Submission to Issues Paper: Improving Australia’s ... equity...Submission to Issues Paper:...

Submission to Issues Paper:

Improving Australia’s Framework for Disclosure

of Equity Derivative Products

31 July 2009

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AFMA DISCLOSURE OF EQUITY DERIVATIVE PRODUCTS

TABLE OF CONTENTS

1. Summary & Introduction ..................................................... 2

2. Critical Framework Issues ................................................... 4

2.1 Is There a Market Failure? ........................................................... 4

2.2 Limited Relevance of the UK CFD Market Experience ....................... 5

2.3 Disclosure Exemption for Equity Derivatives Intermediaries ............. 6

2.4 Delta-adjusted Vs Nominal Reporting ............................................ 8

2.5 Type of Disclosure ...................................................................... 9

2.6 Regulators’ Ongoing Work on OTC Derivatives Market Structures .... 10

3. Answers to Issues Paper Questions ................................... 12

IP3.2 Types of Equity Derivative Instruments ..................................... 12

IP3.3 Trading Platform .................................................................... 13

IP3.4 Usage ................................................................................... 14

IP3.5 Historical Context ................................................................... 16

IP4.1 Cash Settlement and Disclosing Substantial Holding Provisions .... 18

IP5.1 Takeover Provisions ................................................................ 23

IP5.2 Tracing Notice Provisions ......................................................... 24

IP5.3 Director Disclosure Provisions .................................................. 26

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1. Summary & Introduction AFMA agrees with the key proposition that effective financial market regulation is of major importance to the fairness and integrity of Australian financial markets and the broader economy. AFMA is also keen to ensure that the efficiency of the equity derivatives market is maintained, so the provision of associated risk management and investment opportunities to investors is not curtailed or interrupted. Equity derivatives are not a substitute for shares on a systematic basis. The great bulk of equity derivatives transactions are not relevant to control or acquisition situations or a substantial interest. Any disclosure regime must be designed to meet the objectives of effective disclosure and, at the same time, avoid unintentionally obscuring relevant market information or causing harm to the equity derivatives market and the broader financial sector. Our summary views are:

• The Australian equity derivatives market is very different in scale and practice to the United Kingdom (UK) market and presents different regulatory issues.

• Regulation of control situations is the only policy basis for equity derivatives disclosure of the type contemplated in the Issues Paper.

• The existing equity derivatives disclosure regime is satisfactory, following the release of Guidance Note 20 by the Takeovers Panel in 2008.

• Reforms to OTC derivatives market infrastructure should be completed before assessing the need for equity derivatives disclosure reform.

• The stringent disclosure regime being assessed in the Issues Paper would be expensive to implement and especially difficult at a time when the regulatory burden on market participants is growing substantially.

• An effective exemption for intermediaries (most notably market makers) would be a critical component of a new derivatives disclosure regime, if the transparency and efficiency objectives of regulation are to be met.

• The disclosure rules must be clear that the disclosure obligation is placed on the client and not on the derivatives intermediary servicing the client.

• Any required disclosure of equity derivatives positions should be limited to disclosure of the number of relevant securities affected and the type of derivatives in question, given the cost and commercial issues involved.

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AFMA believes equity derivatives should not be used for the purpose of avoiding or undermining the objectives of Chapter 6 of the Corporations Act. We support the targeted measures taken by the Takeovers Panel in Guidance Note 20 to better inform the market and promote market integrity in this area. In his speech to the Confederation of British Industry and Australian Business in April 2008, the Prime Minister made it clear that the Government wants to ensure that Australia's regulatory regime does not impose an undue burden on market participants or inappropriate barriers to foreign equity investment in the Australian market. We agree with the Prime Minister that this approach is vital to the construction and maintenance of an effective regulatory regime. A regulatory obligation to disclose equity derivatives positions must address a particular mischief or market inefficiency that the market itself cannot address satisfactorily under its normal evolutionary momentum. In practice, this means that regulation must discriminate between different purposes in holding and trading equity derivatives. It is obvious from the Issues Paper that developments in the UK in particular have influenced official thinking about possible equity derivatives disclosure rules in Australia. While this is understandable as a starting point, an appropriate balance to regulation in Australia needs to be struck by reference to the characteristics of the Australian market, which are very different to those of the UK. Nonetheless, there are important lessons that we can learn from experiences in the UK and other markets. Compliance with the reporting regime being assessed in the Issues Paper would be expensive and time consuming. In a typical large bank or securities company, there is no one computer application which deals with all the relevant products and contains all the relevant information which would be required for reporting purposes. Amalgamating information across multiple products and systems, often in incompatible formats, will require several people, on a full time basis, to meet the proposed reporting requirements. This would occur at a time when the industry is already incurring the significant cost of implementing other regulatory measures and resources in the industry are constrained, as global firms endeavour to tighten their operations, which is in the interest of ongoing financial stability. Large foreign investors may choose to reduce their holdings in Australian financial products in order to avoid excessive reporting requirements. There is also a risk that the mandated provision of unclear or potentially misleading information to the market could be used mischievously by dishonest persons to manipulate market sentiment. An approach that does not better discern the real control of votes might be abused and impair market efficiency rather than improve it.

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2. Critical Framework Issues

2.1 Is There a Market Failure?

The Issues Paper does not present any form of systematic analysis to assess whether the equity derivatives disclosure in Australia is significantly deficient, or that a material market failure exists in this area. In keeping with the core principle of ‘Better Regulation’, this matter needs to be addressed before a conclusion can be drawn that there is a need for greater regulation. We understand that the Issues Paper asks questions that are intended to serve as initial building blocks for this analysis and are happy to contribute to your analysis and work in this area as it develops further. The Prime Minister, in his speech, made reference to concerns in the UK that the lack of an appropriate disclosure framework covering equity derivatives has:

i. Reduced transparency of ownership changes and takeover moves,

ii. Reduced the ability of companies to identify their effective owners,

iii. Enabled hedge funds to outflank traditional institutional investors by using economic interests to influence companies.

