Regulation and Regulatory Recognition of Over the Counter Markets – Swaps Execution Facilities (SEFs) and Multilateral Trading Facilities (MTFs)

The regulation of capital and financial markets, including of operators and participants, is a sovereign prerogative. Each nation sets their own regulations and standards about who can operate in its jurisdiction(s) and what products and services can be offered to its citizens.

In certain circumstances, nations may delegate the oversight and regulation of markets and investors in their jurisdiction to other nations or supra-national organizations. Reasons for such delegation may include specific market policy and efficiency objectives or broader political objectives. The most obvious example of such delegation of market regulation is the European Union which regulates financial markets of Euro-nations within the Euro-zone.

Despite the system of national financial market regulations, it is generally recognised that capital and financial markets are global, and as such benefit from reduced barriers to trade and movement.

These two objectives, national sovereignty and freedom of capital movement, are in some respect in conflict. But conceding the need to achieve pragmatic trade-offs, nations have worked to develop local regulatory systems based on common principles and mechanisms to recognize similar quality regulatory regimes of other jurisdictions.

With respect to the regulation of market infrastructure and market operators, the general policy principles are based upon the work of the International Organization of Securities Commissions (IOSCO). IOSCO is the International Organization of Securities Commissions and is the international associations of national capital and financial market regulators. Its members are typically primary securities and/or futures regulators in a national jurisdiction or the main financial regulator from each country. IOSCO has members from over 100 different countries and include ASIC, SEC and CFTC (USA), FSA (UK), Securities and Futures Commission of Hong Kong and the Monetary Authority of Singapore.

Each nation has its own laws, rules and regulations, but generally, the regulation of financial and capital markets of IOSCO of member countries is founded upon IOSCO’s Objectives and Principles of Securities Regulation. Factors like fair, orderly, transparent and efficient plus necessary resources, human, financial and technological emanate from these objectives and principles and from there, different jurisdiction have applied them in their own way, and emphasized different parts per their local conditions and requirements

However, within this are 3 notable objectives:

• The protection of investors;
• Ensuring that markets are fair, efficient and transparent; and
• The reduction of systemic risk

Flowing from the objectives are 30 principles related to factors including:

1. The Regulator
2. Self-Regulation
3. Enforcement of Securities Regulation
4. Cooperation in Regulation
5. Issuers
6. Collective Investment Schemes
7. Market Intermediaries
8. Secondary Markets (market operators)

When assessing whether a market infrastructure operator can operate in particular jurisdiction, it is assessed against these objectives and principles. However, when assessing whether a market infrastructure operator, licenced in one jurisdiction can operate in another, its home regulator and regulations are assessed against the foreign ones. Basically, before permitting a foreign operator into its jurisdiction, local authorities will first assess the quality of the foreign authorities

It is possible, and in fact likely, that the regulatory regime of one jurisdiction is not recognised by the other.

Consequentially, if the market infrastructure operator wants to operate in a different jurisdiction, it must ether satisfy the foreign regulator as to the quality of the home regime or alternatively, it must seek to be additionally licenced and regulated in the foreign regime. With this latter option, being actively licenced in multiple jurisdictions, the operator must accordingly manage the associated cost and complexity of being licenced.

Clearly the best means to reduce regulatory barriers to capital mobility would be for regulators to assess and recognize the regimes of other regulators. However, in a world of different political regimes, different legal regimes and finite resources, this is not a practical option. Prioritization needs to guide recognition and as such, a system based on realpolitik has emerged.

In this system, the size of an economy and capital market takes precedence over the quality of a regulatory regime. Thus, large markets such as the US and Europe are often seen as the standard setters to which others need to comply. This does not mean that US and/or European regulatory systems are superior, but as with most issues in global affairs, size matters.

Australia’s marker regulations and regulators are generally well regarded. As leading member of IOSCO and also a mid-power member of the G20, Australian licenced entities can generally benefit from the Australia’s regulatory halo. As testament to its regard, ASIC has numerous memoranda of understanding (MOU) with other national regulators. These MOUs can range from basic information sharing to bi-lateral recognition of regulatory systems and quality. For example, ASIC entered into an MOU with the CFTC in 2014 for the Cooperation and Exchange of Information Related to the Supervision of Cross-Border Covered Entities.

