Financial Stability Standards for Central Counterparties Standard 19: FMI Links

Guidance

A link is a set of contractual and operational arrangements between two or more FMIs that connect the FMIs directly or through an intermediary. A central counterparty may establish a link with another central counterparty for the primary purpose of expanding its services to additional financial instruments, markets or institutions. For example, a central counterparty may establish a link with another central counterparty to enable a participant in the first central counterparty to clear trades with a participant in the second central counterparty without having to maintain two central counterparty relationships. A central counterparty may also establish a link with a different type of FMI. For example, a central counterparty for securities markets must establish and use a link to a central securities depository to receive and deliver securities. This Standard covers links between central counterparties as well as links between a central counterparty and other types of FMI, such as securities settlement facilities, central securities depositories and trade repositories.^[1] If a central counterparty establishes a link, it should identify, monitor and manage its link-related risks, including legal, operational, credit and liquidity risks.^[2] Further, a central counterparty that establishes multiple links should ensure that the risks generated by one link do not affect the soundness of the other links and linked FMIs. Mitigation of such spillover effects requires the use of effective risk management controls, including additional financial resources or the harmonisation of risk management frameworks across linked FMIs.

Identifying link-related risks

19.1.1 Before entering into a link arrangement, and on an ongoing basis once the link is established, a central counterparty should identify and assess all potential sources of risk arising from the link arrangement. The type and degree of risk varies according to the design and complexity of the central counterparty and linked FMIs and the nature of the relationship between them. In a simple case of a vertical link, for example, a central counterparty may provide basic services to another FMI, or vice versa. Such links typically pose only operational and custody risks. Other links, such as an arrangement in which a central counterparty provides clearing services to another central counterparty may be more complex and may pose additional risks to the central counterparty, such as credit and liquidity risks. Cross-margining by two or more central counterparties may also pose additional risk because the central counterparties may rely on each other's risk management systems to measure, monitor and manage credit and liquidity risks (see CCP Standard 6 on margin). In addition, links between a central counterparty and other FMIs may pose specific risks to the central counterparty or other FMIs in the link arrangement. In all cases, link arrangements should be designed such that the central counterparty is able to observe the CCP Standards.

Managing operational risk

19.1.2 A central counterparty should obtain an appropriate level of information about each linked FMI's operations in order for the central counterparty to perform effective periodic assessments of the operational risk associated with the link. In particular, central counterparties should ensure that risk management arrangements and processing capacity are sufficiently scalable and reliable to operate the link safely for both the current and projected peak volumes of activity processed over the link (see CCP Standard 16 on operational risk). Systems and communication arrangements between the central counterparty and linked FMIs also should be reliable and secure so that the link does not pose significant operational risk to the central counterparty and the linked FMIs. Any reliance by a central counterparty on a critical service provider should be disclosed as appropriate to the linked FMI and the central counterparty should require reciprocal disclosure from the linked FMI. In addition, a linked central counterparty should identify, monitor and manage operational risks due to complexities or inefficiencies associated with differences in time zones, particularly as these affect staff availability. Governance arrangements and change management processes should ensure that changes in the central counterparty or a linked FMI will not inhibit the smooth functioning of the link, related risk management arrangements, or non-discriminatory access to the link (see CCP Standard 2 on governance and CCP Standard 17 on access and participation requirements).

Managing financial risk

19.1.3 A central counterparty in a link arrangement should effectively measure, monitor and manage its financial risk, including custody risk, arising from the link arrangement. A central counterparty should ensure that it and its participants have adequate protection of assets in the event of the insolvency of a linked FMI or a participant default in a linked FMI.

19.2.1 A link involving a central counterparty should have a well-founded legal basis, in all relevant jurisdictions, that supports its design and provides adequate protection to the central counterparty. Cross-border links may present legal risk arising from differences between the laws and contractual rules governing the linked FMIs and their participants, including those relating to rights and interests, collateral arrangements, settlement finality and netting arrangements (see CCP Standard 1 on legal basis). For example, differences in law and rules governing settlement finality could lead to a scenario in which a transfer is regarded as final in the central counterparty but not final in the linked FMI, or vice versa. In some jurisdictions, differences in laws may create uncertainties regarding the enforceability of central counterparty obligations assumed by novation, open offer or other similar legal device. For instance, in the case of a link between two central counterparties, differences in insolvency laws may unintentionally give a participant in one central counterparty a claim on the assets or other resources of the linked central counterparty in the event of the first central counterparty's default. To limit such uncertainties, the respective rights and obligations of the linked FMIs and, where necessary, their participants should be clearly defined in the link agreement. In a cross-jurisdictional context, the terms of the link agreement should also set out an unambiguous choice of law that will govern each aspect of the link.

