2010/11 Assessment of Clearing and Settlement Facilities in Australia 6. Special Topic: Default Arrangements

The key function of a central counterparty is to ensure that clearing participants are not exposed to principal or market risk on cleared positions should another clearing participant default on its obligations. In normal circumstances, the central counterparty has a net position of zero in the products it is clearing, since all its positions vis-á-vis counterparties – i.e. clearing participants – are offsetting. However, in the event that a clearing participant defaults on its obligations to the central counterparty, the central counterparty must continue to meet its obligations, and assumes market risk on these positions until they are closed out or otherwise offset.

The central counterparty's capacity to manage these potential exposures, and its procedures for responding to a default, can have important implications for the broader financial system. This is because any disturbance to the smooth functioning of a central counterparty is likely to have implications for the market and participants that it serves. Therefore, it is crucial that a central counterparty has sufficient resources and default management procedures to continue to operate both during and after a default event.

For this reason, the Financial Stability Standard for Central Counterparties sets out requirements (Measure 6 – Default arrangements) that seek to ensure that the central counterparty can manage the default of a clearing participant:

The CS facility licensee as operator of the central counterparty must ensure that it has clear rules and procedures to deal with the possibility of a participant being unable to fulfil its obligations to the central counterparty. The arrangements for dealing with a default must ensure that in this scenario timely action is taken by the central counterparty and the participants in the central counterparty, and that risks to the central counterparty and its participants are minimised. In meeting this requirement, the CS facility licensee as operator of the central counterparty must:

1. require its participants to inform it immediately if they:
   1. become subject to external administration, or have reasonable grounds for suspecting that they will become subject to external administration; or
   2. have breached, or are likely to breach, a risk-control requirement of the central counterparty; and

2. have the ability to close out, or otherwise deal with a participant's open contracts in order to appropriately control risk if a participant:
   1. becomes subject to external administration; or
   2. breaches a risk-control requirement of the central counterparty.

Guidance to the Measure specifies that it is aimed at avoiding any systemic disturbance that may arise from the default of a clearing participant.

In the current assessment period, the Reserve Bank undertook a detailed assessment against Measure 6, on default arrangements, for the two licensed central counterparties. It is the Reserve Bank's assessment that ASX Clear Pty Limited (ASX Clear) and ASX Clear (Futures) Pty Limited (ASX Clear (Futures))' default arrangements satisfy the requirements of this Measure.

The ASX central counterparties, ASX Clear and ASX Clear (Futures), have put in place a common default management framework.^[1] This Section describes and assesses the default arrangements.

Default Management: Procedures and Governance

Measure 6 of the Financial Stability Standards for Central Counterparties requires that the central counterparty has clear rules and procedures to deal with the default of a participant. Given the often rapid nature of a default event, well-tested procedures that set out key decision points and lines of responsibility are crucial for enabling a default to be managed in a timely fashion, and in such a way that minimises the impact on the central counterparty, other clearing participants and the market more broadly. Well-documented procedures can also minimise the risk of legal challenge to any actions taken by the central counterparty during the management of a default. Notwithstanding this, it is appropriate that a degree of flexibility is retained in the procedures to enable the default to be managed in a manner that is best suited to the specific circumstances and market conditions.

The ASX central counterparties have put in place a ‘default management framework’ (DMF), applicable to both ASX Clear and ASX Clear (Futures), to assist in the management of a clearing participant default. The DMF is based on high-level principles regarding the management of a default that have been approved by the clearing and settlement (CS) Boards. In particular, these principles specify that the key aim in handling a default is to minimise the impact of the event on the ASX central counterparties, clearing participants and the market. This is consistent with requirements under the Financial Stability Standards (FSS). The DMF is supported by the Operating Rules and Procedures of each central counterparty.

The DMF covers each stage of a default, from the identification of a default event, to the management of the defaulter's positions, real-time monitoring of financial solvency, and financial offset and reconciliation. It is intended to be flexible, rather than prescriptive, and can be developed and adapted as needed. It therefore identifies the key decision points at each stage of the process.

