Financial Stability Standard for Central Counterparties – Guidance February 2009

Introduction

This guidance is issued in relation to the financial stability standard determined under section 827D(1) of the Corporations Act 2001 (Cth) that applies to Australian clearing and settlement (CS) facility licensees, under Part 7.3 of the Act, that operate a central counterparty.

The objective of this guidance is to provide further information and detail on the measures that the Reserve Bank considers relevant for the meeting of the standard. It is intended to assist in the interpretation of those measures, but is not of itself a standard and is not intended to contain obligations that are binding on CS facility licensees.

1. Legal framework

A well-founded legal basis is critical for the safe and reliable operation of a central counterparty, and for minimising the potential for financial system instability to arise from its operation. The operator of the central counterparty is responsible for identifying and minimising legal risk.

The legal basis of a central counterparty includes its operating rules and written procedures, and contractual agreements between participants and service providers. These should be enforceable given the underlying legislative, regulatory and common law framework within which a central counterparty operates.
[Back to Standard 1]

Measure 1(a) of the Standard

The identification of the operator of the central counterparty as a separate legal entity is of particular importance where an entity related to the operator of the central counterparty is experiencing operational or financial difficulties, including external administration. Related entities which may expose the operator of the central counterparty to risks unrelated to those arising from its function as a central counterparty may include a related securities settlement facility, a financial market, or technology or other service providers.

The legal separation of the operator of the central counterparty from other legal entities may also provide protection to those other legal entities should the central counterparty itself experience operational or financial difficulties.

The measure does not assume, however, that a legal separation will remove all risks that may arise as a result of operational or financial difficulties faced by a central counterparty or related entities. [Back to Standard 1(a)]

Measure 1(b) of the Standard

The contract (or contracts) arising from a central counterparty's legal framework must be enforceable, with a high degree of certainty, in the legal jurisdiction within which the central counterparty operates, is licensed or otherwise regulated. However, rights and obligations arising from a central counterparty's legal framework may also have a connection to other legal jurisdictions, such as where a central counterparty has participants that are established in another jurisdiction, or where the central counterparty offers services in relation to financial products that are issued in another jurisdiction. These other jurisdictions may be relevant to the central counterparty's activities such that the central counterparty would want to ensure that the relevant contracts were legally enforceable in those jurisdictions. However, a jurisdiction with a trivial or merely tangential connection to the central counterparty's activities would be unlikely to be relevant in this context.

The measure may be met by the operator obtaining a written and reasoned legal opinion as to the enforceability of the central counterparty's arrangements under the laws of each relevant jurisdiction. Such an opinion should include a discussion, to the extent that can be objectively determined, of whether the central counterparty's activities in the jurisdiction meet the measure in respect of control of legal risk. [Back to Standard 1(b)]

Measure 1(d) of the Standard

Settlement refers to the final and irrevocable extinguishment of obligations between participants and the central counterparty.

A transaction cannot be unwound once final and irrevocable settlement has taken place. This does not preclude the central counterparty accepting transactions that have the effect of offsetting other transactions.
[Back to Standard 1(d)]

Measure 1(e) of the Standard

The legal framework of a central counterparty will necessarily impose certain rights and obligations upon the central counterparty and its participants. The operator of the central counterparty must ensure that any and all rights and obligations arising from participation in a central counterparty are clearly defined and set out in a central counterparty's legal framework. It is not sufficient for key rights and obligations to be implied.

Where a participant or the operator of the central counterparty is in external administration or is otherwise facing difficulties, there is scope for these events to cause instability in the broader financial system. A high degree of certainty in the legal framework concerning such events can help to limit the capacity for such instability.

It is important that the rules applying to a default situation are set out in advance: this minimises the opportunity for surviving participants to challenge their liability (in a default situation, there are likely to be strong incentives to undertake behaviour to minimise any contribution, and this could amplify systemic risks). A more detailed discussion is contained in the guidance on measure 6: Default arrangements. [Back to Standard 1(e)]

Measure 1(g) of the Standard

The operator of a central counterparty should obtain its own legal advice on legislation that offers legal certainty. For example, if the central counterparty has arrangements involving the netting of transactions, then its operator must seek the benefit of the Payment Systems and Netting Act 1998 (Cth). Cross-jurisdictional issues may also be relevant. [Back to Standard 1(g)]

2. Participation requirements

A central counterparty's participation requirements must aim to ensure that all participants have sufficient resources, both financial and otherwise, to meet obligations arising from participation in the central counterparty. The goal of such requirements is to promote the safety and integrity of the central counterparty, and in doing so limit the potential for financial system instability. The operator of the central counterparty should, at the same time, ensure that access to the central counterparty is not restrictive beyond the need for ensuring financial system stability, and make certain that requirements are fair and are applied equitably across participants.

