Financial Stability Standards for Central Counterparties – December 2012 Standard 7: Liquidity Risk

Guidance

Liquidity risk arises in a central counterparty when it, its participants, or other entities cannot settle their payment obligations when due as part of the clearing or settlement process. Depending on the design of a central counterparty, liquidity risk can arise between the central counterparty and its participants, or between the central counterparty and other entities (such as commercial bank money settlement agents, nostro agents, custodian banks and liquidity providers). It is particularly important for a central counterparty to manage carefully its liquidity risk if, as is typical in many systems, the central counterparty relies on incoming payments from participants or other entities during the settlement process in order to make payments to other participants. If a participant or another entity fails to pay the central counterparty, the central counterparty may not have sufficient funds to meet its payment obligations to other participants. In such an event, the central counterparty would need to rely on its own liquid resources (that is, liquid assets and prearranged funding arrangements, including any arrangements with its participants) to cover the funds shortfall and complete settlement. A central counterparty should have a robust framework to manage its liquidity risks from the full range of participants and other entities. In some cases, a participant may play other roles within the central counterparty, such as a settlement or custodian bank or liquidity provider. These other roles should be considered in determining a central counterparty's liquidity needs.

Sources of liquidity risk

7.1.1 A central counterparty should clearly identify its sources of liquidity risk and assess its current and potential future liquidity needs on a daily basis. A central counterparty can face liquidity risk from the default of a participant. For example, a central counterparty might not be able to convert a defaulting participant's collateral into cash at short notice. A central counterparty can also face liquidity risk from any commercial bank money settlement agents, nostro agents, custodians and liquidity providers, as well as linked FMIs and service providers, if they fail to perform as expected. Moreover, as noted above, a central counterparty may face additional risk from entities that have multiple roles within the central counterparty (for example, a participant that also serves as the central counterparty's money settlement agent or liquidity provider). These interdependencies and the multiple roles that an entity may assume within a central counterparty should be taken into account by the central counterparty.

Managing liquidity risk

7.1.2 A central counterparty should regularly assess its design and operations to manage liquidity risk in the system. It could reduce the liquidity demands of its participants by providing participants with sufficient information or control systems to help them manage their liquidity needs and risks. Furthermore, a central counterparty should ensure that it is operationally ready to manage the liquidity risk caused by participants' or other entities' financial or operational problems. Among other things, a central counterparty that does not settle its funds obligations directly in central bank money (see CCP Standard 9 on money settlements) should have the operational capacity to reroute payments, where feasible, on a timely basis in case of problems with a correspondent bank.

7.1.3 A central counterparty may use other risk management tools to manage its liquidity risk. To mitigate and manage liquidity risk stemming from a participant default, a central counterparty could use, either individually or in combination, exposure limits, collateral requirements and prefunded default resources. To mitigate and manage liquidity risk stemming from a service provider or a linked FMI, a central counterparty could use, individually or in combination, selection criteria, concentration or exposure limits, and collateral requirements. For example, a central counterparty should seek to manage or diversify its liquid resources to avoid excessive intraday or overnight exposure to one entity. This, however, may involve trade-offs between the efficiency of relying on an entity and the risks of being overly dependent on that entity.

7.2.1 A central counterparty should have effective operational and analytical tools to identify, measure and monitor its settlement and funding flows on an ongoing and timely basis, including its use of intraday liquidity. In particular, a central counterparty should understand and assess the value and concentration of its daily settlement and funding flows through any commercial bank money settlement agents, nostro agents and other intermediaries. A central counterparty also should be able to monitor on a daily basis the level of liquid assets (such as cash, securities, other assets held in custody and investments) that it holds. A central counterparty should be able to determine the value of its available liquid assets, taking into account the appropriate haircuts on those assets (see CCP Standard 5 on collateral and CCP Standard 6 on margin).