The Prime Minister stated that these concerns are mirrored in Australia. Accepting that the Government has been given cause to consider these concerns, the next step is to carefully examine the nature and validity of these concerns. For example, it is important to understand who has expressed concern about current disclosure rules and what in particular they are concerned about and also if this concern can be addressed in other ways that do not involve regulatory intervention. Critical analysis of this information would present a sound basis upon which to then determine if there is a real market failure or not. It would be particularly important to target regulation so it addresses valid concerns in an effective manner. The cost of not doing this basic policy analysis, or of getting it wrong, can be significant. For instance, AFMA is currently involved in consultations about disclosure and transparency of short selling transactions. It is clear to us that short selling policy was shaped in the early days by comments in the media about the damage to high profile companies caused by manipulative short selling. Time has shown that company failures initially attributed by some to such short selling were in fact a consequence of inadequate company disclosure or business models that have proved to be unsustainable. We agree that there is a need for more effective disclosure of short selling positions, but the misplaced assumption about the extent of regulatory risk posed by short selling in the early policy thinking has led us to a position where it seems highly likely that market participants and users will have to bear the cost of an expensive and overly elaborate disclosure regime.

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The Financial Services Authority (FSA) in the UK conducted a detailed empirical and qualitative analysis before it determined the need for it to intervene in the market and the form of that regulation. The FSA concluded there was not a systematic failure in its disclosure regime but identified some specific failures that require intervention. Because the market in Australia is quite different to the UK, judgements of the existence and extent of risks should be made independently but with similar depth of rigorous analysis. In conducting this work, we have the benefit of building on significant work already undertaken in Australia. In particular, the Takeovers Panel identified the need for greater disclosure in this context through a comprehensive public consultation and by drawing on its practical experience through transactions brought before it and the courts. Moreover, the Panel has dealt with the matter by issuing Guidance Note 20, which provides guidance on the form of disclosure of equity derivatives that is necessary to avoid the risk of unacceptable circumstances being declared by it. Thus, whilst there may be valid arguments for including equity swap exposure and call options in reporting requirements (in order to prevent ‘surprise’ takeover bids), Australia already has the Takeovers Panel to ensure equity and fairness in Takeover processes.1

2.2 Limited Relevance of the UK CFD Market Experience

The takeover method which the proposed reporting requirements seek to prevent would be considered to be “unacceptable circumstances” by the Takeovers Panel. In short the Takeover Panel seeks to ensure that the Eggleston Principles are adhered to in takeover situations and to ensure that the principles of the Corporations Act are upheld.

The Issues Paper draws attention to the introduction of CFD disclosure regulation in the UK. However, we do not believe the CFD market in the UK is a relevant point of reference because it is very different to the CFD market in Australia and is much larger in relative terms than the equity derivatives market in Australia. CFD trading in the UK in 2007 was around 35% of the value of equity transactions. In Australia, the comparable figure is estimated at about 6% and is much less significant to corporate control. Aggregating OTC equity derivatives with estimated CFD turnover in Australia does not alter this conclusion. In part, this is because the UK CFD market is predominantly an institutional market, while the Australian CFD market is essentially retail. In Australia, the wide spread of underlying shares, and in the main, small dollar value of CFD trades per individual investor would very rarely exert

1 The Takeovers Panel commissioned a report titled “A Report on Stakeholder Assessment of the Takeovers Panel” to assess the effectiveness of the Panel since its inception. Overall the report was positive, finding that the Takeovers Panel was effective and achieving its objectives. Many respondents felt the Panel is successful in “following principles designed to ensure equity and fairness for shareholders in takeover situations”.

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influence on the underlying share price. Moreover, we are unaware of any evidence in Australia of a linkage between CFDs and voting rights. The Australian OTC equity derivatives market (ie excluding CFDs) is predominantly an institutional market, with trading activities carried out by investment banks, fund managers, other financial services licensees and professional traders. However, this also is a very small market relative to the ASX cash equities market (see table 1). Table 1 –Australian Non-Index Equity Derivatives Turnover

A$ billion 2004-05 2005-06 2006-07 2007-08

ASX cash equities 806 975 1,314 1,605

ASX stock options 304 401 409 432

ASX CFDs - - - 1

OTC equity derivatives 10 7 58 58

OTC CFDs 90(e)

Source: AFMA 2008 Australian Financial Markets Report. OTC equity derivatives data exclude in-house trading, as it does not involve a change in relevant interest for the entity in question. OTC CFD turnover is an estimate as an order of magnitude and may not be entirely reliable. AFMA is current processing its survey of OTC markets for 2008-09. We expect to be able to provide Treasury with summary data on OTC equity derivatives turnover (excluding CFDs) on a confidential basis towards the end of August. The global OTC equity derivatives market contracted significantly in 20082

and we expect to record a downturn in Australia in 2008-09 also, though the likely magnitude is unclear.

We do not believe the basic structure of the Australian derivatives market will change in the foreseeable future, as we see no indication that the Australian OTC and CFD equity derivatives market will grow and evolve to mirror its UK counterpart. For instance, the stamp duty motivation to trade CFDs which is important in the UK is entirely absent here. Thus, the UK experience does not provide a justification for the Government to impose additional regulation and cost on the equity derivatives industry in Australia, nor indeed is it even a particularly useful point of comparison in this instance.

2.3 Disclosure Exemption for Equity Derivatives Intermediaries

While AFMA accepts that disclosure of certain derivatives positions is appropriate to ensure the takeovers market is fair and efficient, it is important the disclosure rules achieve the right balance in regulation having regard to the costs and benefits involved.

