Financial markets facilitate the operation of other financial sectors. The main activities in financial markets are typically split into three stages (Figure 2.2).
Figure 2.2: The trade process
- Pre-trade – an investor decides whether they wish to trade, what to trade and at what price.
- Trade – an investor that wishes to buy is connected to an investor willing to sell. A broker (or a dealer or a broker/dealer) generally assists in this process. For most financial products, the broker will use an exchange, an organised financial market where financial products are traded, but can also execute the trade directly with another broker.
- Post-trade – investors swap the financial product and cash. There are two main post-trade processes:
- Clearing – details of the trade are confirmed and counterparties’ obligations calculated. In many markets, a central clearing facility, such as a central counterparty (CCP), will step in to manage the pre-settlement risks that exist between counterparties to a trade.
- Settlement - the financial product is legally transferred to the buyer and the cash is transferred to the seller. A securities settlement facility provides for the final settlement of securities transactions. Settlement in most markets, such as cash equities, occurs quickly. However, derivatives markets are more complex due to the time taken for derivatives to terminate. CCPs manage the risks involved by requiring payment of collateral (called ‘margin’) as security. When derivatives expire, the final margin is paid to reflect the ending position of the contract.
In recent years, the Australian Government has taken steps to increase competition in financial markets. These steps include transferring supervision of Australia’s equities markets to ASIC and otherwise amending regulatory arrangements to allow the entry of the Chi-X exchange in the equities trading market.
There is currently a Government moratorium on competition in clearing trades in Australian cash equities. This was implemented on the 2012 advice of the Council of Financial Regulators (CFR), which proposed it was not the appropriate time for further changes that would have additional cost implications for industry. The Australian Securities Exchange (ASX) has developed a code of conduct for access ahead of the CFR examining options for competition or access regulation in 2015.40
Stakeholders suggest that competition in financial markets is constrained in two areas:
- The time and resources required for market operators to obtain financial market licences, which can be a barrier to entry
- Cross-border operation of financial market infrastructure (FMI), including the moratorium on competition in clearing cash equities
Submissions also identify current licensing arrangements as a barrier to entry for foreign competitors.
Financial market licensing
Generally, financial market operators in Australia must obtain an Australian Market Licence. The Minister can exempt a financial market from requiring a licence if ASIC advises there is no public benefit in regulating the market.
However, the current legislative system has not adapted to market developments. In its submission, Treasury notes that, as new market forms have arisen, the current legislative framework is producing a piecemeal approach to regulation. It is too inflexible to regulate all financial markets appropriately.
The piecemeal approach is reflected in the time taken to assess licence applications. Chi-X noted its licensing process took over three years. An earlier prospective entrant to operate a domestic equities market in Australia, AXE ECN, withdrew its proposal four years after first applying for a licence.41 This is slower than similar processes elsewhere. Exchange approval in the United Kingdom is subject to a six-month time limit. It took five months for BATS Chi-X to have its United Kingdom application to become a regulated stock exchange approved.
To some extent, the longer time for Australian applications may be attributable to the applications raising novel and complex regulatory issues. Introducing Chi-X required transferring responsibility for market supervision from ASX to ASIC and introducing a new regulatory and cost recovery framework.42 Similarly, proposals by foreign clearers to offer services in Australian financial markets required regulators to consider cross-border service provision issues for the first time.
Future market entrants will benefit from the regulatory adjustments to accommodate initial applicants to these markets, but ‘level playing field’ issues remain. The initial applicants bear the cost and uncertainties that arise from seeking regulatory change. Some market innovations, such as crossing systems and dark pools, do not require financial market authorisation.
Treasury has commenced a review of the market licensing framework, which will consider how the framework may better accommodate market developments.
Competition in financial market infrastructure
FMI competition can bring benefits through innovation and lower costs.43 However, options to increase competition in FMI involve a trade-off between boosting efficiency, regulating functionally similar activities in the same way and giving Australian authorities capacity to regulate important FMI, especially in a crisis. Competition can be destabilising to existing market practices, but it can also remove single points of failure – potentially contributing to overall stability.