7.2.2 If a central counterparty maintains prearranged funding arrangements, the central counterparty should also identify, measure and monitor its liquidity risk from the liquidity providers of those arrangements. A central counterparty should obtain a high degree of confidence through rigorous due diligence that each liquidity provider, whether or not it is a participant in the central counterparty, would have the capacity to perform as required under the liquidity arrangement and is subject to commensurate regulation, supervision or oversight of its liquidity risk management requirements. Where relevant to assessing a liquidity provider's performance reliability with respect to a particular currency, the liquidity provider's potential access to credit from the relevant central bank may be taken into account.

7.3.1 A central counterparty should carefully analyse its projected liquidity needs under a range of stress scenarios, and subject this analysis to review by the Reserve Bank and other relevant authorities. In many cases, a central counterparty will need to maintain sufficient liquid resources to meet payments to settle required margin and other payment obligations over multiple days to accommodate multiday hedging and close out activities as directed by the central counterparty's participant default procedures (see CCP Standard 7.8 on liquidity stress testing).

7.4.1 A central counterparty's outright holdings of qualifying instruments, such as cash and assets eligible for pledging as collateral to (or for conducting other collateralised transactions with) the central bank of issue, are generally the most reliable source of liquidity and should form a substantial part of a central counterparty's qualifying liquid resources (see CCP Standard 7.7).

7.4.2 In addition to outright holdings of qualifying instruments, a central counterparty may negotiate committed lines of credit and repos on commercial terms with external third parties. A central counterparty may also conclude contractual agreements with its participants to provide additional qualifying liquid resources in specified circumstances. Such resources may, for example, be provided under committed lines of credit or committed repos. Any such arrangements should be highly reliable and explicitly included in the central counterparty's rules and procedures, ensuring that they have at least as robust a contractual basis as any equivalent commercial arrangement that might be reached with non-participant counterparties.

7.5.1 A central counterparty may consider using non-qualifying liquid resources within its liquidity risk management framework in advance of, or in addition to, using its qualifying liquid resources. This may be particularly beneficial where liquidity needs exceed qualifying liquid resources, where qualifying liquid resources can be preserved to cover a future default, or where using other liquid resources would cause less liquidity dislocation to the central counterparty's participants and the financial system as a whole.

7.6.1 A central counterparty should have detailed procedures for using its liquid resources to complete settlement during a liquidity shortfall. A central counterparty's procedures should clearly document the sequence in which each type of liquid resource would be expected to be used (for example, the use of certain assets before prearranged funding arrangements). These procedures may include instructions for accessing cash deposits or overnight investments of cash deposits, executing same-day market transactions, or drawing on prearranged liquidity lines, including any pre-committed liquidity allocation mechanisms involving participants established under the central counterparty's rules. In addition, a central counterparty should regularly test its procedures for accessing its liquid resources at a liquidity provider, including by activating and drawing down test amounts from committed credit facilities and by testing operational procedures for conducting same-day repos. A central counterparty should also adequately plan for the renewal of prearranged funding arrangements with liquidity providers in advance of their expiration.

7.7.1 If a central counterparty has access to central bank accounts, payment services, securities services or collateral management services, it should use these services, where practical, to enhance its management of liquidity risk. Cash balances at the central bank of issue, for example, offer the highest liquidity (see CCP Standard 9 on money settlements).

7.7.2 A central counterparty that the Reserve Bank determines to be systemically important in Australia and has obligations in Australian dollars should operate its own Exchange Settlement Account at the Reserve Bank to enhance its management of Australian dollar liquidity risk.^[1] This account may be held in the central counterparty's own name or, if approved by the Reserve Bank, in the name of a related body corporate. A holder of an Exchange Settlement Account may access the Reserve Bank's overnight and intraday liquidity facilities, provided it meets the Reserve Bank's other requirements for access to these facilities, including that it can deliver securities eligible as collateral to the Reserve Bank under a repo agreement. In assessing the systemic importance of a central counterparty, the Reserve Bank will consider factors such as:

• the size of the central counterparty in Australia (for example, the value of transactions processed by the central counterparty in Australian dollar-denominated products, or its market share; or the total amount of initial margin held in respect of Australian dollar-denominated products)
• the availability of substitutes for the central counterparty's services in Australia
• the nature and complexity of the products cleared by the central counterparty
• the degree of interconnectedness with other parts of the Australian financial system.

