Topic 4: Regulation, documentation

and tax
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 Topic 4: Regulation, documentation and tax

Tier 1 Derivatives

Contents
Overview ........................................................................................................... 4.3
Topic learning outcomes ............................................................................................ 4.3

1 Supervision of derivatives trading ........................................................... 4.4

1.1 ASIC as market supervisor for financial markets ........................................... 4.4
1.2 ASX 24 Operating Rules .................................................................................. 4.4
1.3 Contract specifications and associated rules ................................................. 4.5
1.4 Market Integrity Rules (ASX 24 market)......................................................... 4.5
1.5 ASX 24 trading participants ............................................................................ 4.5
1.6 Client agreement and trading behaviour of participants .............................. 4.6 4
1.7 Discipline of participants, penalties and code of behaviour .......................... 4.7
1.8 Trading on ASX 24 .......................................................................................... 4.8
1.9 The role of an exchange clearing house......................................................... 4.9
1.10 ASX Clear (Futures) ......................................................................................... 4.9
1.11 Initial margins ............................................................................................... 4.11
1.12 Variation margins ......................................................................................... 4.11
1.13 The SPAN margining system ........................................................................ 4.12

2 Conduct of derivatives business ............................................................ 4.13

2.1 Confirmation of trades ................................................................................. 4.13
2.2 Introducing a client to the market ............................................................... 4.14
2.3 Accounts and audit....................................................................................... 4.15
2.4 Compensation arrangements....................................................................... 4.15
2.5 Offence provisions ....................................................................................... 4.16
2.6 Trading requirements................................................................................... 4.16

3 The OTC market .................................................................................... 4.17

3.1 OTC documentation ..................................................................................... 4.17
3.2 Processing derivative transactions............................................................... 4.19
3.3 Back office (operations) ............................................................................... 4.20
3.4 Middle office ................................................................................................ 4.22
3.5 Self-regulation .............................................................................................. 4.22

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4 Taxation issues to consider for derivatives ............................................ 4.23

Key points........................................................................................................ 4.25

Review questions ............................................................................................. 4.26

Suggested answers........................................................................................... 4.26

References ....................................................................................................... 4.26

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 Topic 4: Regulation, documentation and tax

Overview
This topic examines regulations, market supervision and taxation considerations in
relation to derivatives. It also looks at two aspects of derivatives — clearing and
settlement — including documentation and the operation of exchange clearing houses
and their use of initial and variation margins to manage risk.
The topic outlines the processes involved in the settlement of over-the-counter (OTC)
derivatives transactions. Sound legal documentation is critical for participants in
financial markets, especially in the case of OTC derivatives, which typically are not
centrally cleared like exchange-traded derivatives. The protection afforded by legally
enforceable documentation and efficient processes for confirmation and collateral
management are paramount.

Topic learning outcomes

On completing this topic, students should be able to:
• define what ASX 24 Operating Rules involve
• explain the difference between the two different types of ASX 24 participants
• explain the general role of a clearing house and the key functions of
ASX Clear (Futures)
• identify different types of margins in futures trading and the function of margin calls
4
• understand the key obligations when conducting a derivatives business
• understand the requirements for OTC transaction documentation
• explain the functions and purpose of front office, middle office and back
office operations
• understand the taxation issues to be considered when dealing with derivatives.

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1 Supervision of derivatives trading

The rules of the exchanges and clearing houses within the ASX Group (that is, the ASX,
ASX 24, ASX Clear and ASX Clear (Futures) Operating Rules) serve to regulate the
behaviour of participants in their relationships with the exchange, with other
participants and, especially, with clients. The rules set out the terms of the contracts
traded on the markets operated by ASX 24 or the ASX.
The ASX and ASX 24 supervise the market behaviour of the participants. The Australian
Securities & Investments Commission (ASIC) regulates trading and market integrity.
There are a number of futures and options contracts traded on the ASX and ASX 24.
For the sake of simplicity, this section discusses the compliance obligations governing
activities on ASX 24, as this is where the futures business is transacted. Many of the
requirements are similar to those that apply to securities trading.

1.1 ASIC as market supervisor for financial markets

In a statement released on 24 August 2009, the federal government announced that
ASIC would assume responsibility for supervising brokers who trade listed and unlisted
securities in financial markets. ASIC would supervise real-time trading on all of
Australia’s domestic licensed financial markets, incorporating market surveillance and
participant supervision. This included brokers trading via the ASX and ASX 24 (previously
the Sydney Futures Exchange). These two markets were previously the domain of the
ASX’s market supervision arm.
The change was necessitated by the government’s decision to accept applications for
Australian market licences from entities seeking to set up rival exchanges. The government
fulfilled its aim for the handover and the transfer of supervisory responsibility for Australia's
domestic licensed financial markets. This took place on 1 August 2010.

1.2 ASX 24 Operating Rules

The ASX 24 Operating Rules contain:
• the key Rules regulating the admission and supervision of participants in ASX 24 markets
• information relating to the various derivative market contracts available for trading
on ASX 24
• the Trading Rules with which ASX trading participants must comply; including
procedures for orderly trading, the settlement of disputes, cancellations and
trading errors
• a structure for disciplining participants who breach ASX 24 Rules
• general rules; including the exercise of ASX powers; fees and charges relating to
trading done on ASX Trade24; compensation arrangements; and guidelines relating
to records, information, returns and recordings done by trading participants
• a framework setting out the rights and obligations of the various classes
of participants.

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1.3 Contract specifications and associated rules

The ASX 24 contract specifications and associated rules contain the rules that set out
the standardised futures contracts that are available on the ASX Trade24 platform.