The DMF also outlines the key roles and responsibilities in managing a clearing participant default. The ASX Group has established a Default Management Committee (DMC), comprising senior management from relevant policy and operational areas, to be the primary decision-making entity for the management of a default. The DMC's responsibilities range from recommending declarations of default and suspensions, to devising a risk neutralisation plan and overseeing its implementation.

The DMF further outlines how the ASX Group (ASX) will communicate with internal and external stakeholders during a default event. Broadly, communications will be handled by the DMC, assisted by ASX's Media and Communications unit. General advice to participants will be made primarily through existing communications channels (e.g. the e-mailed market notices and circulars); and through the ASX website.

The DMF is reviewed on an annual basis, or more frequently as needed. The effectiveness of the DMF is regularly tested. In-house default management ‘fire drills’, conducted each calendar year, test a hypothetical default of a participant, and follow through the entire default management process. The tests ensure that relevant ASX personnel are familiar with the default management process, and identify areas where the DMF should be updated.^[2]

Legal framework

The procedures that are set out in the DMF relate to the exercise of powers established by the Operating Rules and Procedures of ASX Clear and ASX Clear (Futures). The Corporations Act 2001 provides legislative backing to the Operating Rules and Procedures of the central counterparties, stating that they have effect as a contract under seal between the central counterparty and its participants. The Corporations Act also protects these contractual obligations in the event of insolvency of a clearing participant.

In addition, ASX Clear and ASX Clear (Futures) have been approved as ‘netting markets’ under the Payment Systems and Netting Act 1998, which means that netting of novated obligations undertaken by the CS facilities cannot be unwound if a participant becomes insolvent. Nevertheless, under the current legal framework, the insolvency of a participant may affect the manner in which the ASX central counterparties may manage the default – this is discussed in more detail below.

Establishment of a Default

For any central counterparty, identification of an actual or potential default by a clearing participant is not only a trigger for the default management process but a crucial component of effective risk management. Ultimately, the inability of a clearing participant to meet its obligations will be confirmed at the point where that participant fails to settle those obligations (e.g. via margin calls or meeting delivery or payment obligations).

To facilitate early identification of an inability of a clearing participant to meet its obligations, central counterparties typically establish, through their contract-based rules, a range of events that may signal a default, or potential default, that must be notified to the central counterparty. These events may trigger default management procedures. However, it is possible that some settlement-related events do not indicate an underlying inability of a clearing participant to meet its obligations, but instead reflect operational or other temporary difficulties.

For this reason, central counterparties usually build in some flexibility in selecting the appropriate response to a possible default event. Any decision to suspend or terminate a clearing participant on the grounds of default must be taken, and seen to be taken, within a formal framework that reflects the gravity of that decision. In particular, a decision taken on the grounds that a participant is likely to fail to meet its obligations may have wider ramifications for that participant and, potentially, the central counterparty and the market more generally.

As with operators of other central counterparties, ASX has developed mechanisms to identify default circumstances. The Operating Rules and Procedures of ASX Clear and ASX Clear (Futures) specify the events that may be treated as ‘events of default’ of a clearing participant. These include, but are not limited to, failure to meet payment or settlement obligations, insolvency (or potential insolvency) of a participant, the appointment of an external administrator, breach of the central counterparty's rules or procedures, default of the clearing participant at another central counterparty or exchange, or regulatory notification of an imminent default or similar serious event. The rules of both central counterparties also provide them with discretion to declare a default in a range of other circumstances.

The rules of each of the ASX central counterparties explicitly require that a clearing participant notifies the central counterparty if a default event occurs, or is likely to occur. This requirement is legally binding and would continue to apply even in the event that an external administrator had been appointed to the clearing participant. The Operating Rules and Procedures of the central counterparties specify that such communications must be made to the Managing Director, in the case of ASX Clear (Futures), or the General Manager, Clearing and Settlement, in the case of ASX Clear. The ASX central counterparties may also become aware of a participant default or potential default through its ongoing participant monitoring (see Section 5.1), or through communications with regulators or other central counterparties. Further, the Operational and Technical Standards of ASX's Trade Acceptance Service require that an approved market operator notifies ASX Clear immediately of a potential event of default by a common (market) participant.