2 See Bank for International Settlements data -- http://www.bis.org/statistics/otcder/dt21c22a.pdf

http://www.bis.org/statistics/otcder/dt21c22a.pdf�

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AFMA members involved in the equity derivatives business have identified significant costs and potential market inefficiencies associated with the unrefined ideas for reform in the Issues Paper. This primarily reflects a superfluous disclosure obligation, especially on entities who have no net economic exposure to a company or interest in any corporate control action but who would, nonetheless, be required to report positions to the market in great detail. It is especially important that potential changes to the disclosure rules for equity derivatives include an exemption for market makers and brokers who facilitate client business. There is international precedent for this approach in other jurisdictions, notably the new CFD disclosure regime in the UK and the UK Takeover Code. There is also precedent in the treatment of market making and client facilitation in the new short selling disclosure regime being introduced in Australia. The absence of targeted exemptions for intermediaries who provide liquidity that is essential to the smooth operation of the market would lead to:

• Disclosure that may mislead or confuse investors;

• Equity derivatives market inefficiency. In the normal conduct of their business, equity derivatives intermediaries regularly buy and sell equity derivatives in order to meet their clients’ demands. They hold derivative and stock positions largely for trading and hedging purposes, rather than for investment. Thus, their gross derivatives exposures are a product of their clients’ business and do not reflect investment decisions by them as an intermediary. They typically have large offsetting equity derivatives positions because, in order to prudently manage risk on their trading book, they generally keep their net economic exposure to a minimum. Because the rules being assessed in the Issues Paper do not permit netting of derivatives positions, an entity with a zero economic exposure could be required to report a substantial interest in securities, when in fact the entity has no economic interest in the relevant company. In some instance there would be a gross overstatement of an intermediary’s interest in securities. Consequently, there is a risk that the reporting of an intermediary’s positions may obscure the genuine economic interest of other investors in a company’s securities and/or that the reporting of the gross positions may mislead the market in relation to its position. For example, it is market convention that many OTC derivatives are struck to expire on specific dates (usually future/option expiry) to facilitate efficiency in hedging. These derivatives are bought and sold against varying counterparties. The derivatives risk is then extinguished; however, credit risk to various parties still exists. Under the rules being assessed it would appear that all long positions are to be aggregated and declared. These long positions could well be closed out so no economic interest exists. Thus, the

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rules being assessed would force derivatives intermediaries to disclose positions when they hold no underlying shares and, in this respect, creates the risk of misleading disclosure. The regular release of this information by intermediaries, most of which would be related to normal business activity and not a takeover, would create speculation amongst investors and potentially mislead rather than inform the market, thus harming the price discovery process and market efficiency. It would also make life more difficult for the regulators, as the data generated through the disclosure regime would have to be carefully sifted to exclude the exceptional ‘noise’ embedded in it in order to distinguish the relatively few control related transactions from the large volume of normal trading that would be reported. This requirement would also impose an unreasonable cost on these entities by requiring them to put in place specific compliance reporting systems that would have no purpose other than to track the disclosure requirements. Information would need to be compiled by the Compliance Department across a number of business divisions and not all would have the systems in place or the personnel to provide the information requested. It would require significant time and cost to build systems to cope with the reporting measures being considered and even then it may not be possible to give absolute quality assurance on data generated. Moreover, an unnecessarily extensive disclosure regime would increase the risks borne by the intermediaries who provide liquidity to the market, which would curtail their willingness to support the market (especially in the current economic climate where financial intermediaries, consistent with the expectations of regulators, are intent on reducing their business risks). Equity derivatives intermediaries would be constrained in meeting their clients’ needs, market liquidity would be impaired and costs would increase, which would harm the efficiency of the derivatives market. In these respects, the proposals being considered creates the risk of equity market inefficiency. We recommend that any reform requiring greater disclosure of equity derivatives business should exclude equity derivatives intermediaries from the reporting obligation in respect of equity derivatives positions. For this purpose, we would define derivatives intermediaries to be client-serving intermediaries when they are acting in a client-serving capacity, which is similar to the concept adopted in the UK. This would include licence holders dealing as principal in this capacity (including as market-makers) and equivalent overseas persons and persons in the same group as them.

2.4 Delta-adjusted Vs Nominal Reporting

As discussed below, equity derivatives are heterogeneous and collectively have a variable relationship with the company share that they are referenced to. This introduces new complexity into the disclosure process as it should

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capture the relative effects of different equity derivatives and discriminate between derivatives with very different characteristics and economic effects. For example, call options that are well out of the money and have a low delta reflect a small economic interest and should not be treated as relevant for disclosure purposes. If a simple nominal disclosure approach is taken, then an option with a delta of 0.1 would be treated in the same manner as an agreement for the forward purchase or the direct holding of a share (delta of 1.0) – which would obviously be misleading. The absence of a mechanism to recognise delta would cause poor quality of disclosure but there is a real challenge in overcoming this policy implementation problem. In theory, one way to deal with many of the problems outlined above would be to allow derivatives holders to measure exposures by reference to delta. However, while in practice this is feasible for individual trading books it is problematical in other areas of business and creates complex monitoring issues as delta may change over the life of a derivative. In addition, we understand that all disclosing firms may not necessarily use the same delta calculations, which would lead to some inconsistency of reporting. These compliance issues are particularly acute for global financial institutions that, for example, may have trading books located in a number of jurisdictions and other businesses, like asset management. In summary the form of required disclosure is a matter that requires further consideration and consultation with industry, should some form of disclosure be required in the near future. A practical approach that we suggest should be considered in this context is to define the concept of equity derivative narrowly for the purpose of disclosure and then require disclosure on a nominal basis. This would allow a timelier, systems-based and less costly approach to disclosure of derivatives positions. This is an important consideration given the wide range of other securities market disclosures and reforms that the industry is currently being required to implement.

2.5 Type of Disclosure

The Issues Paper does not consider the form and detail of disclosure that might be required. However, the nature of the reporting requirement is a key determinant of the usefulness of the information generated, the level of regulatory intrusion into commercial business, the impact on market efficiency and the cost of implementation. In the event that a new disclosure regime for equity derivatives is being seriously contemplated for implementation, this matter should be open to industry consultation before decisions are made on either the form or the technical detail of reporting obligations. It is our view that if equity derivatives disclosure is required, it should be limited to disclosure of the number of relevant securities affected and the type

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of derivative (eg put option, call option, equity swap etc). In principle, the reporting obligation should be no greater for OTC derivatives than that required for a physical holding of stock. A process that involves too many variables currently cannot be automated given the variety of derivative structures. Parties are entitled to commercial confidentiality, unless there is a valid public interest in having the nature of their contractual arrangement disclosed. Financial markets business is intensely competitive and participants can be disadvantaged and left open to commercial harm if they are required to disclose the depth of information being considered. For example, the disclosure to the market of the required details in respect of a large derivatives transaction could result in other market participants seeking to front run the position of one of the counterparties. The increased risk for traders would have to be compensated for by a higher return to the writer (or cost for the holder). More generally, we note that while transparency is generally beneficial to markets, regulators do recognise situations where this may not be in the interest of a liquid market. For example, ASIC in Consultation Paper 95 on competition in market services recognises the potential harmful price impact associated with the market being made aware of a large trade before it occurs and, therefore, does not propose to mandate pre-trade transparency. This example illustrates the interplay between disclosure of information and the associated cost to market liquidity and efficiency in some situations. The same issue applies in principle to a new equity derivatives disclosure requirement; the release of certain information in relation to a transaction could provoke a reaction by other market participants that would adversely impact the efficiency of the market as a whole.

