2008/09 Assessment of Clearing and Settlement Facilities in Australia 5. Assessment of CS Facilities against the Financial Stability Standards

The Reserve Bank monitors licensed CS facilities' compliance with the Financial Stability Standards on an ongoing basis and reports on its assessment once a year, covering the period to end-June. All four ASX licensees report financial information to the Reserve Bank quarterly, with the two central counterparties also reporting detailed risk-management information, including stress-test outcomes. These reporting requirements are supplemented by a regular dialogue with the licensees on issues relevant to compliance at both an operational and a policy level, and the provision of data on activity, exposures and operational performance.

The assessments that follow describe the key developments over the year to end-June 2009 for each facility and consider the implications of these developments for each facility's compliance with the relevant Standard. All four facilities were found to have complied with the relevant Standards over the assessment period.

Details of the information that the Reserve Bank has used to assess each facility against the relevant measures is presented in the Attachment, which builds on material included in prior Assessments.^[1]

5.1 Australian Clearing House (ACH)

Background

ACH provides central counterparty services for a range of financial products traded on the ASX market, including cash equities, warrants and equity-related derivatives. Via a process known as novation, ACH becomes counterparty to every eligible trade, managing the associated risk by applying a range of risk-management tools.

The rights and obligations of ACH and its participants are set out in ACH's Clearing Rules. Under Section 822B of the Corporations Act, these rules constitute a contract under seal between ACH and each of its participants, and between participants. The netting arrangements contained in ACH's Clearing Rules are further protected under Part 5 of the Payment Systems and Netting Act 1998.

ACH applies three layers of risk-management protections:

Participation requirements and ongoing monitoring: Following a change which took effect on 1 January 2009, ACH participants clearing cash equities or options are required to hold at least $2 million in ‘core liquid’ capital.^[2] Over time, ACH plans to implement a further increase in the minimum capital requirement to $10 million.
Margining and other collateralisation of exposures by participants: Margins are routinely collected from participants in respect of derivatives exposures, but not for cash equities. Where exceptionally large or concentrated exposures in either derivatives or cash equities are identified through stress testing, calls are made under the Contributions and Additional Cover (CAC) regime. The margins and other collateral posted by a defaulting participant would be drawn on first by ACH in the event of a default.^[3]
The maintenance of a buffer of risk resources, including own capital: Finally, ACH has access to pooled risk resources of $550 million to meet losses arising in extreme market conditions. Of these additional resources, $250 million are fully paid up (including funds paid into a restricted capital reserve from the National Guarantee Fund (NGF) in 2005, a subordinated loan provided by ASX Limited, and a subordinated loan of $100 million from a commercial bank). These funds are supplemented by ‘emergency assessments’, of up to $300 million, which can be levied on surviving participants in the event of a default.

At the end of the assessment period, ACH had 57 participants, including 27 Australian brokers, 20 subsidiaries of foreign banks and brokers, eight subsidiaries of Australian banks, and two specialist clearers. Nine participants resigned during the period, while one new participant joined.

Assessment of Developments in 2008/09

Against a backdrop of turbulent conditions in financial markets, ACH continued to develop its risk and operating framework over the assessment period. Among the most notable changes, ACH implemented the first phase of an increase in minimum capital requirements for participants, made further enhancements to its stress-testing arrangements, and revised the composition of pooled risk resources following further downgrade of its provider of default insurance. Also, following the broker failures of early 2008, ASX carried out detailed reviews of participant-monitoring arrangements and default-management processes, which also had implications for SFECC. Finally, ASX continued to develop the legal framework for migration of both central counterparties' treasury and funding activities to ASX Clearing Corporation (ASXCC). In this year's Assessment, the Reserve Bank focused particular attention on these changes to the risk and operating framework and also reviewed ACH's response to the market volatility of late 2008.

Participation requirements

In July 2008, ACH announced that it intended to increase the minimum capital requirement for participants from $100,000 to $2 million with effect from 1 January 2009, and further to $10 million with effect from 1 January 2010. This prospective change was noted in the 2007/08 Assessment.

In December 2008, the Reserve Bank and ASIC were asked by the Minister for Superannuation and Corporate Law to review the prospective change in participation requirements. Following consultation with ACH participants, a report, Review of Participation Requirements in Central Counterparties, was published in April 2009.^[4] The report concluded that there was a strong in-principle case for ACH to raise the minimum capital requirement for participants. However, given developments in financial markets, and uncertainties in the market for third-party clearing, the report recommended a more gradual implementation of the increase in minimum capital requirements. This would allow additional time for the third-party clearing market to deepen and provide further scope for smaller brokers to examine various alternative business strategies.^[5]

ACH expressed broad agreement with the conclusions of the report and announced an extension to its timetable for increasing minimum capital requirements. The revised timetable is:

an increase to $5 million effective 1 July 2010 (and to $10 million for third-party clearers); and
a further increase to $10 million, effective 1 January 2012 (with a higher requirement for third-party clearers to be confirmed).

The Reserve Bank and ASIC remain in dialogue with ACH on these plans and will continue to monitor the implementation of the new requirements. Both authorities also continue to take a close interest in developments in the market for third-party clearing, the effectiveness and robustness of which is important to ACH's plans in respect of participation requirements, and more generally critical to the smooth functioning of the clearing and settlement infrastructure.

Participant monitoring

Participant-monitoring arrangements were an important focus of the Reserve Bank's 2007/08 Assessment, following the financial difficulties faced by several brokers early in 2008. During 2008/09, the Reserve Bank remained in dialogue with ASX on enhancements to these arrangements and also examined more generally the objectives of participant monitoring for a central counterparty (see Box A).

As described in the 2007/08 Assessment, monitoring of clearing participants is predominantly conducted by two units within ASX: ASXMS, a separate subsidiary with its own board; and Clearing Risk Operations, which is located within the central counterparties. ASXMS is responsible for capital and liquidity monitoring, as well as investigations and enforcement. Clearing Risk Operations focuses more on day-to-day participant activity and monitors risk profiles, open positions and settlement of obligations to the central counterparties.^[6]

During the year, ASXMS undertook a thorough review of its capital- and liquidity-monitoring arrangements and has set in train a number of projects to deliver enhancements. These include:

Enhancement to the risk-calculation methodology: Drawing on international benchmarking work, this project will review and develop methodologies for the calculation of risks arising from a range of alternative transaction types, including securities lending and margin lending.
Spot checks of the accuracy of returns: ASXMS developed some triggers for follow-up enquiries and detailed investigation, including on-site visits.
Participant re-authorisation: This project will systematically review the status of individual participants to ensure that they are completing returns appropriate for the range of business activities that they undertake.
Introduction of a new technical solution for participants' delivery of capital and liquidity returns and a new system for production of information and exceptions reports: System development is due to be completed in December and the new system is expected to be rolled out in April 2010.

The Reserve Bank welcomes these enhancements to the participant-monitoring framework. In particular, revision to the risk-calculation methodology to more accurately capture specific sources of off-market risk should go some way towards addressing issues raised in the 2007/08 Assessment around gaps revealed by the broker failures of early 2008. Also, regular spot checks should have the beneficial effects of increasing the frequency of dialogue with participants and promoting accurate completion of returns.

During the assessment period, the Reserve Bank also explored whether the location of the capital- and liquidity-monitoring function within ASXMS could lead to the loss of clearing-risk-relevant information, or more generally compromise the effectiveness of the central counterparties' monitoring of clearing participants. Given the vertically integrated structure of ASX, the capital- and liquidity monitoring unit in ASXMS supports ASX's supervision of market participants as well as clearing participants. Hence, consolidation of this activity delivers synergies and operational efficiencies. The Reserve Bank is of the view that arrangements are in place to ensure an appropriate flow of information to Clearing Risk Operations to support the central counterparties' risk-monitoring activities. Furthermore, steps have been taken to further enhance this through the introduction of monthly liaison meetings involving senior and working-level personnel from ASXMS, Clearing Risk Operations and Clearing and Settlement Operations. These meetings facilitate the exchange of clearing-risk-relevant information on clearing participants and complement the regular exchange of quantitative information from participants' capital and liquidity returns and other more ad hoc dialogue.

Arrangements in this area may, however, change in due course following the announcement by the Minister for Financial Services, Superannuation and Corporate Law in August 2009 that ASIC would be given responsibility for whole-of-market supervision of Australia's financial markets, including a role in supervising brokers' trading activities. The Reserve Bank will be in dialogue with ASX and ASIC during 2009/10 to examine how this may alter the central counterparties' arrangements for monitoring clearing participants.

Performance of ACH during the market turbulence of late 2008

ACH acted in a timely manner to intensify its risk-management activities in response to the heightened market volatility during late 2008 and concerns over some participants' financial standing. This occurred within the existing risk-management framework in the areas of participant monitoring, margining and stress testing. While the Reserve Bank considers that the steps taken by ACH were appropriate, the experience of this period suggests that further enhancement to ACH's risk-management framework should be considered, and in particular the routine margining of cash equities (see Box B).

