Financial Stability Standard for Central Counterparties February 2009

This Standard is no longer in effect. See the current Financial Stability Standards for Central Counterparties.

Introduction

This standard is determined under section 827D(1) of the Corporations Act 2001 (Cth) and applies to Australian clearing and settlement (CS) facility licensees, under Part 7.3 of the Act, that operate a central counterparty. For the purposes of this standard, a central counterparty is a clearing and settlement facility operated by an Australian CS facility licensee where the CS facility licensee interposes itself between trade counterparties, taking on the trade obligations of trade counterparties to each other. A separate standard applies to CS facility licensees that operate a securities settlement facility.

The objective of this standard is to ensure that CS facility licensees identify and properly control risks associated with the operation of the central counterparty, thereby promoting the stability of the Australian financial system. Primary responsibility for risk control lies with each CS facility licensee's board and senior management.

This standard sets a general requirement for a CS facility licensee that operates a central counterparty to conduct its affairs in a prudent manner. This objective test is then supplemented by a series of measures which the Reserve Bank considers relevant for the purposes of meeting the standard.

Terminology

In this standard and associated measures:

"cash settlement asset" is an asset which carries little or no credit or liquidity risk and is used to settle payment obligations arising from trades in financial products;

"central counterparty" is a clearing and settlement facility operated by an Australian CS facility licensee where the CS facility licensee interposes itself between trade counterparties, taking on the trade obligations of trade counterparties to each other. The central counterparty enters into a new contract, as principal, with each of the existing counterparties, or with new counterparties who take on the obligations of the original counterparties to the central counterparty. This process is a form of novation (see definition below);

"close out" is the process of offsetting an existing contract by entering into a new contract of an equal and opposite position;

"contingency" is the failure of one or more components of a system;

"delivery-versus-payment", in the settlement of a financial product transaction, means the action of a facility in ensuring that the final transfer of a financial asset occurs if and only if the final transfer of another financial asset (typically, a payment) occurs;

"Exchange Settlement Account" means an account held at the Reserve Bank of Australia which is used for the final settlement of obligations between Exchange Settlement Account holders;

"external administration" has the meaning given to that term in the Payment Systems and Netting Act 1998 (Cth);

"haircut" is the difference between the market value of a security and its collateral value. Haircuts are taken by a lender of funds, that has taken collateral as security, in order to protect the lender, should the need arise to liquidate the collateral, from losses owing to declines in the market value of the security;

"liquid assets" includes funds held at a central bank, funds held at an Authorised Deposit-taking Institution which are available on the same day, and securities that can be converted to cash settlement assets on the same day;

"novation" means the satisfaction and discharge of existing contractual obligations by means of their replacement by new obligations. The parties to the new obligations may be the same as to the existing obligations, or in the case of a central counterparty, there is a substitution of a new party or parties;

"principal risk" is the risk that the seller of the financial product delivers a financial product but does not receive value for the sale of the financial product, or that a buyer of financial products provides value for the purchase of the financial product but does not receive delivery of the financial product;

"related body" has the meaning given to the term "related body corporate" in section 50 of the Corporations Act 2001 (Cth);

"securities settlement facility" is a clearing and settlement facility operated by an Australian CS facility licensee which enables its participants to transfer title to or other interests in securities, typically in return for payment. Securities settlement facilities usually (although not always) also hold physical securities, or an electronic record of title, or other interests in securities, on behalf of their participants; and

"securities" includes any financial product which gives rise to obligations prescribed under the Corporations Regulations for the purposes of section 768A(1)(b) of the Corporations Act 2001 (Cth).

The Standard - FSS 2009.1

A CS facility licensee must conduct its affairs in a prudent manner, in accordance with the standards of a reasonable facility in contributing to the overall stability of the Australian financial system, to the extent that it is reasonably practicable to do so. This standard applies to all CS facility licensees that operate a central counterparty with the exception of those CS facility licensees granted a licence under Section 824B(2) of the Corporations Act 2001. This exception applies only for such time as the Reserve Bank receives annual documentary evidence from the licensee's overseas regulator that the licensee has complied in all material respects with the requirements of the overseas regulator related to matters affecting stability. Such evidence must be provided in a form and at a time agreed with the Reserve Bank.

