2010/11 Assessment of Clearing and Settlement Facilities in Australia 3. Developments in the Clearing and Settlement Industry in 2010/11

The number of trades on the equities and derivatives markets served by the ASX Group (ASX) central counterparties increased in 2010/11. In the cash equities market, however, the value of trading fell slightly. Volatility in market prices was also lower overall. This lower volatility contributed to a decrease in the margins calculated (but not collected) by ASX Clear Pty Limited (ASX Clear) in respect of cash equities, and that of margins collected by ASX Clear in respect of derivatives. There was a small increase in the initial margins collected by ASX Clear (Futures) Pty Limited (ASX Clear (Futures)) as lower volatility only partially offset the effect of higher trading activity. The value of securities settled by ASX Settlement Pty Limited (ASX Settlement) decreased, reflecting in part the lower value of cash equities traded. The value of debt securities settled by Austraclear Limited (Austraclear) also fell.

There were a number of important regulatory developments in 2010/11. These included a review of the Australian regulatory framework for financial market infrastructures public consultation on the central clearing of over-the-counter (OTC) derivatives in Australia, and drafting of new principles for financial market infrastructures (FMIs) by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO).

Against this backdrop, three new FMIs are looking to begin operation in Australia: Chi-X Australia Pty Ltd (Chi-X), which plans to offer trading in ASX-listed equities was granted a market licence; a new derivatives market – the Financial and Energy Exchange Limited (FEX) – applied for a market licence to offer trading in commodity, energy and environmental derivatives; and LCH.Clearnet Limited (LCH), a London-based central counterparty, applied for a clearing and settlement (CS) facility licence to clear for FEX.

Activity in the Licensed CS Facilities

Activity in ASX-operated financial markets was relatively subdued in the second half of 2010 before picking up in the first half of 2011. Overall there was an increase in the volume of transactions processed by the licensed central counterparties in 2010/11, but a decrease in the value of securities processed by the licensed settlement facilities. Volatility in cash equities prices was slightly lower than that in the previous year, and less than half of that in 2008/09.

In the cash equities market, there was a 9 per cent increase in the average daily number of transactions per month, while the average daily value of transactions fell by 1 per cent (Graph 1). In line with this, the average value of each trade declined to around $9,300 in 2010/11. This is around the same level as seen over the last few years, though it is significantly lower than the average value of each trade five years ago.

Volatility in cash equities prices was generally quite low over 2010/11, particularly when compared with the periods of turbulence during recent years. Average volatility, as measured by the absolute daily per cent change in the S&P ASX All Ordinaries index, fell from 0.8 per cent in 2009/10 to 0.6 per cent in 2010/11 (Graph 2). In 2008/09, at the height of the global financial turmoil following the collapse of Lehman Brothers, average volatility was 1.5 per cent. While there was a spike in volatility in March 2011 following the Japanese earthquake and tsunami disaster, this was somewhat smaller than that which occurred in May 2010 amidst concerns over public debt levels in some European countries. The March spike was also just a fraction of the size of that seen immediately following the Lehman Brothers collapse in September 2008.

Volatility in the Australian market has broadly mirrored that of global equities markets, but has generally been less pronounced (Graph 3). For example, corresponding spikes in the volatility of the All Ordinaries index have been smaller than those in: the Nikkei index following recent Japanese natural disasters; the Euro STOXX index following the European sovereign debt concerns of mid 2010; and most equities indices following Lehman Brothers' collapse in late 2008.

Trading activity was higher on both ASX derivatives markets. The average daily number of derivatives contracts traded on the ASX market (mainly equity derivatives) increased by 7 per cent.^[1] The average daily number of contracts traded on the ASX 24 market grew by 29 per cent, mostly reflecting increased trading of interest rate futures.