Although the rules of the ASX central counterparties set out specific events of default, declaration of a default is never automatic. Instead, the central counterparties maintain the right to investigate a potential default fully, taking into account any extenuating circumstances. The process of investigating, and the subsequent handling of, a potential default depends on its nature. Specifically, the ASX central counterparties distinguish between ‘operational’, ‘compliance’ and ‘financial’ defaults. This differentiation appropriately reflects the gravity and potential ramifications of a declaration of default. Ultimately, the declaration of any default is the responsibility of the Managing Director and Chief Executive Officer of ASX, under delegated responsibility from the CS Boards.

Following a declaration of default, the ASX central counterparties will suspend the defaulting participant's authority to clear.^[3] The participant's authority to clear is initially suspended, rather than terminated, to ensure that the participant is still bound by the central counterparty's rules.^[4] Typically, there are no payments or collateral movements to the clearing participant following suspension. This enables the central counterparty to ‘crystallise’ the defaulting participant's position and generate detailed account and position data (including collateral held), thereby allowing the portfolio to be closed out in an orderly manner.

Potential default during the CHESS batch

The DMF outlines specific processes for handling a potential default of an ASX Clear participant during processing of the Clearing House Electronic Sub-register System (CHESS) batch, as the need for immediate funding decisions for the batch would impose time constraints on any investigation of the potential default.^[5] To handle such an event, ASX Clear has the power under its Operating Rules and Procedures to suspend the participant and implement a back-out algorithm to recalculate settlement.^[6] ASX Clear could then initiate the standard process for investigating and managing the potential default. In the event that a default had already been declared, the default management process would run concurrently with the management of the CHESS batch.

Managing a Default

The financial impact of a clearing participant default on any central counterparty will largely depend on the size and nature of the defaulter's portfolio and the prevailing market conditions. However, the means by which a central counterparty closes out its exposures will also play a role in determining both the value of any loss incurred by the central counterparty, and the impact of the default on surviving clearing participants, (potentially) the clients of the defaulting participant and the stability of the broader market.

Close-out methods

Central counterparties typically have a range of options available to close out (or otherwise manage) the positions of a defaulting participant, including transfer of client positions to a surviving clearing participant, on-market or off-market liquidation of positions, exercising derivatives, allowing options to expire, hedging, enforcing compulsory settlement or auctioning the defaulting participant's portfolio to surviving clearing participants. There are advantages and disadvantages to each method and, in practice, the appropriate option to close out a position will depend on the product in question and the supporting legal framework, as well as market conditions at the time of default.

In general, close out through transfer – enacted by discharging the obligation between the central counterparty and the defaulting participant and replacing it with a new contract between the central counterparty and the transferee participant (which is of the same type as the extinguished contract between the central counterparty and the defaulter) – is likely to minimise any potential disruptions to market stability. However, transfer can be administratively complex, and there are legal barriers to this method of close out in many jurisdictions. (The impact of central counterparty account structures on transfer is discussed in Box A.)

Closing out positions through liquidation, by entering into offsetting transactions, offers full and final treatment of the central counterparty's exposure. On-market liquidation is generally preferable to off-market liquidation, as it is operationally simpler, benefits from transparent pricing, and entails less reputational risk. Expiry and exercise may also be attractive close-out methods – although exercise of deliverable contracts may create new obligations for the central counterparty or, if client positions are exercised, the clients of the defaulting participant.

Some central counterparties have the option to enforce compulsory settlement of positions, by terminating and cash settling contracts held by surviving clearing participants that offset those of the defaulter, at a price determined by the market operator or, where necessary, the central counterparty. This has the effect of mutualising the central counterparty's novation and risk mitigation function among surviving participants. Central counterparties may also close-out their exposures by auctioning the defaulting participant's portfolio to the surviving clearing participants.^[7]

Finally, where the defaulting participant's positions cannot be readily closed out, a central counterparty may also use hedging to manage its exposures until such time as positions can be closed out.