As noted in Box A, within their participant-monitoring activities, the ASX central counterparties assign ICRs. These ratings are based on the external credit rating or net tangible assets (NTAs) of the participant or its parent, and are used to better understand the distribution of the central counterparties' risk exposures and assist in the interpretation of stress-test results. During the weeks following the Lehman Brothers failure, ACH downgraded 8 participants within this framework. As conditions stabilised during the first half of 2009, 6 participants' ratings were upgraded. The central counterparties also maintain a ‘watch list’ of participants deemed to warrant more intensive monitoring. At its peak, 15 ACH participants were on the watch list. By the end of June 2009, this number had dropped back to eight.

During the period of market volatility in late 2008, ACH also took proactive steps to increase the degree of margin coverage for ASX derivatives positions. In the December quarter 2008, ACH carried out eight ad hoc reviews of exchange-traded option margin intervals (in addition to the routine quarterly reviews). This resulted in some often large adjustments to margin intervals, with correspondingly large margin calls on participants. Indeed, notwithstanding that the volume of trading activity declined in the December quarter 2008, margin funds held by ACH increased by 9 per cent, to $1.5 billion. The increase in margin intervals in late 2008 has since been reversed for many – though not all – contracts Graph 5).

The difficult market conditions during the past year also prompted ACH to lower the threshold beyond which intraday margin is called on ASX derivatives positions. ACH called for intraday margin in the event that initial margin was eroded by 40 per cent (or 30 per cent for those participants on the watch list), rather than 50 per cent as previously. This led to an increase in the frequency of such calls, which were also often sizeable. In the December 2008 quarter, 194 intraday margin calls were made, amounting to a total of $485million. The largest single call was for $131 million in December 2008. By comparison, an average of 48 calls were made during each of the preceding quarters of 2008, for an average total of $176 million.

Finally, ACH uses stress testing to assess the adequacy of its risk resources and calls for additional collateral under the CAC regime to cover large exposures identified via the stress-testing process. The extreme market conditions in late 2008 resulted in some price movements that were close to, and in one case exceeded, the scenarios used by ACH in stress testing. The magnitudes of some stress tests were adjusted in conjunction with an expansion of the range of scenarios in December 2008. These changes had been planned prior to the turbulent period in late 2008 and the revised price-move scenarios are all more extreme than those experienced during that period.

Default management project

As reported in the 2007/08 Assessment, the financial difficulties experienced by several ASX brokers during early 2008 highlighted a number of learning points around the detailed management of a default event. In light of this experience, ASX is now working to enhance default-management processes for both ACH and SFECC, with the aim of managing legal, operational and liquidity risks, and minimising potential losses and spillovers that could arise under such circumstances.

In a first phase of this project, ASX carried out a comprehensive analysis of ‘default intentions’, setting out clearly the factors to be taken into consideration, and the decisions to be taken during the default-management process. ASX identified three broad stages in this process: establishment of a default (identification of a trigger event and declaration of a default); close out of a defaulter's positions (for instance, whether and how to liquidate, hedge or transfer positions); and funding any losses arising in the close-out process (or indeed returning surplus funds to a liquidator).

During this phase of the work, ASX also examined legal factors that may impinge on its choice of actions in the default-management process, and in particular the interaction with insolvency law. In this context, ASX looked to international precedent and identified that certain provisions in US and UK law, for instance, afford protections to central counterparties that are not currently available under Australian Corporations law.

In a second stage, ASX will work towards implementation of identified enhancements to operational capabilities, data collection and reporting, and will further clarify the legal underpinning for the default intentions identified. ASX will also determine whether changes to ACH and SFECC Clearing Rules are required. If so, regulatory approval will be sought from ASIC. Some changes have already been implemented, including the formalisation of ex-ante arrangements with brokers to assist in the close out of a defaulting participant's positions, and some rule-book clarifications around the protections afforded by the Payment Systems and Netting Act.

The Reserve Bank welcomes ACH's review of default-management processes, which recognises that detailed ex-ante planning is critical to an effective close-out process. Indeed, lessons learned from recent events, and the default of Lehman Brothers in particular, are likely to continue to shape central counterparties', and their regulators', work in this area over the coming years.

Account segregation

One important issue that has attracted considerable attention in recent months, particularly following the failure of Lehman Brothers, is the segregation of house (proprietary) and client positions in central counterparties. Currently, in the case of cash equities, each participant has a single account with ACH which is used both for house and client transactions. For derivatives, client accounts are individually segregated. In consultation with participants during the assessment period, ACH sought feedback on proposals to introduce new account structures.

Under the proposals, clearing participants for cash equities would be required to operate a segregated omnibus client account. This would assist in the management of a clearing participant default, allowing client positions to be dealt with separately from house positions. For derivatives, participants would have the option to continue to hold client positions in individually segregated accounts, or alternatively operate an omnibus client account.

Segregation is regarded as industry best practice, with an omnibus client account structure (which provides netting efficiencies across clients) the most commonly observed internationally. An omnibus structure would also be consistent with practice at SFECC. In respect of cash equities, respondents to ACH's consultation stressed the high cost of moving to a segregated account structure. It was also noted that some of the protections afforded by segregation were available through individual segregation of securities accounts in CHESS and client recourse to the NGF.

Notwithstanding the high cost of transition, the Reserve Bank notes the importance of ensuring that ACH's arrangements in this area are consistent with international best practice. Furthermore, segregation would be particularly important should ACH proceed with routine margining of cash equities. In such circumstances, separate identification and attribution of margin posted in respect of client positions would be necessary, particularly in the management of a clearing participant default. ACH has accepted participants' views that the costs of account segregation outweigh the benefits in the near term, but retains segregation as a longer term objective. ACH also proposes to revisit the issue in the context of its forthcoming consultation on risk controls, in which routine margining of cash equities is to be considered.

Adequacy of ACH's risk resources

The risk resources available to ACH to meet losses arising in the event of a participant default comprise any margin or other collateral collected from the defaulting participant, and ACH's pooled risk resources. Having risen significantly between 2005 and 2007, the aggregate value of ACH's pooled risk resources remained at $550 million over the latest period (Graph 7).

The composition of these resources did change, however. In particular, following the downgrade of Radian, ACH's provider of default insurance, to BBB− in April 2009, ACH took the decision to exit its insurance arrangement. This had been under review for some time, in light of earlier downgrades and in the context of a broader review of the composition of the central counterparties' risk resources. As a transitionary arrangement, ACH negotiated a fully drawn-down subordinated-loan facility from a commercial bank, increasing the fully paid-up component of risk resources from $150 million to $250 million. This also replaced $100 million of the $150 million committed liquidity facility previously in place from the same commercial bank provider.

Ultimately, ACH had intended to replace the default insurance component of risk resources with funds sourced from the issuance of principal-reducing notes by ASXCC, the legal holding company for ACH and SFECC.^[10] Given the turbulent conditions in financial markets, plans to issue these notes were placed on hold until towards the end of the assessment period and have since been postponed indefinitely. The Reserve Bank will remain in dialogue with ASX in relation to an alternate long-term source of funding to replace the insurance component of its pooled risk resources. This will be done in the context of a wider ranging discussion of the composition of pooled risk resources and the balance between own capital and other sources of funding. It is anticipated that issues around composition will also be referenced in ASX's forthcoming consultation on the central counterparties' risk control frameworks.

Currently, ACH calls for CAC whenever a participant's projected stress-test losses on its cash equity and derivatives positions exceed a common stress-test exposure limit (STEL) of $150 million (taking into account any margin already posted). Until the recent exit from default insurance, $150 million was the fully paid-up component of ACH's pooled risk resources. Comparison of projected stress-test losses with the level of available risk resources or the STEL offers some guidance as to the resilience of the central counterparty to a participant default in extreme market conditions. During the assessment period, there were 13 instances of stress-test exposures exceeding the paid-up component of risk resources, reflecting the positions of four participants. As in previous periods, these excesses tended to be concentrated at quarter ends, reflecting large cash equity trades associated with the quarterly expiry of equity index futures contracts.^[11] (Graph 8, top panel).

During the period, all projected stress-test losses in excess of $150 million were fully covered by CAC calls. As foreshadowed in the 2007/08 Assessment, ACH intends to introduce STELs that vary according to the ICR of the participant.^[12] A similar regime is already in place at SFECC. In the recent Review of Participation Requirements in Central Counterparties, the Reserve Bank encouraged ACH to proceed with implementation of this regime, seeing this as a means of managing ACH's exposures to less well-capitalised participants. It is intended that this will be introduced early in the 2009/10 assessment period, following discussion with some potentially affected participants.^[13]

The Reserve Bank regards reliance on variable collateral called under the CAC regime as an appropriate approach where projected stress-test excesses are relatively infrequent, short-lived or typically concentrated on a small number of participants, as has been the case in the past year. However, there are shortcomings to such reliance. In particular, as noted in the 2007/08 Assessment there will inevitably be a lag in calculation and settlement of additional collateral requirements, and in extreme circumstances calling for additional collateral could in itself precipitate a default.^[14] The Reserve Bank therefore encourages ASX to establish some clear guidance on when the central counterparties would increase fixed risk resources (either routine margining or pooled resources). This guidance might consider factors such as the size, frequency and duration of calls for additional collateral, and their dispersion across participants.