1.4 Market Integrity Rules (ASX 24 market)

The market integrity rules (ASX 24 market), which are now set and monitored by ASIC,
apply to market operators, market participants and other prescribed entities.
The rules apply to:
• the activities or conduct of the market
• the activities or conduct of persons in relation to the market
• the activities or conduct of persons in relation to financial products traded
on the market.
The rules provide for matters, such as:
• prudent risk management procedures
• trading principles for orders entered on the market
• provision of data by the participant to assist with surveillance of activities and
conduct on the market 4
• capital, accounting, reporting, margin and disclosure requirements
• prohibitions on certain practices which prejudice a fair market
• penalties for breaches of the rules.

1.5 ASX 24 trading participants

ASX 24 has two categories of trading participation:
1. Trading participants who provide execution services for organisations and their
clients. A trading participant must be an ASX Clearing Participant for futures or have a
clearing agreement with a third-party clearing provider. Capital requirements may
apply.
2. Principal traders who can only trade for themselves. This class of participant has
direct access to the ASX 24 trading platforms. A principal trader must be an ASX
Clearing Participant for Futures or have a clearing agreement with a third-party
clearing provider. There are no capital requirements under the ASX 24 Operating
Rules for this category of trader.

Clearing participants
Participants of ASX 24’s clearing house (ASX Clear (Futures)) are known as clearing
participants and must also comply with the rules of ASX Clear (Futures), including a
requirement for minimum net tangible assets (NTA) of $5 million.

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Admission criteria
The rules provide ASX 24 with criteria for examining applicants for participant status.
ASX 24 may consider the business integrity, financial probity and standard of training
and experience of the applicant. The rules prohibit admission as a participant where any
individual associated with the participant has, within a period of five years before the
application, been declared bankrupt or has been convicted of an offence.

1.6 Client agreement and trading behaviour of participants

ASX 24 Operating Rules require that agreements between full participants and clients
contain certain minimum conditions. These include:
• the client and participant are to be governed by the Rules and the customs,
usages and practices of ASX 24 markets
• an obligation for the client to provide information
• provisions relating to margins
• client’s rights against the participant
• an agreement that telephone conversations will be recorded.
The trading behaviour required of participants dealing for clients includes the following:
• Participants must call from their clients (unless those clients are clearing participants
or a trade is allocated to another clearing participant to hold on behalf of the client)
the minimum initial margin on each contract, as set down by the clearing house.
• Participants must call margins from their clients when a client has a net debit margin
position, but have the discretion to call when the amount of the call is less than $1000.
• Where a client is in default by failing to pay a call (or lodge approved securities in lieu
thereof), a participant has the right to close out any or all of that client’s futures
market positions without further notice.
• Margins must be paid within 24 hours (48 hours for an overseas client).
• Instructions received from clients and orders for the participant’s own account are to
be executed in the sequence in which they are received, unless it would be fair and
equitable, as determined by ASX 24, to execute orders out of sequence. ASX
24 procedures give specific examples of the application of this rule.
• Participants must not engage in various practices such as:
– market manipulation
– misleading acts or practices
– entering orders without intent to trade.

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1.7 Discipline of participants, penalties and code of

behaviour

Discipline
Market integrity rules, which have been set and monitored by ASIC since 2010,
provide a structure for disciplining participants with respect to breaches of those rules.
These rules are designed to protect investors and other users of these markets.

The Markets Disciplinary Panel (MDP)

The Markets Disciplinary Panel (MDP) is a peer review body established by ASIC to make
decisions about disciplinary action for breaches of the market integrity rules. It took
effect on 1 August 2010. The panel members are people with appropriate market or
professional experience. The sitting panel, consisting of three members, is responsible
for issuing infringement notices or accepting enforceable undertakings for each alleged
breach.
Regulatory Guide 216: Markets Disciplinary Panel, should be read in conjunction with
Regulatory Guide 214: Guidance on ASIC market integrity rules for ASX and ASX 24
Market (RG 214) and RG 225: Markets Disciplinary Panel practices and procedures.
These guides outline ASIC's approach to the supervision of its market integrity rules for
4
the ASX and ASX 24 markets.
ASIC regulatory guides can be found at http://www.asic.gov.au —> Regulatory resources
—> find a document —> regulatory guides.

Penalties
There are a range of remedies for proven breaches of the market integrity rules.
They include civil penalties and other civil proceedings or infringement notices and
enforceable undertakings as an alternative to court action.

Civil penalties
Serious contraventions of the market integrity rules may result in the court ordering a
person to pay a financial penalty of up to $1 million to the Commonwealth.
Other civil proceedings for a breach of the market integrity rules include the payment of
compensation and publication orders.

Infringement notices and enforceable undertakings

As an alternative to civil proceedings, the regulations can require a person who has
contravened a market integrity rule to pay a penalty to the Commonwealth, undertake
or institute remedial measures (e.g. education programs), accept sanctions other than
payment of a penalty or enter into a legally enforceable undertaking.

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Code of behaviour
The rules set down minimum standards of behaviour for participants. For example, trading
participants are obligated to:
• comply with the ASIC market integrity rules and ASX 24 operating rules
• notify ASIC or the ASX of breaches, depending on the nature of the breach
• notify ASIC or the ASX of any regulatory action against the participant
• undertake prudent risk management
• comply with margin requirements
• meet order and client record-keeping requirements.