7.8.1 As part of a central counterparty's assessment of the sufficiency of its liquid resources through stress testing, it should consider any strong interlinkages or similar exposures between its participants, as well as the multiple roles that participants may play with respect to the risk management of the central counterparty, and assess the probability of multiple failures and the contagion effect among its participants that such failures may cause.

7.8.2 Liquidity stress testing should be performed on a daily basis using standard and predetermined parameters and assumptions. In addition, on at least a monthly basis, a central counterparty should perform a comprehensive and thorough analysis of stress-testing scenarios, models and underlying parameters and assumptions used to ensure they are appropriate for achieving the central counterparty's identified liquidity needs and resources in light of current and evolving market conditions. A central counterparty should perform stress testing more frequently when markets are unusually volatile, when they are less liquid, or when the size or concentration of positions held by its participants increases significantly. A full validation of a central counterparty's liquidity risk management model should be performed at least annually.

7.8.3 A central counterparty should conduct, as appropriate, reverse stress tests aimed at identifying the extreme default scenarios and extreme market conditions for which the central counterparty's liquid resources would be insufficient. In other words, these tests identify how severe stress conditions would be covered by the central counterparty's liquid resources. A central counterparty should judge whether it would be prudent to prepare for these severe conditions and various combinations of factors influencing these conditions. Reverse stress tests require a central counterparty to model extreme market conditions that may go beyond what are considered extreme but plausible market conditions in order to help understand the sufficiency of liquid resources given the underlying assumptions modelled. Modelling very extreme market conditions can help a central counterparty determine the limits of its current model and resources; however, it requires the central counterparty to exercise judgement when modelling different markets and products. A central counterparty should develop hypothetical very extreme scenarios and market conditions tailored to the specific risks of the markets and of the products it serves. Reverse stress tests should be considered a helpful risk management tool but they need not, necessarily, drive a central counterparty's determination of the appropriate level of liquid resources.

7.9.1 In certain extreme circumstances, the liquid resources of a central counterparty or its participants required under CCP Standard 7.3 may not be sufficient to meet the payment obligations of the central counterparty to its participants.^[2] In a stressed environment, for example, normally liquid assets held by a central counterparty may prove not to be sufficiently liquid to obtain same-day funding, or the liquidation period may be longer than expected. A central counterparty should establish explicit rules and procedures that enable the central counterparty to effect same-day and, where appropriate, intraday and multiday settlement of payment obligations on time following any individual or combined default among its participants. These rules and procedures should address unforeseen and potentially uncovered liquidity shortfalls and should aim to avoid unwinding, revoking or delaying the same-day settlement of payment obligations. These rules and procedures should also indicate the central counterparty's process to replenish any liquidity resources it may employ during a stress event, so that it can continue to operate in a safe and sound manner.

7.9.2 If a central counterparty allocates potentially uncovered liquidity shortfalls to its participants, the central counterparty should have clear and transparent rules and procedures for the allocation of shortfalls. These procedures could involve a funding arrangement between the central counterparty and its participants, the mutualisation of shortfalls among participants according to a clear and transparent formula, or the use of liquidity rationing (for example, reductions in payouts to participants). Any allocation rule or procedure must be discussed thoroughly with and communicated clearly to participants, as well as be consistent with participants' respective regulatory liquidity risk management requirements. Furthermore, a central counterparty should consider and validate, through simulations and other techniques and through discussions with each participant, the potential impact on each participant of any such same-day allocation of liquidity risk and each participant's ability to bear proposed liquidity allocations.