Derivatives margins: system capabilities

In both the 2006/07 and 2007/08 Assessments, the Reserve Bank encouraged ACH to progress plans to introduce system capability to make intraday margin calls in response to sizeable intraday changes in participants' positions, as well as to changes in prices, which are already captured. This system enhancement had been planned as part of the second phase of ACH's ongoing Risk Management System (RMS) project, and was scheduled for implementation during the current assessment period. In the event, following a re-appraisal of project time-lines, ASX negotiated a narrower scope for this phase of work with the system vendor.

In conjunction with this reprioritisation, work on intraday capabilities was decoupled from the RMS project and brought within the scope of a broader project under which margin-setting calculations currently carried out under the Theoretical Intermarket Margin System (TIMS) methodology will be migrated from outsourced software to ACH's in-house Derivatives Clearing System (DCS). This project is expected to run until mid-2010. This is an interim measure, since ASX has announced that in time it intends to migrate both central counterparties' derivatives margining to the CME version of the Standardised Portfolio Analysis of Risk (SPAN) margining system (SFECC currently uses the RIVA version of the SPAN system).

While accepting the reasons for the delay in implementation of these system enhancements, and the need to prioritise project resources, the Reserve Bank reiterates its close interest in delivery of this intraday capability and will continue to monitor progress during the forthcoming assessment period.

Settlement of derivatives margins

Under current arrangements, ACH participants can choose whether to settle routine margin payments in respect of ASX derivatives positions via Austraclear or via the daily batch-settlement process in CHESS. Where settled in CHESS, settlement of margins – a key risk-management tool for ACH – is dependent on the completion of settlement in the cash equity market. The potential risk of such dependence was highlighted by the significant delays in the batch settlement of Australian equities transactions in January 2008. In the 2007/08 Assessment, the Reserve Bank encouraged ASX to consider the removal of ACH derivatives margins from the CHESS batch, requiring instead that all be settled via Austraclear. Having consulted with industry on this issue (along with a number of other possible enhancements to the equity settlement process, discussed in more detail in Section 5.3), ACH intends to proceed with the removal of derivatives margins from the CHESS batch.^[15]

In a related development foreshadowed in the 2007/08 Assessment, ACH recently gained approval to operate an Exchange Settlement (ES) account with the Reserve Bank. ACH will use the account for margin-related funds movements and treasury investment-related settlements in the Reserve Bank Information and Transfer System (RITS). These payments were previously settled under an agency agreement with a commercial bank. The Reserve Bank supports this development, which should reduce operational risk and, by providing a vehicle for direct settlement in central bank money, reduce counterparty risk against ACH's commercial bank provider.

Treasury investment policy

In the 2007/08 Assessment, it was noted that both ACH and SFECC had revised their treasury investment policies, setting counterparty exposure limits within capital for all counterparties with the exception of the four largest domestic banks. While acknowledging the improvement over previous arrangements, the Reserve Bank expressed concerns around the potential size and concentration of exposures to the major banks and undertook to continue to discuss these arrangements further with ASX.

Some refinements were made to the central counterparties' treasury investment policies during the period. These were in part associated with the establishment of the treasury investment mandate for ASXCC, which was approved by the ACH Clearing Board in October 2008. Among the most substantive changes, ASX introduced the concept of an Ordinary Liquidity Requirement (OLR), equal to 10 per cent of the relevant central counterparty's treasury portfolio. The establishment of the OLR recognises that a central counterparty can face high liquidity needs even in the absence of a default event, perhaps associated with the return of margin to participants, or the replacement of cash collateral with non-cash collateral. The OLR is calibrated to provide sufficient liquidity at a confidence interval of 99 per cent; liquidity requirements in excess of this level would be met through the sale or repo of investment assets. Overall, ACH must maintain, at a minimum, liquid assets equal to the sum of the Default Liquidity Requirement (which is currently set at $300m, less the amount of any committed or drawn-down standby facility) and the OLR.

During the assessment period, as counterparty credit risk concerns mounted, ASX reduced investment limits for some counterparties, with the effect that treasury investments became even more highly concentrated in the large domestic banks. The Clearing Board was content with this shift, seeing it as appropriate given the high credit standing of Australian banks relative to many overseas investment counterparties. Indeed, given prevailing conditions in the market for short-term Australian dollar paper, ASX did not see a viable alternative to concentrating investments with the largest domestic banks if the credit and liquidity profile of the portfolio was to be maintained. The Reserve Bank explored alternative treasury investment options with both central counterparties and acknowledges that there are currently constraints to implementing these. The main alternative models to unsecured treasury investment applied internationally are:

Disincentivising the use of cash collateral: Central counterparties applying this model pay little or no interest on cash posted to meet margin calls. Combined with a list of eligible non-cash collateral assets typically restricted to government securities, this approach mitigates the investment counterparty risk associated with reinvestment of a cash margin portfolio. It does, however, introduce liquidity risk and reliance on committed liquidity facilities, and market risk also remains on the collateral assets posted.
Investing on a secured basis (reverse repo): In this case, funds are invested on a secured basis via repo arrangements, perhaps managed by a tri-party agent. The repos are typically of short maturity, ensuring adequate liquidity, and the assets taken in as security conform to restrictive credit-quality criteria (typically government securities).

In ASX's view, these models are not currently viable, given the absence of a deep and liquid market for government securities and, consequently, the small scale of the Australian dollar repo market. ASX considers that investments with the four largest domestic banks currently offer the best high-quality liquid alternative to government securities. However, were the domestic repo market to deepen, perhaps due to continued expansion of government debt issuance, ASX would consider exploring a secured alternative for at least a portion of the central counterparties' treasury portfolios. The Reserve Bank acknowledges the current constraints, but encourages ASX to keep under review the various options for reducing concentration in its treasury investments.

Operational performance

ACH's core systems are DCS and CHESS. Details of operational performance during the period and relevant policy changes are provided in Section 6.

Harmonisation and linking of central counterparty activities

Since the merger of the Australian Stock Exchange and SFE Corporation in 2006, ACH and SFECC have continued to operate as separate central counterparties. In December 2008, ASX released a consultation document on the possibility of harmonising and linking the activities of the two central counterparties, with a view to taking advantage of potential efficiencies. Feedback was sought on several specific initiatives, including migration of both central counterparties to the latest version of the CME SPAN margining system, introduction of margin offsets between derivatives contracts cleared by ACH and SFECC, and establishment of a single point of lodgement for collateral. Comments were also sought regarding the full integration of the central counterparties.

Having considered the responses, ASX recently announced its conclusions.^[16] As noted, it is intended that both central counterparties will in time migrate to CME SPAN margining. Analysis is also underway to assess the potential for introduction of margin offsets between the SPI equity index futures contract cleared by SFECC and the equity index options contract cleared by ACH. Other margin offsets will be considered over time, as will harmonisation of the definition of ‘house account’ across the two central counterparties. There was little support for the other initiatives proposed and these will not be pursued further in the near term.

New market operators

As reported in the 2007/08 Assessment, three companies have applied for market licences to offer competing trading platforms for ASX-listed equities. A decision has yet to be taken on these licence applications, but some work continued at ASX during the period to establish arrangements for the new trading platforms to clear and settle via ACH and ASTC. There was further dialogue with industry and market licence applicants on these arrangements, and in December 2008 ASX published draft high-level business equirements for the provision of these services to non-ASX trading platforms. The Reserve Bank remains of the view that arrangements which as far as possible mirror those in place to clear and settle trades executed on the ASX market should be consistent with continued compliance with the Financial Stability Standard.

Summary

It is the Reserve Bank's assessment that ACH complied with the Financial Stability Standard for Central Counterparties during the assessment period.

The Assessment highlights a number of important developments during the period under review. These include the following:

Risk-management actions during the market turbulence: As market conditions became more volatile during the assessment period, ACH responded with more intensive participant monitoring, more frequent intraday margin calls, and pro-active increases in margin intervals.
Review of participant-monitoring arrangements: Further to the broker failures of early 2008 and heightened counterparty credit concerns more generally, ASXMS undertook a review of participant-monitoring activities and launched a range of projects to enhance capital- and liquidity-monitoring arrangements. ACH also proceeded with an increase to minimum capital requirements and revised the time-line for implementation of further increases.
Review of default management processes: ASX embarked on a thorough review of default-management processes, identifying key decision points and reviewing capabilities. In a second phase of the work, ASX aims to further clarify the legal underpinning for intended actions, identify any necessary rule changes, and implement identified enhancements.
Continued refinement to the risk framework: ACH continued to refine its risk framework. Steps taken during the period included: exit from default insurance arrangements and replacement with a subordinated loan from a commercial bank; expansion of the range of stress-testing scenarios (and some scenario increases); progress towards implementation of ratings-dependent stress-test exposure limits within the CAC regime; and the prospective removal of ACH derivatives margins from the CHESS settlement batch. ASX also continued to work on the legal and operational arrangements for migration of treasury and funding arrangements to ASXCC, the central counterparties' holding company, though the proposed external issuance of debt by ASXCC has since been placed on hold indefinitely.