1.8 Trading on ASX 24

Access to trade futures on ASX 24 is through established broker networks. A number of
futures brokers are able to offer online trading access to their clients. Clients must enter
into client agreements with brokers. They must also establish clearing arrangements
with a clearer.
ASX 24’s electronic trading system, ASX Trade24, operates 24 hours a day, enabling
market participants to effectively manage their exposure to global market developments
around the clock. Liquidity is further enhanced by the night session that spans the US
trading day, which currently represents around 20% of ASX 24’s total volume.
ASX Trade24 operates in a similar fashion to most electronic screen dealing systems by
matching buy and sell orders that are entered by market participants. ASX Trade24
matches orders on a price and time priority basis. This means that the highest buy price
(bid) and the lowest sell price (offer) are given priority. The time that the order is
entered into the system is also taken into account. The first participant to enter the
price has priority over other participants should bid or offer prices be identical. When a
bid price is identical to an offer price, ASX Trade24 automatically matches the two prices
together and a trade occurs. The volume of contracts traded will be equal to the volume
attached to the bid and offer.

Example: Matching of buy and sell orders

If a trader wishes to sell 100 contracts at a price of $97.00, and there is a
bid in the market of $97.00 for just 25 contracts, ASX Trade24 automatically
registers a trade of 25 contracts at $97.00, with the balance of 75 contracts
being offered staying on the screen. This could be matched against other
bids at $97.00 that are entered into ASX Trade24 at a later time, or the
trader could decide to alter their dealing price down, or cancel the order
entirely should no buyers be available.

Execution brokers and clearing brokers

To trade ASX 24 futures and options, people must buy and sell through brokerage firms
that are ASX 24 trading participants. The broker then executes the order through the
ASX Trade24 system. Orders for execution on ASX Trade24 can be relayed by telephone
or by electronic order entry systems provided to clients by ASX 24 trading participants.

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1.9 The role of an exchange clearing house

The existence of an efficient and financially sound clearing organisation is a prerequisite
for the successful operation of any futures market.
Clearing houses provide the fundamental financial integrity to futures markets
by allowing participants to deal freely without credit risk constraints. Through the
collection of initial margins and variation margins (daily settlements), clearing houses
provide the framework for market participants to be confident that the financial
obligations arising from their transactions will be honoured.
Unlike derivative products traded in OTC markets (that often do not have any formalised
margining system) the margining regime adopted by exchange clearing houses is well
established and strictly enforced. It prevents participants from accumulating large
unpaid losses that could threaten the financial position of other market users.
Such is the success of the clearing house model that global regulators have begun to
require central clearing for standardised OTC derivatives, such as credit default swaps.
This is through legislation such as the Dodd-Frank reforms in the US.
On 12 December 2014, the federal government announced that it would mandate
central clearing of OTC interest rate derivatives denominated in Australian dollars and
four global currencies for the major domestic and foreign banks.
This brings Australia into line with other countries in implementing reforms, agreed by 4
the G20 in the aftermath of the global financial crisis.
The intention of this initiative is that it will serve to improve the transparency of the OTC
market and better alert regulators and market participants alike to any problems arising
from the potential default on an OTC derivatives position.
Public consultation on this initiative took place in 2015.
In 2012, ASX launched a clearing service for OTC equity options for ASX participants.
ASX also offers an OTC Interest Rate Derivatives Clearing Service, which was launched on
1 July 2013.

1.10 ASX Clear (Futures)

ASX Clear (Futures) has full responsibility for the registration, clearing and processing of
all trades executed on ASX 24.
The operation of ASX Clear (Futures) is crucial to the operation of the Australian futures
market and provides the basis for its financial integrity. Participation is open to
corporations that satisfy the clearing house admission requirements.

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Functions of ASX Clear (Futures)

The key functions of ASX Clear (Futures) are:
• To confirm and register all trades. Whenever a deal is concluded, a record is passed
to ASX Clear (Futures), where it is processed. The following morning a statement is
issued to the clearing participant describing the trades registered in their name.
• Novation. After the futures contract is registered by ASX Clear (Futures)
(in the names of the two clearing participants) the nexus between the two original
contracting parties is broken. ASX Clear (Futures) then becomes the buyer to the
seller, and the seller to the buyer. The identity of the other party to a futures
contract is no longer of importance, nor are parties to an original contract obliged to
return to each other to complete or unwind the contract.
• Set and collect margins. ASX Clear (Futures) can guarantee the payment of any
profits made on futures contracts and ensure delivery where contracts are held to
maturity. This is because of the system of initial and variation margins (daily
settlements) it imposes, as well as ASX Clear (Futures)’s substantial financial backing.
• Monitor clearing participants’ positions. In protecting its guarantee, ASX Clear
(Futures) monitors the size of each participant’s position relative to the overall
market. It also assesses each clearing participant’s ability to give or take delivery
when contracts approach the maturing month.
• Facilitate delivery or cash settlement. At maturity of a futures contract, clearing
participants with open sold or bought contracts are obliged, through the ASX 24
Operating Rules and ASX Clear (Futures) Rules, to deliver or take delivery of the
specified commodity/financial instrument or, in those markets where no delivery
provision exists, to make cash settlement. It is at this point that ASX Clear (Futures)
connects the remaining parties.

Apply your knowledge 1: Key functions of ASX Clear (Futures)

Summarise the primary objective and key functions of ASX Clear (Futures).

Note: Students can access ‘Suggested answers’ for this activity at the end of this topic.

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1.11 Initial margins

Every trader in the futures market is required to post an initial margin for each contract
they trade. The amount of initial margin for each contract varies according to the price
volatility of the underlying asset, but is typically less than 10% of the notional value of
the derivatives contract. Interest rate futures contracts typically require a lower initial
margin (in terms of percentage of contract value) than equity or commodity-related
futures, owing to the lower volatility in interest rate markets.
This initial margin is returned when the contract is closed out or settled, whether by
delivery or cash settlement or by an opposite transaction on the futures market.
The initial margin should be thought of as a performance bond rather than a down
payment on the futures contract. Its function is to protect the clearing house and its
participants against the risk of non-payment of losses by a defaulting participant.
Refer to Table 1.