The standard does not apply to CS facility licensees granted a licence under Section 824B(2). This exception applies only for such time as the Reserve Bank receives annual documentary evidence from the licensee's overseas regulator that the licensee has complied in all material respects with the requirements of the overseas regulator related to matters affecting stability. The required form of such documentary evidence will be discussed with the licensee and its overseas regulator, but it is expected that it would include the following: details of any assessments carried out over the preceding period relevant to the licensee's compliance with the requirements of the overseas regulator; and details of any specific areas of investigation by the regulator. Such documentary evidence must be received prior to the commencement of operations under the licence and on an annual schedule thereafter.

The Reserve Bank will also, from time to time, seek additional information directly from the licensee regarding its activities and risk management processes. Furthermore, notwithstanding that an overseas regime may be sufficiently equivalent to that in Australia, there may be some differences in the detailed application of principles or standards. The Reserve Bank will, in such cases, seek sufficient information to carry out a direct assessment of the CS facility licensee in respect of specific aspects of its operations. Subject to the outcome of such an assessment, the Reserve Bank may recommend that additional risk-mitigating actions be taken by the licensee.

At a minimum the Reserve Bank would expect to receive the following information on a regular basis:

  • details of any material changes in the licensee's activities, processes, or people: The licensee is expected to provide activity reports and information on material changes in the conduct of its business − including changes to products, people and operational processes. The Reserve Bank expects to be informed in advance where material changes in these areas might be relevant to an assessment of systemic risk. Audited annual accounts, quarterly management accounts and data detailing stress-test outcomes relative to the facility's risk resources would also be expected; and
  • additional information to allow assessment of specific aspects of the licensee's operations: The form and scope of the information necessary to carry out such an assessment will differ according to the coverage of the overseas regime. The Reserve Bank's expectations in this regard will be discussed periodically with the licensee.

In some cases it may be appropriate to establish a formal framework for cooperative oversight alongside the overseas regulator. Under such circumstances, the required level and frequency of information flow from both the regulator and the facility might be greater.

How A Licensee Meets the Standard

Parts 1–10 below identify the minimum measures that the Reserve Bank considers are relevant in determining whether a CS facility licensee has met the standard.

The standard is to be interpreted in accordance with its objective, and by looking beyond form to substance. Where the requirements of the measures and those of the Corporations Act 2001 (Cth) and Corporations Regulations are inconsistent, the requirements of the Corporations Act 2001 (Cth) and Corporations Regulations will prevail to the extent of such inconsistency.

The Reserve Bank may, from time to time, issue guidance containing further information on specific aspects of the measures listed below.

1. Legal framework

The central counterparty must have a well-founded legal basis. The CS facility licensee as operator of the central counterparty must: [See also Guidance Measure 1]

  1. be a legal entity (whose primary business activity is operating the CS facility) and one which is separate from other entities which may expose it to risks unrelated to those arising from its function as operator of a central counterparty; [See also Guidance Measure 1(a)]
  2. have rules which constitute a clear and legally enforceable contract or contracts, in all relevant jurisdictions, between the central counterparty and its participants (and between each participant and each other participant); [See also Guidance Measure 1(b)]
  3. have rules which clearly define the nature and scope of any obligation it undertakes to provide clearing support to the participants in the central counterparty;
  4. have rules which identify the conditions under which final and irrevocable settlement of obligations between the central counterparty and the participants in the CS facility has taken place;
    [See also Guidance Measure 1 (d)]
  5. have rules which define its rights and obligations, and those of its participants, including in the event of the default or suspension of one or more of its participants; [See also Guidance Measure 1(e)]
  6. have rules which will operate according to their terms in the event of external administration; and
  7. to the extent possible, obtain legal certainty for its rules under all relevant legislation.
    [See also Guidance Measure 1(g)]

2. Participation requirements

The requirements for participation in the central counterparty must promote the safety and integrity of the central counterparty and ensure fair and open access. Participation requirements must:
[See also Guidance Measure 2]

  1. be based on objective and publicly disclosed criteria; [See also Guidance Measure 2(a)]
  2. ensure that participants in the central counterparty are of a sufficient financial standing such that the central counterparty is not exposed to unacceptable credit risks; [See also Guidance Measure 2(b)]
  3. require that participants have the operational capacity to settle their obligations with the central counterparty in a timely manner; and [See also Guidance Measure 2(c)]
  4. allow the CS facility licensee as operator of the central counterparty to suspend or cancel the participation of an institution which breaches the applicable participation or other risk-control requirements. [See also Guidance Measure 2(d)]