The reference to fair and open access is directed towards transparency and the reduction of systemic risk, rather than towards competition issues, which are dealt with in Australia under other legislation. [Back to Standard 2]

Measure 2(a) of the Standard

Participation requirements (particularly those relating to risk) should be set out in the central counterparty's rules. If tiering exists, each class of participation should be clearly defined and the participation requirements should be the same for all applicants of the same class.

If the central counterparty's rules require that key personnel be of good character, the operator of the central counterparty should ensure that the process of making this judgement is as objective as possible.
[Back to Standard 2(a)]

Measure 2(b) of the Standard

The participation requirements should include various financial requirements, such as a minimum credit rating or level of net tangible assets, so as to reduce the exposure of the central counterparty to credit and other risks.

The operator of the central counterparty must have procedures in place to ensure that its financial requirements are met on an ongoing basis. Ordinarily, this requires the operator to receive regular financial reports from each of its participants. It also requires participants to advise the operator of the central counterparty of any material change in their financial standing, including any change to external credit ratings. [Back to Standard 2(b)]

Measure 2(c) of the Standard

Each participant should be required to have sufficient capacity to process the expected volumes and values of transactions with the required speed, particularly at peak times and on peak days.

Participation requirements must be ongoing. Any breach or potential breach should be required to be reported to the operator of the central counterparty. [Back to Standard 2(c)]

Measure 2(d) of the Standard

An appeals process should not detract from the operator's ability to suspend or cancel participation. For serious breaches, the preferable approach would provide for the suspension or cancellation to persist during an appeal, with reinstatement upon a successful appeal, rather than the suspension or cancellation being put on hold until an appeal were heard. [Back to Standard 2(d)]

3. Understanding risks

The operating rules and procedures of a central counterparty play a key role in enabling participants to understand the financial risks they incur. The rules need to be clear, comprehensive and up-to-date to facilitate understanding by participants and prospective participants of the risks they can face through participation in the system. Explanatory material written in plain language, although not necessarily binding legally, can aid understanding of the facility's design and processes, thus improving understanding of risks that may arise through participation.

Participants and prospective participants should be able to understand the basic design of the system, as that will be an important determinant of their rights and obligations. Rules and procedures should be readily available to all participants and prospective participants and at least the key rules relating to financial risks should be publicly disclosed. Consideration should be given to publicly disclosing all rules.

The rules and procedures should describe the roles of participants and the system operator and the procedures that will be followed in various circumstances (for example, which parties are to be notified of specific events and the timetables for decision-making and notification). They should make clear the degree of discretion parties are able to exercise in taking decisions that can have a direct effect on the operation of the system. There should be clear processes for changing rules and procedures. The degree of discretion the CS facility licensee as operator can exercise to make unilateral changes to the rules or procedures, and any period of notice it must give to participants, should be clear.

Where the operator of a central counterparty allows tiered participation (for example, different classes of participation have different rights and obligations in the facility), rules and procedures should cover the impact of tiering arrangements. [Back to Standard 3]

4. Novation

The identification of the point in the clearing process at which a central counterparty takes on (through novation) the counterparty obligations of participants is important in assessing where risks lie. [Back to Standard 4]

Measure 4(a) of the Standard

The nature and scope of novation must be legally certain, and made known to all participants. The way in which the central counterparty interposes itself between counterparties in the novation process should be described. [Back to Standard 4(a)]

Measure 4(b) of the Standard

The point in the clearing process at which novation takes place must be legally certain and made known to all participants. This will help to ensure that participants understand the point in the process at which any guarantee (provided by the central counterparty) commences. Ordinarily, a central counterparty would aim to minimise the time between trade agreement or matching between trade counterparties, and the time at which the central counterparty takes on trade obligations. [Back to Standard 4(b)]

5. Settlement

This measure is aimed at reducing the risk of systemic disturbance by eliminating principal risk faced by a central counterparty and its participants. It does not preclude the use of netting or batch processing in the clearing process.

