Insight: Australia looks to root out lower capitalized FX brokers with strong new ruling - FinanceFeeds

Insight: Australia looks to root out lower capitalized FX brokers with strong new ruling

The FX industry has been suffering from a lack of trust. This lack of trust is evident both between participants in the market and, at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately” – Guy Debelle, Deputy Governor, Reserve Bank of Australia

FinanceFeeds has been conducting ongoing research into the Australian government’ perspective with regard to its firm stance against undercapitalized and small retail margin FX brokerages.

During the past few years, Australia’s FX industry has become renowned as one of the highest quality electronic trading environments in the world, and rightly so.

Australia’s retail FX firms are well organized and operated by highly knowledgeable senior industry professionals with substantial interbank and institutional electronic trading experience, backed by Australia’s high quality corporate ethos and sensible and orderly business environment.

The Australian Securities and Investments Commission (ASIC) has kept abreast of this commercial advantage and since the rise of Australia as an electronic trading center which serves the Asia Pacific region and is highly respected across that geographic area and the Western world, has made stringent steps toward preserving Australia’s reputation for quality.

Many firms in Australia have welcomed the zeal with which ASIC operates, its real-time surveillance system making continual checks for irregularities within all companies, and its ability to wind up the corporate entities of wrong-doers and enforce criminal prosecution orders on executives that seek to bilk their customers, as this assists greatly with the reputational strength that Australia has earned.

Last year, it became clear that Australia’s government had begun to demonstrate concern over lower capitalized brokerages to the point that it wants them out of Australia completely.

One way of doing this was to consider the emulation of Britain’s proposed leverage cap, which was described to FinanceFeeds during a meeting in Sydney, Australia with Sophie Gerber, Director of Sophie Grace Pty Ltd, who explained the proposals as follows:

  • A maximum 1:25 leverage for all retail clients who have 12 months or less CFD trading experience;
  • A 1:50 leverage cap for all retail clients; and
  • Lower leverage caps according to risks across a range of asset classes.

Other changes highlighted by Ms Gerber included product intervention powers. Ms Gerber explained “The Australian Government and its Departments (ASIC) to ban or modify a financial product which has a high risk of consumer detriment.”

“In the initial inquiry it was noted that the product intervention power would only be used as a last resort, however, with ASIC’s ongoing scrutiny of the retail CFD industry, the concern is that such an intervention could take place at any time and without warning. The financial services industry still awaits further information on whether this recommendation will be accepted” – Sophie Gerber, Director, Sophie Grace Pty Ltd

Today, this has taken further steps toward formulation of a new ruling that could limit smaller, less well capitalized firms.

A source in Melbourne, Australia explained to FinanceFeed “My understanding is that the changes may have far reaching effects on the lower capitalised FX Brokers operating in Australia.”

This time, instead of implementing rulings on client money via ASIC, the Australian government is looking at doing so at central government level under the Corporations Act 2001, authored by the Minister for Revenue and Financial Services.

Adding to this, Guy Debelle, Deputy Governor of the Reserve Bank of Australia said last week whilst in London, addressing a panel of senior financial sector executives regarding the launch of the FX Global Code “Today marks the culmination of two years’ effort to develop the FX Global Code and the associated adherence mechanisms.”

“It has involved considerable input from many foreign exchange market participants, both public and private. Today I will reiterate the motivation for the work, highlight the main features of the Code and adherence, summarise how we have developed the Code and outline the way forward” he said.

“Firstly, why is the work going on? The FX industry has been suffering from a lack of trust. This lack of trust is evident both between participants in the market and, at least as importantly, between the public and the market. The market needs to move toward a more favourable and desirable location, and allow participants to have much greater confidence that the market is functioning appropriately” – Guy Debelle, Deputy Governor, Reserve Bank of Australia

New proposals this week provide that the Governor-General may make regulations prescribing matters required or permitted by the Act to be prescribed, or necessary or convenient to be prescribed by such regulations, for carrying out or giving effect to the Act.

Paragraph 981C(a) of the Corporations Act provides that the regulations may deal with the circumstances in which payments may be made out of an account (including circumstances in which money may be withdrawn and invested, and the kinds of investment that may be made) maintained for the purposes of section 981B of the Corporations Act.

The purpose of the Corporations Amendment (Client Money) Regulations 2017 (the Client Money Regulations) is to provide greater protection for retail client money held by Australian financial services licensees (AFS licensees).

