Assessment of ASX Clearing and Settlement Facilities – October 2023 5. Special Topic – Credit Risk

5.1 Summary and Rating

During the assessment period, the Bank conducted a detailed assessment of ASX CCPs' compliance with the Credit Risk FSS,^[17] including the supplementary CPMI-IOSCO guidance – Resilience of Central Counterparties (CCPs): Further Guidance on the PFMI (‘CCP Resilience Guidance’). ^[18]

While both ASX Clear and ASX Clear (Futures) were generally found to have a robust framework to manage credit risks arising from their clearing processes, there were several gaps identified during the assessment. Three are considered issues of concern that should be addressed in a defined timeframe. Accordingly, ASX's adherence to the Credit Risk standard is consistent with a rating of broadly observed for both ASX CCPs; this rating has been unchanged since 2018.

5.2 Background

Credit risk is broadly defined as the risk that a counterparty will be unable to fully meet its financial obligations to the CCP as they fall due or at any time in the future. In the event of a participant default, the CCP assumes the obligations of that participant's portfolio, including any uncovered losses realised in closing out that portfolio. Under the FSS, the ASX CCPs are required to ‘establish a robust framework to manage its credit exposures to its participants and the credit risks arising from its clearing processes’.

There are five broad ways that both ASX CCPs manage credit risk exposures to clearing participants:

Participation requirements: This includes minimum capital requirements for participants.

Variation margin: ASX CCPs collect variation margin to prevent the build-up of current exposures between a CCP and its participants as prices move.

Initial margin: ASX CCPs collect initial margin from participants to mitigate potential future credit exposures during times of normal volatility.

Default fund and stress testing: ASX CCPs maintain a default fund that can be used to meet any losses in excess of initial margin collected to mitigate potential future credit exposures in the event of a participant default during times of stress.

Recovery of credit losses: If prefunded resources are inadequate upon the default of a participant, ASX CCPs have explicit rules and procedures to recover any credit losses it may face.

5.3 Detailed findings and recommendations

5.3.1 ASX Clear (Futures) excluded two historical scenarios from stress tests without following appropriate governance processes

ASX CCPs conduct stress tests including scenarios based on historical events. The CCP Resilience Guidance indicates that ‘historical scenarios carry an initial presumption of plausibility because they are based on events that have, in fact, occurred’ and ‘if a CCP's management recommends removing any historical event from the margin assumptions or stress-testing scenarios, then the board should require management to perform a comprehensive, rigorous analysis’. As part of the 2020/21 Assessment, the Bank identified that ASX Clear (Futures) excluded the 1987 stock market crash from its stress test scenarios and accordingly introduced an Area of Supervisory Focus requiring ASX to validate whether its stress scenarios should cover an event of similar severity to the 1987 stock market crash, considering differences in the current market environment.

ASX engaged an external firm to validate its approach, which concluded that the exclusion was reasonable and in line with international practice. The report found that there were several changes to market infrastructure since that event that would make the magnitude of the scenario implausible in the current market environment.

During this assessment period, the Bank found that ASX Clear (Futures) also excluded the 1989 stock market crash as well as an intra-day ‘flash crash’ in the 10-year bond futures market in 2020 from its stress testing scenarios. ASX's clearing risk policy specifies that the boards of ASX's CCPs must review and approve the exclusion of historical scenarios that are determined to be implausible. However, the boards were not given an opportunity to review and approve the exclusion of these scenarios from stress tests. The Bank believes it is important that ASX ensures appropriate oversight and governance of such decisions.

5.3.2 ASX Clear should monitor and mitigate its exposure to wrong way risks

The CCP resilience guidance indicates that a CCP should consider potential wrong way risks in its stress test framework. Wrong way risk arises when the credit exposure to a counterparty increases with the risk of a counterparty's default.

ASX Clear allows participants to clear equities for a related entity as well as posting equity of a related entity as collateral for client positions. The default of a clearing participant may coincide with a significant decline in the value of the securities of a related entity. This is not currently captured in ASX Clear's stress test scenarios. During the assessment period, ASX Clear conducted a materiality assessment and found that some of the wrong way risks were material, and that stress test results may have understated potential exposures to some participants. In rare cases, the exposures were a significant fraction of the ASX Clear default fund size. Accordingly, the Bank sees this as an issue of concern that should be addressed in a defined timeframe.

ASX Clear plans to address this risk by introducing additional stress test scenarios that capture wrong way risks and collect additional margin where necessary.

5.3.3 ASX CCPs assume margin requirements have been fully paid at the time of stress test calculations

Both ASX CCPs conduct stress tests at the conclusion of the day using closing prices and positions. These stress tests assume that, at the time of a stress test calculation, initial and variation margin have been fully paid. However, in practice, margin is called in arrears and is only required to be posted the following morning for any outstanding margin at the end of the day.^[19] This means that any mark-to-market losses since the previous margin call or unpaid initial margin from new positions are not accounted for in the stress test calculation. As a result, the calculation may underestimate the potential losses faced by the CCP.