Table 1 ASX Clear (Futures) initial margin rates (as at 16 December 2014)
Initial margin Spread margin
Contract (price scanning range) (inter-month spread charge)

ASX SPI 200 Futures $6,000 $430

90-day bank-accepted bills $600 Tiered

30-day interbank cash rate $225 Tiered

4
3-year Government bonds $750 $260

10-year Government bonds $2400 $500

WA Wheat $350 $350

ASX SPI 200 Financials ex AREITS $5,500 $1,000

Futures

ASX SPI 200 VIX Futures $2,700 $2,000

Source: <http://www.asx.com.au/data/clearing/marginrates.pdf>.

1.12 Variation margins

In addition to the initial margins required to open positions, any adverse price
movements in the market must be covered daily by further payments known as
‘variation margins’. These ‘mark-to-market’ payments are designed to ensure market
users pay up any losses on their futures positions on a daily basis. By doing this,
no market user can accumulate large unpaid losses that they are eventually unable
to meet.
For example, a market user who has sold futures will be required to pay variation
margins to their broker, should the price of the contract subsequently rise, while
another user who has bought futures will likewise be required to pay variation margins if
the price of the futures contract falls.
Clearing participants acting on behalf of both themselves and their clients must meet
debit variation margins (daily settlements) promptly when called by the clearing house
on a daily basis. Under the mark-to-market system, unrealised profits on futures
contracts are also paid out to clearing participants as credit margins. Non-payment of
margins entitles a broker to close out a client’s position without notice.

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The following table gives an example of the workings of variation margins. Note that the
figures shown in Table 2 have been calculated using the underlying contract formula for
the 90-day bank bill futures contract. The example shows the variation margins that
would be paid and received on a sold (short) position of 100 contracts in the 90-day
bank bill futures contract.

Table 2 Variation margin – example

Date Price Position Settlement price Price movement Variation margin

Day 1 92.60 –100 92.55 –0.05 CR $11,890

Day 2 –100 92.64 +0.09 DR $21,403

Day 3 –100 92.59 –0.05 CR $11,892

Day 4 92.51 0 –0.08 CR $19,020

Buyers of futures options are not required to pay the entire premium of the option upfront.
Instead, they pay a proportion of the initial margin of the underlying futures contract when
the option contract is first opened. The option contract is then marked-to-market on a
daily basis. Although the full premium might not be posted to a selling clearing participant’s
account until the option position is closed out or expires unexercised, the seller will receive
a credit for any move in the market that results in a favourable move in the premium of
the option.
The option seller also pays an initial margin and has their contract marked-to-market on
a daily basis. As the risk of selling options is greater than buying options, the clearing
system used by ASX Clear (Futures) will require the option seller to post a level of margin
that reflects the risk on the options position. The system that ASX Clear (Futures) uses to
calculate the level of initial margins required to support a portfolio of futures and
options is known as SPAN. The basic principles of SPAN are discussed in the next section.

1.13 The SPAN margining system

ASX Clear (Futures) uses a margining system known as SPAN.
The SPAN, or Standard Portfolio Analysis of Risk, was originally developed by the
Chicago Mercantile Exchange in 1988. It has since become the most widely adopted
margining system in the international futures industry. It is used in every major
exchange and clearing house in the US, as well as many other exchanges throughout
Europe and the Asia-Pacific region.
SPAN adopts a portfolio-style approach to the margining of futures and options.
Unlike strategy-based systems that consider futures and options positions in isolation,
SPAN assesses what the risk on a portfolio will be given changes in futures prices and option
volatilities. In making calculations, SPAN subjects the portfolio to 16 different risk scenarios,
where futures prices and volatilities are modified to varying degrees and the resultant
highest margin liability is then used as the basis for determining initial margin levels.
These 16 scenarios form a ‘risk array’ that is calculated by ASX Clear (Futures) at the
close of trading on each business day.
It is important to note that the risk array is calculated from the perspective of a long
position; that is, having bought the instrument. When calculating the margin of a short
position, this array is multiplied by the appropriate negative number of contracts.

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The risk arrays are then applied to the selected portfolio of transactions with the
individual risk arrays being aggregated by scenario. The largest loss (represented by
a positive value) across the 16 scenarios becomes the SPAN margin for that portfolio.
This figure is known as the ‘scanning risk’, and forms the first and key element in the
initial margin calculation. This figure can then be adjusted for inter-month margins,
inter-commodity concessions and spot month isolations.

Advantages of SPAN
A major advantage of SPAN is the ability to recognise the unique risk characteristics of
options. As a result, ASX Clear (Futures) is able to offer reduced margins for offsetting
futures and options positions, as well as providing margining concessions on a wide
range of inter-commodity and inter-month spread positions.
By accurately matching initial margin levels to risk, SPAN ensures that ASX Clear
participants always lodge sufficient margins to support their positions. It also serves to
eliminate unnecessary over-margining.

2 Conduct of derivatives business

4

2.1 Confirmation of trades

Issue of contract notes

When a broker executes an order for a client, they are required to issue a contract note
or confirmation to their client detailing the trade. Under the provisions of the
Corporations Act 2001 (Cth) (Corporations Act), (s 1017F) a confirmation must be
provided to retail clients and must comply with the operating rules of the exchange
where the trade occurs. It should include details of:
• the date of the transaction
• a description of the transaction
• amounts paid or payable
• taxes.

