation have also reduced the value of the core capital requirement in real terms.

This proposal aims to create a financial buffer that lowers the risk of market disruption from a disorderly wind-up by ensuring that a market participant can be unwound without losses by clients and creditors. It will also provide greater client money protection by increasing a market participant’s ability to absorb losses, which reduces the risk that a market participant will use client money to fund operating expenses.

The regulator emphasizes that a market participant must hold enough capital to absorb losses incurred from liquidating its own positions or from closing out a customer’s defaulting positions guaranteed to the clearer. ASIC considers a $500,000 core capital requirement is an appropriate level to cover this risk.

ASIC also proposes to insert a rule in the Securities Capital Rules and the Futures Capital Rules that would require market participants to:

(a) prepare a projection of cash flows over at least the next 12 months under both normal and stressed scenarios;

(b) document the calculations and assumptions on which the projection is based, and describe in writing why they are the appropriate assumptions;

(c) update the projection of cash flows when:

(i) those cash flows cease to cover the next 12 months;

(ii) there is a material change; or

(iii) there is reason to suspect that an updated projection would differ materially from the current projection;

(d) have the projection of cash flows approved by the board of directors of the market participant, or, if the market participant is a partnership, by two partners of the market participant, at least quarterly; and

(e) document a contingency funding plan, procedures for managing liquidity risks, and procedures for the escalation of liquidity issues.

ASIC invites submissions on the consultation paper by August 15, 2018.