The Assessment also identifies a number of areas for further consideration by ACH during the forthcoming period. These include:

Routine margining of cash equities: Notwithstanding that the size and duration of replacement-cost risk associated with cash equities is low relative to that in derivatives contracts, recent high volatility in the cash equity market argues in favour of ACH routinely collecting initial and variation margin over the three-day pre-settlement period. This would be consistent with the approach taken by many central counterparties internationally and the Reserve Bank welcomes ACH's decision to consult on this in the near future.
Account segregation: ACH recently consulted on a proposal to require that clearing participants maintain separate house and client accounts for cash equities. Segregation would be consistent with international best practice in this area and would be particularly important should ACH proceed with routine margining of cash equities.
Triggers for an increase in fixed risk resources: The Reserve Bank regards collateral calls under the CAC regime as appropriate where such calls are infrequent, short-lived or highly concentrated among a few participants. This has indeed been the case over the past year. Nonetheless, ACH is encouraged to develop clear guidance on the circumstances in which it would increase its fixed risk resources (either routine margining or pooled resources), rather than relying on additional collateral. As noted in the 2007/08 Assessment, there are shortcomings to relying too heavily on variable calls for additional collateral, particularly given lags in the calculation and settlement of such calls.
Review of the composition of pooled risk resources: In light of the postponement of the proposed external debt issuance, the Reserve Bank will remain in dialogue with ASX in relation to the composition of the central counterparties' pooled risk resources. An important element of this will be ASX's plans in respect of an alternate long-term source of funding to replace the central counterparties' default insurance. It is anticipated that issues around composition will also be referenced in ASX's forthcoming consultation on the central counterparties' risk control frameworks.
Intraday margining capabilities: The Reserve Bank accepts the basis on which ACH has delayed the implementation of system enhancements to improve intraday margining capabilities. However, the Reserve Bank reiterates its interest in delivery of these capabilities and will continue to monitor progress during the forthcoming assessment period.
Treasury investment policy: The Reserve Bank acknowledges that existing treasury investment alternatives are limited for the ASX central counterparties and that it would be difficult to reduce the concentration of investments among the largest domestic banks without compromising credit quality or liquidity. However, were the domestic repo market to deepen, perhaps due to continued expansion of government debt issuance, ASX would consider exploring this alternative for at least a portion of the treasury portfolio. The Reserve Bank encourages ASX to keep under review the various options for reducing concentration in the treasury investment portfolio.
Participant-monitoring arrangements: The Reserve Bank welcomes the enhancements to capital- and liquidity-monitoring arrangements at ASXMS. It is noted, however, that the central counterparties' arrangements for monitoring clearing participants may change further in due course, in light of the recent government announcement of reforms to the supervision of Australia's financial markets. The Reserve Bank will remain in dialogue with ASX and ASIC over 2009/10 to examine any implications of the reforms for clearing participant-monitoring arrangements.

5.2 SFE Clearing Corporation (SFECC)

Background

SFECC provides central counterparty services for derivatives traded on the SFE market.

SFECC operates within a sound legal framework, based on its Clearing Rules. Under Section 822B of the Corporations Act, these rules constitute a contract under seal between SFECC and each of its participants, and between participants. Among other things, the rules set out the rights and obligations of SFECC and each of its participants in respect of SFECC's provision of central counterparty services. The netting arrangements contained in SFECC's Clearing Rules are further protected under Part 5 of the Payment Systems and Netting Act.

Given the concentration of counterparty risk in a central counterparty, effective risk-management processes are crucial. SFECC manages the risk associated with the potential for a participant default through a range of measures:

Minimum participation requirements and ongoing monitoring: SFECC participants are required to hold at least $5 million in NTAs. Over time, SFECC plans to implement a further increase in this NTA requirement to $10 million, with a higher requirement for those clearing for third parties.
Margining and other collateralisation of exposures by participants: SFECC levies margin on all derivatives products to cover any losses potentially arising should a participant default in normal market conditions. SFECC also calls for Additional Initial Margins (AIMs) from participants when individually large and concentrated exposures are identified by capital stress testing.
The maintenance of pooled risk resources in a Clearing Guarantee Fund: Should margin and other collateral collected from a defaulting participant prove insufficient to meet its obligations, SFECC has access to pooled risk resources in a Clearing Guarantee Fund (CGF). The aggregate value of the CGF is currently $400 million, calibrated to ensure coverage in extreme but plausible market conditions. The CGF comprises $100 million in SFECC's own capital (including a subordinated loan provided by SFE Corporation), participant commitments of $150 million (of which $120 million is paid up in advance and $30 million is promissory), and default insurance of $150 million.

At the end of June 2009, SFECC had 15 participants, predominantly large foreign banks and their subsidiaries.

Assessment of Developments in 2008/09

Having implemented some significant enhancements to its risk controls in 2007/08, SFECC made only relatively small refinements to its risk and operating framework in the current assessment period, including to stress-test exposure limits and stress-test parameters. Additionally, further to the cash equity market broker failures of early 2008 and the more general focus on counterparty credit risk, ASX carried out detailed reviews of participant-monitoring arrangements and default-management processes for both ACH and SFECC. Finally, progress continued towards the migration of both central counterparties' treasury and funding activities to ASXCC. This year's Assessment considers these changes and also reviews actions taken by SFECC in response to the turbulent market conditions of late 2008.

Participant monitoring

Participant-monitoring arrangements were an important focus of the Reserve Bank's 2007/08 Assessment. Although the proximate trigger for the Reserve Bank's examination of these arrangements was broker failures in the cash equity market, the experience also highlighted some issues of relevance to SFECC. In particular, the Reserve Bank continued to engage with ASX around enhancements to participant-monitoring arrangements and also examined more generally the role of participant monitoring within the broader risk framework of a central counterparty (see Box A).

As described in the 2007/08 Assessment, monitoring of clearing participants is predominantly conducted by two units within ASX: ASXMS, a separate subsidiary with its own board; and Clearing Risk Operations, which is located within the central counterparties.^[17] During the year, ASXMS reviewed its capital- and liquidity-monitoring arrangements and is in the process of implementing a number of enhancements. While most of these are relevant to monitoring participants' compliance with ACH's risk-based capital requirements (details in Section 5.1), one of the projects underway will also deliver an improved technical solution for delivery of NTA returns by SFECC participants.

As noted in the assessment of developments at ACH in Section 5.1, the recent government announcement of reforms to supervisory arrangements in Australia's financial markets may have implications for the central counterparties' monitoring of clearing participants. The Reserve Bank will be in dialogue with ASX and ASIC during 2009/10 to examine how these reforms may alter these arrangements.

Performance of SFECC during the market turbulence of late 2008

SFECC took a number of steps in response to the increase in market volatility in late 2008, including in the areas of participant monitoring, margining and stress testing.

As part of their participant-monitoring activities, SFECC and ACH assign ICRs, based on the external credit rating or NTAs of the participant or its parent. These credit ratings are used to better understand the distribution of risk exposures and assist in the interpretation of stress-test results (discussed below).^[18] SFECC downgraded two participants within this framework during the heightened market uncertainty in late 2008.

Clearing Risk Operations also maintains a ‘watch list’ of participants deemed to require more intensive monitoring. Up to six SFECC participants were included on this list during the assessment period, with three remaining on the list at end-June 2009. Participants on the watch list are subject to greater scrutiny in respect of the exposures they bring to the central counterparty, and where serious concerns arise restrictions may be placed on their trading or clearing activities.

SFECC also took steps to increase the degree of margin coverage in response to the heightened risks faced during the period. Initial margin rates are reviewed at least quarterly, or more frequently when market volatility rises and these rates are breached. In October 2008, SFECC carried out two reviews of initial margin rates for its main contracts (including, the SPI 200 futures contract, the 3 year and 10 year Commonwealth Treasury Bond futures contracts, the 90 day bank accepted bill futures contract, and the 30 day interbank cash rate contract). The resulting margin adjustments included sharp increases in margin rates, particularly for the major interest rate contracts. This led to large calls on participants, amounting to a total of $900 million in October 2008. The large increase in margin rates in late 2008 has since been largely reversed for many – though not all – contracts as market conditions have stabilised (Graph 9).

SFECC also lowered the threshold for calling intraday margin, making calls in the event that initial margin was eroded by 40 per cent (or 30 per cent for participants on the watch list), rather than 50 per cent as previously. The lower erosion threshold, combined with the extremely volatile market conditions, meant that SFECC made almost 100 intraday calls in the final quarter of 2008, mostly in October, for a total of more than $6 billion. This compared with an average of less than 60 calls, averaging a little over $2 billion, in each of the preceding three quarters. Calls were individually large on occasion, the largest single call being for almost $400 million. As market conditions stabilised, the frequency of intraday calls declined. Just 19 calls were made in the first half of 2009, totalling less than $200 million.