Protection of client money

Where monies are paid to a licensee in connection with the provision of financial
services, the futures broker is required to maintain a client’s segregated account.
The provisions apply in relation to retail and wholesale clients.
Under these provisions, client monies must be paid into an account with an authorised
deposit-taking institution (ADI) designated as an account for the purposes of the
provisions. The Corporations Act makes it clear that monies deposited with a licensee
for derivatives trading may be used to meet margin obligations of clients generally,
rather than of the particular client who deposited the funds. This ensures that current
market financial arrangements for the margining of leveraged futures transactions can
continue. Money held in the account is held in trust for the client.

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Financial services licensees who are direct participants of a financial market such as ASX
24 may operate the designated account as either a trust account or a client’s segregated
account, in accordance with the rules of the relevant financial market. The monies can
only be used for the permitted purposes, including margin payments, payment of
brokerage and for permitted investments.
These provisions are designed to ensure that clients’ money is kept separate from the
licensee’s money; protected from use for purposes other than those intended; and that
clients receive priority in the event of insolvency.

Other provisions affecting conduct

There are a number of other provisions in the legislation relating to conduct relevant to
the futures industry. For example, there are restrictions on unsolicited product offerings
and prohibitions on unconscionable conduct by licensees.

2.2 Introducing a client to the market

The provisions of the Corporations Act and ASX 24 Rules are necessarily complicated in
some areas. However, it is possible to trace the purpose of the more significant
provisions by examining the steps involved in the introduction of a client to the market.
• Before becoming a client, they will be given disclosure documents and client
agreements to ensure they are fully aware of their obligations.
• The client will then sign a client agreement form, which ensures their rights and
obligations are clearly established and that any particular instructions are recorded.
• Any margin monies for (or on account of) trading must then be placed in a separate
designated ADI account that is kept for the monies of the licensee’s clients.
This ensures that client monies are not used for the broker’s dealings and it also
protects these monies from general creditors in insolvency. If monies are
misappropriated, that is, stolen from the account, then ASX 24’s fidelity fund or
other compensation arrangements are available, to specified limits.
• Contracts must be executed for the client in a fair manner, generally in the order in
which they are received and without the broker or other clients receiving an unfair
preference or advantage.
• The client must receive full information of their trading and financial position.
• If a client does have a legitimate dispute with a participant of ASX 24 that cannot be
resolved between the parties in accordance with the participant’s internal dispute
resolution procedures, it may be referred to the participant’s external dispute
resolution (EDR) scheme. From 1 November 2018, the Australian Financial
Complaints Authority (AFCA) (http://afc.org.au/about-afca/) replaced the Financial
Ombudsman Service (FOS), the Credit and Investments Ombudsman (CIO) and the
Superannuation Complaints Tribunal (SCT) to become the new external dispute
scheme dealing with financial system consumer complaints.
• In the interests of all participants in the market, the Corporations Act and ASX 24
Rules have provisions designed to ensure an orderly and fair market and to impose
appropriate penalties on those who do not comply. Both the Corporations Act and
ASX 24 Rules impose significant obligations on brokers with a view to protecting
clients in the areas of financial worth, auditing, record keeping and compliance
generally.

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2.3 Accounts and audit

The Corporations Act sets out the provisions relating to accounts and audit.

Accounts to be kept by a licensee

A licensee must keep accounts that correctly record and explain the transactions and
financial position of the financial services business and which can be conveniently and
properly audited. Under ASX 24 Operating Rules, all such records are subject to random
inspection by ASX 24’s compliance staff and outside accountants appointed by ASX 24.

Appointment of auditor by licensee

Within one month of obtaining a licence, a licensee must appoint an auditor who is
eligible in accordance with the provisions of the Corporations Act.

Licensee’s accounts
Every financial year, a licensee is required to prepare financial statements. In the case of
an individual, these must be lodged, together with the auditor’s statement, within two
months of the end of their financial year. In the case of a company, the period for 4
lodgement is three months from the end of the financial year.

Reporting requirements
Where a financial market such as ASX 24 becomes aware of certain matters about its
participants, it must make a report to ASIC. Reportable matters include:
• disciplinary action against a participant
• suspected significant breaches of the market’s Rules or of the Corporations Act
• matters adversely affecting the licensee’s ability to perform its obligations.

2.4 Compensation arrangements

The Corporations Act provides that a financial market, whose participants receive
money or property from retail clients (other than the ASX, which is subject to the
National Guarantee Fund (NGF)), must have arrangements to provide for compensation
in the event that losses arise from fraud (misappropriation or fraudulent misuse).
The compensation arrangements can take the form of a fidelity fund or other suitable
arrangements, such as insurance.
The arrangements need only apply to retail clients, although the market may choose to
extend them to other clients. The provisions only require the arrangements to
compensate for loss where the loss arises in relation to money deposited for the
purposes of trading on the particular market.

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2.5 Offence provisions

In addition to the above ongoing requirements, there are a number of offence
provisions designed to deter undesirable or fraudulent practices. Failure to comply with
the other requirements referred to above may be subject to penalties that are, in some
cases, substantial.
The offence provisions include the prohibition of:
• insider trading
• dishonest conduct
• trading intended to create an artificial price (market manipulation)
• false and misleading statements likely to induce persons to deal or to affect the price
• fraudulently inducing a person to deal in financial products
• misleading or deceptive conduct.