During the assessment, the Bank found several instances where stress test results may have been materially understated. The accuracy of stress test results is important to assess the adequacy of the ASX CCPs to handle participant default(s) in extreme but plausible scenarios. Accordingly, the Bank views this finding as an issue of concern.

5.3.4 Some of ASX's internal policies have not been embedded in practice

The Bank noted several examples of ASX not following internal clearing risk policies in practice. These did not necessarily result in outcomes that were inconsistent with the Credit Risk FSS. However, internal policies play an important role in governing the way in which ASX satisfies the FSS and a cultural lack of adherence may increase the likelihood of future breaches.

Internal Audit reviews of the ASX CCPs policies and standards also identified gaps between documented requirements and observed practices. In response, ASX's clearing risk policy team has set up a schedule for monitoring key clearing risk reviews set out in the policies and standards, highlighting those that are overdue.

5.3.5 Rules are not in place to allow ASX to change the default fund size

Both ASX CCPs are systemically important in multiple jurisdictions and are therefore required to maintain sufficient financial resources that would withstand the default of any two participants (and their affiliates) in extreme but plausible scenarios. Over the assessment period, both CCPs had no situations where they were in breach of this requirement.

Clear processes should be in place to increase pooled financial resources when projected stress test losses for participants are frequent and widely dispersed across participants. While ASX monitors the frequency and dispersion of the extent to which stress test limits are exceeded, ASX self-identified that rule changes (e.g., changes to participant contributions) may be needed to allow for changes in the default fund size. This would require participant consultation before implementing.

During the assessment period, the risk arising from not having these rules in place was low. The frequency and dispersion of the extent that participant stress test limits were exceeded was within ASX's appetite for both CCPs. Moreover, participants that exceed stress test limits must meet additional margin calls to limit credit risk to participants.

5.3.6 ASX CCPs do not conduct intraday stress testing across all products

The FSS CCP guidance indicates CCPs should be capable of calculating exposures to participants intraday and at short notice. Monitoring of intraday stress test exposures was implemented for exchange traded products on ASX Clear (Futures) during the assessment period. However, OTC products on ASX Clear (Futures) as well as all products on ASX Clear are yet to have intraday monitoring of stress testing results. In addition to monitoring, further work needs to be conducted to enable ASX CCPs to call additional margin in response to stress test exposure exceedances.

Without intraday stress testing, CCPs may accumulate significant potential exposures between daily stress tests that coincide with the default of a participant. ASX Clear (Futures) has implemented intraday stress testing for all products except OTC products. ASX Clear monitors the build-up of exposures based on end-of-day options positions and intraday cash market positions and prices. Given these tools ASX has in place during the interim period, this is seen as a minor gap that can be addressed in the normal course of business.

5.3.7 ASX could further enhance its framework to regularly review the risk factors to which the CCP is most exposed

CCPs are also required to identify risk factors they are most exposed to in estimating potential counterparty exposures. The definition of risk factors is broad, but examples include the movement in prices of key products such as equity prices, or scenarios that are modelled through a combination of products such as a steepening of the interest rate yield curve. The CCP Resilience Guidance further indicates that ‘the set of risk factors used … should be justified using a combination of expert judgment and reliable statistical techniques that allow a CCP to identify – on an ongoing basis – the risk factors to which it is most exposed’.

Without a robust framework to review the risk factors to which the CCP is most exposed, scenarios used in stress tests may understate the potential credit exposures a CCP may face. As an example, prior to this assessment period, ASX Clear (Futures) did not include electricity products as a driving risk factor in scenarios. During the assessment period, some participants had relatively concentrated positions in electricity products and the potential exposures of ASX Clear (Futures) to some clearing participants may have been materially understated in stress tests. Following the large moves in electricity prices in mid-2022, ASX remediated this issue by introducing additional scenarios driven by electricity products, which were further enhanced in December 2022. ASX is currently in the process of enhancing its credit stress test scenario selection methodology that will ensure scenarios provide appropriate risk coverage for all risk factors to which the CCP is most exposed.

ASX considers the adequacy of risk factors as part of regular reviews of participants' positions, and it plans to make improvements to its existing framework during the upcoming assessment period. Given ASX is already in the process of reviewing and updating its scenarios, the Bank sees this as a minor gap and is satisfied with ASX's planned approach.

Footnotes

ASX SSFs (ASX Settlement and Austraclear) do not assume credit risk as principal and as such are not assessed against the credit risk standard. [17]

CPMI-IOSCO (2017), ‘Resilience of Central Counterparties (CCPs): Further Guidance on the PFMI’, July. [18]

ASX Clear (Futures) also collects variation margin overnight on some products. [19]