In part because of the fall in the value of cash equities trading, the value of securities transactions settled by ASX Settlement decreased by 4 per cent to an average daily value of $8.1 billion. (This fall in settlement values was larger than the 1 per cent fall in traded values because the former includes settlement of non-market transactions and accounts for multilateral netting of clearing participants' obligations.) For debt securities, the average daily value settled through Austraclear decreased by 5 per cent to $39.5 billion. (This value includes outright purchases and sales of securities, and securities transferred as part of repurchase agreements.)

Risk Management in the Licensed Central Counterparties

The market risk associated with closing out novated positions in normal market conditions in the event of a clearing participant default (as measured by margin requirements) was subject to divergent influences in 2010/11. The increased number of transactions processed by the central counterparties was countered by lower volatility in market prices and, in the case of cash equities, lower values traded.

As part of its internal risk management process, ASX Clear currently calculates, but does not collect, margin requirements on cash equities positions through its ‘Real Risk’ model. (ASX Clear's plans to introduce margining of cash equities are discussed in Section 5.1 of this Assessment.) The Real Risk model quantifies the value at risk to ASX Clear under normal market conditions should it have to close out a defaulting participant's unsettled novated settlement obligations. Average daily notional initial margin requirements calculated by the model decreased by 1 per cent to $311 million in 2010/11 (Graph 4). The average for 2010/11 is inflated by a short period of high notional margin requirements following the initial public offering of QR National in November 2010. ASX noted that this reflected more the current treatment of new stocks in its Real Risk model than a significant increase in actual risk to the central counterparty. ASX Clear's forthcoming cash equities margining model will provide a more tailored treatment of new stocks.

The average of daily margins (both initial and mark-to-market) collected by ASX Clear on derivatives positions fell 22 per cent in 2010/11, to $866 million (top panel of Graph 5). As these positions are mainly in equity options, the lower margin requirements appear to have been driven mainly by the lower volatility in equities prices.

The average of daily initial margins collected by ASX Clear (Futures) increased by 3 per cent to $1.8 billion (bottom panel of Graph 5). Despite the strong growth in trading activity on the ASX 24 market, this relatively small increase in margins in part reflects the fact that margin rates on the most commonly traded interest rate futures contracts were at generally lower levels when compared to the previous year; the margin rate on a contract is largely determined by the recent volatility in its price.

Regulatory Developments

In early April 2011, the Treasurer asked the Council of Financial Regulators (‘the Council’) to provide advice on measures which could be introduced to ensure that Australia's regulatory framework for FMIs continues to protect Australia's interests. A working group, chaired by the Treasury, comprising representatives of the Australian Prudential Regulation Authority, the Australian Securities and Investment Commission (ASIC) and the Reserve Bank has been established to consider the adequacy of oversight, powers of direction and crisis-management arrangements for market operators and clearing and settlement facilities. The Council working group anticipates issuing a consultation paper seeking stakeholder views in the spring of 2011.

At the same time as this review, the Council agencies continue to assess global developments in OTC derivatives markets and consider appropriate policy responses. In June 2011, the Reserve Bank, on behalf of the Council agencies, issued a discussion paper Central Clearing of OTC Derivatives in Australia.^[2] The paper describes the evolving global landscape for OTC derivatives and central clearing, as well as the Australian market for OTC derivatives, and presents a range of considerations that need to be weighed if central clearing in the domestic market is to be established. This work is required in part because of the substantial reforms in this area underway in many offshore jurisdictions. Along with these international developments, the interests of the Australian agencies also reflect a commitment by the G-20 group of countries (of which Australia is a member) to undertake significant reforms to strengthen OTC derivatives markets. In particular, these countries committed to see all standardised OTC derivatives transactions centrally cleared by the end of 2012.

Ahead of making recommendations to the Government on this matter, the Council is seeking feedback on the views and propositions set out in the paper. Written submissions were sought from interested parties by 1 September with the Council agencies continuing to consult with stakeholders over the remainder of 2011.

