When does the single-sided OTC derivatives reporting exemption apply?

By John Bassilios and Max Ding

The Derivative Transaction Rules (Reporting) 2022 is an ASIC-made legislative instrument that imposes reporting requirements on certain ‘reporting entities’ in relation to certain over-the-counter (OTC) derivatives transactions entered into by those entities, including credit derivatives, foreign exchange derivatives, and interest rate derivatives.

Importantly, the reporting entities captured by the rules include many Australian financial services (AFS) licensees which have entered into OTC derivatives transactions, including AFS licensees that act as the trustee or responsible entity of a managed investment scheme and enter into OTC derivatives on behalf of the funds they manage for hedging purposes.

The current Derivative Transaction Rules is a remaking of the ASIC Derivative Transaction Rules (Reporting) 2013 (2013 Rules) in the same form. Under the 2013 Rules, reporting entities such as trustees and fund managers who used OTC derivatives as part of their funds were able to rely on a ‘single-sided reporting exemption’ to be exempted from reporting, subject to certain conditions, including the counterparty to the derivative transaction being required to report the transaction.

However, an apparent drafting error in the Corporations Regulations 2001 (Cth) resulting from the introduction of the Derivative Transaction Rules (Reporting) 2022 has cast doubt on whether the single-sided reporting exemption continues to apply. This is compounded by the unnecessary complexity in structure and drafting of the rules generally, resulting in uncertainty in the application of the rules for stakeholders such as trustees and fund managers.

The complexity in the structure and drafting of these rules illustrates the problems with the current financial services legislation as identified in the recent report by the Australian Law Reform Commission (ALRC) recommending reforms to the financial services laws.

We discuss the ALRC’s report in more detail in our other article in this issue of Fundamental: ALRC says financial services laws are ripe for reform.

Single-sided reporting exemption

The single-sided reporting exemption is set out in subdivision 2.1B of Pt 7.5A of the Corporations Regulations, which provides an exemption from the derivatives reporting requirements under the 2013 Rules, where:

1. the entity is a phase 3 reporting entity (the derivative transaction reporting rules, when first introduced in 2013, applied the new reporting obligations to different types of entities in different phases. A phase 3 entity generally means a reporting entity whose obligations to report under the new derivative transaction reporting rules commenced after 31 December 2013 because it held less than A$50 billion of outstanding derivatives positions at that date);
2. the entity’s total gross notional outstanding positions in derivatives does not exceed A$5 billion on each of the two recent quarter-end days;
3. the entity’s counterparty in the derivative transaction has represented to the entity that it is an ASIC reporting entity required to report the transaction under the Reporting Rules;
4. the entity makes regular enquiries reasonably designed to determine whether the representation is correct; and
5. the entity has no reason to suspect that the representation is incorrect.

The single-sided reporting exemption under the current regulations is specifically stated to apply to the 2013 rules, which has been repealed and replaced with ASIC Derivative Transaction Rules (Reporting) 2022 in the same form.

Despite this, subdivision 2.1B of Pt 7.5A of the Corporations Regulations has not been updated to explicitly apply the single-sided reporting exemption to the 2022 rules and is currently drafted to continue applying to the 2013 rules. In our view, the intention in the Corporations Regulations is for the single-sided reporting exemption to continue to apply to the 2022 rules, as the single-sided exemption hasn’t been repealed, and because the 2022 rules are a remaking of the 2013 rules in the same form.

Nevertheless, this creates uncertainty as to whether the single-sided reporting exemption continues to apply.

ASIC’s Regulatory Guide 251 on the Derivative Transaction Rules is unhelpful in this regard and does not mention the single-sided reporting exemption other than a note which states that Government, as of 2014, is considering implementing the single-sided reporting relief (see RG 251.39 of the Regulatory Guide). This note appears to be outdated, despite the regulatory guide being last updated in February 2023, as the single-sided reporting exemption has since been implemented into the Corporations Regulations.

Other exemptions to the Derivative Transaction Rules

There are also several other exemptions to the reporting requirements of the Derivative Transaction Rules set out within the rules, as well as the Corporations Regulations, which may be relied on by fund managers.

A ‘delegation’ exemption is set out in rule 2.2.7 of the Derivative Transaction Rules, which allows a reporting entity to appoint another person to report on its behalf (such as a counterparty), while remaining responsible for taking all reasonable steps to ensure the completeness, accuracy and currency of the information reported by the other person (rule 2.2.6). The terms of this appointment must be documented in writing, and the reporting entity must make regular enquiries designed to determine whether the appointed delegate is discharging its obligations under the terms of its appointment. This would take the form of a special condition in an ISDA Agreement and requires buy in from the counterparty.