2.6 Regulators’ Ongoing Work on OTC Derivatives Market Structures

Global regulators are pressing for standardised OTC derivatives transactions, including equity derivatives, to be directed to a central clearing house. This issue has also been considered in a recent APRA/ASIC/RBA report on Australia’s OTC derivatives market, in which regulators have made clear their wish for industry to minimise operational risks in our markets. Industry is responding to the regulators, but it is too early in this process to determine how the management of counterparty risk in equity derivatives transactions in the Australian market will be enhanced. The Australian industry response may to some degree depend on developments within the industry globally, which are still being considered. While the likely outcome for the Australian equity derivatives market in terms of market structure is still unclear, there is nonetheless the prospect of greater transparency to the regulators, and potentially the market, in respect of OTC equity derivatives transactions. We believe it would be sensible and a

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good use of industry and regulatory resources to focus on the immediate issues in improving the OTC derivatives market structure and then make an assessment of the need for further transparency of equities derivatives transactions once the structural issues are resolved. This would provide a better informed basis for making the policy judgement on further reforms to disclosure.

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3. Answers to Issues Paper Questions

IP3.2 Types of Equity Derivative Instruments

i) Does the list of equity derivative instruments covered provide

adequate scope for this assessment to determine the effectiveness of the current regulatory regime?

Forward contracts should be included. Apart from this, the list is adequate. However, we caution that derivatives are not homogeneous and classes need to be separately assessed (see above discussion on delta-adjusted reporting in section 2.4). In this context, we agree that derivatives based on general share price indices (including general industry specific sub-index components) are not relevant to the analysis and should be excluded. We would add that broadly based baskets of securities should also be excluded for the same reason as equity indices. We also agree that convertible notes are debt instruments and should be outside scope of the review. From a practical perspective, it is vital that there is clarity about the definition of equity derivatives for the purpose of the disclosure regime. An ambiguous definition of ‘equity derivatives’ will lead to inconsistent reporting by market participants. Each equity derivative subject to the regime should be precisely defined to ensure consistency in the understanding and reporting of holdings by market participants (along with relevant exemptions). The individuals involved in preparing reporting documents are unlikely to be well versed in the intricacies of all of the relevant products, so a broad ‘all encompassing’ definition will not assist these people in identifying the relevant products and business areas subject to the reporting requirements. Likewise people with the required product knowledge may not be able to form an adequate understanding of the scope of the reporting requirements. We understand that these factors are issues in the implementation of the UK regime. Additionally, any reporting requirements for including foreign market participants (ie parent companies of foreign-owned intermediaries) and any interests in the foreign portion of Australian securities which have been dual listed should be clearly identified (ie BHP securities listed on the London Stock Exchange). ii) Should the assessment investigate particular equity derivative

instruments or should equity derivatives be broadly defined? As outlined above, we believe the definition should not be broadly based. Rather, it should encompass only those derivatives arrangements that in practice create a material risk of misuse by an entity to deliberately circumvent disclosure in keeping with the purpose of the proposed regulation.

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IP3.3 Trading Platform

iii) What are the practical differences in disclosing positions in OTC

contracts and exchange-traded contracts? Exchange traded derivatives are novated and contracts are effectively extinguished when a position is closed (the investor’s economic exposure is nil and position is reported on their balance sheet). In contrast, an OTC derivative must be held to maturity, though an offsetting contract may be opened to extinguish the economic exposure (leaving an offsetting long and a short position on the balance sheet). It follows that the value of OTC positions outstanding is higher relative to turnover and, thus, are more likely to require disclosure. Traders maintain records for record keeping purposes for both OTC and exchange traded positions and common booking systems are often used. As outlined above, there would be significant practical complications in aggregating positions across various classes or reportable instruments, were a disclosure obligation to be placed on equity derivatives. The policy approach to any required disclosure should apply in a neutral manner between OTC and exchange traded contract open position. iv) Should exchange-traded contracts, OTC contracts or both types be

considered? Please explain. Regulation should be competitively neutral. If a disclosure obligation is introduced, it should apply on the same terms to both OTC and exchange traded derivatives that are considered relevant from a policy perspective. In practice, active traders and investors are likely to trade in both OTC and exchange traded equity derivatives contracts so a complete insight into positions held will not be obtained solely by access to exchange data. Traders on an exchange platform may use nominee companies or other vehicles to protect their identity and prevent other traders front running or trying to leverage off their trading strategy, so immediate identification of beneficial ownership will not occur through exchange data. The most practical method of disclosure would be to require equity derivatives holders to declare their substantial positions, which is the approach that is taken in respect of direct relevant interests. Finally, global standard setters are pressing for standardised OTC transactions to be directed to a central clearing house, so the practical differences between exchange and OTC markets from the compliance perspective identified in the Issues Paper may be expected to narrow over time.

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IP3.4 Usage

v) Treasury is interested in further data and would welcome additional

information about the usage, purpose and types of equity derivatives in practice.

The equity derivatives market provides valuable trading and risk management services to investors and it contributes significantly to the overall efficiency and effectiveness of Australia’s capital markets and the economy. The applications are many fold, as outlined in the response to the next question. Any reduction in the market’s capability to service investors would represent a welfare loss, which would be significant if the impediment is severe. Equity derivatives are typically traded for investment and risk management purposes and not for the accumulation of a position to facilitate a takeover action or to seek to influence a company’s decision making. We are not aware of any evidence that suggests that equity derivatives are used to systematically circumvent the disclosure rules. Member firms who are major participants in the equity performance swaps market advise that they have not observed abusive behaviour. Section 2.2 above provides information on the market turnover for non-index equity derivatives, which are the subject of the Issues Paper. vi) Treasury is interested in common forms of cash-settled equity

derivatives such as equity swaps and CFDs. - How commonly are these instruments used? - When are they most likely to be used? - Why is their use more prevalent now?