Together with the Treasury Laws Amendment (2016 Measures No. 1) Act 2017 (Client Money Act), which strengthened client money protections in the Corporations Act, these amendments align the Australian client money regime with community expectations regarding the level of protection that should be afforded to retail consumers of complex financial products and services.

In particular, the Corporations Act and the Corporations Regulations 2001 (Corporations Regulations) specify designated accounts into which client money must be deposited, how money can be invested and the circumstances under which the licensee may withdraw client money from designated accounts. Section 981H of the Corporations Act provides that client money is held on trust by the licensee for the benefit of the client.

Regulation 7.8.02 of the Corporations Regulations allows payments to be made out of designated client money accounts in certain circumstances, including:

  • making a payment to, or in accordance with the written direction of, a person entitled to the money; and
  • paying to the AFS licensee money to which the AFS licensee is entitled.

Under this regulation, some AFS licensees obtain broad authorisations in their client agreements and product disclosure statements to make withdrawals from client money accounts for any purpose, including as working capital and for proprietary trading.

Once money has been withdrawn from client accounts it ceases to be protected by the statutory trust, thereby exposing clients to higher levels of counterparty risk. That is, there is a higher risk that clients may not be able to recover their money if there is a deficit in the client money account and the AFS licensee becomes insolvent or is otherwise unable to pay the deficiency.

Counterparty risk is of particular concern in markets for derivatives, due to the complexity of evaluating counterparty risk in that context, and exceptions to the limitations in the Corporations Act on the use of money related to derivatives or a dealing in a derivative.

The use of derivatives has developed beyond what was contemplated when the existing client money regime came into effect. For example, at that time, it was uncommon for retail clients to deal in over-the-counter derivatives. This is no longer the case.

Wholesale clients typically have substantial experience dealing in derivatives and the capacity to assess risks associated with the use of their money. However, when providing authorisations to withdraw moneys from their accounts, retail clients may not understand or appreciate the risks associated with their client money being used for any purpose of the AFS licensee. Thorough assessment and evaluation of counterparty risk in derivatives markets is complex, and cannot be reasonably expected of retail clients. The changes contained in the Client Money Regulations ensure retail client money is appropriately protected.

The Client Money Regulations prevent payments being made out of a client account to the extent that the relevant direction or entitlement allows the AFS licensee to use derivative retail client money:

  • as the AFS licensee’s capital, including working capital;
  • for the purpose of meeting obligations incurred by the AFS licensee other than on behalf of the client; or
  • for the purpose of hedging the licensee’s exposures arising from its transactions with the client.

The amendments made by the Client Money Regulations apply in relation to payments made, on or after the commencement of the Client Money Regulations, out of an account maintained for section 981B of the Corporations Act, whether the relevant direction or entitlement was given before, on or after that commencement.

A policy paper on the proposed changes, ‘Enhanced Protection of Client Money’, was released for public consultation on 22 December 2015. An exposure draft of the proposed legislative amendments was released for public consultation on 29 February 2016. Forty-nine submissions were received.

Almost all stakeholders agreed that retail client monies should be better protected; and with the proposals to increase reporting and reconciliation, and prohibit the use of retail client money as AFS licensees’ working capital.

However, there were divergent views about how best to protect client money.

Stakeholders including the Australian Securities and Investments Commission (ASIC) and a number of industry representatives strongly supported the proposed reforms; while others, including a subset of AFS licensees that issue over-the-counter retail derivatives, sought a compromise in order to mitigate potential impacts on their profitability.

Following careful consideration of these submissions, Treasury officials met with a range of stakeholders to explore issues raised and to test potential refinements.

The Government ultimately determined that the amendments should proceed as drafted, as none of the alternatives would have given retail clients sufficient protection. However, the start date of the reforms was deferred by 12 months (from Royal Assent of the Client Money Act 2016) to give affected licensees time to adjust.

There are no conditions that must be satisfied before the power to make the Client Money Regulations is exercised.

A Regulatory Impact Statement (RIS) has been prepared in respect of the amendments made by the Client Money Regulations and Schedule 5 to the Client Money Act. The Office of Best Practice Regulation has confirmed that a separate RIS for the Client Money Regulations is not required. The RIS is set out in Attachment D.