19.3.1 Prior to entering into a link arrangement with another FMI that is relevant to its operations in Australia, a central counterparty should consult with the Reserve Bank. As part of this consultation, the central counterparty should provide the Reserve Bank with a comprehensive description of the link arrangement. This description should include details of the legal basis of the link, and any financial obligations or operational interdependencies created by the link, including obligations created for both the central counterparty and the linked FMI. A central counterparty should provide sufficient detail to demonstrate that the link arrangement will not adversely affect its compliance with the CCP Standards. Where the Reserve Bank identifies aspects of the proposal that may create unacceptable risks for the central counterparty, the central counterparty should make any necessary changes to the proposal to control or mitigate these risks prior to implementation. These changes may be necessary to ensure that the central counterparty continues to comply with the CCP Standards and equivalent standards in other relevant jurisdictions.

19.3.2 Where a linked FMI's principal place of business is not in Australia, the Reserve Bank may also consult with the regulator of the linked FMI in its principal place of business, in order to understand the overseas regulator's assessment of the link arrangement and to ensure that all relevant legal, regulatory, operational and financial risk issues have been considered and addressed.

19.4.1 A central counterparty may establish links with one or more other central counterparties. Although the details of individual link arrangements among central counterparties differ significantly because of the varied designs of central counterparties and the markets they serve, there are two basic types of central counterparty links: peer-to-peer links and participant links.

19.4.2 In a peer-to-peer link, a central counterparty maintains special arrangements with another central counterparty and is not subject to normal participant rules. Typically, however, the central counterparties exchange margin and other financial resources on a reciprocal basis. The linked central counterparties face current and potential future exposures to each other as a result of the process whereby they each net the trades cleared between their participants so as to create novated (net) positions between the central counterparties. Risk management between the central counterparties is based on a bilaterally approved framework, which is different from that applied to a normal participant.

19.4.3 In a participant link, one central counterparty (the participant central counterparty) is a participant in another central counterparty (the host central counterparty) and is subject to the host central counterparty's normal participant rules. In such cases, the host central counterparty maintains an account for the participant central counterparty and would typically require the participant central counterparty to provide margin, as would be the case for a participant that is not a central counterparty. A participant central counterparty should mitigate and manage its risk from the link separately from the risks in its core clearing and settlement activities. For example, if the host central counterparty were to default, the participant central counterparty may not have adequate protection because the participant central counterparty does not hold collateral from the host central counterparty to mitigate the counterparty risk posed to it by the host central counterparty. Risk protection in a participant link is one-way, unlike in a peer-to-peer link. A participant central counterparty that provides margin but does not collect margin from another linked central counterparty should therefore hold additional financial resources to protect itself against the default of the host central counterparty.

19.4.4 Both types of links – peer-to-peer and participant links – may present new or increased risks that should be measured, monitored and managed by the central counterparties involved in the link, particularly with respect to the risk management of the financial exposures that potentially arise from the link arrangement. Before entering into a link with another central counterparty, a central counterparty should identify and assess the potential spillover effects from the default of the linked central counterparty. If a link has three or more central counterparties, a central counterparty should identify and assess the risks of the collective link arrangement. A network of links between central counterparties that does not properly acknowledge and address the inherent complexity of multi-central counterparty links could have significant implications for systemic risk.

19.4.5 Because of the different possible types of link arrangements, different types of central counterparties, and differences in the legal and regulatory frameworks in which central counterparties may operate, different combinations of risk management tools may be used by the central counterparty. When linked central counterparties have materially different risk management frameworks, the risks stemming from the link are more complex. In this case, a central counterparty should carefully assess the effectiveness of its risk management models and methodologies, including its default procedures, in order to determine whether and to what extent the inter-central counterparty risk management frameworks should be harmonised or whether additional risk mitigation measures would be sufficient to mitigate risks arising from the link.