Moreover, regulation 7.5A.50 of the Corporations Regulations also provides an ‘end user’ exemption, which provides that ‘the class of persons on whom the derivative transaction rules cannot impose requirements consists of end users’.

An end user is defined under regulation 7.5A.50 as a person who is not:

1. an Australian authorised deposit-taking institution; or
2. a clearing and settlement facility licensee; or
3. a financial services licensee; or
4. a person:
   1. who, in this jurisdiction, provides financial services relating to derivatives to wholesale clients only; and
   2. whose activities, relating to derivatives, are regulated by an overseas regulatory authority.

Regulation 7.5A.50(2A) provides that the derivative transaction rules cannot impose requirements relating to a class of derivatives on financial services licensees:

1. who are taken not to be end users only because they are a financial service licensee; and
2. whose Australian financial services licenses do not authorise them to provide financial services in relation to that class of derivatives.

The effect of the end user exemption on AFS licensees is that the Derivative Transaction Rules only apply to AFS licensees who are authorised under their AFSL to provide financial services in relation to the class of derivatives they are a counterparty to.

Given the uncertainty of the application of the single-sided reporting exemption, reporting entities, including trustees and fund managers to which the Derivative Transaction Rules apply, and who do not wish to report derivative transactions themselves, may therefore be better advised to rely on the delegation exemption under rule 2.2.7 of the Derivative Transaction Rules for greater certainty, or consider whether the ‘end user’ exemption applies to them by reviewing the authorisations under their AFSL.

Unnecessary complexity in Derivative Transaction Rules

The uncertainty created by the application of the single-sided reporting exemption is illustrative of, and compounded by, the unnecessary complexity in the structure and drafting of the Derivative Transaction Rules

This complexity can be seen in attempting to determine which derivatives are captured by the rules and which reporting entities the rules apply to in the first instance.

The source of the Derivative Transaction Rules arises out of section 901A and 901B of the Corporations Act 2001 (Cth), where section 901A provides that ASIC is responsible for making and enforcing derivative transaction rules, including those that apply to the reporting of derivative transactions, and section 901B provides that the Minister has the power to determine one or more classes of derivatives for which reporting requirements may be imposed.

The Corporations (Derivatives) Determination 2013 (Ministerial determination) made on 2 May 2013 empowers ASIC to make rules imposing reporting requirements for credit derivatives, equity derivatives, foreign exchange derivatives, interest rate derivatives and commodity derivatives that are not electricity derivatives.

Therefore, although the prescribed classes of derivatives that are subject to reporting rules are determined under a Ministerial determination, the substance of the rules that apply to those prescribed classes, including the rules concerning which reporting entities those rules apply to, must be found in a separate legislative instrument, being the Derivative Transaction Rules (Reporting) 2022.

The reporting entities to which the Derivative Transaction Rules apply are set out in rule 1.2.5 of the rules and includes any Australian entity (being an entity incorporated or formed in Australia) which is a counterparty to an OTC derivative.

Although Rule 1.2.5 appears broad in its application to ‘any’ Australian entity, practically it does not apply to all Australian entities due to the operation of the ‘end user’ exemption in regulation 7.5A.50 of the Corporations Regulations as discussed above. The effect of the operation of the ‘end user’ exemption is that the Derivative Transaction Rules do not apply to ‘any’ Australian entity, but only those Australian entities that are not ‘end users’, such as an Australian ADI or an AFS licensee that is authorised under its license to deal in the class of derivatives in question.

In summary, in determining how the Derivative Transaction Rules applies to any given entity, a user must, at a minimum, navigate the Corporations Act, the Corporations Regulations, a Ministerial Determination and an ASIC instrument. An AFS licensee must also look to their own license to determine whether they are authorised to provide financial services in relation to the class of derivatives they are a counterparty to.

ASIC has also issued a number of instruments granting relief to reporting entities, in addition to the general exemptions to the Derivative Transaction Rules set out in the rules themselves, as well as the Corporations Regulations discussed above. Therefore, an entity will also need to check whether any of these other exemptions also apply.

The difficulty in the structure of the Derivative Transaction Rules and the apparent error in the drafting of the single-sided reporting exemption may be seen to be symptomatic of a broader issue of unnecessary complexity in financial services legislation in general, as identified by the ALRC in its recent report on recommendations to reform financial services laws.

You can read about the ALRC’s report in more detail in our further article in this issue of Fundamental: ALRC says financial services laws are ripe for reform.

For more information reach out to John Bassilios, Max Ding or a member of the HW Funds Team.