SFECC also calls for AIMs to cover large and concentrated exposures identified via the stress-testing process. During October and November 2008, some high exposures were identified, which led to a peak in AIMs held of more than $300 million (see below). The extreme market conditions in late 2008 also resulted in some price movements that were close to the scenarios used by SFECC in stress testing. SFECC's annual review of its stress-test parameters in late 2008 resulted in increases to some parameters.

Default management project

As discussed in detail in Section 5.1, in light of the financial difficulties experienced by several ASX brokers during early 2008, ASX is working to enhance default-management processes for both ACH and SFECC. This project is directed towards managing legal, operational and liquidity risks and minimising potential losses and spillovers that could arise in the case of a default event. The Reserve Bank welcomes this review of default-management processes, which recognises that detailed ex-ante planning is critical to an effective close-out process.

SFECC's risk-management framework

Some significant changes were made to SFECC's risk-management framework in the 2007/08 period, with the implementation of a new stress-testing methodology and an increase in the size of the CGF. By comparison, only relatively small refinements were made in the current assessment period, including to STELs and stress-test parameters.

The risk resources available to SFECC to meet losses arising in the event of a participant default comprise any initial margin or other collateral (ie, AIMs) collected from the defaulting participant, and pooled risk resources held in the CGF.

There was no change to the margin-setting methodology during the period, although further to ASX's consultation on harmonisation and linking of the central counterparties, a decision was taken shortly after the end of the assessment period to migrate SFECC from the RIVA SPAN methodology to the latest version of CME SPAN. Some refinements were made, however, to risk-monitoring processes to allow more comprehensive assessment of margin coverage, taking into account a two-day as well as a one-day close-out period. SFECC also implemented some system changes to automate the monitoring of margin and collateral erosion and thereby support the intraday margining process.

The size of SFECC's CGF remained at $400 million during the period and its composition was unchanged
(Graph 10). However, following a downgrade of the credit rating of its insurer, Radian, to BBB−, SFECC announced its intention to exit these arrangements in due course. While ACH had already exited its insurance arrangement with Radian, SFECC took the decision to retain its policy in the near term.

Nevertheless, from 1 July 2009, SFECC temporarily reduced its participants' STELs to exclude the value of the insurance. That is, AIMs for higher rated participants will be called at a lower threshold projected stress loss. The STELs will be re-adjusted once the default-insurance coverage has been replaced. SFECC has indicated that if its insurer's credit rating falls further in the near term, it will accelerate its exit from these arrangements. Indeed, an ‘in principle’ subordinated-loan agreement, similar to that negotiated by ACH, has been reached with a commercial bank, which it is anticipated could be triggered at relatively short notice.

Ultimately, SFECC had intended to replace this component of risk resources with funds sourced from the issuance of principal-reducing notes by ASXCC, the legal holding company for ACH and SFECC. As noted in Section 5.1, the external issuance of debt has since been placed on hold indefinitely. It is now particularly important that attention be paid to securing an alternative source of funding to replace default insurance. The Reserve Bank will remain in dialogue with ASX on this matter over the forthcoming period, in the context of a broader discussion on the composition of pooled risk resources. It is also anticipated that issues around composition will be referenced in ASX's forthcoming consultation on the central counterparties' risk frameworks.

Comparison of projected stress-test losses with the level of available risk resources or participants' STELs offers some guidance as to the resilience of SFECC to a participant default in extreme market conditions. During the assessment period, AIMs calls were made on 66 occasions, with these highly concentrated and all driven by open positions in the SPI 200 futures contract (Graph 11).

In response to the volatility in markets late in 2008, SFECC reviewed the parameters underpinning its stress-test scenarios. The strength of 17 of the scenarios was increased, including all of the single contract upward price-change scenarios. This had the effect of increasing AIMs calls.

The Reserve Bank regards reliance on variable collateral called under the AIMs regime as an appropriate approach where projected stress-test excesses are relatively infrequent, short-lived or typically concentrated on a small number of participants. This was broadly the case during the assessment period: while such calls were frequent during the December quarter, they remained very highly concentrated and did not persist into the first half of 2009. However, as noted in the 2007/08 Assessment, there are shortcomings to reliance on variable collateral, not least arising from the lag in calculation and settlement of additional collateral requirements. At SFECC, this lag can be up to 42 hours. There is, therefore, a case for establishing some guidelines as to when SFECC would increase either routine margin coverage or the size of the CGF. This guidance might consider factors such as the size, frequency and duration of calls for additional collateral, and their dispersion across participants.

Treasury investment policy

Some further changes were made to the central counterparties' treasury investment policies during the period. These were in part associated with the establishment of the treasury investment mandate for ASXCC, which was approved in October 2008. Among the most substantive changes, SFECC introduced a liquidity stress-testing model to assess the adequacy of its liquidity arrangements. The model, which is similar to that used by ACH for some time, calculates the maximum liquid funds that SFECC would need to access in order to meet obligations arising in the event of a clearing participant default and is based on SFECC's capital stress tests.

The outcome of the liquidity stress test is compared with the liquid component of SFECC's CGF: the so-called Default Liquidity Requirement (DLR). The DLR is currently set at $220 million, comprising SFECC's own capital ($100 million) and the clearing participants' paid-up commitments ($120 million). Breaches of the DLR trigger a review of the adequacy of the DLR. This review takes into account the outcome of the capital stress test, as any AIMs calls will provide extra liquidity.

During the period, ASX also formalised the concept of an OLR, a portion of the treasury portfolio to be kept in liquid assets to meet liquidity requirements unrelated to a participant default. Liquidity needs might arise, for instance, when initial margin is returned to a participant following the close out of a position. The OLR has been set equal to 10 per cent of the value of the treasury portfolio. The total liquidity requirement for SFECC is equal to the sum of the DLR and OLR.

As described in the Assessment of ACH in Section 5.1, the central counterparties increased further the scale of their treasury investments with the large domestic banks over 2008/09, reflecting the favourable relative credit standing of these banks as counterparty credit risk concerns mounted internationally. The Reserve Bank's continuing concerns around the resulting concentration in the treasury investment portfolio are also discussed in detail in Section 5.1, and ASX is encouraged to keep under review the various options for reducing such concentration.

Operational performance

SFECC's core system is the SECUR system. As noted in the 2007/08 Assessment, SFECC recently brought in-house some of the support for this system, which had previously been provided by NASDAQ OMX. In November 2008, SFECC finalised a new agreement with NASDAQ OMX in respect of ‘third-level’ support from the software developers.^[19] Details of operational performance during the period and relevant policy changes are provided in Section 6.

Summary

It is the Reserve Bank's assessment that SFECC complied with the Financial Stability Standard for Central Counterparties during the assessment period.

The Assessment highlights a number of important developments during the period under review. These include the following:

Risk-management actions during the market turbulence: As market conditions became more volatile during the assessment period, SFECC responded with more intensive participant monitoring, more frequent intraday margin calls, and pro-active increases in margin rates.
Review of default management processes: ASX embarked on a thorough review of default-management processes for both central counterparties, identifying key decision points and reviewing capabilities. In a second phase of the work, ASX aims to further clarify the legal underpinning for intended actions, identify any necessary rule changes, and implement identified enhancements.
Continued refinement to the risk framework: Some refinements to SFECC's risk framework were made during the period. Most notably, SFECC announced its intention to exit from its default insurance arrangement with Radian, following the insurer's ratings downgrade. As an interim measure, SFECC reduced the threshold beyond which calls would be made for additional initial margin. Further steps were taken through the period to provide the legal underpinning for migration of both central counterparties' treasury and funding arrangements to ASXCC, the central counterparties' holding company, though the proposed external issuance of debt by ASXCC has since been postponed indefinitely.

The Assessment also identifies a number of areas for further consideration by SFECC during the forthcoming period. These include:

Triggers for an increase in fixed risk resources: The Reserve Bank regards collateral calls under the AIM regime as appropriate where such calls are infrequent, short-lived or highly concentrated among a few participants. This has generally been the case over the past year. Nonetheless, SFECC is encouraged to develop clear guidance on the circumstances under which it would increase its fixed risk resources (either routine margining or pooled resources), rather than relying on additional collateral. As noted in the 2007/08 Assessment, there are shortcomings to relying too heavily on variable calls for additional collateral, particularly given lags in the calculation and settlement of such calls.
Review of the composition of pooled risk resources: In light of the postponement of the proposed external debt issuance, the Reserve Bank will remain in dialogue with ASX in relation to the composition of the central counterparties' pooled risk resources. An important element of this will be ASX's plans in respect of an alternate long-term source of funding to replace the central counterparties' default insurance. It is anticipated that issues around composition will be referenced in ASX's forthcoming consultation on the central counterparties' risk control frameworks.
Treasury investment policy: The Reserve Bank acknowledges that existing treasury investment alternatives are limited for the ASX central counterparties and that it would be difficult to reduce the concentration of investments among the largest domestic banks without compromising credit quality or liquidity. However, were the domestic repo market to deepen, perhaps due to continued expansion of government debt issuance, ASX would consider exploring this alternative for at least a portion of the treasury portfolio. The Reserve Bank encourages ASX to keep under review the various options for reducing concentration in the treasury investment portfolio.
Participant-monitoring arrangements: The Reserve Bank welcomes the enhancements to capital- and liquidity-monitoring arrangements at ASXMS. It is noted, however, that the central counterparties' arrangements for monitoring clearing participants may change further in due course, in light of the recent government announcement of reforms to the supervision of Australia's financial markets. The Reserve Bank will remain in dialogue with ASX and ASIC over 2009/10 to examine any implications of the reforms for clearing participant-monitoring arrangements.