Along with increased global regulation of OTC derivatives markets, another significant global regulatory development is CPSS and IOSCO's impending introduction of revised standards for FMIs. In March 2011, CPSS and IOSCO released for consultation a draft of a single set of Principles for FMIs, which is intended to replace the three existing sets of standards.^[3] The new principles reflect lessons learnt from the financial crisis and other contemporary developments, such as the prospective new regulatory environment for OTC derivatives. CPSS and IOSCO are reviewing the comments received during the consultation process, with the aim of releasing a final report and set of principles in early 2012. They propose that relevant authorities include the new principles in their legal and regulatory frameworks by end 2012. Upon release of the final principles, the Reserve Bank will consider whether any changes need to be made to the Financial Stability Standards. It is anticipated that FMIs that fall within the ambit of the new principles will not be required to comply immediately.

New Financial Market Infrastructure

Chi-X, which plans to offer trading in ASX-listed equities, was granted a market licence by the Minister for Financial Services and Superannuation on 4 May 2011. This followed the finalisation by ASIC in late April of the regulatory framework for competition between markets trading equities.^[4] Upon launching, Chi-X's trades will be cleared and settled through ASX's Trade Acceptance Service. However, Chi-X's market licence permits clearing and settlement to be conducted by any CS facility licensee approved for the purpose.

A new derivatives exchange, FEX, has also applied for a market licence. FEX plans to offer trading in commodity, energy and environmental derivatives, and has approached LCH to provide CS services. LCH is a London-based central counterparty that clears equities and derivatives for a number of exchange-traded and OTC markets overseas. It is regulated and supervised by the UK's Financial Services Authority (FSA). In order to clear for FEX, however, LCH must be licensed in Australia. The Corporations Act 2001 provides for an alternative licensing process for facilities that are overseas based and are operating under a regulatory regime sufficiently equivalent to the Australian regime.^[5] LCH's application is being considered under that process. If LCH is granted a licence it will be exempt from the Reserve Bank's Financial Stability Standard for Central Counterparties (the Standard provides for this exemption) so long as the Reserve Bank receives documentary evidence from the FSA that LCH complies with the FSA's regulations. The effect of this is that the Reserve Bank's annual assessment of CS facilities would not necessarily assess in detail LCH against each of the measures of the relevant Financial Stability Standards (FSS) (as it does for the ASX CS facilities). However the annual assessment must still contain an assessment of whether LCH has done all other things necessary to reduce systemic risk (as required of all CS facilities by the Corporations Act).^[6] The Reserve Bank will rely largely upon information provided by the FSA (LCH's direct overseer) and will seek to assess LCH on an equivalent basis to domestic facilities undertaking equivalent activities.

Footnotes

In May 2011, the standard equity option contract size was changed from 1,000 shares to 100 shares. The calculation of the 7 per cent growth figure involves an adjusted measure of trading volume in 2010/11 which corrects for the change in contract size. See <http://www.asxgroup.com.au/media/PDFs/ma110706ASX_Group_Monthly_Activity_Report_-_June_2011_-_final.pdf>. [1]

Available at <https://www.rba.gov.au/publications/consultations/201106-otc-derivatives/pdf/201106-otc-derivatives.pdf>. [2]

The three existing sets of standards are: ‘Core Principles for Systemically Important Payment Systems’ (CPSS, 2001); ‘Recommendations for Securities Settlement Systems’ (CPSS and IOSCO, 2001); and ‘Recommendations for Central Counterparties’ (CPSS and IOSCO, 2004). [3]

‘ASIC Market Integrity Rules (Competition in Exchange Markets) 2011’, available at
<http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Market%20integrity%20rules>. [4]

While ‘sufficient equivalence’ is not defined in the Corporations Act, the Reserve Bank has nominated the aspects of a foreign regulatory regime that it considers in making an assessment of equivalence. These are available at <https://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/standards/overseas-equivalence.html>. [5]

The Reserve Bank's detailed assessment against the FSS normally overlaps this requirement. [6]