The Client Money Regulations commence at the same time as Schedule 5 to the Client Money Act. Schedule 5 to the Client Money Act commences 12 months after Royal Assent.

Details of the Corporations Amendment (Client Money) Regulations 2017

 

The Client Money Regulations commence at the same time as Schedule 5 of the Treasury Laws Amendment (2016 Measures No. 1) Act 2017 (Client Money Act).

The Client Money Regulations use the new definition of ‘derivative retail client money’ inserted into section 761A of the Corporations Act 2001 (Corporations Act) by the Client Money Act. This commencement provision ensures that the new definition is in force when the Client Money Regulations commence.

 

 

The Client Money Regulations amend the Corporations Regulations 2001 (Corporations Regulations) to limit the ways in which Australian financial services licensees (AFS licensees) can use derivative retail client money.

These include:

  • making a payment to, or in accordance with the written direction of, a person entitled to the money; and
  • paying to the AFS licensee money to which the AFS licensee is entitled.

Item 1 adds a clause at the end of each of those paragraphs making it clear that they only operate subject to the restrictions imposed in new regulation 7.8.02A.

Item 2

Item 2 inserts a new regulation 7.8.02A after regulation 7.8.02 that prevents payments being made out of a client account to the extent that any written direction given by a client (as set out in paragraph 7.8.02(1)(a)) or entitlement (as set out in paragraph 7.8.02(1)(c)) allows the AFS licensee to use derivative retail client money:

  • as the licensee’s capital, including working capital;
  • for the purpose of meeting obligations incurred by the AFS licensee other than on behalf of the client; or
  • for the purpose of entering into, or meeting obligations under, transactions that the AFS licensee enters into to hedge, counteract or offset the risk to the AFS licensee associated with a transaction between the AFS licensee and the client.

This means that client money cannot be used for these three purposes, which narrows the scope of uses to which client moneys can be put and reduces the risk to retail clients of losing their money, especially in cases of insolvency of AFS licensees.

Item 3

Item 3 inserts an application provision in Part 10.26 of the Corporations Act providing that the Client Money Regulations apply in relation to payments made, on or after the commencement of the Client Money Regulations, out of an account maintained for section 981B of the Corporations Act, whether the relevant direction or entitlement was given before, on or after that commencement.

 

Summary of amendments made in Schedule 5 of the Treasury Laws Amendment (2016 Measures No. 1) Act 2017

Schedule 5 to the Treasury Laws Amendment (2016 Measures No. 1) Act 2017 (Client Money Act) makes amendments to the Corporations Act 2001 (Corporations Act) to provide that Australian financial services licensees (AFS licensees) may only use derivative retail client money or property to meet an obligation where:

  • the entry into of the derivative is cleared through:

–               a licensed clearing and settlement facility; or

–               a clearing and settlement facility, the operator of which is authorised to operate the facility in a foreign country in which the operator’s principal place of business is located, and that meets any requirements specified in regulations; and

  • the AFS licensee incurred the obligation, in connection with the derivative, under the operating rules of the clearing and settlement facility.

Definition of derivative retail client money

Schedule 5 to the Client Money Act inserts a new definition of ‘derivative retail client money’ into section 761A of the Corporations Act.

‘Derivative retail client money’ is money paid to a financial services licensee by or on behalf of a client in connection with:

  • a financial service that:

–               has been, will or may be provided to the client; and

–               is or relates to a dealing in a derivative; or

  • a financial product that is a derivative; and
  • the financial service or product would be provided to the client as a retail client if the service or product were provided to the client when the money was paid.

For the purposes of the definition of ‘derivative retail client money’, Schedule 5 provides that ‘retail client’ includes clients who are sophisticated retail investors as set out in section 761GA.

This ensures that the sophisticated investor carve-out contained in section 761GA cannot be exploited to circumvent the amendments in the Client Money Act and the Corporations Amendment (Client Money) Regulations 2017.

While sophisticated investors are generally high net worth individuals, the Australian government concurs that like other retail clients, they may not always have the requisite knowledge of complex financial services such as derivatives to adequately evaluate the risks associated with how licensees use derivative retail client money.

Guy Lebelle’s diatribe echoes this government directive. “One of the guiding principles underpinning our work is that the Code should promote a robust, fair, liquid, open and transparent market. A diverse set of buyers and sellers, supported by resilient infrastructure, should be able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behaviour” he said.

 

 

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