Financial Stability Standards for Central Counterparties Standard 12: Participant Default Rules and Procedures

Guidance

Participant default rules and procedures facilitate the continued functioning of a central counterparty in the event that a participant fails to meet its obligations. Such rules and procedures help limit the potential for the effects of a participant's failure to spread to other participants and possibly undermine the viability of the central counterparty. Key objectives of default rules and procedures should include: ensuring timely completion of settlement, even in extreme but plausible market conditions; minimising losses for the central counterparty and for non-defaulting participants; limiting disruptions to the market; providing a clear framework for accessing central counterparty liquidity facilities as needed; and managing and closing out a defaulting participant's positions and liquidating any applicable collateral in a prudent and orderly manner. In some instances, managing a participant default may involve hedging open positions, funding collateral so that the positions can be closed out over time, or both. A central counterparty may also decide to auction or allocate open positions to its participants.^[1] To the extent consistent with these objectives, a central counterparty should allow non-defaulting participants to continue to manage their positions and transactions as normal.

Rules and procedures

12.1.1 A central counterparty should have default rules and procedures that enable the central counterparty to continue to meet its obligations to non-defaulting participants in the event of a participant default. A central counterparty should explain clearly in its rules and procedures what circumstances constitute a participant default, addressing both financial and operational defaults.^[2] A central counterparty should describe the method for identifying a default. In particular, a central counterparty should specify whether a declaration of default is automatic or discretionary, and if discretionary, which person or group shall exercise that discretion. Key aspects to be considered in designing the rules and procedures include: the actions that a central counterparty can take when a default is declared; the extent to which such actions are automatic or discretionary; potential changes to the normal settlement practices, should these changes be necessary in extreme circumstances, to ensure timely settlement; the management of transactions at different stages of processing; the expected treatment of proprietary and customer transactions and accounts; the probable sequencing of actions; the roles, obligations and responsibilities of the various parties, including non-defaulting participants; and the existence of other mechanisms that may be activated to contain the impact of a default. A central counterparty should involve its participants, the Reserve Bank and other relevant authorities, and other relevant stakeholders in developing its default rules and procedures (see CCP Standard 2 on governance).

12.1.2 In the event of a participant default, financial and other obligations created for non-defaulting participants should be proportional to the scale and nature of participants' activities. Disproportionate obligations may place undue demands on participants at a time of wider market distress. Obligations placed on non-defaulting participants may include calls for additional default fund contributions, unfunded loss or liquidity allocations, or compulsory participation in auctions or allocations of the defaulting participant's open positions. In these cases, a central counterparty may consider making the size of participant contributions or allocation of positions dependent on the risk and scale of the participant's activities. Where compulsory participation in auctions or allocations of the defaulting participant's open positions is used, procedures should include consideration of the risk profile and portfolio of each receiving participant before allocating positions, so as to minimise additional risk for the non-defaulting participants. The scope of an individual participant's activities should also be considered. For example, where a central counterparty clears multiple products with distinct risk profiles, it should consider the potential impact on participants that are active in only a subset of these products when determining whether to operate a commingled default fund, or separate default funds based on product types. As another example, where a participant holds most of its positions in Australian dollar-denominated contracts, a central counterparty's loss allocation arrangements could be designed to avoid allocating positions in other currencies to that participant.

Use and sequencing of financial resources

12.1.3 A central counterparty's default rules and procedures should enable the central counterparty to take timely action to contain losses and liquidity pressures, before, at and after the point of participant default (see also CCP Standard 4 on credit risk and CCP Standard 7 on liquidity risk). Specifically, a central counterparty's rules and procedures should allow the central counterparty to use promptly any financial resources that it maintains for covering losses and containing liquidity pressures arising from default, including liquidity facilities. The rules of the central counterparty should specify the order in which different types of resources will be used. This information would enable participants to assess their potential future exposures from using the central counterparty's services. Typically, a central counterparty should first use assets provided by the defaulting participant, such as margin or other collateral, to provide incentives for participants to manage prudently the risks, particularly credit risk, they pose to a central counterparty.^[3] The application of previously provided collateral should not be subject to prevention, stay or reversal under applicable law and the rules of the central counterparty. A central counterparty should also have a credible and explicit plan for replenishing its resources over an appropriate time horizon following a participant default so that it can continue to operate in a safe and sound manner. In particular, the central counterparty's rules and procedures should define any obligations of the non-defaulting participants to replenish the financial resources depleted during a default so that the time horizon of such replenishment is anticipated by non-defaulting participants.