In its submission, ASX presents two potential long-term choices for Australia’s FMI:
- A domestic mandate for critical FMI, with all competitors required to comply with the same location and ownership requirements
- An open global market, with all participants, including ASX, free to optimise the economics of their arrangements
Submissions from Chi-X and LCH.Clearnet support introducing competition for clearing for ASX-quoted securities when the moratorium expires, but did not comment on domestic location requirements.
However, a potential competitor is likely to offer a cheaper service if it can use existing infrastructure, which is typically located offshore. Requirements of scale and Australia’s relatively small market mean that, in most cases, competition in FMI will come from foreign entrants, relying to some degree on cross-border infrastructure. Foreign entrants can also increase funding opportunities for domestic business.44
Chi-X suggests that a regulator, either ASIC or the ACCC, be given specific legislative responsibility for maintaining and supervising competition in Australia’s FMI.
Guidance and recommendations from the Council of Financial Regulators
To facilitate competition from international participants, the CFR has provided guidance of its expectations for international participation in Australia’s FMI.45 That guidance seeks to retain appropriate oversight, particularly for clearing and settlement facilities. Where FMI is systemically important and highly connected to domestic service provision, ‘regulatory influence requirements’ apply to ensure critical elements of infrastructure are located in Australia and subject to local regulation.
Further, the guidance imposes liquidity requirements on operators to ensure that, if a crisis occurs, a central counterparty, even one offering services from overseas, would have sufficient liquidity to meet its Australian obligations.46 Foreign and domestic central counterparties will be required to manage their Australian dollar liquidity using an RBA Exchange Settlement Account. They must maintain sufficient assets in Australia, which would be eligible to enter into repurchase arrangements with the RBA to obtain liquidity. Other elements of the guidance address legal incorporation, governance arrangements and some location requirements for critical infrastructure.
The CFR has also made recommendations to strengthen Australia’s FMI regulatory architecture and tools. This was done at the request of the Government following the rejection of the merger proposal between the ASX and the Singapore stock exchange.47 The suggested reforms included:
- New powers to require systemically important market infrastructures to have aspects of their operations located in Australia, when the conditions set out in the CFR’s regulatory influence framework are met
- New powers to ensure FMIs are overseen by ‘fit and proper’ persons
- Increased power for regulators to intervene if infrastructure experiences substantial difficulties
- New resolution processes48
The Inquiry understands that CFR agencies have developed a set of legislative proposals to address these reforms.
Implementing the CFR recommendations for FMI and changes to market licensing would provide greater certainty to existing and future FMI operators. It would create a framework under which competition and international financial integration could be increased. The CFR proposals would also promote improved stability, as discussed in the Stability chapter.
42 Bowen, C (Minister for Financial Services, Superannuation and Corporate Law) 2009, Reforms to the supervision of Australia’s financial markets, media release no. 013, 24 August, Canberra.
43 Council of Financial Regulators 2012, Competition in Clearing Australian Cash Equities: Conclusions, December.
44 For example, see: Asian Development Bank 2008, Emerging Asian Regionalism, Chapter 4: Integrating Financial Markets, Philippines.
45 Council of Financial Regulators 2014, Application of the Regulatory Influence Framework for Cross-border Central Counterparties, March.
46 Heller, D and Vause, N 2012, ‘Collateral requirements for mandatory central clearing of over-the-counter derivatives’, BIS Working Papers No 373, March.
47 Council of Financial Regulators 2011, Review of Financial Market Infrastructure Regulation: Consultation Paper, October.
48 Stevens, G 2012, Review of Financial Market Infrastructure Regulation, letter to the Deputy Prime Minister and Treasury, Reserve Bank of Australia, Sydney, 10 February, viewed 23 June 2014.