A central counterparty must have appropriate arrangements in place to ensure that its exposures are clearly and irrevocably extinguished on settlement. Typically, this will involve either arrangements with a securities settlement facility, or arrangements for settlement of payment obligations. The concept of settlement through a securities settlement facility is dealt with in detail in the financial stability standard for securities settlement facilities.
[Back to Standard 5]

Measure 5(a) of the Standard

Where settlement involves the exchange of one asset for another (for example, securities for payment) the operator of the central counterparty must ensure that transactions novated to it are settled on an appropriate delivery-versus-payment (DvP) basis. Typically, DvP is achieved in one of three ways:

• where the final transfer of payment from buyer to seller and the final transfer of security from seller to buyer occur simultaneously and on a trade-by-trade basis;
• where final securities transfers are settled on a trade-by-trade basis, with final payment transfers settled on a net basis at the end of the processing cycle; or
• where both final securities transfers and final payment transfers occur on a net basis at the end of the processing cycle.

The timing of DvP settlement of trades is important. Where the final simultaneous transfer of securities and payment occurs continuously throughout the day, principal risk is eliminated. Where final transfer of securities occurs continuously, but final payment is deferred until some later time, sellers of securities are exposed to principal risk. Where both securities and payments are exchanged with finality at the end of the day there is a prospect that, even though principal risk is eliminated, net obligations may be sufficiently large that a participant default would cause survivors to face significant liquidity pressures, which could result in systemic disruption.

Only where settlement values are not large may the payment transfers and/or final securities transfers occur on a net basis. In those circumstances both securities transfer and payment must occur contemporaneously unless this is precluded by operational requirements. Where netting is involved, the operator of the central counterparty should ensure that steps have been taken to ensure the certainty of netting arrangements. At a minimum, the final and irrevocable settlement of obligations should be completed by the end of the settlement day.
[Back to Standard 5(a)]

Measure 5(b) of the Standard

Notwithstanding the DvP method chosen, settlement of any obligations between the providers of cash settlement assets must be by an irrevocable real-time payment method, i.e. real-time gross settlement (RTGS).

Where settlement involves the exchange of one asset for another (a DvP transaction), the settlement of obligations requires up to three steps:

• the security (or title over the security) needs to be transferred from seller to buyer;
• payment must be transferred from the buyer's account at its provider of cash settlement assets to the seller's account at its provider of cash settlement assets; and
• where the buyer and seller have different providers of cash settlement assets, funds must be transferred from the buyer's provider to the seller's provider through Exchange Settlement Accounts held by the providers at the Reserve Bank.

Settlement of obligations between providers of cash settlement assets is often referred to as ‘settlement of the interbank leg’. The term ‘provider of cash settlement assets’ is used in recognition that parties other than banks may be involved in this process.

In the case of a DvP transaction, it is the transfer of funds between the buyer's provider of cash settlement assets to the seller's provider that must be made by an irrevocable real-time payment method to meet the measure.

In the case of non-deliverable (such as derivatives) obligations, settlement of obligations consists of payment transactions between clearing participants and the central counterparty (or a provider of cash settlement assets that acts on the central counterparty's behalf). In this case, the settlement of payments between participants and the central counterparty (or its provider of cash settlement assets) must be made by an irrevocable real-time payment method.

The risk-control requirements of the measure accept that in extreme circumstances the central counterparty may not be able to meet its settlement obligations in full. To limit any systemic disruption that may follow from a failure of the central counterparty, the central counterparty's rules and procedures must describe how settlement is to be effected in such circumstances.

The rules should ensure that obligations due by the central counterparty to its participants are equitably settled on the day of default to the maximum extent possible and, at a minimum, to the full extent of coverage provided by risk controls. [Back to Standard 5(b)]

6. Default arrangements

This measure is aimed at avoiding any systemic disturbance that may arise from the default of a participant. To comply with the measure, the central counterparty's rules and procedures should provide for timely settlement (typically by the end of the settlement day) notwithstanding a default.

There is a difference between external administration and cases where a participant may have sufficient assets to meet its obligations, yet be unable to complete settlement of its obligations due to operational failure or liquidity pressures. This distinction should be recognised in the rules of the central counterparty.