3. Understanding risks

The central counterparty's rules and procedures must enable each participant to understand the central counterparty's impact on each of the financial risks the participant incurs through participation in the central counterparty. [See also Guidance Measure 3]

4. Novation

The rules and procedures governing the central counterparty must clearly identify:
[See also Guidance Measure 4]

  1. the nature and scope of novation; and [See also Guidance Measure 4(a)]
  2. the point in the clearing process at which trades are novated. [See also Guidance Measure 4(b)]

5. Settlement

Settlement arrangements must ensure that the central counterparty's exposures are clearly and irrevocably extinguished on settlement. This requires that: [See also Guidance Measure 5]

  1. where settlement involves the exchange of one asset for another, it must be done on an appropriate delivery-versus-payment basis; and [See also Guidance Measure 5(a)]
  2. where payments, including net payments, are made to extinguish other obligations, payment must be made by real-time gross settlement. [See also Guidance Measure 5(b)]

Notwithstanding the existence of risk controls (refer measure 7: Risk controls), circumstances may arise whereby the central counterparty is unable to settle all of its obligations. To deal with such an eventuality, the central counterparty must have rules and procedures that specify how unsettled obligations will be treated.

6. Default arrangements

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: [See also Guidance Measure 6]

  1. require its participants to inform it immediately if they: [See also Guidance Measure 6(a)]

    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.

7. Risk controls

The CS facility licensee as operator of a central counterparty must have comprehensive risk-control arrangements in place. These arrangements must provide the operator of the central counterparty with a high degree of confidence that, in the event of extreme volatility in relevant markets, the central counterparty will be able to settle all of its obligations in a timely manner. As a minimum, the risk-control arrangements must provide the CS facility licensee as operator of the central counterparty with a high degree of confidence that the central counterparty will be able to settle its obligations in the event that the participant with the largest settlement obligations cannot meet them. In all but the most extreme circumstances, a central counterparty must be able to settle its obligations using liquid assets as defined in this standard. [See also Guidance Measure 7]

The CS facility licensee as operator of a central counterparty must:

  1. ensure that its risk-control measures, typically a combination of its own capital, margins, guarantee funds and pre-determined loss-sharing arrangements, provide sufficient coverage and liquidity; and [See also Guidance Measure 7(a)]
  2. undertake regular and rigorous stress testing to ensure the adequacy of its risk controls.
    [See also Guidance Measure 7(b)]

The adequacy of risk-control measures must be approved by the board of the central counterparty, or an appropriate body as delegated by the board.

i. Margins

Where the CS facility licensee as operator of a central counterparty requires margin payments, it must have the ability to: [See also Guidance Measure 7(i)]

  1. levy initial and variation margins, as well as intraday margins (e.g. in the event of significant changes in market volatility or a participant's credit worthiness);
  2. set and rigorously enforce times by which all margin payments must be paid, and set appropriate penalties for failure to pay on time;
  3. take haircuts on non-cash collateral, where such collateral is accepted for margins;
  4. mark-to-market the value of participants' positions, ordinarily at least once a day, and more frequently during times of market stress;
  5. determine in a timely fashion whether intraday or variation margins are required; and
  6. in the event of default by a participant, use margin payments from the defaulter, together with receipts from the sale of any securities or any other asset due to be delivered to the defaulter, to satisfy its obligations to other participants.

ii. Guarantee fund

Where the CS facility licensee as operator of a central counterparty uses a guarantee fund:
[See also Guidance Measure 7(ii)]

  1. it must have clear rules for access to the guarantee fund; and
  2. the rules must make it clear that the contributions, if any, of all participants, not just those in default, may be called upon in the event of a default of one or more participants.

iii. Loss sharing

Where loss-sharing arrangements are used, those arrangements must be: [See also Guidance Measure 7(iii)]

  1. documented and legally enforceable; and
  2. acknowledged by all participants in the central counterparty.