OTC Equity Derivatives The OTC equity derivatives market is very small relative to the size of the exchange traded and cash equities markets but it is a significant market in its own right and offers valuable services to investors and traders. The market’s growth up to 2007 was impressive but this was from a small base in terms, so growth is not a good guide to the relevance of the market in terms of the regulatory issues under consideration. For instance, the market is of an entirely different scale to the UK market and does not present the same extent of regulatory risk. Equity derivatives trading may be used to facilitate a range of trading and investment strategies; for example diversification, hedging, investing, volatility protection and trading, relative-value strategies and correlation trading. Within this framework, equity derivatives trades may be done on the OTC market to enable customisation of contract specifications (eg terms and expiry), avoid leaving a footprint on very large trades, mitigate exchange and transaction costs, or to manage risk under a master netting agreement.

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Institutional investors, banks and hedge funds use OTC equity derivatives (as well as futures and exchange traded options) to replicate positions in some securities or markets in an efficient and cost effective manner. For example, equity swaps provide a means to get equity exposure through a counterparty without necessarily taking a position in the underlying ‘cash’ shares. This may offer funding and collateral advantages and provide a mechanism to manage regulatory compliance issues associated with cash holdings (eg FIRB rules). Total return swaps allow direct exposure to equity or equity index returns in exchange for a periodic floating rate. Investment banks and securities companies provide essential liquidity to the OTC derivatives market through client facilitation and market making services, as well as trading, investing and hedging. Some banks and securities firms use equity derivatives to structure products they on-sell to their clients. Structured products provide investors with a means of gaining exposure to an equity or equity index with pre-determined upside and downside risk. For example, retail and high net worth investors who seek to invest in a relatively low risk manner will purchase capital protected products (eg capital protected loans and instalment warrants), which combine loan and options. Other widely offered products present an opportunity to get exposure to a market (eg an emerging market) that is otherwise difficult to access for cost or regulatory reasons. For example, the most common profile for a direct deferred purchase agreement investor is an individual or a superannuation fund that faces hurdles in obtaining either direct or otherwise sufficiently diversified direct access to the underlying markets. CFDs The introduction of CFD products to Australia has opened up new avenues for risk management and wealth creation for retail investors. Whilst increasing acceptance and understanding of equity classes of investments have grown the share market over the past 15 years, derivative markets have not been made accessible to retail investors. With smaller contract sizes and ease of online trading, the Australian CFD market has captured the hedging/risk-reduction benefits of derivative markets and tailored the product to suit retail investors. The primary benefit of trading CFDs is that it offers investors access to leverage. Investors outlay a relatively small amount of money to secure a larger exposure to investment assets. By taking on an investment exposure that is larger than the amount of funds invested, potential gains are magnified. Leverage allows investors to more efficiently utilise the funds available to them, and offers diversification opportunities through different asset classes and geographic regions.

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As in the underlying market, investors benefit from capital gains in a rising market. CFDs also enable strategies for trading in falling markets, by taking short positions. The ability to take on short positions provides an efficient tool for managing the risks of existing physical investments. Since investors can trade both rising and falling markets, market-neutral strategies such as pairs trading can be efficiently implemented on the CFD market. The quantity and dollar value of CFD trades means that there is no systemic risk that CFDs can be used as a means to circumvent disclosure rules. Transactions of a scale that would have this effect would be out of character with the market and would thus receive careful business risk and compliance scrutiny. CFD trading is primarily related to leverage and cost effectiveness.

IP3.5 Historical Context

vii) To what extent are equity derivative instruments used to avoid

ownership disclosure requirements in practice? Equity derivatives are typically used to meet trading and risk management objectives and not for corporate control purposes. Equity derivatives are not shares and do not offer key attributes of shares (eg they carry no voting rights and are ephemeral in nature, not perpetual). For example, a fundamental aspect of equity performance swaps is that they give no control to the holder; otherwise they would have a relevant interest problem to deal with. There are only about 4 or 5 significant institutional OTC derivatives writers in the Australian market, which in practice significantly reduces the likelihood that an entity could widely spread an exposure across a number of banks. Nonetheless, this could be relevant in a takeover situation, as historical experience has shown. However, the Takeovers Panel Guidance Note 20 on equity derivatives was developed in response to those issues and provides an adequate tool to control regulatory risk in a takeovers situation. We have received feedback from members to the effect that control may have been relevant in maybe 20% of swaps prior to the Takeovers Panel Guidance Note 20, but now the position is lower and has to be declared. Most positions are not control related; rather, the investor just seeks the economic exposure. In this context, we note that the two examples cited in the Issues Paper, concerning US and German companies, would on the face of it have required disclosure if the approach adopted by the Australian Takeovers Panel had been applied by the local regulatory authorities in those instances.3

3 We have not explored the detail of the US and German cases cited in the Issues Paper, as this would have delayed the presentation of our submission.

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As discussed above, we do not believe the CFD market can be used to circumvent the disclosure requirements. Relevant member firms have reported that they have monitoring and reporting mechanisms that are sufficient to identify and escalate any such instances. viii) Has this resulted in the market being inadequately informed? If so,

please explain in what way. We believe that the Takeovers Panel Guidance Note 20 on equity derivatives provides an adequate tool to control regulatory risk in a takeovers situation and keep the market properly informed. We do not believe there are situations outside of a control context where the market is potentially not adequately informed, to the extent that a significant and costly market intervention is required. To our members’ knowledge, the current regime is ensuring adequate and timely disclosure. There is a genuine and significant risk that unrestrained, mandatory disclosure of equity derivatives positions would obscure information that is relevant to the market, make disclosure information much more difficult to interpret and potentially mislead some investors (especially those who are less sophisticated). To be of any practical benefit, the reporting of equity derivative positions would have to be separated out into the various types of derivate (including subgroups) in order to assess the true position of an entity’s holdings. This level of disclosure may effectively drown many investors in information, and serve to confuse in terms of the possible overlap in holdings reported (notifications in excess of 100%). Unsophisticated investors will not fully understand the purpose of, or motivations behind the acquisition or disposal of the numerous equity derivative products currently available. If investors misunderstand or become overwhelmed with information, it may also lead to adverse reactions and disrupt the market. Professional investors, broadly speaking, enjoy the benefits of sophisticated applications and analyst recommendations at their disposal but these are not available to unsophisticated investors, who are less well placed to understand derivatives anyway. Hence, disclosure of the type envisaged may simply place ‘mum and dad’ investors at an even greater disadvantage. Finally, we reiterate an important qualification to our answers to this and other questions. For the reasons provided in section 2.3 above, including enhancing rather than reducing the quality of information flow to investors, market makers and derivatives intermediaries (who would typically have many and significant offsetting long and short positions) should be excluded from any disclosure regime that might be considered.