2.6 Trading requirements

Licensees are required by the Corporations Act to give priority to client orders.
The Corporations Regulations 2001 (Cth) specify particular requirements in this regard in
relation to financial markets. As permitted by the Corporations Regulations, ASX 24 Rules
allow orders received at about the same time to be allocated otherwise than in strict
sequence, provided that a fair, equitable and consistent method, as determined by ASX 24,
is used. Records must be kept for the receipt, transmission and execution of orders.
Certain dealings by (or with) employees of licensees are prohibited. Again, these provisions
are designed to ensure fair treatment of clients and to avoid conflicts of interest.

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3 The OTC market

In the OTC market, counterparties deal directly with each other. Generally, these
transactions are agreed over the telephone or by various electronic dealing systems.
The contractual agreements, which include the terms of the transactions, are totally
negotiable and are set out between the dealing counterparties. The agreements are
flexible and may be structured to exact requirements. There are many terms and
conditions that can be incorporated into such a derivative. This is in contrast to
contracts traded on exchanges, which are standardised. The ability of OTC markets to
tailor a product to a client’s needs, together with the increasing sophistication of users,
has seen these markets expand exponentially over recent years. Derivatives traded in
the OTC markets include:
• interest rate and cross-currency swaps
• interest rate caps, collars and floors
• forward rate agreements (FRAs)
• interest rate options and ‘swaptions’
• currency options
• credit derivatives
• equity swaps and options
• commodity forwards, swaps and options
• contracts for difference. 4

3.1 OTC documentation

Documentation
The spectacular expansion of the OTC markets led to the need for a streamlined legal
contractual environment; that is, a basis on which organisations can transact, or in other
words, a master agreement.
Before a trading/dealing relationship begins, the rights of each party in the event the
other party fails to meet its obligations under the transaction(s) must be set out;
for example, in the event of non-payment, liquidation and force majeure.
Legal documentation in the form of a master agreement sets out the legal rights and
obligations of both parties and the procedures that should be followed in the worst-case
scenario.
Master agreements often address the following issues:
• authority and capacity of both organisations to enter into the specified transactions
• events of default, and termination events
• definitions and terms used for confirmations
• payments-netting arrangements
• close-out netting (this is an important feature of the master agreement,
i.e. the ability to net outstanding obligations with a defaulting counterparty).

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International Swaps and Derivatives Association

The International Swaps and Derivatives Association (ISDA) is the global trade
association representing leading participants in the privately negotiated derivatives
industry, a business which includes interest rate, currency, commodity and equity
swaps, as well as related products such as caps, collars, floors and ‘swaptions’.
The ISDA was established to:
• promote practices conducive to the efficient conduct of the business of its members
in swaps and other derivatives, including the development and maintenance of
standard documentation for derivatives
• foster high standards of commercial honour and business conduct among its members
• create a forum for the discussion of issues of relevance to participants in derivatives
transactions and to cooperate with other organisations on issues of mutual concern,
in order to promote common interests
• advance international public understanding of derivatives
• inform its members of legislative and administrative developments affecting
participants in derivatives transactions; provide a forum for its members to examine
and review such developments; and to represent effectively the common interests of
its members before legislative and administrative bodies and international
quasi-public institutes, boards and other bodies
• encourage the development and maintenance of an efficient and productive market
for derivatives through action in furtherance of the foregoing purposes.
The ISDA 2002 Master Agreement is the recommended standard for global financial
markets. The ISDA Master Agreement is commonly used between counterparties dealing
in multiple transactions in multiple currencies.

Structure of the ISDA Master Agreement

There are several documents that together comprise a negotiated ISDA agreement:
the ‘Master Agreement’ (or the body), the ‘Schedule’ and the ‘Definitions’.
The Master Agreement contains standard wording with a number of elections, or
choices, that must be activated via the schedule. The definitions provide clear meanings
for the many words and terms used in documenting OTC derivatives.
Each transaction under the agreement is then supported by a ‘confirmation’ that
incorporates the definitions. Additional documents include the ‘credit support annex’
and the ‘investment manager supplement’.
Parties may incorporate a credit support annex to the ISDA Master Agreement where
collateral is required by one or both parties.
The executed ISDA Master Agreement should reflect the current relationship between the
parties and therefore may require updating or amendment from time to time.
Where there are inconsistencies between the master agreement and the schedule,
the schedule prevails. Where there is an inconsistency between the schedule and the
confirmation, the confirmation prevails.

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It is important that organisations have sound controls in place for master agreements;
for example:
• clear policies regarding the use of master agreements
• close monitoring of exceptions
• setting of priorities
• responsibility is clearly assigned with adequate resources.

Other master agreements

Other master agreements that are used in the OTC financial markets include:
• Public Securities Association/International Securities Market Association (PSA/ISMA),
for repurchase agreements
• International Foreign Exchange Master Agreement (IFEMA)
• International Currency Options Master Agreement (ICOM).
Organisations must have master agreements in place to ensure the best
possible protection.

3.2 Processing derivative transactions

The processes of structuring, pricing, hedging and trading derivatives are generally the 4
trading/risk management functions of the dealing room or front office.
Execution of a derivative product/transaction triggers a wide range of tasks related to
the ongoing management of the transaction over its life. These tasks are carried out by a
variety of different areas that support the front office. These can include the back office
(sometimes called operations or settlements), middle office, accounting and
reconciliation.
Front office tasks include:
• authority to trade the type of instrument is checked (i.e. eligible instrument list)
• credit limits are checked
• prices, terms and conditions are agreed
• transactions are executed
• deal tickets (manual or electronic) are prepared
• cash flow is monitored
• risk positions are monitored.
Middle office undertakes checking of:
• credit limits
• transaction details
• risk management (positions against limits)
• dealer profit and loss.
The back office provides support. The key roles of the back office are:
• recording
• confirmation
• settlement
• reconciliation.