The rules of the central counterparty should outline the steps to be taken once it has determined that a participant is in default. The central counterparty should have the ability to suspend or cancel the participation of a participant in default, thus preventing that participant from continuing to take on trade obligations.
[Back to Standard 6]

Measure 6(a) of the Standard

The operator of the central counterparty should have a legally binding requirement for participants to notify it should they be in default or reasonably suspect that this is the case. Similar notification should be made in the event of a breach or likely breach of any risk-control requirement of the central counterparty. Any communication should be at an appropriately high level both within the participant organisation and the central counterparty. [Back to Standard 6(a)]

7. Risk controls

The risk controls of a central counterparty are crucial in ensuring that the central counterparty is able to provide a safe and efficient service. Meeting the risk-control measure involves the operator identifying, measuring and managing the risks that a central counterparty faces. In meeting the standard, the operator of a central counterparty should carefully consider the advantages of upgrading its risk controls to provide a high degree of confidence in its ability to settle in the event of the default of more than one participant on the same day.

In its risk controls a licensee should address how it would intend to undertake any replenishment of funds used as a result of the failure of one or more of its participants. Such a measure may include insurance arrangements. [Back to Standard 7]

Measure 7(a) of the Standard

The measure does not prescribe how the operator of a central counterparty must control risk. The measure leaves it to the operator to choose which risk control, or combination of risk controls, is appropriate for the risks faced in that central counterparty. It does, however, require the operator to monitor the level of risk, and it specifies minimum levels of protection. [Back to Standard 7(a)]

Measure 7(b) of the Standard

At a minimum, the operator should conduct stress testing quarterly, but ideally this would be done more frequently. Assumptions used in stress testing should be modified over time as participant obligations vary in size and composition, and as volatility in financial markets changes.

The operator of a central counterparty must ensure, through the use of stress testing, that in all but the most extreme circumstances, it will be able to meet its obligations to participants in the event that the participant with the largest obligations is unable to meet them.

The operator of a central counterparty must also ensure that its risk controls provide coverage that is sufficiently liquid to enable the central counterparty to settle all its obligations on a timely basis, including where the participant with the largest obligations is unable to meet them. An inability to do so increases the potential for systemic disturbance. [Back to Standard 7(b)]

Section (i) of Measure 7: Margins

Where margins are used, the operating rules and procedures of the central counterparty should specify how initial, variation, intraday, and any other margins are calculated. This includes margins that may be called in extreme or unusual circumstances. [Back to Standard 7(i)]

Section (ii) of Measure 7: Guarantee fund

The operator of a central counterparty may use a guarantee fund to support a guarantee it provides to its participants. The guarantee fund will consist of a range of assets, some of which will be contributions from participants as well as from the operator of the central counterparty. The size of the guarantee fund will depend on the quality (and quantity) of other risk controls – the more rigorous a margining system, for example, the less pressure is likely to be placed on the guarantee fund.

Where a guarantee fund is used, it should be funded and used in such a way that all participants, as well as the operator of the central counterparty, have incentives to ensure that risk controls are effective and well managed. Normally, the rules of the central counterparty would stipulate the order in which funds are to be used in an event of default. For example, the contributions of the defaulting participant would typically be used prior to the contributions of surviving participants. [Back to Standard 7(ii)]

Section (iii) of Measure 7: Loss sharing

Loss sharing refers to the process whereby a settlement shortfall is allocated between participants. Settlement of revised obligations incorporating this allocation of a settlement shortfall represents settlement of the obligations accepted for settlement by the central counterparty. In effect, the allocation of the settlement shortfall to participants represents loss sharing. Notwithstanding this, the arrangements should not preclude the central counterparty from taking action as a creditor in the external administration of a defaulting participant. In the extreme circumstance where a central counterparty fails, the arrangements should not prevent surviving participants from taking similar action against the central counterparty.

The implementation of loss-sharing rules can add a further level of protection to a set of central counterparty arrangements. Properly constructed, they should provide an appropriate set of incentives for the operator of a central counterparty and its participants to manage the risks they undertake, and help to ensure that operations of the central counterparty do not contribute to instability in the financial system.

It may be possible to design loss-sharing arrangements that provide the operator of a central counterparty with the same protection as liquid assets. At a minimum, this would require that the rules and procedures allow the operator of a central counterparty to adjust settlement positions, on the day of default, to expunge any shortfall following the default of a participant. [Back to Standard 7(iii)]

8. Governance

The measures in relation to governance apply to the area of management specific to the control of the financial risks faced by a central counterparty. Risk management should be dealt with at very high levels within the operator of a central counterparty.