The ASX central counterparties' approach to close out

The Financial Stability Standard for Central Counterparties requires that a default is managed in such a way that timely action is taken, and that risks to the central counterparty and its participants are minimised. The DMF and the Operating Rules and Procedures of the ASX central counterparties establish that the central counterparties may use a variety of methods to manage their exposures, including, but not limited to transfer, on- or off-market liquidation, expiry, exercise, compulsory settlement (generally considered to be a ‘last-resort’ method of closing out) and hedging. The specific close-out method used will depend on market conditions,and the products in question.

The nature of the default may also have some bearing on the ASX central counterparties' choice of close-out method. In particular, provisions in the Corporations Act restrict parties dealing with the assets and liabilities of an entity placed under administration. The ability of the ASX central counterparties to manage, in a timely fashion, the portfolio of a defaulting participant that has been placed under administration may be affected in several ways, including the central counterparties' ability to settle on behalf of, or with respect to, obligations of the insolvent company; and to use transfer to manage its exposures.^[8] Specifically, in the case where a defaulting participant is in administration, transfers could only occur with the prior written consent of the administrator or Court.

In a situation of multiple participant defaults (either at a single central counterparty or simultaneous defaults across the two ASX facilities) the principles set out in the DMF would continue to apply.

Ongoing operations

During the default management process, the ASX Limited Board and the CS Boards continue to be responsible for ensuring the performance and meeting the licence obligations of their respective trading, clearing and settlement functions. The ASX central counterparties have processes in place to ensure that day-to-day functions (e.g. operations and risk management) continue on a ‘business as usual’ basis while a participant default is being managed, such as by delegating responsibilities and separating the DMC from day-to-day operations.

Financial Resources

Central counterparties maintain default resources to enable them to withstand losses arising from a clearing participant default. Currently, international standards (and the Financial Stability Standard for Central Counterparties) require that central counterparties must hold sufficient default resources to be able to meet any losses arising from the default of the clearing participant with the largest exposure in all but the most extreme circumstances. Resources must be held in sufficiently liquid form such that the central counterparty can meet its obligations (e.g. variation margin- and settlement-related payments arising from the defaulter's positions) and close out the defaulter's portfolio in a timely manner.

If a loss eventuates and causes default resources to be drawn upon, a central counterparty must be able to restore its resources so that it can continue to comply with regulatory requirements. While, ideally, some comfort might be drawn from putting in place committed ex-ante replenishment arrangements, this may not always be practical. Nevertheless, given that a sizeable call on default resources would necessitate a rapid replenishment to restore confidence, central counterparties should consider and document options for replenishment and the benefits and costs of these under a range of scenarios. ASX's replenishment considerations are discussed below.

Central counterparty solvency and ongoing monitoring

While central counterparties must hold robust risk resources sufficient to withstand a default in extreme circumstances (i.e. unusually high market volatility) the possibility remains that a tail event might occur such that the financial viability of the central counterparty is threatened. Just like any other corporation, directors and management of central counterparties need to be alert to the legal risk of continuing to operate while insolvent.^[9] The DMC monitors the financial position of the central counterparty on an ongoing basis throughout the default management process, assessing the estimated loss from liquidating the defaulting clearing participant's portfolio against the central counterparty's financial resources. This ongoing assessment considers both current market prices and hypothetical stressed market prices (based on the central counterparty's existing stress-test scenarios), and also takes into account the ability of ASX Clear to reschedule settlement. The ASX central counterparties have procedures in place so that if the potential for future financial weakness at the central counterparty is identified, more frequent reviews of solvency may be implemented.

Ongoing monitoring is also used to help prioritise closing out, managing liquidity and determining whether promissory default resources from remaining participants should be called. The central counterparty would make a call on these resources if it determined that prior-ranking financial resources were insufficient or likely to be insufficient to meet the loss resulting from the default event.

Liquidity

Access to adequate liquidity is clearly crucial in default management (e.g. to meet variation margin, settlement and other obligations to non-defaulting participants).

In the first instance, the ASX central counterparties would meet obligations arising from a participant default from collateral lodged by that participant. Collateral may be in the form of cash, a bank guarantee or letter of credit, or eligible securities.^[10] Where the defaulting participant's contributions are insufficient, the central counterparty may draw upon other ‘available financial resources’.^[11] ASX Clear's available financial resources include a $50 million liquidity facility from ASX Limited.^[12] ASX Clear also has the power under its Operating Rules and Procedures to reschedule settlements to manage its liquidity needs.