5.3 ASX Settlement and Transfer Corporation (ASTC)

Background

ASTC operates the securities settlement facility for cash equities and warrants traded on the ASX market.

ASTC operates within a sound legal framework, based on its Settlement Rules. Under Section 822B of the Corporations Act, these rules constitute a contract under seal between ASTC and each of its participants, and between participants. Among other things, the rules set out the rights and obligations of ASTC and each of its participants, including in the event of default or suspension. ASTC's netting arrangements are approved under Part 3 of the Payment Systems and Netting Act. This provides certainty for the netting process in the event of the insolvency of an ASTC participant or a payment provider.

ASTC's securities settlement system is CHESS. Settlement risk in CHESS is mitigated by the use of a Model 3 DVP mechanism, whereby settlement of securities transfers and associated cash payments occurs in a multilateral net batch at around noon each day, with interbank payments made across ES accounts at the Reserve Bank. Securities title is updated upon notification of funds settlement.

Assessment of Developments in 2008/09

Following the disruption to the equity settlement process in January 2008, the Reserve Bank published a Review of Settlement Practices for Australian Equities and recommended that ASTC consider a number of enhancements to its settlement arrangements. In the 2007/08 Assessment, the Reserve Bank focused particular attention on two of the recommendations: modifications to improve the functioning of the existing batch-settlement model; and improving the transparency of securities lending activity. In the 2008/09 Assessment, the Reserve Bank focused on ASTC's progress towards meeting these recommendations. At the time of the 2007/08 Assessment, ASTC had already announced its intention to deliver enhancements in a third area of interest, the settlement-fails regime, which were ultimately implemented during this assessment period.

Modifications to improve the functioning of the existing batch-settlement model

Following significant delays to the completion of settlement of Australian equities transactions on two days in January 2008, the Reserve Bank carried out a detailed review of settlement arrangements.^[20] The review recommended a number of potential enhancements to the equity settlement process, which were subsequently discussed in detail with ASX.

ASTC has since made a number of changes to equity settlement practices to improve the robustness of the settlement process. One important development was the introduction of an earlier start-of-day for CHESS applications. The problems in early 2008 were in part related to the participant receiving new settlement instructions close to 10.30am – the deadline for new batch-settlement instructions – leaving little time for arrangements to be made to meet any resultant change in its settlement obligations. Accordingly, from 1 December 2008, CHESS transaction processing commenced two hours earlier – at 6am rather than 8am – allowing final batch-settlement instructions to be received earlier and thus giving more time for settlement problems to be identified and resolved.

Steps have also been taken both to improve communication to participants about their responsibilities in the clearing and settlement processes, and to enhance the flow of information to the market more generally when incidents occur.

In December 2008, ASX released a consultation document Enhancing Australia's Equity Settlement System, in which participants' feedback was sought on some further potential enhancements.^[21] The Reserve Bank remained in close dialogue with ASX throughout the consultation process. The changes due to be implemented in the near term, announced in early September 2009, include the following:^[22]

A firm deadline for the back out of settlement obligations: ASTC plans to establish a firm deadline for the back out of settlement obligations in the event that a participant fails to meet its payment obligations (although some flexibility will be retained in the event of operational problems). Had such arrangements been in place in January 2008, the back out of the troubled participant's settlement obligations and the recalculation of the batch could have been accelerated, reducing the overall length of the settlement delay, and mitigating the uncertainty and spillover to the market at large.
Increasing ASTC's powers to facilitate same-day settlement of backed-out settlement obligations: Since the incidence of batch recalculation could increase once a firm deadline for the back out of settlement obligations has been imposed, ASTC proposes to seek rules-based powers to require and facilitate the intraday settlement of certain backed-out settlement obligations if this was deemed necessary to avoid further disruption to the settlement process.
Removal of ACH derivatives margins from the CHESS settlement batch: This will ensure that ACH's risk-management arrangements are not dependent on the completion of settlement in the cash equity market. This is discussed in more detail in Section 5.1.
Development of standards for payment providers: ASX consulted on the possibility of pre-agreed settlement limits for payment providers (ie, those settling funds obligations on behalf of settlement participants), so as to avoid delays associated with the approval of settlement obligations for their clients. Following the consultation process, rather than proceed with pre-agreed limits, ASTC decided to work towards establishing a set of standards for payment providers.

Further to the consultation with participants, ASTC decided not to proceed with some other proposed changes. Amongst these, ASTC decided not to remove certain cash equity transaction types from the batch and will not require that all participants connect to CHESS RTGS (the settlement functionality in CHESS that allows individual securities and funds transfers to be settled on a DVP basis in real time, rather than in the once-daily net batch settlement).

The Reserve Bank views the real-time gross settlement (RTGS) mode of settlement as a useful contingency vehicle for DVP settlement: (i) should a batch-settlement problem arise and some settlement obligations have to be backed out and rescheduled; and (ii) should transactions not be submitted in time to enter the batch-settlement process. ASTC acknowledges these benefits and, although it has decided not to pursue mandatory connectivity, it will strongly encourage participants to connect. The Reserve Bank encourages ASTC to keep mandatory connectivity to CHESS RTGS under consideration, at least for the largest settlement participants in respect of which the systemic benefits of a contingent vehicle for same-day DVP settlement are likely to be greatest.

Transparency of securities-lending activity

The Reserve Bank made the case for improved transparency of equities securities lending in its Review of Settlement Practices for Australian Equities. The disruption to equity settlement in January 2008 arose, in part, from a participant's inability to meet obligations arising from securities-lending transactions. This episode revealed that, since securities-lending transactions are currently settled in the CHESS settlement batch alongside equity trades that have been novated to ACH, any disruption to their settlement can have spillover effects to settlement in the wider market. For this reason, the Reserve Bank saw a strong case for ASTC, regulators and market participants to have access to data on activity in the securities-lending market, and the scale of outstanding positions. With this information, participants would gain a better understanding of potential future settlement risks and the role of securities lending in broader market functioning. Transparency of this activity would also improve the balance of information in the market; currently, only those directly involved in these transactions have access to such information.

The Reserve Bank undertook extensive consultation with ASX and market participants on these issues during the assessment period. This process included the release of a consultation document in October 2008 proposing a variation to a measure of the Financial Stability Standard for Securities Settlement Facilities to require that facilities settling equity transactions collect and publish data on securities lending activity. Industry input to the design of the disclosure regime proved extremely valuable and the details of implementation were ultimately finalised (and the variation to the Standard given effect) in February 2009 (see Section 4). The key features of the implementation are:

Real-time tagging of allsecurities loan-related settlement instructions submitted to CHESS. These data will be particularly useful for ASTC as operator of the securities settlement facility, to give visibility of loan-related transactions submitted for settlement and allow settlement performance of such trades to be monitored effectively.
Daily reporting to ASX of settlement participants' outstanding on-loan and borrowed positions, by security. These data will offer a gauge of outstanding loans which might be subject to recall, and allow for separate identification of chains of loans. The Reserve Bank will also work with ASX and others to encourage non-settlement participants to provide similar data on a voluntary basis.
Quarterly reporting of the aggregate number of shares committed to lending programs by settlement participants. The Reserve Bank will also work with ASX and the industry to obtain these data from non-settlement participants on a voluntary basis.
Daily publication by ASX of the number and value of tagged transactions and the aggregate on-loan position in each security. These will be published alongside relevant comparative statistics and explanatory notes.

ASX is working towards implementation of real-time tagging by 2 November 2009. This will be implemented as part of a new release of the CHESS software. Direct positional reporting is due to be implemented in December 2009. In the meantime, a pilot phase for the direct positional reporting began in late May 2009, during which the Reserve Bank is working with ASX and reporting parties to refine the requirements, test systems and processes, and ensure data quality.

Settlement-fails regime

In the context of examining the incidents in January 2008, ASX and the Reserve Bank also considered measures to minimise the potential for settlement failures. Although low by international standards, at substantially less than one per cent, such failures can nevertheless impose costs on the wider market. Accordingly, a number of changes were made to ASTC's arrangements for dealing with settlement fails.