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IP4.1 Cash Settlement and Disclosing Substantial Holding Provisions ix) Do substantial cash-settled equity derivatives transfer significant

effective control over shares? If so, how? In general cash-settled equity derivative transactions do not transfer significant effective control over shares from the ‘writer’ to the ‘taker’. However, there can be specific and very limited instances where substantial derivatives positions can give a material level of effective control. The Takeovers Panel Guidance Note 20 (paragraphs 20 to 29) provides a good description of those limited circumstances, which relate to the hedging actions of the derivatives writer. We are unaware of other situations that might be relevant. x) Have you seen instances of market failure as a result of non-disclosure

resulting from the holding of equity derivatives? Where possible, please provide details of the case.

There can be instances where an entity may hold a significant equity derivatives position in terms of the underlying securities on issue. However, these are dealt with satisfactorily in accordance with the Takeovers Panel Guidance Note 20. We are not aware of instances of market failure since the Takeovers Panel Guidance Note 20 was issued, either in relation to equity derivatives generally or more especially in relation to CFDs. xi) Can equity derivatives give certain investors undue advantage in

gaining interests in companies without having to disclose these interests? What are these advantages?

The Takeovers Panel Guidance Note 20 outlines the limited situations. In particular, by creating the economic incentive to hedge and then by controlling the unwinding of the hedge, the taker of a long equity derivative position may affect the market in the underlying securities, eg by bringing about a reduction in the free float of the company. This may, in turn, affect:

a) control or potential control of the company;

b) the acquisition or proposed acquisition of a substantial interest in the company; or

c) the efficient, competitive and informed market for control of the company’s voting securities.

Our members believe that Guidance Note 20 provides a competent regulatory response to these concerns.

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It is important to note that equity derivatives disclosure regulation would impact on two areas of policy covered by the Corporations Act:

• Chapter 6 – The basic objective of this regulation is to provide an efficient market for corporate control. An efficient market for corporate control is characterised by a competitive and informed market in which shareholders know the identity of potential bidders, are given adequate information and sufficient time to consider proposals and there is equal opportunity to participate in the benefits under a proposal.

• Chapter 7 – A key objective of this regulation is to enhance the efficiency and fairness of financial markets, including the equity derivatives market. An efficient financial market is typically characterised by competition, an effective price discovery process, low transaction costs and good liquidity to facilitate trading and risk management, amongst other things.

Disclosure regulation needs to be proportionate in the totality of its impact in these policy areas. Against this backdrop, we note that there can also be disadvantages with mandated disclosure of equity derivatives positions that can impact adversely on market efficiency. For instance, if a derivative holder needs to disclose full terms of their contract (including maturity), then third parties may position themselves to take advantage of the situation if they know the position must be unwound on a given day. This risk does not exist in the cash market, as a share holder does not need to disclose how long they intend to hold a position for. Similarly, it should not be necessary to disclose commercially sensitive information such as pricing (again, by analogy, the commission paid to a broker on a cash market transaction does not have to be disclosed). xii) It appears that issuers of equity derivative contracts typically hedge

their positions by acquiring the referenced shares. In practice, are there instances in which this does not happen? Is this typically required by the contract or by internal risk protocols?

For risk management and regulatory purposes, securities companies and investment banks involved in the derivatives business will generally wish to hedge their related exposures rather than run speculative positions. This makes best use of their capital and provides a relatively stable return to shareholders based on the spreads and margins earned as an intermediary. We are not aware of contacts under which the writer of a derivative is obliged to hedge the exposure created by purchasing the underlying shares. Hedging is conducted to meet internal risk management controls.

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Hedging is frequently done by purchasing the underlying shares. However, issuers of equity derivatives, as market makers and active intermediaries, may hedge their equity derivatives positions in the derivatives market as an alternative to purchasing shares. xiii) If there is physical hedging by the counterparty, how common is it for

the taker to be aware of this hedging? Derivatives writers decide whether to hedge a position, and how to hedge the position if they so decide, independently of the client (ie the client has no input to this decision). Any hedging conducted may also be done on a portfolio basis by the relevant trading desk of the derivative writer (as opposed to hedging on a delta-1 basis). The feedback from our members is that the actual hedging arrangement for a specific derivative to be entered into is not typically confirmed, or discussed, with the client. Equity derivative contracts based on ISDA documentation also use a broad definition of Hedge Positions, which extends to a range of hedging mechanisms and not just physical holdings.4

Members have also advised that the greater the extent with which the client is involved in discussions relating to the firm's actual hedging for the specific derivative, the greater the risk that (a) the derivative writer and the client are seen to be "associates" under the Corporations Act, and (b) that the client is taken to have a "relevant interest" in any physical hedge shares held by the writer. Moreover, while a client may reasonably make an assumption about the likelihood of a hedge being put in place, or that the writer is physically hedging, it may be practically difficult for the client to identify a hedge position given market flows, normal buying and selling by a broker, and particularly where the writer is hedging its obligations on a portfolio basis.

xiv) In practice, do counterparties in equity derivative contracts typically issue voting instructions to the direct holder of the referenced shares, or seek to influence voting in any way?

No, it would be quite exceptional for this situation to occur. If it were to occur, it would give rise to a relevant interest that would need to be disclosed under the substantial shareholding provisions (and the s.672 tracing notice provisions), so above 5% the market should be informed. Moreover, the internal policies of the major investment banks and securities firms would preclude this practice from occurring, which is why compliance and legal personnel are normally involved in establishing significant swap transactions. Some firms have a policy to not vote shares held as a hedge. xv) It appears that cash-settled equity derivatives present the main

4 "Hedge Positions" means any purchase, sale, entry into or maintenance of one or more (i) positions or contracts in securities, options, futures, derivatives or foreign exchange, (ii) stock loan transactions or (iii) other instruments or arrangements (howsoever described) by a party in order to hedge, individually or on a portfolio basis, a Transaction." (emphasis added).