Financial offset and replenishment of default resources

Although the ASX central counterparties' risk management processes are designed, in all but the most extreme circumstances, to avoid any call upon mutualised default resources, the risk remains that there will be some call upon those funds. If a default does result in a loss to the central counterparty, this will be allocated against the central counterparty's financial resources in the order determined by its rules.

If it suffers a loss of default resources, a central counterparty must be able to restore these resources. The current draft of the CPSS–IOSCO Principles for FMIs contemplates establishing an ex-ante plan regarding how default resources might be replenished (and potentially how a central counterparty insolvency may be resolved).

ASX has documented a process for making decisions regarding replenishment of a central counterparty's default resources following any draw down arising from a participant default. Responsibility for determining if the default resources will be replenished and, if so, how this should be achieved, ultimately lies with the ASX Limited Board, which would make this decision in consultation with the relevant CS Board. ASX's documented replenishment intentions canvass several options; the particular approach taken will depend on the specific circumstances, including the severity of the loss and the market environment. ASX Limited has also committed to maintaining a certain level of equity capital in the central counterparties, provided certain conditions are met including that the central counterparty is solvent. For its part, the Reserve Bank will require that any potential new formulation of default resources continues to meet the FSS and thereby be consistent with ensuring the stability of the financial system.

Summary

The ASX central counterparties have developed comprehensive and legally robust rules and procedures to deal with the default of a clearing participant. The arrangements recognise the potential systemic disturbance that may arise from the default of a clearing participant, and provide the central counterparties with appropriate flexibility to tailor the management of such an event to the particular market circumstances. It is the Reserve Bank's assessment that the default arrangements of ASX Clear and ASX Clear (Futures) satisfy the requirements of the default arrangements Measure of the Financial Stability Standard for Central Counterparties.

Nevertheless, the Reserve Bank notes that international standards in respect of default management continue to evolve, and the licensed CS facilities should respond to these changes as appropriate.

Footnotes

Some differences arise because of factors such as the nature of the products that each central counterparty clears. [1]

The product clearability guidelines, used to assess whether a new product is suitable for clearing, cover default management requirements – including whether a broker agreement is in place and whether there is a process for compulsory settlement of the product. [2]

If required, the defaulter's status as a participant of ASX's exchanges or other CS facilities may also be suspended. ASX's central counterparties also have the power to impose conditions on a participant's ongoing participation in the facility prior to any declaration of default, including trading and financial constraints. [3]

In the event that the clearing participant is under administration, the administrator is also bound by the rules of the central counterparty. [4]

If the default event occurs outside the batch payment authorisation process, the clearing participant's outstanding novated obligations can be rescheduled before settlement begins. [5]

ASX Settlement's back-out algorithm seeks to remove as few transactions from the batch as possible, maximising settlement values and volumes, while minimising the spillover to other participants. Non-novated settlement obligations are typically backed out first. [6]

Closing out through auction is typically used by central counterparties that clear complex or over-the-counter products. Use of auctions to close out exposures is less likely to be considered by ASX. [7]

This is not a situation unique to Australia. Internationally, best practice is moving towards amending legislation to facilitate transfer. However, there are other important public policy considerations in general insolvency law that must be taken into account. [8]

Under the Corporations Act (s588G), if an entity trades while insolvent, the directors of that entity may be personally liable for debts incurred during that time. [9]

ASX accepts bank guarantees and letters of credit as acceptable ‘collateral’. If called, a bank will deliver cash to the central counterparty. [10]

The available financial resources are $300 million for ASX Clear and $370 million for ASX Clear (Futures), reflecting the ‘paid-up’ component of the default resources, plus an additional liquidity facility for ASX Clear. [11]

As noted above, in the cash equities market ASX Clear requires liquidity to meet the buy obligations arising from the defaulting participant's positions over the T+3 settlement cycle. These liquidity pressures do not arise in derivatives markets, as there is no such settlement cycle in these markets. [12]