As reported in the 2007/08 Assessment, ASTC now provides participants with settlement performance statistics for themselves and their peer group. In order to further increase incentives to settle on time, as of 1 September 2008 the minimum daily settlement-delay fee charged to participants was raised from $50 to $100 per failed transaction, and the maximum fee was raised from $2,000 to $5,000. The value-based fee of 0.1 per cent of the transaction value was unchanged. ASX reported that under the previous fee structure participants often absorbed the minimum settlement-delay fee rather than passing it on to clients, with the majority of fails (by number) being for small amounts.

Action was also taken to limit the duration of any settlement delay. From 30 March 2009, ASTC Settlement Rules require participants to close out any position remaining unsettled two days after the scheduled settlement date (ie, on the fifth day after the trade date). Should such action not be taken, disciplinary procedures would be accelerated.

These changes appear to have succeeded in reducing the incidence of settlement fails. With the exception of a transitory increase in settlement fails during the period of market turbulence in late 2008, the settlement-fail rate has drifted lower throughout the assessment period.

The average rate of initial fails was above 0.2 per cent in the September 2008 quarter; this had dropped to around 0.1 per cent by the June 2009 quarter (Graph 12).

Operational performance

ASTC's key system is CHESS. Details of operational performance during the period and relevant policy changes are provided in Section 6.

New market operators

As noted in the Assessment of ACH (Section 5.1), ASX has remained in dialogue with industry on clearing and settlement arrangements for trading platforms seeking licences to offer alternative markets in ASX-listed securities. A number of key decisions in respect of these arrangements are seen as being dependent on the detail of the ministerial decision on the licence applications. The Reserve Bank will assess the implications of any new arrangements for the risk profile of ACH and settlement processes at ASTC once a decision is made.

Summary

It is the Reserve Bank's assessment that ASTC complied with the Financial Stability Standard for Securities Settlement Facilities during the assessment period.

The Reserve Bank welcomes the measures taken by ASTC in response to the Review of Settlement Practices for Australian Equities, including the enhancement to the settlement-fails regime, and the preparations for implementation of securities-lending disclosure.

The Reserve Bank also welcomes the consultation process undertaken by ASX in respect of modifications to the existing settlement model, and in particular the decisions to introduce firm deadlines for completion of batch settlement and to remove settlement of ACH derivatives from the batch. The Reserve Bank does, however, encourage ASTC to keep under consideration making connectivity to CHESS RTGS mandatory, at least for the largest settlement participants.

5.4 Austraclear

Background

Austraclear operates a securities settlement facility for trades executed in the OTC market for fixed income securities, including government bonds and repos.

Austraclear operates within a sound legal framework, based on its Regulations. Under Section 822B of the Corporations Act, these have effect as a contract under seal between Austraclear and each of its participants, and between participants. Among other things, the rules set out the rights and obligations of Austraclear and each of its participants, including in the event of default or suspension. The finality of settlements undertaken by Austraclear is reinforced by its approval as an RTGS system under Part 2 of the Payment Systems and Netting Act. This approval protects the finality of payments made through Austraclear should a participant enter external administration.

Austraclear addresses settlement risk by the use of a Model 1 DVP mechanism, involving settlement of individual transactions on a gross basis. The interbank cash leg is paid through the Reserve Bank's RTGS system, with simultaneous transfer of securities title in Austraclear.

Assessment of Developments in 2008/09

The operating framework of Austraclear was broadly unchanged during the assessment period, with only some small changes to the legal framework, and some expansion of its agency services. The principal focus of the 2008/09 Assessment was again operational risk management, in part reflecting a lengthy outage to Austraclear's EXIGO system in March 2009.

Operational risk management

As noted in the 2007/08 Assessment, Austraclear brought in-house some of the support for its key EXIGO system in April 2008. This had previously been provided by NASDAQ OMX.^[23] In November 2008, Austraclear finalised a new agreement with NASDAQ OMX in respect of the so-called ‘third-level’ support provided by the products' suppliers (manufacturers, software developers etc).

Overall during the period, the EXIGO system achieved availability of 99.91 per cent. One significant operational outage occurred, however, with the system unavailable for 2½ hours on 25 March 2009. In the event, the system was restored shortly after 3.00pm and all of the day's transactions were successfully settled. However, a 30 minute extension to the RITS settlement day was required. The outage was caused by an accidental change to code within the live production database, carried out by a system support staff member who was simultaneously connected to both the live and test environments. Steps have since been taken to physically separate the test and production systems. ASX has also tightened its procedures around access to the production system, formalising arrangements for monitoring and auditing access, and obtaining senior approval. ASX does, however, see an advantage in certain staff retaining authority to access the production system without first obtaining formal procedural approval from senior staff. This flexibility might, for instance, be valuable to expedite system recovery following an operational failure. ASX emphasises, however, that such authority would be granted (and used) only rarely, under strict guidelines.

The Reserve Bank is satisfied that Austraclear is taking appropriate steps to address the specific issues raised by this incident and will follow up with Austraclear once the new arrangements have been fully implemented.

Some issues were also raised by a separate incident in December 2008, in which users accessing EXIGO via an internet connection were unable to do so. Although Austraclear switched to its business-recovery system to facilitate access for these users, it was found that some participants had misconfigured their firewalls, preventing access to the business-recovery system. So as to avoid a recurrence of this incident, ASX enhanced its testing plans to specifically test internet connectivity to the business-recovery system every six months. The next such test is scheduled for October 2009.

The Reserve Bank carried out a more detailed examination of operational risk issues for all four ASX facilities in this assessment period, with findings presented in Section 6.

Legal framework

During the year, Austraclear prescribed three additional circumstances in which a participant must withdraw securities from the system:

An insolvency event occurs with respect to the obligor in relation to the security.
Austraclear considers it is desirable to remove the security, under its obligations as a CS facility licence holder.
An event occurs which, in Austraclear's opinion, is likely to result in the paying agent failing to effect a payment in relation to the security when it is due.

Changes to this effect were made to the Austraclear Procedures.

New products and services

Austraclear finalised operational changes required to introduce new agency arrangements. These included the following changes: clarifications to Austraclear's service offering; a new form of agency agreement; enhanced customer-relationship management; and revised fees for some services. Most of the changes came into effect on 1 July 2009, with new fee categories effective from 3 August 2009.

Summary

It is the Reserve Bank's assessment that Austraclear complied with the Financial Stability Standard for Securities Settlement Facilities during the assessment period. Further to the operational incident in March 2009, however, the Reserve Bank will continue to monitor closely the operational performance of Austraclear and the control procedures in place to ensure ongoing system resilience.

Box A: Participant Monitoring in a Central Counterparty

In addition to assessing developments in ACH's participant-monitoring activities, the Reserve Bank considered more generally the appropriate boundary of a central counterparty's participant monitoring.

While it would be ideal for a central counterparty to be in a position to foresee any future threats to a participant's solvency and its ongoing ability to meet its obligations, in practice this is not possible. Given the breadth and complexity of many clearing participants' activities, there will be a natural limit to the accuracy with which a central counterparty can quantify the risk of default, in particular where shocks to a participant's solvency may arise from off-market activities or the activities of other (perhaps overseas) related entities. The data available to the central counterparty will often not be sufficiently granular, comprehensive or timely to offer a reliable ‘early warning’ of a participant's financial difficulties.

As clearing participants' businesses become more complex and international in scope, a central counterparty's ability to capture and process sufficiently reliable and timely information on individual sources of risk becomes more limited. For this reason, a central counterparty typically seeks to rely wherever possible on the relevant prudential supervisor, who will have access to more timely, more granular, and more comprehensive data than will typically be available to a central counterparty. Indeed, in this regard, ACH is seeking to permit direct participation by Authorised Deposit-taking Institutions (ADIs) and as part of this initiative is developing a framework for efficient reliance, where appropriate, on (domestic and foreign) prudential regulators.

Given the difficulties associated with participant monitoring, a central counterparty will typically emphasise other elements within its risk framework, to ensure that it could continue to meet its obligations on a timely basis should a participant default. These include, in particular:

high-level filters, such as threshold participation requirements and ICRs;
triggers for follow-up enquiry, based for instance on the observation of trends in financial ratios, market data, corporate events, and other qualitative information;
close monitoring of risks brought to the central counterparty and application of statistical analysis and stress testing to ensure that the calibration of both margin and pooled risk resources offer adequate coverage in the event of a participant default; and
appropriate default-management arrangements to ensure minimal spillover from the central counterparty's close out of a defaulter's open positions.

Both of the central counterparties operated by ASX have enhanced their capabilities in most of these areas in recent years. Both ACH and SFECC have refined their use of high-level filters, such as participation requirements and ICRs, and have recently enhanced their margining and stress-testing methodologies. Work is also currently underway to strengthen default-management arrangements (see below).

Box B: Margining Cash Equities

ACH does not routinely collect margin from participants in respect of cash equities positions, instead covering the risk exposures arising from these positions through its pooled risk resources and, in the case of large exposures, through calls for additional collateral under the CAC regime.