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challenge to the current ownership disclosure framework. Do the features of delivery-settled contracts also present similar or other problems for disclosure? If so, how?

Delivery settled contracts are usually reportable under the existing substantial notice regime (subject to the exemption for market traded options in s.609(6), which require reporting when the requirement to make or take delivery of the securities arises). xvi) The existing ownership disclosure regime requires disclosure of voting

interests in shares. Would disclosure of short derivative positions have any benefit to market transparency? Would it be desirable only where an offsetting long equity or long derivative position has been disclosed? What are the advantages of disclosure of short equity derivative positions?

Share ownership embodies a set of rights and benefits. In this context, it is important to understand that the right to vote as a shareholder has a real value of itself that is separate to the other benefits of share ownership (such as the right to receive distributions or sell shares for a capital gain). Thus, it is one of the economic benefits to owning a share (albeit one of particular importance in the takeovers situations).5

If a shareholder holds a short derivatives position to hedge a share investment they intend to retain, this can at best be a transitory state, as derivatives are relatively short dated while shares are perpetual instruments. An investor may quite legitimately wish to reduce exposure to a company for a temporary period (eg to obtain liquid funds by selling upside exposure over a given period), but not give up their long term exposure to the company’s growth and business development or, critically in this context, their right to influence these outcomes through the company voting process. In addition, the ‘hedged’ shareholder may retain access to dividend flows and franking credits for tax purposes, which are very important economic benefits to share ownership. It is also relevant to note that shareholders who hold a short position because they have purchased a put option on their shares still have every incentive to actively use their votes in a manner that will maximise the value of the company. Thus, it is conceptually incorrect and practically unhelpful to characterise a short derivatives position as simply separating voting and economic ownership because it is a more complex relationship than this and the underlying purposes are quite varied. The underlying policy principle being considered here is even more complicated than the analysis in the Issues Paper suggests. Shareholders

5 It should be noted in this context that industry practice discourages vote renting. In response to a Senate Committee question, ASIC recently advised that its regulatory experience over recent years does not indicate that there is widespread abuse of vote renting. IFSA as the industry body representing fund managers actively opposes vote renting practices.

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may hedge their investment in a company through a variety of instruments. For instance, the holder of a share investment in a gold company may hedge their investment by selling gold forward rather than hedging the company’s shares through a derivative. Similarly, a shareholder in company A may hedge this by selling short shares in company B whose performance is typically highly correlated with company A. The Issues Paper (correctly) does not envisage placing a disclosure obligation on ‘short’ investors in these instances but this calls into question the reason why it should be required when an equity derivatives contract is used to achieve the same economic outcome. Against this backdrop, it is important for the regulatory objective of a disclosure obligation for short positions to be clear and certain. We believe that in the interest of regulatory and market efficiency, disclosure of short equity derivatives positions should be limited to:

• Takeovers situations;

• Situations where the derivatives ‘taker’ has a long cash share or derivatives position of a size that must be disclosed as a relevant interest.

This approach would target the disclosure provision to information content that is relevant to the market and to relevant situations, without the need to unreasonably intrude into the private business affairs of investors. xvii) How common is ‘empty voting’? Does this practice undermine the

fairness and transparency of the market? Members are not aware of this occurring as a specific practice or, indeed, if the concept is very meaningful at all. For example, it would not arise in the context of the way in which equity performance swaps are established. We do not agree with the premise that shareholders who have hedged positions through cash-settled derivatives do not retain a relevant economic interest in the company and, hence, may vote without any beneficial interest in the company. While the exposure of these shareholders to the economic performance of the company may be reduced (and in some cases very significantly), it may not be eliminated or reduced to the point where their exposure is trivial. In theory, it is possible that a fully hedged investor might, for example, vote to block a scheme of arrangement so they benefit from any price fall. However, this type of misconduct is captured under the existing market manipulation provisions of the Corporations Act. It is also unlikely that an entity with this intent would observe an equity derivatives disclosure obligation. This behaviour would adversely affect members’ businesses, were it to occur. In practice, members report no evidence of manipulative behaviour of this kind.

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The action taken by shareholders in hedging their position is fully reflected in the market price for the share, the pricing between the derivatives market and the cash market is integrally related. The only information that the market does not know is the identity of the person who has a hedged position. We do not believe it is in the interest of market efficiency to require investors to disclose this personal investor information outside of takeovers situations. IP5.1 Takeover Provisions xviii) If substantial holder notice provisions were to be expanded to include

equity derivative positions, would there still be a regulatory gap that allows equity derivative holders to circumvent takeover provisions?

We are not aware of gaps or potential gaps that might exist if substantial holder notice provisions were to be expanded to include equity derivative positions. However, we note that in the absence of effective relief for derivatives intermediaries, there would be substantial overreach in the scope of the regulatory regime, which would significantly impair its effectiveness. xix) Would such a gap be a problem in practice? No – given the previous answer. xx) To what extent could the market be relied on to price in a control

premium, thereby sufficiently rewarding shareholders with the premium that an acquirer of direct stakes normally has to offer in a takeover bid?

The market would operate efficiently and could be relied upon to price a control premium. xxi) Would there be scope for the Takeovers Panel to address these issues

when they arise in practice? The existing Takeovers Panel Guidance Note 20 is adequate, and has proven itself to be so. For example, any swaps involving potential control issues are now declared. xxii) If substantial holder notice provisions were expanded to include equity

derivative positions, should the law be amended so that positions over 20 per cent must also comply with the takeover provisions? Should the assessment consider whether the takeover provisions in the Corporations Act 2001 would benefit from an expansion to include

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equity derivatives holdings? The law should retain the existing 20% test (focussed on direct relevant interests) because equity derivatives positions that may have to be disclosed under the rules being assessed in many cases would not reflect control over shares (either direct or indirect) and in other cases they would constitute only an indirect control of shares. Thus, extending the existing 20% rule restrictions that apply to direct stakes to equity derivatives generally would lead to actions being required by investors and traders that are inappropriate from a policy perspective. Thus, we reiterate our view that the existing Takeovers Panel Guidance Note on equity derivatives is adequate to facilitate disclosure in a takeovers situation. IP5.2 Tracing Notice Provisions xxiii) Do companies that issue shares on the market require information

about equity derivative contracts that reference substantial parcels of their shares?