8. Governance

The central counterparty must have effective, accountable and transparent governance arrangements. This requires that: [See also Guidance Measure 8]

  1. the board of the CS facility licensee have appropriate expertise and independence;
    [See also Guidance Measure 8(a)]
  2. the board of the CS facility licensee be responsible for oversight of the operation of the central counterparty; and [See also Guidance Measure 8(b)]
  3. the risk-control function of the central counterparty must not be adversely influenced by its business, marketing or other operations.

9. Operational risk

The CS facility licensee as operator of a central counterparty must identify sources of operational risk and minimise these through the development of appropriate systems, controls and procedures. [See also Guidance Measure 9]

i. Security and operational reliability

The CS facility licensee as operator of a central counterparty must ensure that: [See also Guidance Measure 9(i)]

  1. key systems, such as computer and communication systems, are secure and have robust access controls, with security reviewed and tested periodically;
  2. key systems are operationally reliable, with standards of operational reliability defined formally and documented;
  3. systems have sufficient capacity to process the expected volumes of transactions with the required speed, including at peak times and on peak days; [See also Guidance Measure 9(i)(c)]
  4. changes to technical systems and supporting infrastructure do not disrupt its usual operations; and [See also Guidance Measure 9(i)(d)]
  5. it has well-trained and competent personnel to ensure that all key systems are operated securely and reliably.

ii. Business continuity procedures

The CS facility licensee as operator of a central counterparty must have in place arrangements to ensure the timely recovery of its usual operations in the event of a contingency. This requires that the operator of a central counterparty: [See also Guidance Measure 9(ii)]

  1. have detailed contingency plans, including back-up arrangements for its critical communications and computer systems and key personnel; [See also Guidance Measure 9(ii)(a)]
  2. require its participants to have appropriate complementary arrangements in the event of a contingency; [See also Guidance Measure 9(ii)(b)]
  3. undertake regular industry testing of its business recovery arrangements; and
    [See also Guidance Measure 9(ii)(c)]
  4. conduct regular reviews of the adequacy of these arrangements and make such changes as are necessary and desirable.

iii. Outsourcing

Security, operational reliability and business continuity procedures must extend to systems and processes which have been outsourced. The CS facility licensee as operator of a central counterparty must ensure that service providers meet the same standards as apply to the operator of the central counterparty with respect to the function outsourced. However, even when systems and processes are outsourced, the operator of the central counterparty remains responsible for those systems and processes. [See also Guidance Measure 9(iii)]

iv. External administration of a related body

The CS facility licensee as operator of a central counterparty must ensure that it would have access to the necessary staff, technical and other resources needed to continue operating in circumstances where a related body becomes subject to external administration. [See also Guidance Measure 9(iv)]

10. Regulatory reporting

The CS facility licensee as operator of a central counterparty must inform the Reserve Bank as soon as reasonably practicable if: [See also Guidance Measure 10]

  1. it breaches, or has reason to believe that it will breach: [See also Guidance Measure 10(a)]

    1. the standard; or
    2. its broader legislative obligation to do, to the extent that it is reasonably practicable to do so, all things necessary to reduce systemic risk;
  2. it becomes subject to external administration, or has reasonable grounds for suspecting that it will become subject to external administration;
  3. a related body to the operator of the central counterparty becomes subject to external administration, or if the operator of the central counterparty has reasonable grounds for suspecting that a related body will become subject to external administration;
  4. a participant becomes subject to external administration, or if the operator of the central counterparty has reasonable grounds for suspecting that a participant will become subject to external administration;
  5. a participant fails to meet its obligations under the central counterparty's risk-control requirements or has its participation suspended or cancelled because of a failure to meet the central counterparty's risk-control requirements;
  6. it fails to enforce any of its own risk-control requirements;
  7. it plans to make significant changes to its risk-control requirements or its rules and procedures;
  8. it proposes to grant a security interest over its assets (other than a lien, right of retention or statutory charge that arises in the ordinary course of business);
  9. it proposes to incur or permit to subsist any loans from participants or members unless such loans are subordinated to the claims of all other creditors of the operator of the central counterparty; or
  10. any other matter arises which has or is likely to have a significant impact on its risk-control arrangements.

The CS facility licensee as operator of a central counterparty must also provide to the Reserve Bank, on a timely basis:

  1. audited annual accounts;
  2. management accounts on a regular basis, and at least quarterly; and
  3. a quarterly report on the results of stress testing and on the adequacy of its risk-control measures.