19.4.6 A central counterparty linked to one or more other central counterparties should maintain arrangements that are effective in managing the risks arising from the link; such arrangements often involve a separate default fund to cover that risk. In principle, the risk management measures related to the link should not reduce the resources that a central counterparty holds to address other risks. The most direct way to achieve this outcome is for a central counterparty not to participate in another central counterparty's default fund, which may in turn mean that the central counterparty will need to provide additional margin. However, in arrangements in which central counterparties have agreed, consistent with their regulatory framework, to contribute to each other's default funds, the central counterparty should assess and mitigate the risks of making such contributions via specific conditions. In particular, funds used by a central counterparty to contribute to another central counterparty's default fund must represent prefunded additional financial resources and must not include resources used by the central counterparty to satisfy its regulatory requirements to hold sufficient capital or participant margin funds (or any other funds, including independent default fund resources) held by the central counterparty to mitigate the counterparty risk presented by its participants. Nor should it include funds held by the central counterparty to fund its plans for recovery or orderly wind-down (see CCP Standard 14 on general business risk). The contributing central counterparty should further ensure that any consequent exposure of its own participants to the risk of a participant default in the linked central counterparty is fully transparent to and understood by its participants. The contributing central counterparty may, for example, consider it appropriate that the default fund contribution is made only by those of its participants that use the link, if applicable. Moreover, the resources provided by one central counterparty to another should be held in such a way that they are ring fenced from other resources provided to that central counterparty. For example, securities could be held in a separate account at a custodian. Cash would need to be held in segregated accounts to be considered acceptable collateral in this case. Finally, in case of a participant default in the first central counterparty, the use of the linked central counterparty's contribution to the default fund of the first central counterparty could be restricted or limited. For example, the linked central counterparty's contribution to the default fund could be put at the bottom of the first central counterparty's default waterfall.

19.4.7 Link arrangements between central counterparties will expose each central counterparty to sharing in potentially uncovered credit losses if the linked central counterparty's default waterfall has been exhausted. For example, a central counterparty may be exposed to loss mutualisation from defaults of a linked central counterparty's participants. This risk will be greater to the extent that the first central counterparty is unable directly to monitor or control the other central counterparty's participants. Such contagion risks can be even more serious in cases where more than two central counterparties are linked, directly or indirectly, and a central counterparty considering such a link should satisfy itself that it can manage such risks adequately. A central counterparty should ensure that the consequent exposure of its own participants to a share in these uncovered losses is fully understood and disclosed to its participants. A central counterparty may consider it appropriate to devise arrangements to avoid sharing in losses that occur in products other than those cleared through the link and to confine any loss sharing to only participants that clear products through the link. Depending on how losses would be shared, a central counterparty may need to increase financial resources to address this risk.

19.4.8 A central counterparty should ensure that default fund contributions or allocation of uncovered losses are structured so that: the central counterparty is not treated less favourably than the participants of the other central counterparty; and the central counterparty's contribution to the loss sharing arrangements of the other central counterparty is proportional to the risk that the first central counterparty poses to the linked central counterparty.

19.5.1 Exposures faced by a central counterparty from a linked central counterparty should be identified, monitored and managed with the same rigour as exposures from a central counterparty's participants to prevent a default at one central counterparty from triggering a default at a linked central counterparty. Such exposures should be covered fully, primarily through the use of margin or other equivalent financial resources. In particular, each central counterparty in a central counterparty link arrangement should be able to cover, at least on a daily basis, its current and potential future exposures to the linked central counterparty and its participants, if any, fully with a high degree of confidence without reducing the central counterparty's ability to fulfil its obligations to its own participants at any time (see CCP Standard 6 on margin). Financial resources used to cover inter-central counterparty current exposures should be prefunded with highly liquid assets that exhibit low credit risk. Best practice is for a central counterparty to have near real-time inter-central counterparty risk management. However, at a minimum, financial exposures among linked central counterparties should be marked to market and covered on a daily basis. A central counterparty also needs to consider and address the risks arising from links in designing its stress tests and calibrating its prefunded default arrangements. A central counterparty should also take into account the potential effects on its risk management framework of contributions to other central counterparties' prefunded default arrangements, exchange of margin, common participants, major differences in risk management tools, and other relevant features, especially in relation to legal, credit, liquidity and operational risks.