We do not accept a general proposition that companies as a matter of course require information on derivatives contracts that reference substantial parcels of their shares. Companies are ultimately governed by investors who own the shares in their company and control it through their voting rights. The holders of equity derivatives do not have these ownership rights and the management of companies should resist any attempt by derivatives holders to inappropriately influence them. We do not believe that regulatory intervention should inadvertently support or promote governance rights being implicitly accorded to derivatives holders through a disclosure process nor should it create confusion in any other way about the accountability of a company to its shareholders. Within this framework, we believe that a company should be able to obtain beneficial ownership information in relation to significant parcels of shares held as a hedge by the issuer of an equity derivative, where the issuer transfers control of voting rights to the taker of the derivative under the terms of the derivatives contract. That is, where a derivatives holder has in effect purchased control over the voting rights attaching to shares, the company should be made aware of this as part of the substantial shareholder notice provisions. This outcome is achieved under the current law. We would also argue that it is important that the directors of a company in a takeovers situation should be provided with information on investors with a substantial interest (direct and indirect through derivatives) in their company. This is achieved through the Takeovers Panel Guidance Note 20. xxiv) Should the assessment consider extending the tracing notice

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provisions to include equity derivatives? No - The extension of the tracing notice provisions to include equity derivatives would be a serious retrograde step to the efficiency and competitiveness of Australia’s regulatory system. We outline several reasons for this below.

Need for Disclosure Not Established

There is not a demonstrated policy basis for disclosure of equity derivatives positions outside of a takeovers situation. The concerns that might justify the exceptional extension of regulatory intervention in this manner have neither been presented nor tested. We do not believe that a sustainable case can be presented to support extended disclosure of this nature. This would be even more strongly the case if the substantial shareholder notice provisions were extended in the same way to require equity derivatives disclosures to the market. We believe that arguments in favour of extending disclosure in this manner should be open to review and comment by industry before a decision is taken in respect of their relevance and validity.

Practical Issues

The Issues Paper presents no insight into how a disclosure regime of this type could be made operational or on what basis reporting might have to be made (ie nominal or delta adjusted data). Some global banks operating in Australia have regional ‘disclosure of interest’ units, who are responsible for managing the global aggregate positions of the myriad of operational entities within the bank group, so data can be collated for reporting purposes. The complexity of the challenge for them in having to respond to ad hoc Australian specific notice requests relating to equity derivatives positions, potentially on a very frequent basis, would be enormous. We do not think this can be made operational in a cost effective manner, especially given the very marginal benefit (if any) that might emerge from disclosure. The access point for the issuance of s.672 notices is the company register that records the members of a company or scheme ie notices can be issued to members. The simple extension of s.672 notices to derivatives holders would not be feasible, unless derivatives holders are required to somehow declare themselves as an indirect member of the company or scheme, which would require establishment of new registries. The notices could be directed to an existing ‘direct’ member of a company or scheme but this would capture only a subset of the information sought and, in any event, would not provide a reliable guide to beneficial ownership given the variable and indirect nature of the interest.

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In addition, derivatives issuers, traders and investors would have to put in place systems to capture the data being sought. In many cases the information requirements would transverse across several markets, several geographical regions and several internal information systems. It would be a vastly expensive exercise to prepare systems to compile and report the information sought. Section 672 is already being misused - this will be exacerbated if it is extended to equity derivatives.

The Existing s.672 Regime is Defective

The current s.672 notice regime which deals only with direct relevant interests is defective and operates in a manner that is open to abuse and imposes an unfair demand on notice recipients. The manner of its operations is contrary to the Government’s intention to reduce the regulatory burden on business and this has been the subject of several AFMA submissions to Treasury (February 2006, February 2007 and September 2007), which Treasury has several times agreed to consider. The submissions explain the precise nature of the problem. In brief, AFMA’s members are being inundated with notice requests by listed companies and company registries representing them because the $5 scheduled fee paid by issuers of notices provides no economic cost check to the frivolous and excessive issuance of notices. In effect, members are being forced to subsidise businesses that offer investor relations products, including intelligence on share ownership or changes in the share register. We appreciate and support the policy objectives of the current s.672 regime. It is common for a custodian or nominee company to hold shares on behalf of a third party whose identity would not be apparent from a review of a company’s shareholder register. There are a number of circumstances, especially in the context of takeovers, where there is a public interest in the identity of beneficial owners of shares being made available to third parties. However, section 672 notices have become increasingly used by independent company analysts engaged by their clients for private commercial purposes unrelated to the policy purpose for s.672. Further, we note that no measures are proposed in the Issues Paper to curtail the issuance of frivolous or vexatious notice requests being issued in respect of equity derivatives. Therefore, having regard to the above matters, it would be inappropriate in the current circumstances to extend s.672 notices to cover derivatives. IP5.3 Director Disclosure Provisions xxv) Are you aware of instances of directors covertly accumulating or

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disposing of interests in companies through the use of equity derivatives?

Members advise that some instances of non disclosure can be assigned to the directors of listed companies not disclosing their own personal holdings in the companies they manage. In these instances, it is not clear that the full weight of the provisions in the Corporations Act have been tested. Some of these individuals have found themselves to be ‘over leveraged’ through the use of derivatives, which has contributed to market uncertainty at the onset of worsening economic conditions. Rather than introducing full disclosure by all market participants, it should be considered if the existing laws are being effectively applied and fully utilised. xxvi) Should the assessment consider expanding the relevant legislation to

incorporate equity derivative holdings in director disclosure provisions? xxvii) The scope of this assessment excludes short equity derivatives.

However, should an examination of expanding director disclosure provisions to provide investors with information about any director holdings of short equity derivatives be considered? What risks might this pose?

Rather than using general derivative disclosure measures, or s.672 type notices, to obtain information on directors’ economic interests in a company, it would be more appropriate to enhance s.205G if the Government perceives there to be a legislative gap in this area.

*****

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