The pooling of risk resources economises on opportunity costs arising when each participant is individually required to post initial margin. However, there may be costs to relying too heavily on pooled resources. In particular, drawing on pooled resources to fund a default may carry reputational costs. For instance, the central counterparty's risk-management approach may be called into question. Furthermore, replenishing paid-up resources following a draw could be difficult, again leading to a loss of confidence in the central counterparty.

Requiring participants to post margin avoids these problems and also provides participants with good incentives to manage the risk they bring to the central counterparty. The participant bears a direct opportunity cost when it brings a trade to the central counterparty, and will therefore factor this into its trading decision. It also bears a direct cost (the loss of all margin posted) if it ‘walks away’ from a loss-making trade, therefore reducing any strategic incentive it may have to do so.^[7]

For these reasons, the use of margining as a risk-management tool is universal among central counterparties that clear derivatives, and most central counterparties that clear cash equities also routinely margin exposures. While the size and duration of exposures is somewhat lower in the cash equity market than in the derivatives market, the impact of a call on pooled risk resources could still be sizeable in the event of a participant default.

Indeed, as noted in Section 3, volatility in the cash equity market has risen markedly over the past two years, notwithstanding a dip more recently (Graph 2). ACH monitors the risk in participants' cash equity exposures by calculating a notional value of initial margin and mark-to-market margin. These averaged $175 million, and $41 million, respectively, across participants during the year to end-June 2009. Notional initial margin peaked at more than $600 million (Graph 6).^[8] While the largest individual participant exposures are covered by additional collateral calls linked to the stress-testing regime, there would seem to be a strong case for ACH to reduce its dependence on these collateral calls and pooled risk resources by introducing routine margining for cash equities.^[9]

ASX will include routine margining of cash equities by ACH in an upcoming consultation on the risk-control framework for the central counterparties. The consultation will also consider potential issues in implementation. These are likely to include the following:

the lag between establishment of a position and the settlement of margin, which is important given the short duration of the three-day settlement cycle;
the liquidity implications for participants; and
the potential spillover to trading activity from introducing margining.

In discussion with ACH, one option under consideration is a regime whereby the initial margin calculation takes into account participants' ‘typical’ exposures over time. Such an approach would avoid large daily swings in margin requirements as settling trades fall out of the calculation and new positions enter. Large concentrated positions would continue to be covered by additional collateral calls.

Footnotes

Assessments for 2006/07 and 2007/08 may be found at: <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/assessments/>. [1]

‘Core liquid’ capital is defined by ASX to be the sum of: all paid-up ordinary share capital; all non-cumulative preference shares; all reserves, excluding revaluation reserves; and opening retained profits/losses, adjusted for current year movements. In addition, ACH participants are subject to a risk-based requirement under which they must hold sufficient ‘liquid capital’ to cover counterparty risk, large exposure risk, position risk and operational risk. [2]

While ‘Additional Cover’, posted in respect of derivatives positions, is equivalent to margin and hence can only be used in the case that the participant posting the collateral defaults, ‘Contributions’, posted in respect of cash equities positions, are a mutualised resource. In due course, ACH expects to introduce margining powers to its Clearing Rules, which could result in any such Contributions being treated as equivalent to margin. [3]

The document, Review of Participation Requirements in Central Counterparties, is available at: <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/consultations/review-requirements/rprcc-032009.pdf> [4]

In addition to these conclusions, ASIC and the Reserve Bank each made some recommendations related to their particular regulatory responsibilities. ASIC suggested that ACH explore whether alternative interim arrangements might be applied for some existing participants. The Reserve Bank encouraged ACH to consider other risk-control measures during the longer implementation phase and also suggested that a higher minimum capital requirement for third-party clearers might be considered. [5]

The unit is also responsible for determining and reviewing participants' ICRs, drawing on information provided by participants in their returns to ASXMS. [6]

Of course, there are also costs. In particular, imposing margin requirements may in some cases pose liquidity problems for participants and lead to a reduction in trading activity. [7]

During the assessment period, the system used by ACH to calculate notional initial and mark-to-market margin considered only exposures to the largest and most liquid 200 listed securities, which typically comprise more than 90 per cent of novated settlement value. Since the end of the assessment period, ACH has expanded the scope of its notional margin calculations to include other less-liquid securities. Within the expanded model, a very conservative notional initial margin is applied to the least actively traded securities, with no offset against other positions. As such, the expansion of the model has led to a material increase in total notional initial margin. The distribution of notional margin across participants has also changed, with significant increases for some smaller clearing participants, who tend to generate higher exposures to less-liquid securities. In absolute terms, however, notional initial margin for these participants generally remains low. [8]

Or other routine collateralisation of cash equity market exposures in normal market circumstances. [9]

That is, it had been intended that the principal value repayable by ASXCC would reduce in the event of a draw on the funds raised following either a participant default or the failure of a treasury investment counterparty. To support the debt issuance, ASX sought external credit ratings, with ratings of AA− and A assigned by Standard and Poors in June 2009 for ASXCC and the notes (based on indicative terms of issue), respectively. Throughout the period, ASX also continued to work on the legal basis for the new treasury and funding arrangements under ASXCC, liaising with the Reserve Bank and ASIC during this process. [10]

These positions are related to index-arbitrage transactions. Index arbitrage is a trading strategy which seeks to profit from a difference between the actual and theoretical spread between futures prices and prices in the underlying physical market. The trading strategy involves taking either a long futures position and selling stock, or taking a short futures position and buying stock. The gains from the trading strategy are realised when the futures position expires: the futures position is liquidated and the stock is either bought (if stock had originally been sold) or sold (if the stock had originally been bought). The scale of these cash equity trades can cause spikes in ACH participants' projected stress losses. [11]

Furthermore, in normal market conditions, highly rated counterparties will be required to cover only a proportion of the excess exposure beyond the stated threshold. ACH would suspend discounting if the exponentially-weighted moving average (EWMA) of SPI S&P/ASX 200 volatility was 20 per cent higher than historical volatility. [12]

Had the proposed new arrangements been in place during 2008/09, B-rated participants would have been called less often (on four occasions, rather than nine occasions), but C- and D-rated participants more often. C-rated participants would have been called five, rather than four times, and a D-rated participant would have been called on one occasion, whereas there were no calls on D-rated participants under the existing regime. [13]

In the 2007/08 Assessment it was noted that, given the timing of ACH's daily stress tests, collateral can only be called in respect of the position at the close of the previous day's trading. Therefore, ACH can retain uncovered exposure for more than 24 hours (and longer over weekends). ACH was encouraged to give further consideration to how the regime might be enhanced so as to allow for calls to be made sooner after a large position had been executed. ACH confirmed that there would be system and technological challenges to addressing this in the near term. [14]

In considering the implementation, ASX identified a potential daylight principal risk associated with the exercise of low-exercise-price options (LEPOs). A LEPO is a European-style call option (ie, can only be exercised on expiry date) with a strike price of one cent. There is no up-front option premium and both buyer and seller pay margins through the life of the LEPO. Upon exercise at expiry, the buyer pays premium and final margin payments to the seller (via ACH) and the securities are transferred against consideration of just one cent. Since the final margin and premium payments represent the full value of the securities, where these are not settled in the CHESS settlement batch, a daylight principal risk arises between the time at which they settle in Austraclear and the time at which securities are transferred in CHESS. The Reserve Bank encouraged ACH to find a solution to this principal-risk issue as a matter of priority, particularly since it already arises where participants choose to settle their payments in Austraclear. ACH has identified a long-term solution, which involves settlement of securities delivered at expiry at the prevailing stock price, rather than the strike price of one cent. This will take some time to implement, however, and hence an interim solution has been proposed, whereby ACH will withhold all outward margin payments until it is has been confirmed that the CHESS batch has settled. The Reserve Bank accepts that this solution will mitigate the daylight principal risk faced by ACH in respect of LEPOs, but encourages ACH also to proceed with the longer term solution. [15]

The document Delivering Efficiencies to the Marketplace through the Harmonisation and Linking of CCP Activities: The Way Forward may be found at: <http://www.asx.com.au/about/pdf/market_information_paper_delivering_efficiencies.pdf>. [16]

ASXMS is responsible for capital and liquidity monitoring, as well as investigations and enforcement. Clearing Risk Operations focuses principally on day-to-day participant activity and monitors risk profiles, open positions and settlement of obligations to the central counterparties. [17]

SFECC also uses ICRs to determine the threshold beyond which the AIMs cover will be called when large exposures are identified by stress testing. [18]

Similar new contractual arrangements were finalised for Austraclear's principal system, EXIGO. [19]

The document, Review of Settlement Practices for Australian Equities, is available at: <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/pdf/practices-au-equities-may08.pdf>. [20]

The document Enhancing Australia's Equity Settlement System, is available at: <http://www.asx.com.au/about/pdf/consultation_paper_enhancing_equity_settlement_system.doc>. [21]

The document Enhancing Australia's Equity Settlement System: The Way Forward may be found at: <http://www.asx.com.au/about/pdf/market_information_paper_enhance_equity_settle.pdf>. [22]

Similar new ‘in-sourcing’ arrangements were introduced for SFECC's principal system, SECUR. [23]