In addition to the MOUs, Australian licenced entities are often well received in other jurisdictions, not only because of the regulatory regime, but also because of the general openness of Australia to foreign entrants and because of the quality of Australia’s legal system. In particular with regard to property rights and low sovereign risk. Such recognition is also recognised through the multiple and various free-trade agreements Australia has entered into with other nations and supra-nations; some of which specifically provide for the mutual recognition of financial and capital market regulatory regimes. For example, the Australia-United States of America Free Trade Agreement provides specifically for a non-discriminatory environment with regard to financial services. Notable, this free trade agreement deals with cross-border trade in financial services by service suppliers of the other country.

The welcoming of Australian licenced entities in other jurisdictions also a reciprocal of the welcoming of certain foreign licenced entities into Australia. The Australian financial market infrastructure regime has long provided for the concept of “foreign” licences whereby ASIC can authorize an overseas licenced market infrastructure operator in Australia if its home regulatory regime is sufficiently robust. In its Regulatory Guide 172 Financial markets: Domestic and overseas operators, ASIC states that it has an alternative licensing route, a “route for overseas market venues is intended to facilitate competition and avoid regulatory duplication while maintaining investor protection and market integrity”. It is through this regime that the large international derivatives exchanges (specifically CME, ICE, Eurex) have obtained authority to operate in Australia.

In assessing whether to grant recognition to an overseas regulatory regime, ASIC gives consideration to the equivalence of the foreign regime to the Australian regime. Specifically, ASIC will consider whether the regime:

• Is clear, transparent and certain;
• Is internationally consistent (based on IOSCO principles);
• Is adequately enforced in the home jurisdiction;
• Has the same regulatory outcomes; and
• Has adequate cooperation arrangements.

Similarly, US CFTC has a similar concept of a Foreign Board of Trade (FBOT) as a means to authorize non-US derivatives exchanges to operate in the US.

This system of regulator and market infrastructure operator recognition generally worked well as it was originally designed for large traditional exchanges. However, post 2008, a new system of recognition was necessitated flowing from the G20 decisions around the reform of OTC markets.

The Financial Stability Board (FSB) was established out of this G20 meeting which agreed to implement a number of OTC market reforms. These reforms included the electronic trading, central clearing and central recording of OTC trades. From this, new types of entities emerged and with them new regulatory regimes:

• Swaps Execution Facilities (SEFs) from US regulations (Dodd-Frank);
• Multilateral Trading Facilities (MTFs) from European regulations (MIFID I and MIFID II); and
• OTC trade repositories.

It is worth noting that, depending on the outcomes of Brexit negotiations, there may be another major European financial services regime for the United Kingdom.

Australia had a regulatory regime licencing OTC market operators before the G20 meeting, being the existing market license regime, so no specific legislation regulation was necessary for Australia to implement licencing of OTC market operators. Yieldbroker received the first market license for an OTC platform in February 2004 and Mercari received the second in May 2005. Although Yieldbroker was first, it was initially limited to a bond trading and distribution platform. Mercari was Australia’s and possibly the world’s first licenced electronic OTC derivatives trading platform.

Since the 2008 G20 meeting, most countries have implemented regulatory regimes for electronic OTC trading venue. These can be seen on page 62 of the FSB OTC Derivatives Market Reforms - Twelfth Progress Report. Notably Australia’s progress and Mercari licencing are recognised.

Although individual jurisdiction progress on OTC market infrastructure has been achieved, cross- border recognition is in its very early days. Because OTC trading venues are a new type of infrastructure, the tradition exchange pathways have not generally been applied.

When it comes to recognition of 3rd country regulatory equivalence regimes, the US has developed one; with the Australian regime known as Qualified Australian Licensed Market (QALM), Europe does not (yet) have regime per se. Rather they have a set of arrangements varying across the different pieces of legislation, where no arrangement is identical.

The Australian regulatory regime and regulators are clearly well regarded internationally. Coupled with existing recognition and information sharing MOUs between ASIC and other national regulators and the various free trade agreements Australia has entered into, this allows Australian domiciled and regulated entities, such as Mercari, opportunities and advantages to operate in other major capital market jurisdictions.