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Other functions
Depending on the size and nature of an organisation, the operations department
(or back office) might be responsible for other functions, including:
• risk management
• documentation
• reporting
• systems
• staffing and resourcing.
All deals have common characteristics, including the requirement to be recorded in the
organisation’s system, inward and outward confirmation and settlement of one or more
cash flows. Strict control at each step of the processing chain is essential.

3.3 Back office (operations)

The back-office function encompasses the following range of activities.

Recording
Every deal executed by the front office must be recorded in the company’s systems.
This can be done by:
• a manual deal ticket used to support a data entry function
• a dealer manually entering details of the deal into a front-end system, or
• an electronic feed.

Dealing ticket
Deal information is recorded on a pre-numbered dealing slip. The slip is passed to the
back office for entry into the company’s system. On occasions, the back-office system
will complete certain details, such as standard settlement instructions, on the deal
before it goes to the next step.
For vanilla (that is, straightforward) transactions, very little intervention is required as
standard settlement instructions are automatically applied to the deal.
Where deals are entered into a system from a deal ticket prepared by a dealer, a check of
output versus source documentation is required to verify the accuracy of the data entry.

Real-time
Real-time deal capture is carried out by the dealer who executed the deal. Information is
keyed directly into a front-end system, allowing dealers access to real-time positions and
limited information. Dealers are prompted to provide any missing information, reducing
the likelihood of incomplete deals.

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Direct feed
Technology can allow direct feed of deal information into the company’s system on
execution of the transaction.

Confirmation of transactions
In the OTC markets, transactions may be entered into verbally, usually over the telephone
or via an electronic dealing system, and need to be confirmed. The trader will either
manually or electronically complete a deal slip from which the operations staff will
validate, confirm and process. Confirmation of the transaction is sent to the
counterparty/client, in written or electronic form, and represents the intention of the
parties that they are legally bound to the terms to which they have agreed. The
confirmation process is a vital control within treasury operations. Failure to effectively
confirm a transaction can lead to market, credit and settlement risks not being managed.
Typically, both parties will complete and send a confirmation to the other party for
verification. If a financial institution executes a transaction with a corporate
counterparty then, depending on the systems at the corporate level, the financial
institution may issue a confirmation in duplicate for the corporate to verify, sign and
return one copy. This process of issuing a confirmation in duplicate for the counterparty
to sign and return is also common between banks for more complex transactions.
4
Settlement of transactions
Once a transaction has been confirmed and processed, it awaits some form of settlement.
Settlement refers to a payment to be made to or received from another party in
settlement of the principal, interest or premium associated with the transaction.
Generally, these payments are made using electronic systems.
In most derivative transactions, settlement is for a net amount payable by one party only.
Where there are two-way flows (e.g. a cross-currency interest rate swap), then settlement
risk exists for the period between when this organisation releases its payment and the
time when irrevocable funds (or transfer of title) are received in return.

Clearing house confirmation and settlement

Some OTC derivative transactions can be recorded, confirmed and settled via a
clearing house.
ASX Clear and ASX Austraclear, for example, offer a wide range of clearing (ASX Clear)
and settlement (ASX Austraclear) services for a number of cash and derivative products.
These include matching interest rate swap and FRA confirmations and subsequent
settlement of the AUD leg of the cross-currency transaction.
In 2012, ASX launched a clearing service for OTC options for ASX participants.
Transactions are registered anonymously by the clearing house and do not require ISDA
documentation to be lodged. Contracts are cleared in the same way as regular ETOs.
In July 2013, ASX launched an OTC Interest Rate Derivatives Clearing Service.
On 12 December 2014, the federal government announced that it will mandate central
clearing of OTC interest rate derivatives denominated in Australian dollars and four
global currencies for the major domestic and foreign banks.

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This brings Australia into line with other countries in implementing reforms agreed by
the G20 in the aftermath of the global financial crisis.
Public consultation on these initiatives took place in 2015.

Reconciliation
The back office might be responsible for several reconciliation processes, including:
• cash position/daily liquidity
• rate sets
• nostros (accounts used for currency settlement)
• brokerage.

3.4 Middle office

The middle office function is important in that it has responsibility for monitoring the
risk of the trading activity. The middle office is independent of both front and back office
and therefore has no formal operational role in trading, confirmation, documentation or
settlement of transactions. The middle office may also be responsible for statutory and
management reporting.

3.5 Self-regulation
Industry bodies such as the Australian Financial Markets Association (AFMA), have done
much in the way of self-regulation of the financial markets and the establishment of
market conventions.
AFMA’s market committees produce industry-accepted standards of practice which
cover conventions, standards and procedures for a range of OTC products.

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4 Taxation issues to consider for derivatives

Unless licensed to do so, financial advisers should not give taxation advice.
They should, however, be aware of some of the taxation issues which may arise when
dealing with derivatives.
It pays to keep the taxation treatment of trading or investing in derivatives in mind as
taxation affects investors’ ultimate return on investment. Similarly, proper money and risk
management suited to each investor’s needs is essential to minimising losses and
maximising returns.
At present there is no single regime that consistently treats such gains and losses.
Rather, the taxation of these types of financial instruments often depends on the
taxpayer’s circumstances and purpose in using them.
It is beyond the scope of this course to provide a detailed explanation of taxation issues
that are relevant to trading or investing in derivatives. Always take taxation into
consideration when advising clients on derivatives.
Taxation issues will differ greatly from client to client. It is therefore important to discuss
the client’s taxation situation with them or with their accountant to ensure that any
advice given will not have adverse taxation implications.
When assessing a client’s situation, a financial adviser could ask such questions as:
• Is the client classified as a trader, speculator or hedger? 4
• Is a trade on revenue account or on capital account? In other words, has the business
made ordinary income in the course of its ordinary business, or has it made a capital
gain? More importantly, if a business has incurred expenses, are those costs a
deduction or part of the cost base for capital gains tax purposes?
• At what time is income derived and when can deductions be obtained? Because
businesses account for a financial year — usually ending 30 June and starting 1 July
— income and expenses related to one derivatives transaction may take place in
different financial years, which gives rise to many of the taxation law issues
associated with derivatives.
• Where an option or other hedging strategy is in place around the time a stock
goes ex-dividend, is the client in danger of not satisfying the 45-day holding period
rule and therefore disqualified from receiving the franking credits attached to
the dividend?
• Could the exercise of an option position crystallise a taxation event for the
underlying shareholding?
In general, a number of conventional rulings apply, although in some cases there may be
specific taxation rulings for a derivative.