This measure is not intended to cover wider issues of corporate governance, including obligations in the Corporations Act 2001 (Cth) and good market practice. [Back to Standard 8]

Measure 8(a) of the Standard

The board should have the level of experience, knowledge and skills necessary to operate the central counterparty. The nature and degree of the skills, experience and expertise required will depend on the size, scope and nature of the business conducted by the central counterparty. The board should have an appropriate degree of independence from the operator's management, and from related bodies including its participants. [Back to Standard 8(a)]

Measure 8(b) of the Standard

The board should have regard to formal and informal structures and processes in meeting the measure, such as reporting lines and job descriptions. It should also exercise appropriate control over the day-to-day management of the operator of the central counterparty, including with regard to any potential trade-off between the strength of the risk-control measures and the cost-effective provision of the service. [Back to Standard 8(b)]

9. Operational risk

The aim of this measure is to minimise the risk that deficiencies in information systems or internal controls, or a failure of personnel or management, will result in losses to participants of the central counterparty and potential systemic disturbance. [Back to Standard 9]

Section (i) of Measure 9: Security and operational reliability

Measure 9(i)(c) of the Standard

Operational and back-up computer systems, and links between systems, should have ample, scalable capacity for anticipated daily volumes, and be subject to stress testing. [Back to Standard 9(i)(c)]

Measure 9(i)(d) of the Standard

All procedures relating to change management should be thoroughly documented. Such procedures should include notification to participants where significant changes occur that may have an impact on the operations of the CS facility.

In the normal course, the operator should ensure that all changes to existing systems and supporting infrastructure are thoroughly tested outside of the production environment. [Back to Standard 9(i)(d)]

Section (ii) of Measure 9: Business continuity procedures

The operator of the central counterparty should have comprehensive arrangements in place to address a contingency, i.e. the failure of one or more components of the system. [Back to Standard 9(ii)]

Measure 9(ii)(a) of the Standard

Business continuity procedures should be available to participants. These procedures should in general seek to ensure that minimum service levels are maintained. In extreme circumstances, the procedures may allow for suspension of services.

The transition to back-up systems should be timely and reliable. In general, back-up systems should be capable of the timely completion of daily transactions. [Back to Standard 9(ii)(a)]

Measure 9(ii)(b) of the Standard

The participants of a central counterparty should have complementary business continuity arrangements that are appropriate to the nature and size of the business undertaken by that participant. Rules and procedures should clearly and fairly specify the requirements of participants in this regard. [Back to Standard 9(ii)(b)]

Measure 9(ii)(c) of the Standard

The degree of industry participation in the testing should be appropriate to the nature and size of the business undertaken by individual participants. [Back to Standard 9(ii)(c)]

Section (iii) of Measure 9: Outsourcing

The central counterparty should ensure that the risks associated with outsourcing key business functions are clearly identified and properly managed. The operator should have a formal policy, determined by its board, which sets out the process for entering into, maintaining and exiting key outsourcing arrangements.

Before an outsourcing arrangement is established, senior management should identify the business, operational and other risks involved and ensure that these risks can be adequately monitored and controlled by the facility.

The board should approve the establishment of any outsourcing arrangement for a key business activity and be informed on a regular basis of the performance of the service provider. [Back to Standard 9(iii)]

Section (iv) of Measure 9: External administration of a related body

Agreements between an operator and its related bodies should be in place to ensure that, to the extent permissible by law, the operator of a central counterparty is able to ensure that it continues to access key resources. [Back to Standard 9(iv)]

10. Regulatory reporting

The Corporations Act 2001 (Cth) imposes requirements for notification to regulators in certain circumstances. The measure imposes additional reporting requirements.

Oral notification to the Reserve Bank may be appropriate, particularly in circumstances where timely communication is needed. In practice, this should be followed by notification in writing.

To assist in meeting the measure, formal points of liaison will be agreed upon between the operator of the central counterparty and the Reserve Bank.

The Reserve Bank will review information contained in a CS facility licensee's annual report to the Australian Securities and Investments Commission. [Back to Standard 10]

Measure 10(a) of the Standard

This refers to a CS facility licensee's obligations under subsection 821A(aa) of the Corporations Act 2001 (Cth). [Back to Standard 10(a)]