Close out or transfer of positions

12.1.4 A central counterparty should have rules and procedures to facilitate the prompt close out or transfer of a defaulting participant's proprietary and customer positions. Typically, the longer these positions remain open on the books of the central counterparty, the larger the central counterparty's potential credit exposures resulting from changes in market prices or other factors. A central counterparty should have the ability to apply the proceeds of liquidation, along with other funds and assets of the defaulting participant, to meet the defaulting participant's obligations. It is critical that a central counterparty has the authority to act promptly to contain its exposure, while having regard to overall market effects, such as potential sharp declines in market prices.

12.2.1 This Standard is aimed at avoiding any systemic disturbance that may arise from the default of a participant. 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. 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 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.

12.2.2 A central counterparty should be well prepared to implement its default rules and procedures, including any appropriate discretionary procedures provided for in the rules. Management should ensure that the central counterparty has the operational capacity, including sufficient well-trained personnel, to implement its procedures in a timely manner. A central counterparty's rules and procedures should outline examples of when management discretion may be appropriate and should include arrangements to minimise any potential conflicts of interests. Management should also have internal plans that clearly delineate the roles and responsibilities for addressing a default and provide training and guidance to its personnel on how the procedures should be implemented. These plans should address documentation, information needs and coordination when more than one central counterparty or authority is involved. In addition, timely communication with stakeholders, in particular with the Reserve Bank and other relevant authorities, is of critical importance (see also CCP Standard 21 on regulatory reporting). The central counterparty, to the extent permitted, should clearly convey to affected stakeholders information that would help them to manage their own risks. The internal plan should be reviewed by management and the relevant board committees at least annually or after any significant changes to the central counterparty's arrangements.

12.2.3 A central counterparty should have the information, resources and tools to close out positions promptly. In circumstances where prompt close out is not practicable, a central counterparty should have the tools to hedge positions as an interim risk management technique. In some cases, a central counterparty may use seconded personnel from non-defaulting participants to assist in the close out or hedging process. The central counterparty's rules and procedures should clearly state the anticipated scope of duties and term of service of seconded personnel. In other cases, the central counterparty may elect to auction positions or portfolios to the market. The central counterparty's rules and procedures should clearly state the scope for such action, and any participant obligations with regard to such auctions should be clearly set out. The close out of positions should not be subject to prevention, stay or reversal under applicable law and the rules of the central counterparty.

12.3.1 To provide certainty and predictability regarding the measures that a central counterparty may take in a default event, a central counterparty should publicly disclose key aspects of its default rules and procedures, including: the circumstances in which action may be taken; who may take those actions; the scope of the actions which may be taken, including the treatment of both proprietary and customer positions, funds and other assets; the mechanisms to address a central counterparty's obligations to non-defaulting participants; and, where direct relationships exist with participants' customers, the mechanisms to help address the defaulting participant's obligations to its customers. Such transparency should facilitate the orderly handling of defaults, enable participants to understand their obligations to the central counterparty and to their customers, and provide for informed decisions by market participants about their activities in the market. A central counterparty should ensure that its participants and their customers, as well as the public, have appropriate access to the central counterparty's default rules and procedures and should promote their understanding of those procedures in order to foster confidence in the market in the event of a participant default.

12.4.1 A central counterparty should involve relevant participants and other stakeholders in the testing and review of its default procedures, including any close out procedures. Such testing and review should be conducted at least annually and following material changes to the rules and procedures to ensure that they are practical and effective. The periodic testing and review of default procedures is important to help the central counterparty and its participants understand fully the procedures and to identify any lack of clarity in, or discretion allowed by, the rules and procedures. Such tests should include all relevant parties, or an appropriate subset, that would likely be involved in the default procedures, such as members of the appropriate board committees, participants, linked or interdependent FMIs, the Reserve Bank and other relevant authorities, and any related service providers. This is particularly important where a central counterparty relies on non-defaulting participants or third parties to assist in the close out process and where the default procedures have never been tested by an actual default. The results of these tests and reviews should be shared with the central counterparty's board of directors, risk committee, and the Reserve Bank and other relevant authorities.

12.4.2 Furthermore, part of a central counterparty's participant default testing should include the implementation of the resolution regime for a central counterparty's participants, as relevant. A central counterparty should be able to take all appropriate steps to address the resolution of a participant. Specifically, the central counterparty, or if applicable a resolution authority, should be able to transfer a defaulting participant's open positions and customer accounts to a receiver, third party or bridge financial company.

12.5.1 A central counterparty should ensure that its default management procedures take appropriate account of the interests of all relevant stakeholders across the jurisdictions in which it operates, including those of its direct and indirect participants. A central counterparty's governance arrangements should ensure that these interests are taken into account (see CCP Standard 2 on governance). The actions that a central counterparty takes in the event of a default, such as closing out a defaulter's positions or auctioning or allocating open positions to surviving participants, could potentially impact on pricing, liquidity and stability in relevant financial markets. A central counterparty should consider these wider market impacts of its default management actions, and take mitigating action to minimise market impacts as appropriate.