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Conventional rulings include the following:

• Deductibility rules. Investors, who have borrowed to trade derivatives to produce
assessable income, may be able to claim interest on the borrowings as a
deductible expense.
• Capital gains or losses. Investors who are not considered traders may accrue capital
gains or losses when disposing of an asset which has been purchased as an
investment asset.
• Franking credit offset. Where a derivative has an entitlement to dividends, the
owner may be entitled to franking credits.
• Residency of the investor. Australian residents are taxed on worldwide assessable
income. Non-residents are usually only taxed on income sourced in Australia;
however, they may be exempt under double tax agreements.
• Tax avoidance and Part IVA. Any derivatives that are purchased with the objective of
reducing taxable income may be in breach of Part IVA of the Income Tax Assessment
Act 1936 (Cth). This is particularly applicable to planning that involves structured
financial products.
Any taxation issues involving derivatives must be referred to a specialist.

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Key points
• The ASX Operating Rules and ASX 24 Operating Rules address a range of issues that
govern how ASX Trading Participants and ASX 24 Trading Participants operate.
These include their access and conduct in trading markets provided by the ASX, and
their rights and responsibilities in connection to their dealings with their clients and
the ASX.
• ASX 24 has two categories of trading participation:
– Trading participants, who can trade both for themselves and for clients.
A trading participant must be a clearing participant or guaranteed by a clearing
participant.
– Principal traders, who can only trade for themselves.
• Participants of ASX 24’s clearing house (ASX Clear (Futures)) are known as
‘clearing participants’ and must also comply with the rules of ASX Clear (Futures).
• The ASX 24 Operating Rules also contain the key rules regulating the admission and
supervision of participants in ASX 24 markets and provide a structure for the
discipline of participants with respect to breaches of ASX 24 Rules.
• The ASIC market integrity rules (ASX 24 Market) set out ‘trading principles’ for
futures contracts traded on ASX 24.
• Clearing houses provide financial integrity to futures markets by allowing participants
to deal freely without credit risk constraints. ASX Clear (Futures) is a wholly owned
subsidiary of ASX 24 and is responsible for the registration, clearing and processing of 4
all trades executed on ASX 24.
• Each trader in the futures market is required to post initial margins for each contract
they trade to provide ASX Clear (Futures) and their participants with protection
against the risk of contract default caused by the non-payment of losses.
• Variation margins must be paid to cover any current unrealised losses made on a
futures or options contract.
• A margin call is an instruction requiring payment of a variation margin. Payments are
sought to cover unrealised losses, while positive variation margin payments reflect a
profit when price movements are favourable to the contract holder.
• For OTC derivatives trading, a master agreement is established. The agreement sets
out the legal rights and obligations of both parties, as well as the procedures that
should be followed in the worst-case scenario.
• The International Swaps and Derivatives Association (ISDA) is the global trade
association representing leading participants in the OTC derivatives industry.
The ISDA 2002 Master Agreement is the recommended global standard for global
financial markets, and is commonly used between dealing counterparties.
• The process of structuring, executing and settling derivatives transactions is shared
between front office, middle office and back office functions.
• The front office generally undertakes structuring, pricing, hedging and trading
functions.
• The middle office typically undertakes checking of credit limits, transaction details,
risk management and dealer profit and loss.
• The back office provides a support function with respect to recording, confirmation,
settlement and reconciliation.

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• Licensees must comply with ASIC and ASX 24 requirements in the areas of:
– disclosure
– confirmation of trades
– the protection of clients’ money
– introducing a client to the market
– transaction, client and financial record keeping
– compensation arrangements
– avoiding undesirable and fraudulent practices
– adhering to trading requirements.
• Financial advisers should only give taxation advice if they are licensed to do so.
• With respect to the use of derivatives, potential taxation issues include:
– whether the client is classified as a trader, hedger or speculator
– whether a trade is on revenue account or capital account
– the time when income is derived and whether (and when) deductions can be obtained
– whether a hedging strategy satisfies the 45-day holding period rule
– whether the exercising of an option position crystallises a taxation event for the
underlying shareholding.

Review questions
Students can access the ‘Review questions’ for this topic at KapLearn.

Suggested answers

Apply your knowledge 1: Key functions of ASX Clear (Futures)

The objective of clearing houses is to provide financial integrity to futures markets by
allowing participants to deal freely without credit risk constraints. The key function of
the clearing house is to provide, through the collection of initial margins and variation
margins (daily settlements), the framework whereby market participants can be
confident that the financial obligations arising from their transactions will be honoured.

References
ASX 2019, ASX Clear (Futures) Margin Parameters, viewed 3 April 2019,
<http://www.asx.com.au/data/clearing/marginrates.pdf>

Legislation
Corporations Act 2001 (Cth)

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